Erosion (in Finance)

Refers to any unfavorable influence on a company's associated assets or funds.

Any unfavorable influence on a company's associated assets or funds is considered erosion. 

Profits, sales, and tangible assets, such as manufacturing equipment, can all be affected by erosion. 

It is frequently seen as a general risk element in a company's cash management system because the losses are often gradual and occur over time.

Time decay is a term used to describe how some financial assets, such as options contracts or warrants, erode in value over time.

Here are some standard definitions in different financial contexts: 

  • Short-term losses are more likely to be erosion than a pattern of long-term degradation in a company's operations.
  • When profits are diverted to other enterprises or costs grow, profit erosion happens.
  • Long-term sales decreases, such as those caused by new competitors or price undercutting, are referred to as sales erosion.
  • There are different types of erosion in finance.

The tendency to decline with time, especially those that appear to be escalating, is most commonly referred to as erosion. In other words, it signifies a long-term change in business conditions.

short term losses

We can also categorize Short-term losses as one-time charges or nonrecurrent losses rather than erosion. 

Standard expected depreciation and the cyclical nature of certain product sales are frequently accepted as standard business practices. But, unfortunately, we can also call it a downhill trend.

Profit Erosion

Profit erosion can creep up on you without causing substantial changes in your operations, threatening your long-term ambitions or your capacity to stay in business. 

The term is an informal business term that refers to declining earnings caused by rising expenses or a mix of increased costs and decreased sales rather than decreased sales.

profit

The steady diversion of capital from profitable parts or projects within a corporation to new projects or areas is known as profit erosion. Although money moving into new projects is nearly always viewed by managers as an investment in long-term growth, the short-term result is a steady cash flow erosion. 

Cash flow refers to any amount of cash that comes in and out of an organization due to its day-to-day operations. 

It is typically represented in a company's profit margin since funds are utilized to fund areas that may or may not be successful in the future.

Furthermore, it might occur even when sales volumes are close to earlier levels. For example, it can happen when the cost of creating a product grows, possibly due to changes in the cost of materials or labor, while the product's sales price remains unchanged.

Reasons

A few of the reasons are:

a) It has diverse causes and processes at different phases of business development. 

To control profit loss, business owners must carefully study the sources of profit loss at all stages to develop strategies to reduce profit loss and increase efficiency.

profit-cost

The start-up and growth period's inertia is almost inevitable. Many companies are on a path to nowhere because they still use stage management, characteristic of blind pursuit of growth. 

Such an expansion path belongs to the enterprise that can't find the direction of the typical symbol, similar to a ship lost at sea, and it's easy to end up on the rocks. As a result, keeping up with the times and innovating the business operation model is critical. 

Furthermore, it is vital to continually determine the firm's business direction in innovation and develop the enterprise more robust to guarantee a good source of profit for the business.

b) Scale is pursued mindlessly due to a lack of managerial thinking. 

The scale itself tends to become a burden, if not a hardship, for enterprises, and the scale itself will pay for itself with the profits made. The operator is the heart and soul of a business, and his decision-making thinking defines the company's future orientation. 

managerial thinking

As a result, the operator's management philosophy, which serves as the theoretical foundation for guiding the enterprise's operations, is critical. It is also known as a company's vision and mission.

For the company to create a focused "captain," always grasping the trend of enterprise profits, company management requires practical, systematic, and simple qualities to fall into, broadening the ideological pattern of operators.

c) Turnover is pursued blindly. 

The quantity of sales determines the magnitude of the turnover, and many managers believe that increasing sales will automatically boost profitability. 

turnover

As a result, many businesses will treat the number of sales as a performance measure, leading salespeople to accept orders while ignoring internal friction blindly. 

The ideal strategy for increasing profits is to adhere to the rule of "profit maximization, expenditure minimization." If an operator only focuses on improving sales while neglecting expenses, they will know it is a waste of time by the time the year-end settlement comes around.

Asset Erosion

Depreciation is the process by which certain assets lose value over time. Therefore, unanticipated asset erosion might happen despite significant asset depreciation factoring into the business's calculations. 

asset

These losses can occur due to widespread equipment use or technical advancements that render current assets less valuable or obsolete.

It reduces the book value of the firm's assets, lowering the company's perceived value as a whole. In addition, intangible assets with an expiration date, such as patents or trademarks, lose weight over time, especially as that day approaches. 

For example, generic manufacturers joining the market can erode pharmaceutical businesses' products and be a significant source of concern. Amortization is a normal accounting process that reduces the value of intangible assets over time.

Another example is that options contracts are derivatives, which means that the value of the underlying asset determines the value of the contract. So, for example, stock options offered to corporate executives or employees can depreciate over time. 

Options contracts usually have an expiration date, and their rights must be exercised before the contract expires. As a result, the time value of those contracts erodes as the expiration date approaches, a phenomenon known as time decay.

contract

In other words, the possibility of profiting from the option diminishes over time-if it isn't already lucrative. As a result, the value of options decreases or disappears over time.

Employee stock options have grown in importance as a balance sheet item for many large corporations, making this type of value loss vital to consider when reviewing financial statements.

1. Tangible asset erosion

It refers to the loss of value of tangible assets over time. 

tangible asset

Assets that can be directly examined and touched are known as tangible assets. Machinery, equipment, vehicles, and buildings are examples.

Most tangible assets have a usable life and wear out over time, which is recorded as "depreciation" in accounting. A car, for example, will typically have a finite useful life based on the distance driven or the number of years used.

2. Intangible asset erosion

It refers to the over-time loss of value of intangible assets. Intangible assets are those that cannot be seen or handled physically.

intangible asset

Patents, trademarks, goodwill, and brand value are some examples.

Patents, for example, may expire over time, so some intangible assets have a useful life. The accounting term for this is "amortization." On the other hand, Intangible assets have an indefinite life and are periodically assessed for impairment.

When an intangible asset is determined to be impaired, there is a significant reduction in its value. This occurs when intangible asset markdowns continue over time.

3. Financial asset erosion

It refers to the over-time loss of value of financial assets. Financial assets are instruments and securities held for financial purposes. For example, either speculating for a profit or hedging against potential losses. 

financial asset

The following are some instances of financial assets: derivatives, equity securities, and fixed-income securities.

Because equity securities are so volatile over time, it's difficult to spot a long-term, consistent downward trend. Likewise, it's similarly difficult to see a long-term negative trend in value in fixed-income instruments.

It is prevalent in derivative instruments like options. Options contracts have an expiration date after which we cannot exercise the option. As a result, the option's value depreciates over time, eventually reaching zero at expiration.

Sales Erosion

Meaning

It refers to the process of continuous, long-term losses in overall revenue.

sales

These are distinct from transient sales drops in that they are frequently regarded as widespread, potentially indicating a long-term trend in the company's operations.

This can be caused by various circumstances, such as new entrants into the market for that particular product or competitive price undercutting. 

If new product improvements make the current corporate offering seem outmoded, technological advancements in the area might lead to sales loss.

Reason

Sales erosion usually refers to more than just a drop in sales. The phrase "erosion" denotes a more permanent state than the term "decline." 

sales

When you hear that a company's sales are declining, you can assume that it's losing market share to growing competitors while shrinking. 

For various reasons, including new competitors in an industry that might erode its market share, a company may lose market share to other businesses. Events that alter how the public views a business and its goods can also reduce market share.

Imagine, for instance, that a report reveals that a specific fast-food restaurant does not adhere to government standards for food safety. As a result, the chain's market share can be reduced due to specific customers avoiding it.

There are risks of losing market share due to poor product quality, technological advancements, and consumer preference changes.

Additionally, a decline in market share may indicate a rise or fall in competition. For example, small businesses gain market share when a large corporation loses market share, increasing competition.

On the other hand, if small businesses see their market shares decline, it can indicate that larger enterprises are gaining their market shares. Excessively low market shares could cause companies to lose money and leave the market, reducing competition.

To combat it, you must understand the causes as a small-business owner. The following are some ways to avoid losing market share and sales erosion: 

  1. First, utilize innovation to remain connected.
  2. Valuing adaptability
  3. Practice innovative marketing by purchasing a rival market share
  • New competition

If your sales are consistently declining, check for a new competition on the horizon in the marketplace. Examine and learn from what your competitors are doing to reclaim some of your clients. 

Sales erosion may indicate that you need to adapt your growth strategy by inventing and adopting the techniques of your competitors.

  • Price Undercutting

Someone else may be undercutting your prices on similar products, resulting in sales erosion. It is typically the case when your product or service has many substitutes. For instance, if you are selling a homogenous product like toothpaste, you might have a lot of competitors in the market. 

This isn't to say you should engage in a price war. You can afford to wait if you feel the company with the low prices is working on razor-thin profit margins. It can also translate that it may soon run out of cash and go out of business. In the meantime, you can focus on customer service and quality. Not every customer is looking for a good deal. 

You will regain your consumer base and avoid appearing to be a discount retailer if you can deliver actual value above and beyond pricing.

price undercutting

  • Customer service

Consistent revenue decline could indicate a problem with your customer care department. Inquire about your customer's experiences with your business. If you get a lot of complaints, you know you're losing business because of bad service at the front desk or over the phone. 

Hire customer service representatives who go above and beyond to meet the needs of their customers. You want a 'can-do' mentality at your front desk, not a 'can't-be-bothered' attitude. 

Observe your customer care representatives and retrain or hire personnel who can positively make your customers' first contact with your organization.

  • New technology

Because of technological advancements, your company's sales may suffer. If you offer products that use old technology, you'll need to update them quickly. As a result, the erosion indicates your company's relevance in the marketplace erodes. 

It would help if you also looked into your order fulfillment department's technology. Due to obsolete technologies, your rival may outperform you in terms of efficiency if you are not filling and tracking orders on time. Customers despite having to wait for goods.

Price Erosion

Meaning

Erosion is linked to a reduction in existing product cash flows.

This occurs when you're obliged to cut your price-and thus the perceived value of your product-to compete with unlicensed vendors or merchants who've broken your pricing policy. It's the steady decline in goods prices over time.

price erosion

If your brand is experiencing price erosion, it's a solid sign of a problem with your retail partners somewhere down the line. 

One severe bid is all it takes to spark "race-to-the-bottom pricing," in which all of your retail partners violate your pricing policy to compete with the initial offender, and your price decreases to the point that retailers must sell at cost to compete.

Some brands are unconcerned.

Take, for example, Apple. The price is the same no matter where you buy their stuff. Across the board, it's the same. That isn't by chance. Apple and other brands work hard to establish the value of their products, and they work even harder to maintain that value.

  • What can we do to combat price erosion
    • Choose your retail partners carefully
    • Establish a pricing policy
    • Take pricing enforcement seriously
    • Protect your price
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Researched and authored by Ruxue BaiLinkedIn

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