Mutual Complementarity in the Dupont System and the Value of Marginal Improvements

Abstract

In the well-known DuPont system of financial analysis, return on equity is decomposed into margins, turnover, and leverage. This paper shows that these three conceptual measures are mutually complementary and that their effects are superadditive: an increase in one?s magnitude increases the marginal effect on ROE of increases in the other two. Consequently, managerial attention aimed at improving ROE will have maximal effect if directed towards the lowest of these three complementary drivers, shoring up the firm?s weaknesses rather than extending its strengths. Both calculus-based derivations and numerical illustrations show the ROE advantages of balancing these three profitability drivers to exploit the superadditivity of marginal improvements. A small improvement in one lagging component can offset disproportionately large decreases in two leading components without loss of ROE. Finally, we examine empirical implications of the theory?s predictions about the effects on future profitability of certain common managerial initiatives aimed at increasing one or more DuPont components and some challenges in formulating tests of complementarity based on accounting data.