What is Erosion?
Erosion can include any negative impact on a company’s associated assets or funds. Erosion can be experienced with regard to profits, sales or tangible assets, such as manufacturing equipment. Erosion is often considered a general risk factor within an organization’s cash management system, as the losses may be slow and occurring over time.
- Erosion generally applies to longer-term downward trends in a company’s business; short-term losses are usually not considered erosion.
- Profit erosion can happen when profits are redirected elsewhere in a business or costs rise.
- Unexpected asset erosion, for example due to technical innovation, can lower the perceived value—or book value—of a business.
- Sales erosion happens when there are long-term declines in sales, perhaps due to new competition or price undercutting.
Understanding the Types of Erosion
Erosion most often applies to longer-term downward trends, especially those that seem to be accelerating. Often, short-term losses are not categorized as erosion, but listed as one-time charges or nonrecurrent losses. Standard anticipated depreciation, or the cyclical nature of certain product sales, are often considered a normal part of business functions. These are more likely to be referred to as downward trends.
Profit erosion can refer to the gradual redirection of funds from profitable segments or projects within a business to new projects and areas. Although managers almost always consider money flowing into new projects as investments in long-term growth, the short-term effect is a slow erosion of cash flow.
The risk involved in erosion of this nature is generally reflected in the company’s profit margins, as the monies are used to fund areas that may or may not be profitable in the future.
Additionally, profit erosion can occur even when sales numbers are comparable to previous levels. This can occur when the cost of producing a particular product rises, possibly due to increases in the costs of materials or labor, but the sales price of the product is not raised to compensate.
Certain assets lose value over time, a process often referred to as depreciation. Though much asset depreciation is accounted for within the business’s figures, unexpected asset erosion can still occur. These losses can occur due to general use of equipment or technological advances that make the current assets less valuable.
These losses can lower the perceived value of the business as a whole, as it lowers the book value of the assets associated with the company. Intangible assets such as patents or trademarks, which have an expiration date, also have their value eroded over time, especially as that date nears. For pharmaceuticals especially, where generic producers can then enter the market, this is a real issue of concern. Amortization is the regular accounting process whereby intangible assets' values are reduced over time.
Options contracts or warrants extended to managers or employees may also be subject to an eroding value over time. These contracts typically come with an expiration date, where the rights embedded in those contracts must be exercised prior to expiration. As the expiration date approaches, the time-value (or extrinsic value) in those contracts erodes in a process known as time decay. Employee stock options have become a large balance sheet item for many large companies, and so this form of value loss is important in analyzing financial statements over time.
Sales erosion refers to the process of steady, long-term declines in overall sales numbers. These differ from temporary sales declines because these losses are often considered fairly widespread, possibly qualifying as a long-term trend within the business’s activities.
Sales erosion can be experienced due to a number of factors, including new entries into that particular product’s market, or price undercutting on the behalf of the competition. Technology advances in the field can also lead to sales erosion if newer product developments make the current company offering seem obsolete.