Notes

This lesson looks at how companies measure property, plant, and equipment asset efficiency to improve sales revenue. Learn how to measure equipment efficiency, calculate an asset turnover ratio, and generally improve efficiency.
Measuring Equipment Efficiency
Urban Sneaks is a shoe company that's been in business for 30 years, enjoys considerable success and is known for a high-quality product. Some of Urban Sneaks' equipment is getting quite old, and the owner of the company, Ms. B. Shue, is wondering if it's time to replace it. She needs a way to measure how efficient her equipment is in making money for her business.

Calculating Asset Turnover Ratio
Since resources are finite, it is important for every business to use its assets (items that it owns) as efficiently as possible. Property, plant, and equipment assets are defined as large items (like machinery, equipment, and buildings) that a company uses to generate sales revenue. Since property, plant and equipment assets usually represent a significant monetary investment for any company, it's important to determine whether or not the company is using these assets in an efficient manner to produce sales.

The best way to measure the efficiency with which a company is using its property, plant, and equipment assets is to calculate the asset turnover ratio. The formula for the asset turnover ratio is net sales divided by average property, plant, and equipment assets.

Let's assume that the Urban Sneaks Company had property, plant, and equipment assets of $500,000 last year and $650,000 this year, with net sales of $2,500,000 in the current year. The asset turnover ratio would be 4.35: $2,500,000 / (($500,000 + $650,000) / 2). A ratio of 4.35 means that the company generates $4.35 of sales for each dollar that it spends on property, plant, and equipment assets. Generally, the higher the ratio, the more efficiently the company is using its property, plant, and equipment assets to generate sales revenue.

The asset turnover ratio should always be compared with a company's past performance, as well as other companies in the same industry. For example, Ms. B. Shue would want to compare this year's asset turnover ratio for Urban Sneaks to the prior year's results, and also to that of her largest competitor, Quality Shoes 4 You. The industry in which the company operates is important because different industries have different needs for property, plant, and equipment assets. For example, an insurance company would not need to spend as much money on property, plant, and equipment as a large airplane manufacturing company.

Improving Efficiency
There are several steps that a company can take to improve the efficiency with which it's using its property, plant, and equipment assets. For example, the company could review its current listing of property, plant, and equipment assets and identify those assets that are obsolete, or no longer useful, and those which are underutilized or simply not used at all. Property, plant, and equipment assets that are not used to generate sales should be liquidated. In some cases, it may be better for a company to lease some of its assets to avoid problems with obsolescence. This strategy is useful when dealing with technology, as obsolescence occurs very quickly with these assets.

Lesson Summary
Companies must ensure that their property, plant, and equipment assets are used in the most efficient manner possible. Calculating the asset turnover ratio and comparing it with information from prior years, as well as with its competitors' results, will assist a company in determining how efficient its property, plant, and equipment assets are in generating sales revenue for the company.