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Cummins Capitalizes On Six Sigma To Minimize Long Term Interest Rate Risk
Cummins Capitalizes On Six Sigma To Minimize Long Term Interest Rate Risk
Cummins Capitalizes On Six Sigma To Minimize Long Term Interest Rate Risk
Cummins Capitalizes On Six Sigma To Minimize Long Term Interest Rate Risk
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Cummins Capitalizes On Six Sigma To Minimize Long Term Interest Rate Risk

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Cummins Capitalizes On Six Sigma To Minimize Long Term Interest Rate Risk

Cummins Capitalizes On Six Sigma To Minimize Long Term Interest Rate Risk

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  • 1. Making the Case for Quality Cummins Capitalizes on Six Sigma to Minimize Long-Term Interest Rate Risk Groundbreaking Use of Six Sigma in Capital Markets by Janet Jacobsen When Cummins Inc. took a leap of faith nearly six years ago in labeling Six Sigma as the process improvement methodology for the company, top leadership meant the entire company, not just the engineering departments and the shop floors where their renowned diesel engines are produced. At Cummins, the scope of Six Sigma extends well beyond typical manufacturing operations—it branches from the legal department to manufacturing to human resources and even to the treasury department, where innovative employees are saving the company millions of dollars by conducting Six Sigma projects to reduce earnings volatility and to lower interest rate expenses. At a Glance . . . About Cummins Inc. Established in 1919, Cummins is a global power leader that designs, manufactures, sells, and services • Cummins Inc., a leading manufacturer of diesel diesel engines and related technology. Cummins serves its customers through a network of 550 engines, utilizes Six Sigma company-owned and independent distributor facilities and 5,000 dealer locations in more than 160 in virtually every facet of its countries and territories. The company enjoyed its most profitable year in 2005, earning $550 million worldwide operations, on sales of nearly $10 billion, due in part to its far-reaching Six Sigma initiative. saving nearly $1 billion in six years. To date, Cummins has: • Employees in Cummins’ • More than 5,000 Six Sigma projects completed, resulting in nearly $1 billion in savings, treasury department, a • 3,700 employees who have taken Six Sigma training, nontraditional area for Six Sigma, have embraced Six • 500 Black Belts, and Sigma, using it to make a • 65 Master Black Belts. recommendation to optimize the company’s Can Six Sigma Improve Treasury Processes? ratio of fixed- to floating- rate debt. The treasury department at Cummins’ Columbus, Indiana, headquarters is divided into two segments: • A Green Belt project cash management and capital markets. Within the capital markets group, three employees serve two employing the DMAIC primary functions: corporate finance and risk management, which include managing the interest rates process resulted in an on the company’s debt. interest rate swap that saves Cummins $1 million Until recently, virtually 100% of Cummins’ debt was at a fixed interest rate rather than a floating rate. annually through a long- Historically, floating-rate debt is less expensive than fixed, so a change to the company’s financial strat- term risk reduction strategy. egy by shifting some of the debt to a floating rate provided a potential opportunity to minimize earnings volatility. The American Society for Quality ■ www.asq.org Page 1 of 4
  • 2. While a few previous attempts were made to “swap” interest DMAIC steps. Once I realized that I didn’t have to use every rates when rates were low, these were short-term tactics con- tool, only those that applied to my project, Six Sigma became ducted with a specific savings goal in mind rather than as a easier,” he notes. longer-term risk reduction strategy—until Cummins sent Craig In addition to process mapping and cause-and-effects matrices, S. Moore, a new employee in the treasury department, to the Moore used the following tools for his groundbreaking Six company’s Six Sigma training program. Sigma project: Moore, now the manager of the capital markets group in the • Failure mode and effects analysis (FMEA) treasury department, was anxious to begin the four, one-week • Multi-vari studies internal Six Sigma training sessions after studying former • Monte Carlo simulation General Electric (GE) CEO Jack Welch’s writings, which FMEA detailed GE’s success with Six Sigma. Early in the train- For an overview of Six Sigma at Moore conducted an FMEA to detect potential obstacles that ing Moore began to envision Cummins, see the case study “Six could develop during the interest rate swap transaction. He using Six Sigma tools to Sigma Saves Nearly $1 Billion, Key reports that one key issue identified during this analysis was the devise a recommendation Customers, and a Company.” possibility of not receiving the desired short-cut accounting treat- on the company’s fixed- to ment: He didn’t want the accounting staff to be required to floating-rate debt ratio. document effectiveness each quarter on this transaction because “Part of our goal tree for our department was to reduce risk, it is such a tedious process. which fits with our company mission to grow profitable, stable By identifying this issue before setting up negotiations with earnings. This (Six Sigma project) was one way for treasury to financial institutions to carry out the transaction, Moore was able contribute to that initiative by reducing risk and helping to to work through this potential obstacle up front and thus save reduce variability in our business results,” Moore explains. time and money down the road. “This was an area where Six Utilizing the DMAIC Process to Reduce Financial Risk Sigma was very useful as we were able to identify key issues and work through them with our accountants ahead of time. We had Moore, with his sponsor, Dean Cantrell, embarked on the everyone on board with the proper accounting before we even Fixed/Floating Strategy Green Belt Six Sigma project in began talking to banks,” notes Moore. December 2004, following the define, measure, analyze, improve, and control (DMAIC) process that is widely used Multi-Vari Analysis throughout Cummins’ worldwide Six Sigma initiative. Moore also ran a regression analysis of Cummins’ earnings to Moore’s ultimate goal was to execute an interest rate swap on interest rate cycles. As shown in Figure 1, a high correlation a company debt instrument (which mirrored a long-term bond existed between earnings and interest rates. He notes that during that was issued by Cummins) utilizing Six Sigma tools. He times of higher earnings the company should theoretically be viewed this rate swap not as merely a savings tool, but rather able to support higher interest rates; and conversely during as a risk-reducing strategy that would become part of slower economic times, the Federal Reserve typically lowers Cummins’ capital framework. interest rates. “What this correlation told us was that it doesn’t His first step was to define the opportunity, which in this case make sense to have 100% fixed rates,” recalls Moore. was finding the right percentage of floating-rate debt for the company’s balance sheet. “No one had ever done that analysis In another multi-vari analysis Moore studied historical interest before to say what is the right percentage. Zero wasn’t correct, rate cycles as depicted in Figure 2. Here the forward curve or the but no one knew the right amount,” Moore recalls. orange line shows where interest rate traders predict that interest rates will stand in two to three years or more. The blue line rep- The measurement phase for this project was a very straightfor- resents actual interest rates under the London Interbank Offer ward process, according to Moore. He merely validated the Rate (LIBOR). As the chart indicates, interest rate traders nor- current interest rate status, which showed that an overwhelming mally overpredict where interest rates will be by approximately majority of the debt was at a fixed rate. This step also included 75 basis points. “If they say interest rates are going to be 6% in reviewing debt on and off the balance sheet to confirm that a the future, it actually is more likely to be 5.25%, so there’s majority of Cummins’ debt was at a fixed interest rate. opportunity there to generate some savings,” says Moore. It was during the analyze and improve stages that Moore, a Monte Carlo Simulation finance expert who was new to quality tools before joining Cummins, was ultimately able to use some of the tools he’d stud- The multi-vari studies determined a strong rationale for having a ied during his belt training. “I finally realized that I didn’t have floating-rate debt, but the next obvious question was, How much to use all of the tools in the Six Sigma bag; the objective was the floating-rate debt should Cummins have on the balance sheet? The American Society for Quality ■ www.asq.org Page 2 of 4
  • 3. Figure 2 Historical Floating/Forward Rate Analysis Thus a Monte Carlo simulation was conducted with hundreds of different interest rate scenarios to chart interest expenses on a Historical Forward 3m London Interbank Offer Rates “y” axis and volatility on an “x” axis. 11.0% This analysis determined the optimal fixed- to floating-rate ratio 10.0% for Cummins by creating an efficient frontier curve as shown in 3m forward curve (orange lines) Figure 3. “On this curve, you minimize the average volatility and 9.0% your interest rate expense when you are roughly between a 30% to 40% floating rate. This is how we were able to determine the 8.0% right percentage for Cummins,” explains Moore. 7.0% Of course the final step in the DMAIC process focuses on con- Yield 6.0% trolling or sustaining the gains that were achieved. Moore says 5.0% that he was able to put a control plan in place by looking back at the results of the FMEA. Cummins was extraordinarily prepared 4.0% before negotiating with banks and was quite specific about how 3.0% it wanted to complete the deal because the potential failures were 3m LIBOR spot (blue line) addressed in detail ahead of time. 2.0% The long-term control plan now involves a quarterly review of 1.0% Jan-88 Oct-91 Jul-95 Apr-99 Jan-03 Oct-06 Jul-10 the balance sheet to review the fixed- to floating-rate ratio and ensure that Cummins’ finances remain in the target range as The forward curve generally overpredicts where London Interbank Offer Rate (LIBOR) determined by the analysis for this project. actually sets interest rates. Figure 1 Cummins’ Earnings Before Interest/Interest Rate Correlation Figure 3 Fixed/Floating Rates Achieve Risk Diversification Earnings Before Interest (EBIT) Versus London Interbank Offer Rate (LIBOR) One-year LIBOR (bps) EBIT (USD mm) The efficient frontier demonstrates that combining fixed and floating LIBOR EBIT 1,000 600 debt can reduce interest expense volatility as well as cost. Financial year end 400 • The fixed-floating “efficient frontier” is a graphical representation of 500 200 the tradeoff between the interest expense and volatility of a mixed 0 0 portfolio of fixed- and floating-rate debt. 1992 1993 1994 1995 1996 1998 1999 2000 2001 2002 2003 1997 • A portfolio of 100% fixed-rate debt has the highest cost, while a portfolio of 100% floating-rate debt has the lowest cost and highest volatility. Observations • However, the relationship is not straight-line, as overall volatility is • Cummins’ earnings before interest (EBIT) versus interest rates: reduced by combining two instruments that are not perfectly correlated. • EBIT and average one-year London Interbank Offer Rate (LIBOR) • The tradeoff between fixed and floating is therefore one of interest have shown a positive correlation over the past business cycle. cost versus interest expense certainty. • 1992–2003: r2 = 0.84 Change in EBIT Versus % Change in LIBOR 7.5% 100% Fixed Current portfolio Annual percentage change 7.3% 100% 80% % change in LIBOR Change in EBIT 0% 60% 10% in one year LIBOR 7.1% Target portfolio Financial year end 50% 20% 40% EBIT change 6.9% 20% 30% Interest expense 0% Minimum risk: 0% 40% 6.7% 40% floating (20)% (50)% 50% (40)% 6.5% 60% (60)% (100)% 6.3% 70% *based on lognormal changes (80)% (150)% Higher (100)% 80% 6.1% 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 cost 90% 5.9% 100% 5.7% Higher risk Observations 100% Floating 5.5% • Cummins’ change in EBIT versus change in interest rates: 4% 6% 8% 10% 12% 14% 16% 18% 20% • LIBOR levels have been very low compared with the historical trends Average volatility since 1992. • Correlation between annual percentage change in interest rates and EBIT: Rates since 1968: U.S. 3m T-Bills vs. 10-year bonds. • 1992–2003: r2 = 0.48 Assumes 10% of portfolio is refinanced every year. The American Society for Quality ■ www.asq.org Page 3 of 4
  • 4. Rate Swap Saves Money, Reduces Risk Contributing to This Article Craig S. Moore is manager of the capital markets group in Once the project received approval from the Cummins’ board of Cummins’ treasury department. A certified treasury professional, directors in spring 2005, financial market conditions were such Moore earned his MBA from DePaul University. Moore is a Six that a brief hold was placed on the execution of the interest rate Sigma Green Belt and has participated in 11 Six Sigma projects swap until the market shifted back to a desired point. Ultimately at Cummins in his two years with the company. the rate swap was completed in late 2005, shifting approximately 30% of Cummins debt to a floating rate of interest. About the Author According to Moore, the company will save an average of more Janet Jacobsen is a freelance writer specializing in quality and than $1 million per year until the debt instrument’s maturity date. compliance topics. A graduate of Drake University, she resides He calculates this savings based on the average interest rate in the in Cedar Rapids, Iowa. last 15 years versus the Cummins’ interest rate for this transaction. Moore says that these results met company expectations and accomplished the project’s goals. “The results were substantial and one of the best things to come out of this was a risk-reducing strategy, which fits within our overall mission,” he notes. Jump Start for Future Projects Moore credits the fixed/floating rate project for putting a positive spin on Six Sigma in a nontraditional setting. “It broke through the mental barrier people have in thinking Six Sigma is only for manufacturing and doesn’t apply to nonmanufacturing roles like treasury,” he says. Now on his sixth Green Belt project, Moore sees growing acceptance for Six Sigma in the finance area. He reports that the cash operations area has really taken Six Sigma to the next level and they have a hopper of Six Sigma projects with at least 16 potential ideas. “We’ve really adopted Six Sigma and it is now a part of the DNA of the treasury department. Once we successfully com- pleted the first project, people then realized how it could apply to them and improve decision making in addition to building stronger processes and controls,” states Moore. For More Information • To learn more about Cummins’ groundbreaking fixed/floating interest rate Six Sigma project, contact Green Belt Craig Moore via e-mail at craig.s.moore@cummins.com. • For more information about Cummins Inc., visit the com- pany’s Web site at www.cummins.com. • Read the companion case studies to this piece: • Six Sigma Saves Nearly $1 Billion, Key Customers, and a Company • Cummins Six Sigma Project Results in a Smoother Ride for Dodge Ram Pickup The American Society for Quality ■ www.asq.org Page 4 of 4

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