Return on Capital = Profit/Sales x Sales / Capital
‘Profit to sales’ ratio does not always give a true picture of the results of or industrial enterprise as profit depends on many external factors like, statutory controls, government policies, political and economical influences etc. on which management has little control. ‘Sales to capital’ is better measure to assess performance or, rather it should be modified as ‘sales to working capital’ ratio, as little can be done with regard to Fixed Capital.
According to an analysis of capital investment in 29 major industries in India given by central statistical organisation, approximately 90% of the working capital is invested in inventories.
Capital which is fixed in the form of land and buildings, plant and machineries etc. is not amenable to reduction. So, almost nothing can be done to reduction. So almost nothing can be done to reduce it. There remains then the working capital, of which a large part is invested in inventories.
Materials in stores, in the process of fabrication and in the form of finished goods are crystalised capital. It is essential, therefore, to keep this form of capital investment at minimum.
Importance of Variety Reduction:
Since the numbers of items are reduced due to variety reduction, the increased quantity of an individual item can lead to more economical price, because of larger quantities. It is possible to establish specifications for parts and route wise purchase activities.
The purchasing activity can be made truly competitive by eliminating special lots and brand names. Standardisation results in effective communication, which promotes better understanding between different departments, in order to avoid constant disputes and misunderstanding.
The variety reduction scheme in general offers the following advantages:
1. Fewer items will mean more personalised attention and there will be fewer stock outs and service level will also improve.
2. Inventory carrying cost will come down because less inventories will be held.
3. Less procurement cost as fewer numbers of purchases for lesser number of items will have to be made. Further, since quantities per item will increase, better quantity discounts will become available and unit cost of each item will come down.