1. Under supervision of Dr. Sadeghi
By:
Ali Bayani
Ali Heydari
Elnaz mahmoodi
Kooshan Gholami
Spring 2011

2. Financial Tools
Three tools for Economic Justification:
Cost Estimating
Economic Measures
Of Merit
Setting Project Priorities

3. Financial Tools
Cost Estimating:
Materials
Labor
Utilities
Maintenance
Plant overheads
Depreciation, taxes, and insurance
General and administrative

4. Financial Tools
Materials:
The equation for estimating material is material price times
quantity produced (units) divided by yield:
Price * (units/yield)

5. Financial Tools
Case Study: Total Materials Used
Improvement Probe
Probe sells 600$
Calculate
material costs

6. Financial Tools
Case Study: Total Materials Used
So they set a target for improvement Probe’s materials

7. Financial Tools
Labor:
1) Total number of people directly working on the
product
2) Average wage rate

8. Financial Tools
Labor cost:
Vacation factor: 1.11
(Hours per year – vacation/holiday = Total hours worked)
Relief factor = 1.23
Benefits factor = 1.3
Supervision factor = 1.3

9. Financial Tools
Annual labors cost:
Number of operation * $ wages rate *
2080*(1.11*1.23*1.3*1.3)

10. Financial Tools
Case Study: Estimating Labor to
Produce Scanning Instruments
Analyze two suppliers
Calculate the labor cost

11. Financial Tools
Case Study: Estimating Labor to Produce Scanning Instruments
The labor costs for the scanning machines were considerable.
Of its $5,400 price tag, Supplier A’s labor costs were $2,184
per unit ($436,800 divided by 200 instruments).
Supplier B was indeed more automated so Mark was a little
puzzled at this point as to why its price was $5,150 when its
labor costs were only $1,613 per unit ($322,560 divided by
200 instruments).
Because of his efforts, he was able to secure a quote
for the 200 instruments from Supplier B at a cost of
$4,650.

12. Financial Tools
Utilities:
Include all the power associated with running the equipment
used to produced the product.
Annual utilities costs
are 2 percent of
investment

13. Financial Tools
Utilities:
We must estimate not only what it would cost to buy the equipment new, but
multiply it by three to include installation, project management, and facilities
associated with getting the equipment ready to run.
Utilities = Total investment (TI) × .02

14. Financial Tools
Maintenance:
Maintenance includes both labor and materials to keep the process
that is making the product or service, such as a mainframe computer,
maintained and producing in an efficient manner. The estimate of
annual maintenance cost is calculated at 6 percent of the total
investment.
Maintenance = .06 × total investment

15. Financial Tools
Plant Overheads:
General plant burden
 Overtime
 Plant administration (management and staff)
 Employee relations
 Medical
 Fire and plant protection
 Internal transportation (shipping and receiving)
 Carrying and acquisition costs
 Communications
 Computers and telephone systems
 Engineering assistance to operations
Grounds upkeep
 Cafeteria

16. Financial Tools
Plant Overheads:
The problem with assigning or allocating overhead costs to a
product or service when there is more than one product or service
produced at a given location is defining the costs to be distributed
correctly. A good formula for estimating for overheads is .75 times
labor:
Overhead = .75 × labor

17. Financial Tools
Depreciation, Taxes, and Insurance:
Depreciation is one of the most misunderstood concepts associated with
cost sheet and cash flow analysis. Depreciation is an accounting element, a
noncash cost in total costs. Basically it is an investment incentive that the
government gives to corporations to encourage them to continue to invest.
Investment depreciation = 10% × total capital investment

18. Financial Tools
Depreciation, Taxes, and Insurance:
To this calculation add property taxes and insurance on the facility at
1 percent and the final equation will be:
Depreciation, taxes, and insurance =
11% × total investment

19. Financial Tools
General and Administrative Costs:
Selling expenses (personal selling expenses such as travel, salaries,
commissions, sales office rental, service, advertising, promotions, and
other marketing functions)
 Executive compensation
 Staff departments
 Legal
 Finance
 Purchasing

20. Financial Tools
General and Administrative Costs:
 Accounting
Central engineering
 Office space
 Insurance
 Property taxes
 Clerical
General and administrative expenses =
15% × total expenses

21. Economic Measures of Merit
• net present value (NPV)
• discounted payback period (DPP)
• Internal rate of return (IRR)

22. NPV

23. Performing a Cash Flow Analysis
• Step 1: Estimate the cash flow streams produced by the
project for 10 years.
• Step 2: Discount the streams by the cost of capital, so that all
streams are in today’s dollars.
• Step 3: Cumulate the discounted cash flow streams and plot.

24. Step 1: Estimate the Cash Flow
Streams.
Revenue
-cash expenses
-depreciation
=Before Tax Operating Income
- taxes
= Net Income
+ depreciation
- capital investment
= Year-End Cash Flow

25. Step 1: Estimate the Cash Flow
Streams.

26. Step 2: Discount the Streams by the Cost of Capital
• Next year:

28. Step 2: Discount the Streams by the Cost of Capital
• Weighted Average cost of capital
Equity 15% × 2/3 = 10%
Debt 7% × 1/3 = 2%
Weighted average cost of capital = 12%

29. Step 3: Cumulate the Discounted
Cash Flow Streams and Plot.

30. Step 3: Cumulate the Discounted
Cash Flow Streams and Plot.

31. Setting Project Priorities

32. Case study
• Company XYZ has $800,000 in its capital forecast for next year and
must prioritize from the projects shown below

33. Case study

34. LIFE CYCLE ECONOMIC
• A quest for a comprehensive life cycle economic model has been
launched
• Classical manufacturing cost models, cost and management
accounting models, and microeconomic models are not adequate
• A comprehensive life cycle economic model is needed for
evaluation of the costs of 'doing' and 'not doing' the right things
to make products and processes environmentally safe.

35. LIFE CYCLE ECONOMIC
• The pace of product and process innovation in the intensely
competitive world market is accelerating
• Everyone has realized that bringing products rapidly to
market by listening to the voice of the customer
• by deploying concurrent (or simultaneous) engineering can
be accomplished only if all issues including economics are
considered up front before the first production run is made

36. CLASSICAL COST MODELS
Taylor's Cost Model
• Metal cutting economics began with the introduction of the now
classical Taylor time and cost models:
Cutting time per cut, tt = (ts + tc + td) = ts + Ic/V + (lc/VT)td (1)
Cost per cut, cc = ts Cr+ lc Cr/V+ (lc/VT)td Cr + (Ic/VT)Y (2)
Taylor tool life equation: logT = a constant - m 1ogV (3)
• By differentiating equations (1 ) and (2) with respect to V and
substituting the value of T from equation (3), Taylor obtained
optimum speeds for minimum cutting time and minimum cost

37. CLASSICAL COST MODELS
Traditional Accounting cost model
• who introduced 'Scientific Management' that the efficiency and
utilization of labor, material and equipment began to be measured
against 'one best way of doing work’:
Total Cost= Fixed Cost + Variable Cost
Fixed Cost=Overhead; Variable Cost=Material Cost + Labor Cost
Microeconomics of Firm
• The classical microeconomic concepts deal with the theory of firm in
pursuit of maximizing its profits and the theory of consumer behavior
during maximization of satisfaction
• Although the classical microeconomic theory provides a much needed
firm foundation, cost models have not resulted from the theory because
it is difficult to establish a production function in practice.

38. RECENT DEVELOPMENTS
Macro- and Micro- economic Models
• The Taylor tool life relationship and its subsequent
refinements mentioned above treated speed or feed or
depth of cut one variable at a time during the
determination of the time and cost optima.
• variables simultaneously leading to a truer optima for
machining tinie and cost; this culminated in the form of
cutting Rate-Tool Life-Functions (R-T-F) which describe
the basic trade-off between tool life and cutting rate and
consequently, machining time and cost.

39. Economic Models for New Process
Development
• Traditionally, the economics of new process development
is investigated only after the technological feasibility of
the process has been established and in most cases.
• The introduction of the conditions for economic
feasibility of a process provided a measure of how much
improvement is necessary and sufficient to justify
investment in the new process and the desirable working
regions where the process should prove economically
feasible, while the technological feasibility is being
established.

40. The necessary condition of economic
feasibility
• states that the cost savings and the value of time
savings by switching to the new process should
be greater than zero.
Δ cc+ Δ tc(oc) > 0
where tc = [(Vr) + (v+va)/R + (v/RT)td
cc = [(l/r) + (v+va)/R + (v/RT)td]Cr + (v/RT)Y
Δ tC=tC-td ; Δ ==cc-cd
tc=time per cut (oc)=opponunity cost (money/hour)
cc=cost per cut (money/cut) l=rapid traverse distance Y=tool cost per usage (money/usage); Cs
V=cutting speed (distance/time); v D=depth of cut (AD=Axial; RD=Radial); a. R=cutting rate (volume/time); CIRP equi., 2
td=tool indedchange time (time); Is..

41. The necessary condition of economic
feasibility
• The time saved at a processing unit can be utilized for processing additional parts
of the same kind or of a different kind, and hence, the opportunity cost (oc) of
time savings is recognize by valuing these savings at the rate it costs to farm out
work done by the machine.
• The above equations apply to the individual cut or a sequence of cuts within a
single setup on a machine tool, and, hence, these equations are called micro-economic
models.

42. The necessary condition of economic
feasibility
• Since a corporation exists in a competitive environment, the
frame work for a life cycle economic model must start from the
competitive strategy that a corporation must employ.
• Often employed successful strategy emphasizes capturing a
desired portion of the market share by the timely introduction
of a product with features and quality desired by the potential
users at a competitive price.

43. COST AND SHARE
• A target cost is determined by subtracting the desired profit
from the competitive price.
• By concurrently designing the products, processes, and
systems that can be continually improved, the actual cost is
brought closer and closer to the target cost.
• Many Japanese companies are known to sacrifice initial
profitability to gain the desired portion of the market share
and subsequently harvest profits as volume increases with the
increase in market share.

44. RISK AND OPPORTUNITY COST
• On the other hand, the actual cost of the product must
include not only the cost of materials, labor, consumables,
and all support functions, but also, the potential penalty costs
resulting from the environmental risks while the product is
being manufactured, stored, in use, disposed or recycled.
• There are also potential opportunity costs, which allow
advantageous positions to be secured by timely competitive
actions, including environmental and ecological
responsiveness, which must be recognized.

45. LIFE CYCLE ECONOMIC MODEL
• Therefore, the life cycle economic model must take the
following form:
(Actual Costs + Penalty Costs - Opportunity Costs) ≥ Target Cost
• Implicit in the costs is the question of timing. Timing can be
deployed only if the strategies are correctly formulated, the
necessary resources deployed, and the logistics executed so
as to achieve competitive introduction of the product:
(Actual Time-to-Market + Penalty Lags - Opportunity Leads) ≥ Target Timing

46. HINTS
• It is well known that over 80% of the costs of a
product are committed before a first production run
is made.
• The opportunities for influencing the costs are few
once the production begins.
• The more successful the concurrent engineering
process is the larger the portion of costs that will be
committed prior to the production run.

47. Economic Justification of
Advanced Manufacturing
Technology

48. Advanced Manufacturing
Technology(AMT)
Technologies for increasing competitiveness of manufacturing
firms.

49. Justification of AMT

50. AMT Justification
Organizational
decision making
analysis
Justification of the
proposal
Economic
analysis
Strategic
analysis

51. Framework for the financial justification of AMT
Level Ι
DCF analysis with refinements NPV=V1
Level ΙΙ
Value of flexibilities mathematical
programming models PV=V2
Level ΙΙΙ
Value of time series linkages learning
curve models PV=V3
Level ΙV
Residual strategic benefits qualitative
analysis
V1≥0
Gap G1=V1
V2≥G2
Gap G2=G1-V2
V3≥G2
Gap G3=G2-V3
Benefits <G3 Benefits ≥G3
Economically not OK Economically justified

52. Level 1
Analyze the easily quantifiable costs and costs using the
traditional discounted cash flow(DCF) models.
Examine the limitations of the traditional DCF analysis and
discuss some refinements.

53. Mechanics of the DCF analysis
Assumption of the status quo of the current cash flows
Terminal Value of the project
Treatment of inflation

54. Level 2
a stochastic mathematical programming model to quantify the
strategic benefits such as flexibility and quality
Analysis at Level2 becomes necessary if the Level1 analysis
results in a negative NPV.

55. Level 3
Quantify the benefits of the time series linkages between the
project currently being justified and a related future project
using a learning curve model

56. Level 4
A qualitative assessment of the benefits which were not
included in the evaluation at the first three levels.