A method for short-term profit analysis

OMEGA, The Int. Jl of Mgmt Sci., Vol. 5, No. 3, 1977. Pergamon Press. Printed in Groat Britain

A Method for Short-Term Profit Analysis' WH GOLDBERG RLM DUNBAR I VERTINSKY International Institute of Management, West Berlin

CC HUANG Memorial University, Newfoundland, Canada

W STANBURY University of British Columbia, Canada

A ERICSON University of Gothenberg, Sweden (Received July 1976; In revised form November 1976)

The focus of this paper is a description of a methodology for identifying corporate strategies which explain short-term profit performance. The methodology is illustrated through its application to the Swedish textile and clothmaking industry. There are three important features of the methodology: (1) A conceptual framework of the firm which cuts across the traditional fields of management. (2) Concepts derived from the framework axe linked to operationalized variables on the basis of their empirical patternings. (3) A quasi-experimental design is used in order to provide causal inferences concerning short-term profit performance.

INTRODUCTION E CONOMISTS investigating the behavior of firms have focused mainly upon equilibrium phenomena and rational decision-making under perfect information. Clearly, a study of short-term behavior in the face of uncertainty and bounded rationality requires an alternative framework for analysis. Examination of the management literature reveals the existence of several relevant frameworks each focusing upon different dimensions o f behavior and structure. A step in the direction o f obtaining an holistic m o d e l o f the firm would link these disaggregated conceptual m o d e l s into one integrated framework. 1 Authors listed in random order. 309

Goldberg--Short- Term Profit Analysis In this study, we attempt to link concepts derived from the behavioral theory of the firm with concepts developed in studies of the functional areas of business such as finance, marketing and accounting. To identify links between concepts and variables, 36 indicators of firm posture and behavior were identified. Data from a sample of 80 firms over a period of 7 years were collected and used as the empirical basis for defining indicators (variables) for the integrated conceptual framework (i.e. the set which is the union of the functional and behavioral concepts appearing in the literature). The statistical method employed to make the link between abstract theoretical concepts and measurable, well-defined variables is factor analysis. On the basis of variable patterning, associations between meanings of concepts and measurements can be inferred. In order to derive, as far as possible, independent concepts, varimax rotation of variables was performed. Variables may assume different meanings in different time periods as a result of the changing constellations with other variables. In order to investigate the consistency of these constellations of variables over time, we have introduced the concept of stability Stability in this paper is taken to mean constancy of pattern of association between variables over time. Stable patterns are interpreted according to the meanings assigned to the factors. The first step in the analysis required the identification of a cross-functional framework for studying the behavior of firms [7]. Cyert and March [3] focused on short-term behavior of firms. They argued that as firms adapt only slowly in the short-term, particularly as far as external demands are concerned, there is ordinarily a disparity between the resources available to them and the payments they must make to the external environment. They called this surplus of resources 'organizational slack'. Clearly, organizational slack can take many forms. Cyert and March saw the concept as a general but useful hypothetical construct which could help explain the adjustment processes firms use to cope with changes in the environment such as movements in demand. They hypothesized that firms absorbed excess resources in relatively good times thus reducing profits. During relatively bad times, the accumulated slack provided a pool of resources to meet ongoing demands on organizational resources and to deal with emergencies Generally speaking, organizational slack may be thought of as a complement to the equally vaguely defined concept 'organizational efficiency'. While Cyert and March hypothesized that in practice and over time, organizations accumulate organizational slack, many social-psychological discussions argue implicitly or explicitly that they should seek to improve efficiency [6], and thus, presumably reduce organizational slack. As this is done, it is also usually implicitly assumed that stated profits will increase. Numerous aspects of organizational structure have received attention in the behavioral literature. For example, there are many studies on the effects of organizational size in the social-psychological literature [8]. For business organ310

Omega, Vol. 5, No. 3 izations, it has been found that as size increases, so does functional specialization and a tendency to adopt more standardized procedures. Intuitively, one might expect greater profits as a result of the economies of scale made possible by this increased rationalization of the work process through specialization and standardization. In contrast to this argument, some theorists have pointed out the tendency of large organizations to become sluggish in their responses to rapidly changing environments. There is little empirical evidence which unequivocably supports either of these hypotheses. These theories, while developing a rigorous theoretical framework have rarely been empirically tested, i.e. their concepts linked to measurable variables. In contrast, work in the fields of marketing, finance, and accounting has focused upon development of concepts based on the empirical patterning of variables. Examples include the linking of financial ratios to form the concepts of financial liquidity [1], long-run solvency, short-term capital turnover, and long-term capital turnover [5], and financial leverage [7]. Using data from the 80 Swedish firms each year of the seven year time horizon 1966-1972, factor analysis with varimax rotation was used to derive our conceptual framework. Table 1 presents a summary of the stable links found between variables and concepts. The links are obtained on the basis of the dominant interpretation assigned to the variables receiving the highest load on each factor with a threshold of 0.6. The latter threshold leads to the elimination of several variables as it was impossible to infer their meanings on the basis of this rule.

THE QUASI-EXPERIMENT Having identified these dimensions of firm behavior which we will consider to be the independent variables in our quasi-experimental design, a new dependent dimension must be added, i.e. that of profit performance. Two profit performance indicators were considered: 1. operating profit/total assets; 2. net profit/net worth. The first indicator was suggested by Horrigan [5]. It focuses upon operating returns on invested assets, independent of the efficiency of financial management. The second indicator takes financial management into account. It measures net equity returns. Pearson correlations between the two profit indicators were significant and positive (r 2=0"3: P<0.01). As in the subsequent analysis only the relative position with respect to the average of each indicator is important, we tested group-overlaps in classification based upon each indicator. The test indicated 70 ~o over-lap among the two classifications. This was considered a satisfactory amount of agreement, and the subsequent analysis is based upon the first indicator of profit. 311

Goldberg--Short-Term Profit Analysis TABLE 1. A LISTING OF THE EMPIRICALLY ESTABLISHED LINKS BETWEEN CONCEPTS (i.e. FACTORS) AND OPERATIONALIZED VARIABLES

Factor

Variables

1. Lack of organizational slack Sales/fixedassets Sales/total assets Fixed assets/number of employees (loading negatively) 2. Sales efficiency

Sales/inventory Personnel costs/sales (loading negatively)

3. Size

Total assets Working capital Sales Net worth/total assets

4. Short-term liquidity

Current assets less inventory/current debt Current assets/current debt Working capital/sales Working capital/total assets

5. Financial leverage

Long-term debt/net worth Long-term debt/total assets

6. Increased market share

Percentagechange in market share Percentage change in sales

7. Independent factors

Net worth/total debt Net worth/long-term debt Net worth/fixed assets Net operating profit/interest payments Sales/accounts receivable Sales/net worth Number of employees/sales Investment/total assets (1 year ago) Investment/total assets (2 years ago) Change in sales/changein costs Cost/sales

T o obtain strong causal inferences, however, it is not possible to rely upon statistical association, unless a proper experimental design has been implemented. Unfortunately, this necessarily large-scale industrial experimentation is not feasible. It is, therefore, useful to approximate, as much as possible, a proper experimental design by using 'nature' (in our case, the sectoral economic environment) as the provider of 'treatments', and by using some structural properties of the population as approximations to 'controls'. The process of identifying such an analog has been termed 'quasi-experimentation' [2]. Figure 1 describes the basic features of the quasi-experimental design used in this study. The particular features of the data which permitted some causal inferences (rather than just indications of associations) were the following: 312

Omega, 1,'ol. 5, No. 3 ExperimenfaI - controls e.g. randomization, efc. : ~

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Analog: quasiLexperimental design Yearly fluctuations in the economic Fast moving Slow moving environment t l Concepts . ~ Treatment I i reclassi form fiea~Ceeach°r dHiIOgWyear hper PrOfitfor

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= Discriminant analysis= for each year ~-CJusal . . . . . . . . . . . . . . . . . . . . . . . inferences

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~G. 1. A flow chart showing the analog used in this study to create a quasi-experimental design.

1. Dependent variables (style and posture variables) were characterized as 'slow' variables while performance variables were 'quick' variables. Relative positions of companies along dimensions of posture and style did not vary much over time, but relative profit positions did vary substantially. 2. Economic environments changed in a marked way during the horizon studied, providing the needed sequence of treatments.

These properties of the data permit the causal linking of posture and style to performance as a function of a given economic environment (the treatments). For each year of the period of the study, firms were classified and reclassified into those with above and below average profit performance. A step-wise discriminant function analysis was then employed, with F = 1 as the default value to find those variables which distinguished between high and low performance. Each year was marked by differing environmental circumstances (i.e. 'treatments'). Variables with high discrimination of performance values were identified. These slow-moving variables are assumed to explain rapidly changing profit performance. In addition, and in order to obtain a basis for comparison with long-term profit behavior, averages of all independent variables were used as potential discriminators between firms with above and below profit performance over the total horizon of the investigation. 313

Goldberg--Short- Term Profit Analysis

E M P I R I C A L OBSERVATIONS The environment: ~ectoral performance The cloth-making and textile sector was characterized over the 7 years of our study by wide fluctuations. A surge of sales and profits in 1967 was followed by a sharp decline in sales in 1968. That year a number of firms closed down and the industry as a whole suffered a 16 ~o drop in profits. Sales recovered in 1969, but an even greater acceleration of costs kept profits falling. This trend continued until 1972 when cost increases came under control, although sales trends then reversed. In 1972 profits increased by more than 30 ~. Turning, now, to the results of the discriminant analysis, the first impression was that the variables which accounted for differences in profit performance did indeed vary as a function of changes in the environment and were often different from variables associated with long-term profitability. As perhaps would have been expected, these last included increased investment in new equipment and lower costs relative to sales. It will be recalled that during 1966-67 the industry experienced an increase in sales. Variables associated with the factor, 'lack of organizational slack', were associated with better than average profit performance during this period. This suggests that at least during an upswing of sales, organizational slack associated with the under-utilization of organizational assets hinders rather than helps profit performance, for it indicates that not all opportunities are being exploited. 1968 was a year of sales and profit crisis for the industry. The difficulties remained to a greater or lesser extent through 1970. During this period, high short-run liquidity was associated with below-average profit. Firms did better when they emphasized sales efficiency, by reducing personnel costs relative to sales and by reducing inventory relative to sales. Similarly, those who were able to increase their market share also had above average profits. Generally, the discriminant analysis suggests that an aggressive management approach towards improved efficiency, along with the elimination of excess working capital were factors associated with improved profit performance during this difficult period. By the end of 1971, recovery seemed to have started for the industry. Profits were able to increase substantially in 1972. One of the variables measuring managerial efficiency is associated with greater profitability, and more organizational slack is again associated with lower profits.

DISCUSSION The discriminant analysis does suggest that at different times, and contingent upon environmental conditions, different variables are associated with different levels of profit performance. Whether management should attempt to eliminate 314

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organizational slack during an upswing in sales, and in this way improve profits, seems questionable. As Donaldson [4] illustrated in a number of financial case studies, when environmental conditions turn against a firm, as they did against Swedish textile firms in 1968, this accumulated organizational slack gives the firm some leeway to manoeuvre and explore, for example, new marketing opportunities. Similarly, during a period of lower sales, higher liquidity may reduce profits but it probably enhances chances of surviving. In practice, it is necessary to take both profitability and survival criteria into account. The method used in this study seems to offer promise for helping our understanding of firm's short-term adjustment behavior to environmental conditions. We intend to carry out further studies using similar methods but based on different data in the hope of improving our understanding of the determinants of short-term profit performance.

REFERENCES 1. ALTMANEI (1968) Financial ratios, discriminant analysis and prediction of corporate bankruptcy. J. Fin. 23, 589-609. 2. CAMPBELLDT & STANLEYJC (1966) Experimental and Quasi-experimental Designsfor Research. Rand McNally, Chicago. 3. CYERTRM & MARCHJG (1963) ,4 Behavioral Theory of the Firm. Prentice-Hall, Englewood Cliffs,NJ. 4. DONALDSONG (1969) Strategy for Financial Mobility. Division of Research Graduate School of Business Administration, Harvard University, Boston. 5. HORRIGANJO (1966) The determination of long-term credit standing with financial ratios. Empirical Research in Accounting: Selected Studies, J. Accounting Res. 4(suppl), 44-62. 6. KATZD & KAI-INRL (1966) The Social Psychology of Organizations. Wiley, New York. 7. PINCHESGE & Mnqc,o K (1973) A multivariate analysis of industrial bond ratings. J. Fin. XXVIII (7), 1-18. 8. S'rARnUCKWH (ed.) (1971) Organizational Growth and Development. Penguin, Harmondsworth. CORRF~PONDENCE:Professor Walter H Goldberg, International Institute for Management, Griegstrasse5-7, D-1000Berlin 33, West Germany

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