Financial analysis towards lean & six sigma


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Financial analysis towards lean & six sigma

  1. 1. Financial Analysis towards Lean  & Six Sigma By Michael R. Buechler 1
  2. 2. The History of Finance „It is not the business of economist to tell the brewer how to  make beer.“ ‐ Alfred Marshall ‐ Financial Analysis by Michael R. Büchler 2
  3. 3. What is Finance? We can define a moderd finance group as managing a firm’s long‐term and day‐to‐day monetary operations and strategy. Its size varies based upon total employee head count, total revenue, industry, and overall business strategy. Purpose; The finance „group“ provides sound fiscal process, policies, planning and strategy. The finance group is responsible for incoming and outgoing payments, budgeting, planning and analysis, asset management (fixed & liquid), tax management, general accounting, and treasury management. Some finance groups may also be responsible for payrole (HR Function), internal audit and compliance, risk management and travel/expense administration, in many cases these functions are outsourced (internal & external). History; Finance in its modern form really dates from the 1950s. The hugh body of research in finance over the last sixthy years falls naturally into two main streams. And no, we don’t mean here „asset pricing“ and „corperate finance“ moreover we can call them business school approach to finance and the economics department approach. This is purely a „notional“ statement, not physical – based on faculties field rather than its location. Financial Analysis by Michael R. Büchler 3
  4. 4. Science Arises from the Discovery of Identity amid Diversity William Stanley Jevons (1 September, 1835 – 13 August, 1882) British economist and logician A General Mathematical Theory of Political Economy (1862) Pure Logic; or, the Logic of Quality apart from Quantity (1864) Elementary Lessons on Logic (1870)  The Match Tax: A Problem in Finance (1871)  A Primer on Political Economy (1878)  „It seems perfectly clear that Economy, if it is to be a science at all, must be a mathematical science. There exists much prejudice against attempts to introduce the methods and language of mathematics into any branch of the moral sciences. Most persons appear to hold that the physical sciences form the proper sphere of mathematical method, and that the moral sciences demand some other method—I know not what.“ Financial Analysis by Michael R. Büchler 4
  5. 5. Classical Dictum of Economics Alfred Marshall (26 July, 1842 – 13 July 1924) British Economist  The Pure Theory of Foreign Trade: The Pure Theory of Domestic Values (1879) Principles of Economics (1890) To someone trained in the classical traditions of economics by the great Alfred Marshall stands out: „It is not  the business of the economist to tell the brewer how to make beer.“  The characteristic economics department  approach thus is not micro, but macro normative. The models  assume a world of micro optimizers, and deduce from that how market prices, which the micro optimizers take  as given, actually evolve. Financial Analysis by Michael R. Büchler 5
  6. 6. Unreliable Estimates Trough Computional Algorithm Merton H. Miller  (May 16, 1923 – June 3, 2000) American economist Co‐author of the Modigliani–Miller theorem (1958) The Theory of Finance (1972) „For the variances and covariance's, at least, past data probably could provide at least a reasonable starting point. The precision of such estimates can always be enhanced by cutting the time interval into smaller and smaller intervals. But what of the means? Simply averaging the returns of the last few years, along the lines of the examples in the Markowitz formula won’t yield reliable estimates of return expected in the future. And running those unreliable estimates of the means through the computational algorithm can lead weird, corner portfolio’s and hardly presume benefits of diversification.“ „For the micro normative wing was concerned with finding the „cost capital,“ in the sense of the optimal cut‐off rate for investment when the firm can finance the project either with debt or equity or some combination of both. The macro normative or economies wing sought to express the aggregate demand for investment by corporations as function of the cost of capital that firms are actually using as their optimal cut‐offs, rather than just the rate of interest on long‐term government bonds.“ „The Modigliani‐Miller (M&M) proposition, in short, like the efficient markets hypothesis, are about equilibrium in the capital markets – what equilibrium looks like, and this is way neither the efficient markets hypothesis nor the M&M proposition have ever set well with those in the profession who see finance as essentially a branch of management science.“ Financial Analysis by Michael R. Büchler 6
  7. 7. Markovitz Mean‐Variance Model The business school or micro nomative stream in finance;  Harry M. Markovitz (August 24, 1927‐ )  American economist Harry Markowitz Model (1952)  "Portfolio Selection". The Journal of Finance (March 1952) Markowitz makes the powerful algebra of mathematical statistics available for the study of portfolio selection; „The immediate contribution of algebra to the famous formula for the variance of sum of random variables; that is, the weighted  sum of the variance plus twice the weighted sum of the covariances.“ This is a common formula used by finance during the last fifty years and that formula shows among other things, that for the  individual investor, the relevant unit of analysis must always be the whole portfolio, not the individual share. The risk of individual  share cannot be defined apart from its relation to the whole portfolio and in particular, its covariances with the other  components. Covariances, and not mere numbers of securities held, govern the risk‐reducing benefits of diversification!  Financial Analysis by Michael R. Büchler 7
  8. 8. Capital Asset Pricing Model  Transforming the Markowitz business model into an economics department model William F. Sharpe (June 16, 1934 ‐ ) American Economist   Portfolio Theory and Capital Markets (1970 and 2000) Asset Allocation Tools (1987) Fundamentals of Investments (2000) Investments (1999) „The CAPM implies that the distribution of expected rates of returns across all risky assets is a liniear function of a single variable,  namely, each asset’s sensitivity to or covariance with the market portfolio, the famous beta, which becomes the natural measure  of a security risk. The aim of sience is to explain a lot with little, and few models in finance or economics do so more than CAPM“ „The CAPM not only offers new and powerful theoretical insights into the nature of risks, buts also lends itself admirably to the  kind of in‐depth empirical investigation so neccessary for development of new field like finance.“ „Besides the market factor, two other pervasive risk factors have by now been identified for common stocks. One is a size effect;  small firms seem to earn higher returns than large firms, on average, even after controlling for beta or market sensitivity. The other is a factor, still not fully understood, but that seems reasonably well captured by the ratio of a firm’s accounting book value  its market value. Firms with high book‐to‐market ratios after controlling for size and for the market factor.“ „That a three‐factor model shown to describe data somewhat better than a single factor CAPM should not detract in any way!“  Financial Analysis by Michael R. Büchler 8
  9. 9. Fischer Black  Myron S. Scholes (July 1, 1941 ‐ ) Canadian‐born American financial economist  Robert C. Merton (31 July, 1944 ‐ ) American economist Fischer‐Black Formula 1997 (Black–Scholes model)  Fischer‐Black Formula 1997 (Black‐Scholes‐Merton formula)  „Options mean, among other things that for the first time in its close sixty‐year history the field of finance can  be build, or rebuild, on the basis of „observable“ magnitudes.“ „The Fischer Black reminded us, estimating variances is orders of magnitude easier than estimating the means  or expected returns that are central to the models of Markowitz, Sharpe or Modigliani‐Miller. The precision of  an estimate variance can be improved, as noted earlier, by cutting time into smaller and smaller units – from  week days to days to hours minutes. For means, however, the precision of estimate can be enhanced only by  lengthening the sample period, given rise to the well‐know dilemma that by the time a high degree of precision  in estimating the mean from past data has been achieved, the mean itself has almost surely  shifted.“ Financial Analysis by Michael R. Büchler 9
  10. 10. Managing for Finance  ... a taste of more to come  Financial Analysis by Michael R. Büchler 10
  11. 11. Instinctive Identification for Todays Finance Professionals  „The common perception of risk even today focuses on the likelihood of losses – on what the public thinks of as the „downside“ risk – not just on the variability of returns.“ ‐ Merton H. Miller‐ Financial Analysis by Michael R. Büchler 11
  12. 12. Show me the Money!  Earnings Before Interest and Tax How profitable is our business, and how do we need to understand on how we need to callculate its profitability?  Revenue minus expenxes, excluding tax and interest is called EBIT and  is also referred to as "operating earnings", "operating  profit" and "operating income", as you can re‐arrange the formula to be calculated as follows: EBIT = Revenue ‐ COGS ‐ Operating Expenses ‐ Depreciation & Amortization In other words, EBIT is all profits before taking into account interest payments and income taxes. An important factor contributing  to the widespread use of EBIT is the way in which it nulls the effects of the different capital structures and tax rates used by different companies. By excluding both taxes and interest expenses, the figure hones in on the company's ability to profit and thus  makes for easier cross‐company comparisons. EBIT was the precursor to the EBITDA calculation, which takes the process further by removing two non‐cash items from the  equation (depreciation and amortization). Financial Analysis by Michael R. Büchler 12
  13. 13. Economic Profit Economic Value Added ‐ EVA Definition of „Economic Value Added – EVA“ • A measure of a company's financial performance based on the residual wealth calculated by deducting cost of capital from  its operating profit (adjusted for taxes on a cash basis). (Also referred to as "economic profit".) • This measure was devised by Stern Stewart & Co. Economic value added attempts to capture the true economic profit of a  company; = Net Operating Profit After Taxes (NOPAT) ‐ (Capital * Cost of Capital) Financial Analysis by Michael R. Büchler 13
  14. 14. Non Performing Asset – NPA   Definition of „Non‐Performing Asset – NPA“ A classification used by financial institutions that refer to loans that are in jeopardy of default. Once the  borrower has failed to make interest or principal payments for 90 days the loan is considered to be a non‐ performing asset. Also known as „non‐performing loan.“ Non‐performing assets are problematic for financial institutions since they depend on interest payments for  income. Troublesome pressure from the economy can lead to a sharp increase in non‐performing loans and  often results in massive write‐downs. Financial Analysis by Michael R. Büchler 14
  15. 15. Managing for Accounting Financial Analysis by Michael R. Büchler 15
  16. 16. The 1922 treatise of Managing Accounting „The essential basis for the work of cost accountant – without it, there could  be no costing – is the postulate the value of any commodity, service, or  condition, utilized in production, passes over into the the object or product  for which the original item was expended and attaches to the result giving it  its value.“  ‐ William Paton ‐ Financial Analysis by Michael R. Büchler 16
  17. 17. Introduction to Financial Accounting • Financial accountancy (or financial accounting) is the field of accountancy concerned with the preparation of financial statements for decision makers, such as stockholders, suppliers, banks, employees, government agencies, owners and other stakeholders. • Financial capital maintenance can be measured in either nominal monetary units or units of constant purchasing power. The central need for financial accounting is to reduce the various principal‐agent problems, by measuring and monitoring the agents’ performance and thereafter reporting the results to interested users. • In short, financial accounting is the process of summarising financial data, which is taken from an organisation’s accounting records and publishing it in the form of annual or quarterly reports, for the benefit of people outside the organisation. Financial accountancy is governed not only by local standards but also by international accounting standard. Financial Analysis by Michael R. Büchler 17
  18. 18. Principles of Financial Accounting Financial accounting is based on several principles known as Generally Accepted Accounting Principles (GAAP), International Financial Reporting Standards (IFRS) and Accounting Regulatory Committee ARC, International Accounting Standards/IAS These include the business entity principle, the objectivity principle, the cost principle and the going‐ concern principle. Business entity principle: Every business requires to be accounted for separately by the proprietor. Personal and business‐related dealings should not be mixed. Objectivity principle: The information contained in financial statements should be treated objectively and not shadowed by personal opinion. Cost principle: The information contained in financial statements requires it to be based on costs incurred in business transactions. Going‐concern principle: The business will continue operating and will not close but will realise assets and discharge liabilities in the normal course of operations Financial Analysis by Michael R. Büchler 18
  19. 19. Benefits of Financial Accounting • Meeting legal requirements: accounting helps to comply with the various legal requirements. It is mandatory for joint stock companies to prepare and present their accounts in a prescribed form. Various returns such as income tax, sales tax are prepared with the help of the financial accounts. • Protecting and safeguarding business assets: Records serve a dual purpose as evidence in the event of any dispute regarding ownership title of any property or assets of the business. It also helps prevent unwarranted and unjustified use. This function is of paramount importance, for it makes the best use of available resources. • Facilitates rational decision‐making: Accounting is the key to success for any decision making process. Managerial decisions based on facts and figures take the organisation to heights of success. An effective price policy, satisfied wage structure, collective bargaining decisions, competing with rivals, advertisement and sales promotion policy etc.. all owe it to well set accounting structure. Accounting provides the necessary database on which a range of alternatives can be considered to make managerial decision‐making process a rational one. • Communicating and reporting: The individual events and transactions recorded and processed are given a concrete form to convey information to others. This economic information derived from financial statements and various reports is intended to be used by different groups who are directly or indirectly involved or associated with the business enterprise. Financial Analysis by Michael R. Büchler 19
  20. 20. Limitations of Financial Accounting One of the major limitations of financial accounting is that it does not take into account the non monetary facts of the business like the competition in the market, forex trades etc. Some of following limitations of financial accounting have led to the development of active based costing accounting: • Unclear operating efficiency: financial accounting will not give you a clear picture of operating efficiency when prices are rising or decreasing because of inflation or trade depression. • Shortcoming not spotted out by collective results: financial accounting reflects the net result only. It does not indicate profit or loss of each department, job, process or contract. It does not disclose the exact cause of inefficiency i.e. it does not tell where the oppurtunity is because it discloses the net profit of all the business activities. Furthermore, loss or less profit disclosed by its profit and loss accounts is a signal of imbalanced businesses, the exact cause of such performance is not identified. • Price fixation: financial accounting, costs are not available as an aid in determining prices of the products, services, production order and lines of products. • Provides only historical data: financial accounting is mainly historical and counts cost already incurred. As financial data is summarised at the end of the accounting period it does not provide day‐to‐day cost information for making effective desions on real time approach and will not help to indicate future evaluation. • Limted analysis on cost of losses: It fails to provide complete analysis of losses due to defective material, idle time, idle plant and equipment. In other words, no distinction is made between avoidable and unavoidable wastage. Financial Analysis by Michael R. Büchler 20
  21. 21. International Accounting Standards • Accurate and reliable financial information is the lifeline of commerce and investing. Presently, there are two sets of accounting standards that are accepted for international use namely, the U.S., Generally Accepted Accounting Principles (GAAP) and the International Financial Reporting Standards (IFRS) issued by the London‐based International Accounting Standards Board (IASB). Generally, accepted accounting principles (GAAP) are diverse in nature but based on a few basic principles as advocated by all GAAP rules. These principles include consistency, relevance, reliability and comparability. • Generally Accepted Accounting Principles (GAAP) ensures that all companies are on a level playing field and that the information they present is consistent, relevant, reliable and comparable. Although U.S. GAAP is only applicable in the U.S., other countries have their own adaptations that are similar in purpose, although not always in design. • IFRS are International Financial Reporting Standards, which are issued by the International Accounting Standards Board (IASB), a committee compromising of 14 members, from nine different countries, which work together to develop global accounting standards. The aim of this committee is to build universal standards that are translucent, enforceable, logical, and of high quality. Nearly 100 countries make use of IFRS. These countries include the European Union, Australia and South Africa. While some countries require all companies to stick to IFRS, others merely try to synchronize their own country’s standards to be similar. Financial Analysis by Michael R. Büchler 21
  22. 22. Active Based Costing Do we count all our activities during our business transactions? In contrast to traditional cost accounting systems, ABC systems first accumulate overhead cost for each organizational activity, and then assigns the cost of the activities to the products, services or customer causing that activity. ABC’s active analysis are most critical for identifying appropriate process output measures of activities and resources, their effects on the costs of making a product or providing a service. Traditional cost accounting systems often allocate costs based on single‐volume measures. Using single‐volume measures seldom meets the cause and effect criterion desired in cost allocations. ABC system have the flexibility to provide special reports facilitating management decision making towards costs of activities undertaken to design, produce, sell and deliver a company’s products or services. Activity‐based costing records the costs that traditional cost accounting does not do! Financial Analysis by Michael R. Büchler 22
  23. 23. Implementation of ABC According to Ray H. Garrison and Eric W. Noreen there are six basic steps required to implement an ABC system:  6. Prepare and  distribute  management  reports 5. Assign cost to cost  objects  using the activity  rates and activity measure  previously determined  4. Calculate  activity rates 1. Identify and  define activities and  activity pools 2. Directly trace costs  to activities (to the  extent feasible)  3. Assign costs to  activity pools  Managerial Accounting, 9th Edition by Ray H. Garrison, Eric W. Noreen and E.W. Noreen (1999) Financial Analysis by Michael R. Büchler 23
  24. 24. Accountable for Financial Accounting ... “Hold everybody accountable? Ridiculous!” ‐ W. Edwards Deming ‐ Financial Analysis by Michael R. Büchler 24
  25. 25. Balanced Scorecard  Financial Analysis by Michael R. Büchler 25
  26. 26. Optimum Quality Costs and Zero Defects: Are They Contradictory Concepts?  „A program of continuous improvement does not necessarily introduce increased  costs as the quality level approaches 100%“ ‐ Arthur M. Schneiderman ‐ Financial Analysis by Michael R. Büchler 26
  27. 27. BalanceScoreCard  • History; The first balanced scorecard was created in 1987 at Analog Devices, a mid‐sized  semiconductor company by its „forgotten“ contributer Arthur  M. Schneiderman former VP Quality  at ADI and now been recognized as „first generation“ balance scorecard also know as the half‐life  concept.  The concept then was popularized by Robert Kaplan and David Norton in the early 1990s. • Purpose; A strategic planning and management system used extensively in business and by  organizations worldwide. Benefits of the system include increasing focus on results, aligning  business activities with organization strategy and improving performance and communications. The balanced score card proposes that the organization should be viewed from four perspectives,  with metrics developed, data collected and analysed  or each of them. These four perspectives are:  Financial, Customer, Internal Business Processes and Learning and Growth. Financial Analysis by Michael R. Büchler 27
  28. 28. Optimum Quality Cost  Juran defines three quality zones relative to the point of  minimum total quality cost. The „zone of improvement  project“ lies below the optimum quality level, while the „zone of perfectionism“ lies above it. Between them,  and of the minimum, lies the „zone of indifference.“   • Quality costs depend on incremental, not total, elementary costs. At the optimum, nothing in general can be said about the relative levels of prevention and failure costs. J.M. Juran Quality Control Handbook 1979 Financial Analysis by Michael R. Büchler 28
  29. 29. Optimum Quality Level  The zone of perfectionism is what most troubles proponents of zero defects, for here Juran suggests relaxing prevention efforts and allowing increased defect rates. Furthermore, he identifies the boundary of the zone of perfectionism as lying typically , at the quality level where failure costs amount to 40 % of the total cost. Translating the rules of thumb, this translates into a defect level only half that which exists in the zone of improvement. • The is no mathematical requirement that the optimum occurs at q < 100%. There may be no optimum in the range of q = 0 to 100%. There might be a minimum rather than an optimum, and it could very well be at q = 100%. Financial Analysis by Michael R. Büchler 29
  30. 30. Never‐ending Eliminating Waste ‐ Muda Schneidermann, Quality Progress (1986)  The Japanese word for continuous improvement is Kaizen. Innovation is perhaps an alternative method to  compare improvement. While innovation is characterized by costly major events, kaizen represents  inexpensive and almost imperceptible continuous improvement. Financial Analysis by Michael R. Büchler 30
  31. 31. The Half‐Life System Quality Improvement Process  • Among QIP we can define defects as; rework, yield loss, unnecessary reports, cycle times in  services, design and administrative processes, unscheduled downtime, inventory, employee  turnover, absenteeism, lateness, unrealized human potential, accidents, late deliveries, order lead  time, setup time, cost of poor quality and warranty costs. • The basic flaw in goal setting is that specific goals should based on means that will be used to  achieve them. Means are rarely known at the time goals are set. The usual result is that if the goal  is too low, we will underachieve the potential. If the goal is to high, we will underperform  expectations. Rational goals with means of prediction is what can be achieved if standard means for  improvement were used! • For each increment of time that equals half‐life, the defect trops by 50%. For example, if the initial  defect level was 10%, and the defect half‐life was six months, then after the first six months, the  defect level would be down 5%, after the next six month 2.5%, and so on. Financial Analysis by Michael R. Büchler 31
  32. 32. Assemble Problem Solving  Continiual problem solving shows the PDCA cycle as diffrent points along the clock face. This formulation emphasized that a quality program is not something an organization does for a year or two to correct some problems and then moves on to something else. Rather, the QIP emodied a continual problem‐solving commitment in which the half‐life method served as the speedometer for measuring how fast the organization was traveling around the PDCA cycle. Financial Analysis by Michael R. Büchler 32
  33. 33. The 7 Steps  Financial Analysis by Michael R. Büchler 33
  34. 34. The Half‐life Financial Analysis by Michael R. Büchler 34
  35. 35. Implementing the Half‐Life Concept 1. The corporate Scorecard is divided into five panels. The top panel, Financial Performance, presents information to  stockholders.  2. The second panel, QIP indicators, presents data how „we“ look to customers and employees.  The measures, such  as lead time, on time delivery and employee turnover, indicate whats importand and what needs to be improved. 3. The third and fourth panels present measures of internal performance. These measures are drive the external  measures shown in the first two panels. 4. The fifth panel shows how well we are doing in introduction new products and achieving the stratgic goals.  This set of concept was  proposed by Schneiderman in 1990 Financial Analysis by Michael R. Büchler 35
  36. 36. Evolution of the First Balanced Scorecard: 1991 Financial Analysis by Michael R. Büchler 36
  37. 37. Kaplan & Norton’s Balance Scorecard Kaplan & Norton's writing on the subject in the late 1990s: Kaplan development of the Balance Scorecard 2010: 1. 2. 3. 4. 1. 2. 3. 4. Translating the vision into operational goals; Communicating the vision and link it to individual performance; Business planning; index setting Feedback and learning, and adjusting the strategy accordingly. Balanced Scorecard for Performance Measurement Strategic Ojectives and Strategy Maps  The Strategy Management Future Opportunities Kaplan and Norton recognized that any comprehensive measurement and management system had to link operational performance improvements to customer and financial performance. Kaplan & Nortons BSC, while incorporating Analog’s operational improvement metrics, also incorporated metrics for innovation, employee capabilities, technology, organizational learning, and customer success. And unlike the stakeholder perspective, Kaplan & Norten placez shareholder value as the highest‐level metric, with all the other stakeholders reflected in how they contributed to the company’s success in maximizing long‐term shareholder value. 37
  38. 38. Economic Value Added/Shareholder Value  Integrating Shareholder Value with the Balance Scorecard • As the BSC emerged in the 1990’s just as two other ideas – Economic Value Added (EVA) and Activity‐Based Costing. • EVA and other shareholder value metrics address two defects in traditional financial reporting of copporate performance; earnings per share or „bottom line“ performance measure and capital used to generate the income and earnings. • To avoid this problem is to divide net income by some measure of invested capital to calculate a return on investment (ROI). Either by increasing the net income or by decreasing invested capital. EVA corrects both the over‐invested and the under‐ invested problem by subtracting cost of capital from the net income; Net Sales  ‐ Operating expenses = Operating profit (EBIT) ‐ Taxes = Net Operating profit after tax (NOPAT) ‐ Capital charges (Invested capital x Cost of Capital) = Economic Valua Added EVA cannot articulating a strategy and complementary processes. The BSC /shareholder expands value approach by defining drivers of revenue growth; objectives and measures for customers, customer value proposition, internal business process for innovation and customer relationships, needed infrastructure investments in people, systems and organizational alignment. Robert S. Kaplan HBS 2001 No. B0101C Financial Analysis by Michael R. Büchler 38
  39. 39. Activity‐Based Costing Model  Activity‐based costing was developed to correct another defect in financial system. Activity‐based costing provides an analytic  model that represents how individual products and customers use different quantities of servicces supplied by indirect and  support resources. The first step of an ABC model, resources drivers link expenses of resources supplied to activities and processes performed (GL). Assigning resources expences to activity and process cost provides the first link between ABC and the BSC Three parameters – cost, quality and time – usually define the performance of any process Quality and time are realatively easy to measure as they are based on physical measurement. Cost however, is an analytic construct, not something tangible that can be measured by manual force Only an ABC model can accurately trace organizational expenses to a manufacturing, distribution, service delivery or process development. Robert S. Kaplan HBS 2001 No. B0101C Financial Analysis by Michael R. Büchler 39
  40. 40. Putting a Balance Scorecard to Work Linking measurments to a strategy is the heart of a successful scorecard development process. The  three key questions to ask here;  1. If we succed with our vision and strategy, how will we look different? • to our  shareholders and customers? • in terms of our internal processes ? • in terms of our ability to innovate and grow? 2. What are the critical sucess factors in each of the four  scorecard     perspectives? 3. What are the key measurement that will tell us wheter  we’re addressing  those success factors  as planned?  Financial Analysis by Michael R. Büchler 40
  41. 41. Supply Chain and Finance Financial Analysis by Michael R. Büchler 41
  42. 42. Financing the Chain "In investing, what is comfortable is rarely profitable."  ‐ Robert Arnott ‐ Financial Analysis by Michael R. Büchler 42
  43. 43. General Background on Credit Conditions  The Eco‐System Approach • SCF is an approach for enhancing working capital for both buyers and sellers in a transaction – using an intermediary tool that links buyers, sellers and third‐party financing entities – thereby reducing supply chain risks/costs and strengthening business relationships. • Simply shifting the burden from one party to another can add significant risk to the supply chain including customer loss, business continuity risk, supplier viability risk, material cost inflation, deterioration support, and other issues. Supply chain finance provides an opportunity to collaborate and create benefits for each side of the transaction. • In favour to buyers using superior credit rating to lower overall financing costs within the supply chain by reducing risk for the supplier in return for an extension of credit terms, thereby enhancing the buyer’s working capital position. • SCF potentially fits best in situations the buyer has access to capital at a lower cost than seller and/or where the buyer has a significant time gap between inventory purchases and cash receipts from sales. Financial Analysis by Michael R. Büchler 43
  44. 44. Supply Chain Financing – How it works How it works; While reducing the amount of capital tied up in Accounts Receivable and minimizing investment  in inventories are fairly straightforward keys that will unlock the value in your supply chain, extending Accounts  Payable terms carries the potential for significant risks – supplier instability, impact to business continuity, and  eroded service among them. To manage and minimize the overall risk inherent in extended payable approaches, leading companies are  turning to SCF, a powerful tool that allows companies to extend the payables cycle in a manner that adds value  to both parties. Buyers hold cash liquidity longer and achieve a more stable supply chain, while sellers gain  quicker access to lower‐cost cash and enjoy improved business continuity. Cash forecasting effectiveness is  enhanced and buyer‐seller relationships are strengthened. Bottom‐line; For companies that have a strong credit rating relative to their suppliers and are willing to explore  alternative working capital strategies, SCF is a powerful tool that brings benefits to multiple parties across the  supply chain.  Financial Analysis by Michael R. Büchler 44
  45. 45. Shouldn’t all suppliers be squeezed? Reason why SCF is needed A comparison of accounting data of industrialized nations shows that median accounts receivable ranged from 14% to 33% of sales in 2006. „If  buyers squeezes its supplier on their days  paymement outstanding – the gap for the supplier is  immense and can lead to poor cost of quality.“ Trade across industries* Financial Analysis by Michael R. Büchler 45
  46. 46. Trade Credit Strategies  Options how to pay Outstandings Three trade credit strategies 1. Win‐win 2. Follow 3. Squeeze Depth interviews (Seifert, Springer Volume 10, 2011) indicate that roughly two‐thirds of companies still apply a  single trade credit strategy;  Financial Analysis by Michael R. Büchler 46
  47. 47. Trade Credit Strategies  Financial Analysis by Michael R. Büchler 47
  48. 48. The Win‐Win Approach The win‐win approach in particular receives much attention from treasury, going beyond  the simple adaptation of  payment terms, finance professionals have combined financial insights with electronic payment platforms and created  reverse factoring solutions.  • Reverse factoring are solutions based on factoring – transactions which suppliers sell receivables to factors for  immediate cash. Because the receivables are sold rather than pledged, tratitional factoring is different from  borrowing – there are no liabilities on the suppliers’ balance sheet.*  • Reverse factoring, however, is different in three important aspects. First, since the technique is buyer‐centric,  factors do not have to evaluate heterognous buyer portfolios and can charge lower fees. Scecond, since these  buyers are usually investment grade companies, factors carry less risk and can charge lower interest rates. Third,  as the buyers participate, factors obtain better information and can release funds easier.  The first question managers should think about what kind of relationship they want to build. Is the supplier a strategic partner? Is  the customer a key account? Will this partner be around for more than a year? Understanding the partners cost of Capital?   Second, if the relationship is of a more transactional nature, mangers determine their company’s competitive position. Third,  even if the company is in a strong position, it should still consider its cost base  Industry observers predict that reverse factoring solutions will evolve over the coming years to create more  value to suppliers Financial Analysis by Michael R. Büchler 48
  49. 49. Traditional Factoring 4 Buyer  Portfolio  Bank,   Factoring  Company 1 Supplier  2 3 Example case First, suppliers sells goods to buyer with accounts payment e.g. 14days. Second, buyers accepts goods however squeezes accounts receivable to e.g. 45 days (The big player approach) Third, supplier has 31 days neededs to be finance either by equity or loan, e.g. from bank or factoring company. Fourth, bank or factoring company will check buyers credit‐rating and lend the outstanding payment to supplier with equivalent interest. This approach is time intensive, expensive and has a negative impact on the whole supply chain finance for all parties. Financial Analysis by Michael R. Büchler 49
  50. 50. Reverse Factoring  As a process, reverse factoring is slightly more complicated than traditional factoring. Citibanks’s process, for example, involves  seven steps. First, the buyers sends a purchase order to the supplier and notifies Citibank. Second, the supplier delivers and  presents documents to Citibank. Third, Citibank checks the documents and notifies the buyer, Fourth the buyer approves or  rejects. Fifth, Citibank notifies the supplier of the buyer’s  acceptance. Sixth, if the supplier requests early payment, Citibank  credits the supplier’s account. Finally, when the invoice is due, Citibank debits the buyer’s account. Financial Analysis by Michael R. Büchler 50
  51. 51. Break‐Even‐Time Financial Analysis by Michael R. Büchler 51
  52. 52. Break‐Even‐Time  „You cannot manage what you cannot measure. What gets  measured gets done!“ ‐ Bill Hewlett ‐ Financial Analysis by Michael R. Büchler 52
  53. 53. Are we Fit for its Purpose Companies lose an extentual amount of money after tax when the deliever late and on overspend on developing new products. More and more manifactures are learning that the time required to develop a new product has more influance on its success than its costs. It is common belief in management practice in todays markets that on of the most effective ways to shorten development cycles is through the collaborative work of cross‐functional development teams. Common language has little collabartion and suffers throughout a companies hierarchy. We can define questions like; what features do customers want? How do features translate into sales? Is the technology available to develop the features? Will the product be manufacturable at the desired price. We need to measure on what we are doing what we agree must be done! A metric which would encourage collabration among different function. Hewlett‐Packard is using a metric called „Return Map.“ The map includes the critical elements of product development – the investment in product development and the return or profits from that investment. The map also shows the breakeven time to develop the product, introduce it and achieve the returns. The greatest virtue perhaps is the goal and measure for all the the functions and thus shifts the teams focus from „who is responsible“ to „what needs to get done!“ Even more important is to estimate and re‐estimate the time and money it will take to complete the overall project success! Financial Analysis by Michael R. Büchler 53
  54. 54. To be on the Spot of the Market The Return Map is intended to be used by all functional managers and business team. Basicially it is a two demensional graph displaying time and money on the x and y axes respectively. The x axis is divided into three segments – Investigation, Development and Manufacturing & Sales. Purpose of investigation is to determine the desired product features, the products cost and prize the feasability of the purpose technolodgieas and the, plan for product development and introduction. Financial Analysis by Michael R. Büchler 54
  55. 55. The Tean Plotes Estimates  Basic Elements Investment Line; total product development effort from beginning to manufacturing and sales release. Sales Line; Sales volume over a given time. Profit Line; volume of sales and the price of product in market place. The critical lines are are systematically plotted on the Return Map include new produc investement equity, sales equity and profit equity. Each of these are plotted by money and time. Financial Analysis by Michael R. Büchler 55
  56. 56. BET – New Metrics The map tracks – equity and months – R&D and manufacturing investment, sales, and profit. Break‐Even‐Time (BET), is the key metric. It is defined as the time from the start of investigation until product profits equal the investment in development. Time‐to‐Market (TM), is the total development time from start of Manafacturing phase to Manufacturing Release. Break‐Even‐After‐Release (BEAR), is the time from Manufacturing Release until investment cost are recovered in product profit. Return Factor (RF), is a calculation of profit equity divided by investment equity at a specific point in time after a product has moved into manufacturing and sales Financial Analysis by Michael R. Büchler 56
  57. 57. Making the Most of the Return Map  The effectiveness of the Return Map involves all three major functional areas in the development and  introduction of new products. The map captures the link between the development team and the rest of the  company and the customer. • Interfunctional teams using the Return Map most appropriately during the investigation phase by  generating estimates for final map including investment, sales, and profit. • Too  often the burden is placed on R&D during the initial project phase – to generate schedules,  functionality and cost goals.  • Empasizing the missed forecast generated for the Return Map in the Investigation phase should be view  valuable information.  The Return Map can be used to provide a visual perspective on sales forcast and expect profits given any  number of hypothetical secenarios. Financial Analysis by Michael R. Büchler 57
  58. 58. Forcasting Financial Performance  Financial Analysis by Michael R. Büchler 58
  59. 59. Forcasting Financial Performance  „Your net worth to the world is usually determined by what  remains after your bad habits are subtracted from your good  ones“ ‐ Benjamin Franklin ‐ Financial Analysis by Michael R. Büchler 59
  60. 60. How to Choose the Right Forcasting Technique The selection of a method depends on many factors – the context of the forecast, the relevance and availability  of historical data, the degree of accuracy desirable, the time period to be forecast, the cost benefit (or value of  the forecast to the company, and the time available for making the analysis. 1. 2. 3. What is the purpose of the forcast – how is it be used? What are the dynamics and componenets of the system for which the forcast will be made?  How important is the past in estimating the future?  Three general forcasting types to be used and once  the proble has been formulated, the forcast will be in a position to choose a method!  Financial Analysis by Michael R. Büchler 60
  61. 61. Beyond the Data Three technique by Chambers, Mullick and Smith (HBS 1971): Qualitative techniques; these are primarily used when data are scarce – for example, when a product is first introduced into a market. Use of human judgmenet and rating schemes to turn qualitative information into quantitative estimates. Time series analysis; these are statistical techniques used when several years’ data for a product or product line are available and when relationsships and trends are both clear and relatively stable. Causal models; when historical data are available and enough analysis has been performed to spell out explicity the relationships between the factor to be forecast and other factors (such as related businesses, economic forces, and socioeconomic factors), the forecaster often constructs a causel model. „Tools designed to predict and shape what consumers want have been around for decades. But as with so  many information technologies, they did not begin to take off until the 1990s“  ‐ Davenport, MIT 2009 ‐ Financial Analysis by Michael R. Büchler 61
  62. 62. What People Want ... And How to Predict It „Consumers began to come to fruition in the late 1990s, when Inc pioneered the widespread commercial use of predictions with collaborative filtering.“ This software made recommadations and making correlations with other products that he or she might like! Predictions of what products will be successful for creators and distributors of cultural content are less common. It is easist after the product has developt, when its attributes are clear and there are some indicators of its popularity. Using regression anlysis will give primary predictions e.g. on how many dvd copies need to be produced. Consider the dilemma faced by consumer trying to „keep up.“ The likely agree with the sentiment expressed by the New York Times media critique;* „Like most Americans, I am overwhelmed by the velocity of everydaylife and the volume media that goes with it.“ Just as a consumer products company wouldn’t dream of launchig a new product without first testing it with  consumers, no company will launch any expensive‐to‐create offering without putting it to some form of  systematic prediction  Financial Analysis by Michael R. Büchler 62
  63. 63. The effect of inflation  • • • The annual rate of inflation is a statistic that measures the rise in prices for  consumer goods and services. Inflation represents “price creep” and illustrates the degree of impact on  your buying power and therefore on your ability to enjoy a fixed standard  of living as your real purchasing power (amount adjusted for inflation)  decreases over time. The impact of inflation is shown by: New Price (t) = Base Price (1 + inflation rate)t Financial Analysis by Michael R. Büchler 63
  64. 64. The effect of inflation  New Price (t) = Base Price (1 + inflation rate)t 1 0 7  1 0 0 (1  . 0 7 ) 114.49 = 100 1 + .07  For one Year 2 1 2 2 .5 0  1 0 0 (1  .0 7 ) 3 For two Years For Three Years If we assume the inflation rate to be 7% then these three totals will be required to buy the same item in the given periods. Financial Analysis by Michael R. Büchler 64
  65. 65. Cash Flow Management  • A cash flow (CF) is a continuous stream of payments which shifts the equations for FV and PV. For instance you need to choose between purchasing a piece of equipment or leasing it at a monthly rate. • There are many factors that enter into this type of question such as the amount of payment required on the lease, the alternative use of capital for other projects and the ability to make a large down payment. The way this type of problem should be worked is to determine if the present value of the leasing payment cash flow is greater than or less than the current purchase price. • Future cash flows may be discounted to account for the effect of inflation (called discounted cash flow – DCF or cost of money is factored‐in) Financial Analysis by Michael R. Büchler 65
  66. 66. Internal Rate of Return (IRR)  • This is a metric that assesses the value of alternate investment proposals to determine their relative worth to the organization. • When this is set as a minimum acceptable return for a project, then this becomes the “hurdle rate” which must be exceeded if the investment is going to proceed. • The cost of capital (COC) is the after‐tax return rate a business must achieve in order to exceed the capital investment that a company could make in the market at large. • If CFn refers to the cash flow of a Project in the nth year of that project (t = total length), then solving the following equation for r (rate) will provide the IRR: CFn Project Cost =  (1+ r)n n=1 t Financial Analysis by Michael R. Büchler 66
  67. 67. Calculating IRR in Excel  Tool: Excel > Insert > fx Function > Financial > IRR Example:  Calculate the internal rate of return after five years for the following investment project.  The initial  investment requirement is $700,000 and the expected return (net expenses) for the next five years is:  $120,000, $150,000, $180,000, $210,000 and $260,000 (Cash Flow)  Answer: 8.66% = This rate should be compared with cost capital. If its higher than project than project should  be accepeted  Financial Analysis by Michael R. Büchler 67
  68. 68. Present Value (PV)  • Description: the concept of present value (PV) is illustrated by the principal on a loan. Interest (I) is the amount of money that you are charged for the use of the principal. Future Value (FV) is the sum of principal (P) and the amount of interest that is accrued over a period of time. The cumulating value of interest (accrual) is the effect of two factors: Time (t) that money is used and the Rate (r) of interest that is charged. • Instructions:  • Applications:    FV1 = PV (1 + r), for one year at simple interest FVt = PV + PVrt, over time at simple interest) • Compound interest would change to:  FVt = PV(1 + r)t   • Example: What is the monthly payment on a loan of $18,000 which must be paid on a monthly basis over 5 years at a simple interest rate of 8%? [HINT: Payments = FV / N payments]. PV + I = Future Value Money now + Interest = Money later Financial Analysis by Michael R. Büchler 68
  69. 69. Present Value – Example   An individual wishes to determine how much money she would need to put  into her money market account to have $100 one year today if she is earning  5% interest on her account, simple interest. The $100 she would like one year from present day denotes the C1 portion  of the formula, 5% would be r, and the number of periods would simply  be  1. Putting this into the formula, we would have;  When we solve for PV, she would need $95.24 today in order to reach $100  one year from now at a rate of 5% simple interest. Financial Analysis by Michael R. Büchler 69
  70. 70. Future Value (FV)  Future values may be established using one of the following three  formulae, depending on the compounding period (n): FV = PV ( 1 +r)n assuming n compounding periods for 1 year. FV = PV ( 1 + r)nt assuming n compounding periods for t years. FV = PV ert  assuming continuous compounding for t years. (2.71828 raised to (Rate x Time) .07 x 2 = .14)=1.15 100 x 1.15=115  Financial Analysis by Michael R. Büchler 70
  71. 71. Future Value (FV) r  FV  PV  1   n  n 10  .10  FV  100  1   12   10  .10  FV  100 1    108.29  12  Financial Analysis by Michael R. Büchler 71
  72. 72. Future Value (FV)  r   FV  PV 1   n  nt 12 5 .1 0   FV  100 1   12   .1 0 6 0 F V  1 0 0 (1  ) 12 F V  1 0 0  1 .6 5  1 6 5 Financial Analysis by Michael R. Büchler 72
  73. 73. Net Present Value (NPV)  • • Net present value is more complex than IRR in that it requires a rate at  which each payment in the cash flow will be discounted and it depends on  the value used as the discount rate. NPV is the difference between the discounted cash flow for a project at  the selected rate and the cost of the project (initial investment cost).  The  formula is similar to that of IRR, except that you are providing the “r”  rather than solving for it. NPV =  CFn (1 + r ) ‐n • If NPV = 0, then the rate provided was the IRR.  If NPV < 0, then the sum of  the present values of the cash flow is less than the initial investment or  there is a loss on the project.  If NPV > 0, then the sum of the present cash  flows is greater than the IRR and you have made a profit on the project. Financial Analysis by Michael R. Büchler 73
  74. 74. Calculating NPV in Excel Tool: Excel > Insert > fx Function > Financial > NPV Example:  Calculate the net present value of the following investment.  The initial investment requirement  is $10,000 and you are expected to receive an income stream for the following three years of $3,000,  $4,200, and $6,800.  Assume that the annual discount rate is 10% for this period. Answer: $1,188.44 Financial Analysis by Michael R. Büchler 74
  75. 75. Cost of Quality Financial Analysis by Michael R. Büchler 75
  76. 76. Cost of Quality ... „Quality is free. Its not a gift, but it’s free. What costs money are  the unquality things – all the actions that involve not doing jobs  right the first time.“  ‐ Philip Crosby ‐ Financial Analysis by Michael R. Büchler 76
  77. 77. Cost of (Good‐Poor) Quality  The concept of quality goes back to the early 1950’s. It was inroducted in Juran’s Quality Control Handbook to  show cost as function of quality expressed as conformance precentage. Costs quality category can be put in  four diffrent groupings:  Prevention; the cost of all activities specifically designed to prevent poor quality in products or services  Appraisal; the costs associated with measuring, evaluating, or auditing products or services to asssure  conformance to quality standards and performance requirements. Internal failure; costs resulting from products or services not conforming to requirements or customer/user  needs. These occur prior to delivery or shipment of the product, or the furnishing of a service, to the customer. External failure; costs resulting from products or services not conforming to requirements or customers/user  needs. External failure costs occur after delivery or shipment of the product, and during or after the furnishing  of a service, to the customer. We can define the first two categories as the cost of good quality and the last two as cost of poor quality the  sum of all categories are called total quality cost!  Financial Analysis by Michael R. Büchler 77
  78. 78. Be aware of the Hidden Peak ... „I never saw a wreck and never have been wrecked, nor was I  ever in any predicament that threatened to end in disaster.“ ‐ Captain Edward Smith ‐ Financial Analysis by Michael R. Büchler 78
  79. 79. The Tip of the Iceberg!  Rejects Maintenance and service Rework and sorting Opportunity cost if sales greater than plant capacity Improvement program costs Lost customer loyalty Process control Scrap Warranty claims Materials Obsolescence Additional labor hours Quality engineering and  administration Expediting Excess inventory Supplier control Longer cycle times Quality audits Cost to supply chain  Cost to customer  Inspection/test (materials, equipment, labor) Financial Analysis by Michael R. Büchler 79
  80. 80. What should your project achieve? Define Measure Analyze Redesign Modify Design ? Yes No Improve Control Financial Analysis by Michael R. Büchler 80
  81. 81. Account for the Cost of Quality While calculating for cost of quality is straightfoward the execution of calculation may not always be! Hidden  factors are either buried in accounting costs or not consider at all! • • Current accounting system measures: – Scrap – Warranty expense – Inspection cost – Labor overtime Current system does not measure: – Rework – Lost sales – Customer dissatisfaction or reputation loss – Engineering and product development errors – Production downtime  – Bill of materials inaccuracy – Rejected raw materials Total Quality cost  is minimized  when perfect  quality is  achived, hence  drive for zero  defects  Defects found by customers are  the most expensive of all! Financial Analysis by Michael R. Büchler 81
  82. 82. Old theory of quality‐cost trade‐offs: Quality Investments result in diminishing returns where further increases in quality are off‐set by  additional cost of achieving this quality performance.  After this point an economic trade‐off must be  made to achieve additional quality performance by compromising with higher product cost. Cost of Prevention: Cost of Quality: Failure analysis Scrap Rework 100% sorting Re‐inspection Re‐test Warranty Downgrading Allowances Overtime Expediting Inventory Defect Rate Cost of Control Point of Diminishing Economic Returns from Quality Investments Process control Training Inspection Testing Audits Redesign Automation 99% Good = 4  Failures Cost The cost of quality must be defined and presented in the language of the management – money! Financial Analysis by Michael R. Büchler 82
  83. 83. New Model of Optimum Quality Cost  1. 2. 3. 4. Attack on failure costs direct in attempt to  drive them to zero  Invest in „appropriate“ prevention activities to  bring about improvement Reduce appraisal costs according to results  achieved  For further gain coninuously evaluate and  redirect prevention Four premises strategy; • • • • For each oppurtunity there is a root cause  Preventing instead of firefighting  Do it right the first time with zero defects Prevetation can save you alot costs Financial Analysis by Michael R. Büchler 83
  84. 84. Cost impact of a 3 quality performance: Defect Level 5 to 7% of Output Level of Internal Defects Poor quality casts a long cost shadow! Poor Quality Costs 20 to 40% of Cost of Goods Cost of Goods Sold Financial Analysis by Michael R. Büchler 84
  85. 85. This Problem Thrives in Functional Silos! Finance Records Sales Finance Performance Credit Check Engineering  Errors in cost  estimates  Hard to assemble  design  Outmoded  technology  Expensive  components Sales &  Marketing Materials ‐ Procurement  Errors in demand  forecast  Product features  do not meet  expectations Finance Sends Invoice Finance Pays/AP  Inaccurate BOM  Supplier’s  Defects  Excess lead times  Delayed  shipments Manufacturing Distribution  Scrap  Excess/ Obsolete  Rework  Wrong mix   products options  Downtime  Overtime  Excess inventory  Excess Capacity  Excess/Obsolete  Warranty & other  product liabilities  Customer frustration  Defective products Defects exist in and between the functions! Finance Counts Inventory Sales &  Marketing  Customer  frustrations  Defective products  Warranty & other  product liabilities 85
  86. 86. Quality costs are not equal inside goalposts What is the total cost of poor quality to society? Lower Control Limit Mean Upper Control Limit Region of Desired Performance Region of Customer Complaints Region of potential loss to the customer! Region of Customer Complaints Region of Specified Performance Region of Questionable Performance Region of Questionable Performance Lower Specification Limit Target Value Financial Analysis by Michael R. Büchler Upper Specification Limit 86
  87. 87. Value Rules in the Taguchi Loss Function: Nominal‐the‐Best Ao T‐Do Smaller‐is‐Better Larger‐is‐Better Do =  =  = Y Less Defects More Defects Less Defects Ao T Ao Do  T More Defects Y T+Do Ao Do Y Target Cost of Repair or Replacement Functional Limit Financial Analysis by Michael R. Büchler 87
  88. 88. How to increase hidden factory efficiency? What can you do to improve? Reduce all work process variation! Eliminate non‐value added  work! Eliminate Scrap! Good Sigma Level High Classical Yield Calculate rolled throughput yield! Reduce Testing! Work Reduce cycle time and set‐ups! No Does the Customer Detect Defects? Yes Eliminate Rework! But, what is the  COQ? Corrective actions are taken Steward process outcomes Manager’s Theory  ‘O’ = no worries! Look into the ‘hidden factory’ operations! Apply ‘lean thinking’ to your routine work activities! Financial Analysis by Michael R. Büchler 88
  89. 89. New view on quality performance: Quality improvement is achieved not by adding inspectors, who are not very efficient, but by  improving the process to eliminate the root cause(s) of poor quality, so problems are resolved  once‐and‐for‐all, not replicated in the next generation of new products. Defect Rate Cost of Control Emphasis of improvement Cost Failures 3 4 5 6 Financial Analysis by Michael R. Büchler 89
  90. 90. Relationship of COQ and Sigma level: Flawless execution is the least costly way to great results! Cost of Quality Yield (PPM) Long‐Term Sigma 30‐40% revenue 308,537 2 20‐30% revenue 66,807 3 15‐20% revenue 6,210 4 10‐15% revenue 233 5 less than 10% revenue 3.4 6 The goal is not perfection, but flawless execution to competitive level. Customers define the  market‐driven competitive performance level. Financial Analysis by Michael R. Büchler 90
  91. 91. Objectives for managing with COQ: • • • COQ is used to identify Six Sigma projects for improvement and provide a financial measure of  improved performance. Over time, reduction in COQ shows managements commitment to continuous improvement of its  work processes. The goal in managing with COQ is to drive the failure costs to zero; to invest in the most appropriate  prevention activities, and to reduce appraisal costs as permanent process improvement is  implemented and results achieved. One company’s improvement journey: Prevention 15% Appraisal 35% Failure 15% Appraisal 35% Time Failure 50% Total = 17% of sales Prevention 50% Total = 2.5% of sales Financial Analysis by Michael R. Büchler 91
  92. 92. Getting to improved bottom‐line results: “The total cost of quality is unknown and unknowable.”   - W. Edwards Deming ‐ • • • • • • • • • Process control is a pre‐requisite for error‐free quality results. Cost of quality (COQ) increases as s a result of poorly controlled processes. Process control can be measured in terms of yield (PPM and sigma). Therefore, there is a direct correlation between yield (PPM and sigma) measurements and COQ. COQ for an average company typically exceeds 20% of sales revenue. COQ accumulates across the value chain from supplier through production to distribution. In almost every company where the COQ is unknown it is safe to estimate that it exceeds the company’s profit margin! Most improvement programs are not tied directly to bottom‐line results, so gains are sub‐optimized and improvements are not accurately reflected in the company’s accounting statements which only show aggregate results. Activity‐based costing helps illustrate gains better than standard methods. Financial Analysis by Michael R. Büchler 92
  93. 93. Cost Benefits from  Improvements Financial Analysis by Michael R. Büchler 93
  94. 94. Driving for Change and Results “One of the great mistakes is to judge policies and programs by  their intentions rather than their results.” ‐ Milton Friedman ‐ Financial Analysis by Michael R. Büchler 94
  95. 95. Measure Business Performance  Operational Metric; There are many ways to measure your business performance. Here are just a  few measures used by some organizations: • • • • • • Maket share Productivity Customer Satisfaction  Present margin/operating profit Service Quality Business growth • • • • • • Product reliability Defects and scrap Time to market Order‐to‐cash cycle Delivery time Inventory levels Business Metric; A key factor that distinguishes Six Sigma and Lean from previous quality related  efforts is the attention newer methods receive from top‐management. One primary reason is the  conversion of improvement results into „equity“ financial measures;  • Return on net assets (RONA) • • Economic value added (EVA • • Return on investment (ROI) • • Earnings before interest, taxes, deprecation,  • and amortization (EBITDA)  Revenue Earnings per Share (EPS) Profit/earnings ratio (P/E) Return on assets (ROA) Financial Analysis by Michael R. Büchler 95
  96. 96. Summarizing in Finance  There are three ways to summarize financial statements, profit and loss (P&L) statement, balance  sheet and cash flow statement. Lets start with profit and loss statement; A P&L statement shows a company’s outcome for a defined period of time – How much money/revenue a company brought in; – How much it spent/expenses and cost;  – And difference between; revenue ‐ expenses and cost = net income; – Cost of Goods Sold (COGS); – Gross margin / gross profit;  – Research & Development (R&D); – Selling, General and Administartion (SG&A);  – Nonreccuring entries  – Income tax epense  Lets have a look at some of these measure in our next slides. Financial Analysis by Michael R. Büchler 96
  97. 97. Impact of a 10% Price increase: Sales Cost of Good Sold Gross Margin $100 75 $  25 $110 75 $  35 Selling, R&D, Admin Operating Profit 14 $   11 14 $  21 10% 91% A 10% Price Increase Results in a 91% Profit Increase! Financial Analysis by Michael R. Büchler 97
  98. 98. Impact of Reducing Cost of Goods Sales Cost of Goods Sold Gross Margin $100 75 $  25 $ 100 67.5 – 10% $32.5 Selling, R&D, Admin Operating Profit 14 $   11 14 $18.5 + 68% A 10% Reduction in CGS Results in a 68% Profit Increase! Financial Analysis by Michael R. Büchler 98
  99. 99. Impact of Reduced SG&A Costs Sales Cost of Goods Sold Gross Margin $100 75 $  25 $100 75 $  25 Selling, R&D, Admin 14 $  11 12.6 – 10% $ 12.4 + 13% A 10% Reduction in SG&A Results in a 13% Profit Increase! Financial Analysis by Michael R. Büchler 99
  100. 100. Home Run: Improve Sales, CGS, and SG&A Sales (UP) $100 Cost of Goods Sold (DOWN) 75 Gross Margin $  25 $110 + 10% 67.5 $ 42.5 – 10% Selling, R&D, Admin (DOWN) 14 12.6 – 10% Operating Profit $   11 $  29.9 + 272% 10% Improvement in Each Item Results in a 272% Profit Increase! Financial Analysis by Michael R. Büchler 100
  101. 101. Impact of Leverage  Leverage A Equity 50 B Loan 50 Investment  $100 Equity 100 Loan 0 Investment  $100 Investment sold at $110 ; Return on equity:  A Revenue                     110 Total investment      100 $  10 Return on Equity   $10/50= 20% B Revenue 110 Total investment      100 $ 10 Return on equity  $10/100=10% Financial Analysis by Michael R. Büchler 101
  102. 102. The Balance Sheet  A balance‐sheet shows an organizations assets, liabilities, and equity. The balance sheet is split in  two sections assets and liabilities & equities;  The two sides need to be balanced, hence the name  balcnace sheet. The balance sheet shows the value  of a business improving or declining over time.  Financial Analysis by Michael R. Büchler 102
  103. 103. How Improvments Contribute to Financials  Given the financial reports and measures that have been described, Six Sigma and Lean initatives  can contribute to either the P&L statement or the balance sheet! Profit & Loss Statement Balance Sheet Statement Improvment areas: • Revenue & cost; increase revenue and  decrease cost  • Hard savings from bottom‐line or top‐line; Reduction in operation or production costs,  reduction in transaction costs, reduce  headcount and increase throughput  Improvment areas: • Increasing cash or decreasing inventory  and their associated costs • Soft savings; Cashflow improvement, cost and capital  spending, reduce of cash tied up in inventory  or decrease spending of capital, increase  customer satisfaction, increase employee  satisfaction etc.  Cash Flow While hard savings are generally related to the P&L statement soft savings are linked to the balance  sheet, both of them can be link to cash flow. Cash flow indicates how effectively the business is  managing to juggle income and expenses, and its ability to meet its current expenses.  Financial Analysis by Michael R. Büchler 103
  104. 104. Weaknesses in cost accounting: • Cost accounting (standard cost) measures average performance and does not reflect process variation or design capability – it is related to Cpk. In effect, Cpk becomes the target performance for standard cost accounting. • Cost accounting measures the ‘cost of doing’ but not the ‘cost of not doing’ ‐ measures the cost of the in‐line processes, but not the cost of off‐ line or corrective action when the process is not able to operate at targeted performance. • Cpk describes the average cost of the process and does not reflect the ‘best day’s performance’ of the process (Cp). Financial Analysis by Michael R. Büchler 104
  105. 105. Productivity Investment Dilemma! Capability Requirement Common Cause Variation = Building the System! ROI Expected Return Capability Acquired Cp Long-term capital budgeting acquisition decision. Capability Applied Capability Erosion Cpk Process Analysis These decisions are unique and  typically are taken  independently of each other – not a good thing to do. Standard Cost Analysis Capacity Planning Yield Production Efficiency Short-term productivity optimization decision. Financial Analysis by Michael R. Büchler ROCE 105
  106. 106. What is process capability? • Process capability (Cp) is a process performance ratio that is used to describe the ability of a process to meet the expectation of its customers for performance. • Process capability is calculated as the voice of the customer (or the width of tolerance in their agreed‐upon specification) divided by the voice of the process (six standard deviations of design performance variation ). • Process capability is not ‘centered’ around mean performance, and represents an absolute ratio of performance – the best that a process can perform based on its designed capability. Financial Analysis by Michael R. Büchler 106
  107. 107. Process capability & acquisition decision: • When capital acquisitions are made, the choice of alternative is based on the design capability of the system (Cp performance measure) and an expectation is set that this design capability (or nameplate performance – the performance that is advertised for a process) will be delivered in the real world. • Comparison of alternative capital acquisitions is based on an analysis of the design capabilities. • Real‐world performance is always degraded from the design capability – leading to a second indicator of process capability. Financial Analysis by Michael R. Büchler 107
  108. 108. Cpk measures current performance: • Process capability (also indicated as Cpk), is a ratio of performance that is related to Cp – only it is referenced to the closest of the upper or lower specification limits. • Cpk represents shifts in performance degradation from designed Cp value based on observed process performance. • Cpk indicates the performance of a process in routine operation. Note: Cpk provides a short-term estimate for more than a point estimate use either an average Cpk or Ppk to capture the long-term performance loss. Financial Analysis by Michael R. Büchler 108
  109. 109. Capital efficiency ratio: • The capital budgeting analysis was based on the Cp of the design, rather than the Cpk of the operating process. • When daily operations are evaluated the measure used for the capital budget is not reflected in routine work – only average performance of standard cost is used. The difference between average and target is a loss in capital efficiency. • This capital efficiency loss can be used to estimate the potential for improvement in ‘return on capital employed’ based that may be obtained by moving from the Cpk to Cp performance level. Financial Analysis by Michael R. Büchler 109
  110. 110. Delivering Bottom Line Performance: Proce s s Ca pa bility Ana lys is Ta rge t LS L Capital Efficiency = Designed process capability (Cp) US L Within Ove ra ll Achieved Cpk Design Cp Achieved process capability (Cpk) 1.5 2.5 3.5 4.5 5.5 6.5 Capital Effectiveness = Capital Employed X Capital Efficiency Return on Capital Employed (Adjusted) = Financial Analysis by Michael R. Büchler Return Capital Efficiency 110
  111. 111. Drive performance gains in entitlements! The financial impact of process capability loss: • Business invests capital to improve efficiency, effectiveness and economic  performance – driving profitable productivity. • Capital investment must be evaluated using contribution that is made to  business performance (e.g., return on the capital employed (ROCE)). • Capital investments purchase process capability – they buy an expected value  of process performance (variation) as compared to specified or desired  performance (tolerance). • This ratio of variation‐to‐tolerance is an entitlement based on the investment  and is called a process capability index (Cp). • Processes rarely operate at their design ideal and a shift in performance from  this target is typically observed and this is expressed as a different process  capability ratio (Cpk). • The gap between Cp and Cpk represents the improvement opportunity that  available from a specific work process. • The return difference represents a potential financial benefit. Financial Analysis by Michael R. Büchler 111
  112. 112. LSS projects must yield bottom line results! Recognize Strategy Cycle Define Analysis Cycle Measure Analyze Redesign Modify Design Yes Design Cycle No Improve Kaizen Cycle Control Integrate Standardize Financial Analysis by Michael R. Büchler 112
  113. 113. Where is the prize? • The return‐on‐project is not always immediately evident to the  neophyte Black Belt. • It is important to “squeeze” each aspect of the return from every  process nook! • Consider leverage opportunities: where can this process learning be  applied quickly to achieve a gain? • Remember to count the “non Six Sigma” projects that you identified  for the process team to attack. • Count a full year’s benefit as the project return. • Divide the return into non‐recurring and recurring benefit categories to  clearly illustrate the “annuity” effect. • Find the gold in related processes that are disclosed after your  investigation ‐ go for the next best project! Financial Analysis by Michael R. Büchler 113
  114. 114. Reviewing Black Belt projects:  Improve Phase Measure Phase Business Review No Re‐direct Project Management Review No Re‐direct  or re‐ define the project Analyze Phase Control Phase Financial validation of opportunity & formal project review  No Re‐direct or Redefine The BB project Yes Formal Review Executive & financial validation Financial Analysis by Michael R. Büchler 114
  115. 115. How do you spell project success? Defects Down! • The process owner and executive sponsor agree that the Six Sigma  project has delivered the claimed return‐on‐project. • The Black Belt has demonstrated all required tools for their first project  and has identified a second project to pursue. • You feel confident in your ability to take on new challenges! Profits Up! Financial Analysis by Michael R. Büchler 115
  116. 116. Thank you! Any Questions?  Financial Analysis by Michael R. Büchler 116
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