financial analysis towards lean & six sigma

Financial Analysis towards Lean & Six Sigma

By Michael R. Buechler

1

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

What is Finance?

We can define a moderd finance group as managing a firm’s long‐term and day‐to‐day monetaryoperations 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. Thefinance group is responsible for incoming and outgoing payments, budgeting, planning andanalysis, asset management (fixed & liquid), tax management, general accounting, and treasurymanagement. Some finance groups may also be responsible for payrole (HR Function), internalaudit and compliance, risk management and travel/expense administration, in many cases thesefunctions are outsourced (internal & external).

History; Finance in its modern form really dates from the 1950s. The hugh body of research infinance over the last sixthy years falls naturally into two main streams. And no, we don’t meanhere „asset pricing“ and „corperate finance“ moreover we can call them business schoolapproach to finance and the economics department approach. This is purely a „notional“statement, not physical – based on faculties field rather than its location.


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 mathematicsinto any branch of the moral sciences. Most persons appear to hold that the physical sciences formthe proper sphere of mathematical method, and that the moral sciences demand some othermethod—I know not what.“


Classical Dictum of Economics

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.

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)


Unreliable Estimates Trough Computional Algorithm

„For the variances and covariance's, at least, past data probably could provide at least a reasonable starting point. The precision ofsuch 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 reliableestimates of return expected in the future. And running those unreliable estimates of the means through the computationalalgorithm 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 forinvestment when the firm can finance the project either with debt or equity or some combination of both. The macro normativeor economies wing sought to express the aggregate demand for investment by corporations as function of the cost of capital thatfirms 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 capitalmarkets – what equilibrium looks like, and this is way neither the efficient markets hypothesis nor the M&M proposition haveever set well with those in the profession who see finance as essentially a branch of management science.“

Merton H. Miller (May 16, 1923 – June 3, 2000)American economist

Co‐author of the Modigliani–Miller theorem (1958)The Theory of Finance (1972)


Markovitz Mean‐Variance Model

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!

Harry M. Markovitz (August 24, 1927‐ ) American economist

Harry Markowitz Model (1952) "Portfolio Selection". The Journal of Finance (March 1952)

The business school or micro nomative stream in finance;


Capital Asset Pricing Model

„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. Theother 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!“

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)

Transforming the Markowitz business model into an economics department model


Fischer Black

„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.“

Myron S. Scholes (July 1, 1941 ‐ )Canadian‐born American financial economist

Fischer‐Black Formula 1997(Black–Scholes model)

Robert C. Merton (31 July, 1944 ‐ )American economist

Fischer‐Black Formula 1997(Black‐Scholes‐Merton formula)


Managing for Finance

... a taste of more to come


Instinctive Identification for Todays Finance Professionals

„The common perception of risk even today focuses on thelikelihood of losses – on what the public thinks of as the„downside“ risk – not just on the variability of returns.“

‐Merton H. Miller‐


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:

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 bydifferent 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).

EBIT = Revenue ‐ COGS ‐ Operating Expenses ‐ Depreciation & Amortization


Economic ProfitEconomic 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)


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.


Managing for Accounting


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 ‐


Introduction to Financial Accounting

• Financial accountancy (or financial accounting) is the field of accountancyconcerned with the preparation of financial statements for decision makers, suchas stockholders, suppliers, banks, employees, government agencies, owners andother stakeholders.

• Financial capital maintenance can be measured in either nominal monetary unitsor units of constant purchasing power. The central need for financial accounting isto reduce the various principal‐agent problems, by measuring and monitoring theagents’ performance and thereafter reporting the results to interested users.

• In short, financial accounting is the process of summarising financial data, which istaken from an organisation’s accounting records and publishing it in the form ofannual or quarterly reports, for the benefit of people outside the organisation.Financial accountancy is governed not only by local standards but also byinternational accounting standard.


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 CommitteeARC, 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 betreated objectively and not shadowed by personal opinion.

Cost principle: The information contained in financial statements requires it to be based on costsincurred in business transactions.

Going‐concern principle: The business will continue operating and will not close but will realise assetsand discharge liabilities in the normal course of operations


Benefits of Financial Accounting

• Meeting legal requirements: accounting helps to comply with the various legal requirements. It is mandatory forjoint stock companies to prepare and present their accounts in a prescribed form. Various returns such as incometax, 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 anydispute regarding ownership title of any property or assets of the business. It also helps prevent unwarranted andunjustified 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. Managerialdecisions based on facts and figures take the organisation to heights of success. An effective price policy, satisfiedwage structure, collective bargaining decisions, competing with rivals, advertisement and sales promotion policyetc.. all owe it to well set accounting structure. Accounting provides the necessary database on which a range ofalternatives 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 aconcrete form to convey information to others. This economic information derived from financial statements andvarious reports is intended to be used by different groups who are directly or indirectly involved or associated withthe business enterprise.


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 thebusiness like the competition in the market, forex trades etc. Some of following limitations of financial accounting haveled to the development of active based costing accounting:

• Unclear operating efficiency: financial accounting will not give you a clear picture of operating efficiency whenprices 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 notindicate profit or loss of each department, job, process or contract. It does not disclose the exact cause ofinefficiency i.e. it does not tell where the oppurtunity is because it discloses the net profit of all the businessactivities. Furthermore, loss or less profit disclosed by its profit and loss accounts is a signal of imbalancedbusinesses, 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. Asfinancial data is summarised at the end of the accounting period it does not provide day‐to‐day cost informationfor 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, idletime, idle plant and equipment. In other words, no distinction is made between avoidable and unavoidablewastage.


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 ReportingStandards (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 basicprinciples as advocated by all GAAP rules. These principles include consistency, relevance, reliabilityand comparability.

• Generally Accepted Accounting Principles (GAAP) ensures that all companies are on a level playingfield 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 thatare similar in purpose, although not always in design.

• IFRS are International Financial Reporting Standards, which are issued by the InternationalAccounting Standards Board (IASB), a committee compromising of 14 members, from nine differentcountries, which work together to develop global accounting standards. The aim of this committeeis to build universal standards that are translucent, enforceable, logical, and of high quality. Nearly100 countries make use of IFRS. These countries include the European Union, Australia and SouthAfrica. While some countries require all companies to stick to IFRS, others merely try to synchronizetheir own country’s standards to be similar.


Active Based Costing

Activity‐based costing records the costs that traditional cost accounting does not do!

Do we count all our activities during our business transactions?

In contrast to traditional cost accounting systems, ABC systemsfirst 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 appropriateprocess output measures of activities and resources, their effectson the costs of making a product or providing a service.

Traditional cost accounting systems often allocate costs based onsingle‐volume measures. Using single‐volume measures seldommeets the cause and effect criterion desired in cost allocations.

ABC system have the flexibility to provide special reportsfacilitating management decision making towards costs ofactivities undertaken to design, produce, sell and deliver acompany’s products or services.


Implementation of ABC

1. Identify and define activities and

activity pools

2. Directly trace costs to activities (to the extent feasible)

3. Assign costs to activity pools

4. Calculate activity rates

5. Assign cost to cost objects using the activity rates and activity measure previously determined

6. Prepare and distribute

management reports

According to Ray H. Garrison and Eric W. Noreen there are six basic steps required to implement an ABC system:

Managerial Accounting, 9th Edition by Ray H. Garrison, Eric W. Noreen and E.W. Noreen (1999)


“Hold everybody accountable? Ridiculous!”‐W. Edwards Deming ‐

Accountable for Financial Accounting ...


Balanced Scorecard


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 ‐


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.


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.“

J.M. Juran Quality Control Handbook 1979

• Quality costs depend on incremental, nottotal, elementary costs. At the optimum,nothing in general can be said about therelative levels of prevention and failurecosts.


Optimum Quality Level

The zone of perfectionism is what most troubles proponents of zero defects, for here Juran suggests relaxingprevention efforts and allowing increased defect rates. Furthermore, he identifies the boundary of the zone ofperfectionism as lying typically , at the quality level where failure costs amount to 40 % of the total cost. Translatingthe 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 theoptimum occurs at q < 100%. There may be nooptimum in the range of q = 0 to 100%. Theremight be a minimum rather than an optimum,and it could very well be at q = 100%.


Never‐ending Eliminating Waste ‐Muda

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.

Schneidermann, Quality Progress (1986)


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.


Assemble Problem Solving

Continiual problem solving shows the PDCA cycle asdiffrent points along the clock face. This formulationemphasized that a quality program is not something anorganization does for a year or two to correct someproblems and then moves on to something else. Rather,the QIP emodied a continual problem‐solvingcommitment in which the half‐life method served as thespeedometer for measuring how fast the organization wastraveling around the PDCA cycle.


The 7 Steps


The Half‐life


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


Evolution of the First Balanced Scorecard: 1991


Kaplan & Norton’s Balance Scorecard

Kaplan and Norton recognized that any comprehensive measurement and management system had to link operational performanceimprovements to customer and financial performance. Kaplan & Nortons BSC, while incorporating Analog’s operational improvementmetrics, also incorporated metrics for innovation, employee capabilities, technology, organizational learning, and customer success. Andunlike the stakeholder perspective, Kaplan & Norten placez shareholder value as the highest‐level metric, with all the other stakeholdersreflected in how they contributed to the company’s success in maximizing long‐term shareholder value.

Kaplan & Norton's writing on the subject in the late 1990s:

1. Translating the vision into operational goals;2. Communicating the vision and link it to individual performance;3. Business planning; index setting4. Feedback and learning, and adjusting the strategy accordingly.

Kaplan development of the Balance Scorecard 2010:

1. Balanced Scorecard for Performance Measurement2. Strategic Ojectives and Strategy Maps 3. The Strategy Management4. Future Opportunities

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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.

Robert S. Kaplan HBS 2001 No. B0101C

EVA corrects both the over‐invested and the under‐invested problem by subtracting cost of capital from thenet 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 complementaryprocesses. The BSC /shareholder expands value approachby defining drivers of revenue growth; objectives andmeasures for customers, customer value proposition,internal business process for innovation and customerrelationships, needed infrastructure investments inpeople, systems and organizational alignment.


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 driverslink expenses of resources supplied to activitiesand processes performed (GL).

Assigning resources expences to activity andprocess cost provides the first link between ABCand the BSC

Three parameters – cost, quality and time –usually define the performance of any process

Quality and time are realatively easy to measureas they are based on physical measurement. Costhowever, is an analytic construct, not somethingtangible that can be measured by manual force

Only an ABC model can accurately traceorganizational expenses to a manufacturing,distribution, service delivery or processdevelopment.

Robert S. Kaplan HBS 2001 No. B0101C


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?


Supply Chain and Finance


Financing the Chain

"In investing, what is comfortable is rarely profitable." ‐ Robert Arnott ‐


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 anintermediary tool that links buyers, sellers and third‐party financing entities – thereby reducing supplychain risks/costs and strengthening business relationships.

• Simply shifting the burden from one party to another can add significant risk to the supply chainincluding customer loss, business continuity risk, supplier viability risk, material cost inflation,deterioration support, and other issues. Supply chain finance provides an opportunity to collaborate andcreate benefits for each side of the transaction.

• In favour to buyers using superior credit rating to lower overall financing costs within the supply chainby reducing risk for the supplier in return for an extension of credit terms, thereby enhancing the buyer’sworking capital position.

• SCF potentially fits best in situations the buyer has access to capital at a lower cost than seller and/orwhere the buyer has a significant time gap between inventory purchases and cash receipts from sales.


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.


Shouldn’t all suppliers be squeezed?Reason why SCF is needed

A comparison of accounting data of industrializednations shows that median accounts receivableranged from 14% to 33% of sales in 2006.

Trade across industries*

„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 Credit Strategies Options how to pay Outstandings

Three trade credit strategies

1. Win‐win2. Follow3. SqueezeDepth interviews (Seifert, Springer Volume 10, 2011) indicate that roughly two‐thirds of companies still apply a single trade credit strategy;


Trade Credit Strategies


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


Traditional Factoring

Buyer Portfolio

Supplier

Bank, Factoring Company1

23

4

First, suppliers sells goods to buyer with accounts payment e.g. 14days. Second, buyers accepts goodshowever squeezes accounts receivable to e.g. 45 days (The big player approach) Third, supplier has 31days neededs to be finance either by equity or loan, e.g. from bank or factoring company. Fourth, bankor factoring company will check buyers credit‐rating and lend the outstanding payment to supplierwith equivalent interest. This approach is time intensive, expensive and has a negative impact on thewhole supply chain finance for all parties.

Financial Analysis by Michael R. Büchler

Example case

49

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.


Break‐Even‐Time


Break‐Even‐Time

„You cannot manage what you cannot measure. What gets measured gets done!“

‐ Bill Hewlett ‐


Are we Fit for its Purpose

Companies lose an extentual amount of money after tax when the deliever late and on overspend ondeveloping new products. More and more manifactures are learning that the time required to develop a newproduct 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 shortendevelopment cycles is through the collaborative work of cross‐functional development teams. Commonlanguage 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 thetechnology available to develop the features? Will the product be manufacturable at the desired price. Weneed to measure on what we are doing what we agree must be done! A metric which would encouragecollabration among different function.

Hewlett‐Packard is using a metric called „Return Map.“ The map includes the critical elements of productdevelopment – the investment in product development and the return or profits from that investment. Themap 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 focusfrom „who is responsible“ to „what needs to get done!“ Even more important is to estimate and re‐estimatethe time and money it will take to complete the overall project success!


To be on the Spot of the Market

The Return Map is intended to beused by all functional managersand business team.

Basicially it is a two demensionalgraph displaying time and moneyon the x and y axes respectively.

The x axis is divided into threesegments – Investigation,Development and Manufacturing& Sales.

Purpose of investigation is todetermine the desired productfeatures, the products cost andprize the feasability of thepurpose technolodgieas and the,plan for product development andintroduction.


The Tean Plotes Estimates Basic Elements

Investment Line; total productdevelopment effort from beginning tomanufacturing and sales release.

Sales Line; Sales volume over a giventime.

Profit Line; volume of sales and theprice of product in market place.

The critical lines are are systematicallyplotted on the Return Map include newproduc investement equity, sales equityand profit equity. Each of these areplotted by money and time.


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 ofinvestigation until product profits equalthe investment in development.

Time‐to‐Market (TM), is the totaldevelopment time from start ofManafacturing phase to ManufacturingRelease.

Break‐Even‐After‐Release (BEAR), is thetime from Manufacturing Release untilinvestment cost are recovered in productprofit.

Return Factor (RF), is a calculation ofprofit equity divided by investment equityat a specific point in time after a producthas moved into manufacturing and sales


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.


Forcasting Financial Performance


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 ‐


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. What is the purpose of the forcast – how is it be used?2. What are the dynamics and componenets of the system for which the forcast will be made? 3. 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 bein a position to choose a method!


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 firstintroduced into a market. Use of human judgmenet and rating schemes to turn qualitative information intoquantitative estimates.

Time series analysis; these are statistical techniques used when several years’ data for a product or product lineare 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 outexplicity 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 ‐


What People Want ... And How to Predict It

„Consumers began to come to fruition in the late 1990s, when Amazon.com Inc pioneered the widespreadcommercial use of predictions with collaborative filtering.“ This software made recommadations and makingcorrelations with other products that he or she might like!

Predictions of what products will be successful for creators and distributors of cultural content are lesscommon. It is easist after the product has developt, when its attributes are clear and there are some indicatorsof its popularity. Using regression anlysis will give primary predictions e.g. on how many dvd copies need to beproduced.

Consider the dilemma faced by consumer trying to „keep up.“ The likely agree with the sentiment expressed bythe New York Times media critique;* „Like most Americans, I am overwhelmed by the velocity of everydaylifeand 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


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


The effect of inflation

New Price (t) = Base Price (1 + inflation rate)t

2114.49 = 100 1 + .07 For two Years

3122 .50 100(1 .07 ) For Three Years

1 0 7 1 0 0 (1 .0 7 ) For one Year

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.


Cash Flow Management

• A cash flow (CF) is a continuous stream of payments which shifts the equationsfor FV and PV. For instance you need to choose between purchasing a piece ofequipment or leasing it at a monthly rate.

• There are many factors that enter into this type of question such as the amountof payment required on the lease, the alternative use of capital for other projectsand the ability to make a large down payment. The way this type of problemshould be worked is to determine if the present value of the leasing payment cashflow is greater than or less than the current purchase price.

• Future cash flows may be discounted to account for the effect of inflation (calleddiscounted cash flow – DCF or cost of money is factored‐in)


Internal Rate of Return (IRR)

• This is a metric that assesses the value of alternate investment proposals todetermine 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 orderto 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 = totallength), then solving the following equation for r (rate) will provide the IRR:

t

n = 1

CFn(1+ r)nProject Cost =


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


Present Value (PV)

• Description: the concept of present value (PV) is illustrated by the principal on aloan. Interest (I) is the amount of money that you are charged for the use of theprincipal. Future Value (FV) is the sum of principal (P) and the amount of interestthat is accrued over a period of time. The cumulating value of interest (accrual) isthe effect of two factors: Time (t) that money is used and the Rate (r) of interest thatis charged.

• Instructions: PV + I = Future ValueMoney now + Interest = Money later

• Applications: FV1 = PV (1 + r), for one year at simple interestFVt = 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 ona monthly basis over 5 years at a simple interest rate of 8%? [HINT: Payments = FV /N payments].


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.


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)=1.15100 x 1.15=115


Future Value (FV)

10

1

.10100 112

nrFV PVn

FV

10.10100 1 108.2912

FV


Future Value (FV)

12 5

60

1

.10100 112

.10100(1 )12

100 1 .65 165

n trF V P Vn

F V

F V

F V


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.

• 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.

NPV = CFn (1 + r ) ‐n


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


Cost of Quality


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 ‐


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!


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 ‐


The Tip of the Iceberg!

Quality engineering and administration

Inspection/test (materials, equipment, labor)

Expediting

ScrapRework and sorting

Rejects Warranty claimsMaintenance and service

Cost to customer

Excess inventory

Additional labor hours

Longer cycle timesQuality audits

Supplier controlLost customer loyalty

Improvement program costs

Process control

Opportunity cost if salesgreater than plant capacity

Materials Obsolescence

Cost to supply chain


What should your project achieve?

Measure

Analyze

ModifyDesign ?

Redesign

Yes

No

Control

Define

Improve


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

Defects found by customers are the most expensive of all!

Total Quality cost is minimized when perfect quality is

achived, hence drive for zero

defects


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.

Defect Rate

Cost of Control

Point of DiminishingEconomic Returns

fromQuality Investments

Failures Cost

Cost of Quality:

Failure analysisScrapRework100% sortingRe‐inspectionRe‐testWarrantyDowngradingAllowancesOvertimeExpeditingInventory

Cost of Prevention:

Process controlTraining

InspectionTestingAudits

RedesignAutomation

The cost of quality must be defined and presented in the language of the management – money!

99% Good = 4


New Model of Optimum Quality Cost

1. Attack on failure costs direct in attempt to drive them to zero

2. Invest in „appropriate“ prevention activities to bring about improvement

3. Reduce appraisal costs according to results achieved

4. 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


Cost impact of a 3 quality performance:

Cost ofGoods Sold

Level ofInternal Defects

Defect Level5 to 7% ofOutput

Poor QualityCosts 20 to 40%of Cost of Goods

Poor quality casts along cost shadow!


This Problem Thrives in Functional Silos!

Excess/ Obsolete Wrong mix products options

Customer frustrations

Defective products Warranty & other product liabilities

FinancePerformanceCredit Check

FinanceRecordsSales

FinancePays/AP

FinanceSendsInvoice

FinanceCountsInventory

Errors in cost estimates

Hard to assemble design

Outmoded technology

Expensive components

Errors in demand forecast

Product features do not meet expectations

Inaccurate BOM Supplier’s Defects

Excess lead times Delayed shipments

Scrap Rework Downtime Overtime Excess inventory Excess Capacity Excess/Obsolete Warranty & other product liabilities

Customer frustration Defective products

Engineering Sales & Marketing

Materials ‐Procurement

Manufacturing Distribution Sales & Marketing

Defects exist in and between the functions! 85

Quality costs are not equal inside goalposts

What is the total cost of poor quality to society?

Lower Specification Limit Upper Specification LimitTarget Value

Region ofCustomerComplaints

Region ofCustomerComplaints

Regionof

QuestionablePerformance

Regionof

QuestionablePerformance

MeanLowerControlLimit

UpperControlLimit

Region ofpotentialloss to thecustomer!

Region ofSpecified

Performance

Region ofDesired

Performance


Value Rules in the Taguchi Loss Function:

Nominal‐the‐BestAo

TT‐Do T+DoY

Smaller‐is‐Better

Ao

DoY

Ao

DoY

Larger‐is‐Better

T = TargetAo = Cost of Repair or ReplacementDo = Functional Limit

LessDefects

MoreDefects

MoreDefects

LessDefects


How to increase hidden factory efficiency?

Does theCustomerDetectDefects?

Correctiveactionsare taken

Good Sigma LevelHigh Classical Yield

ReduceTesting!

EliminateRework!

Eliminatenon‐valueadded work!

Yes

No

Stewardprocessoutcomes

Reducecycle time

andset‐ups!

Calculaterolled

throughputyield!

EliminateScrap!

Manager’s Theory ‘O’ = no worries!

Look into the ‘hidden factory’ operations!

But, what is the COQ?

What can you do to improve?

Apply ‘lean thinking’ to your routine work activities!

Reduceall workprocess

variation!

Work


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.

Failures Cost

Defect Rate

Cost of Control

34

56

Emphasis of improvement


Relationship of COQ and Sigma level:

The goal is not perfection, but flawless execution to competitive level. Customers define the market‐driven competitive performance 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


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:

Failure50%

Appraisal35%

Prevention15%

Time

Total = 17% of salesPrevention 50%

Appraisal35%

Failure15%

Total = 2.5% of sales


Getting to improved bottom‐line results:

• 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’saccounting statements which only show aggregate results.

• Activity‐based costing helps illustrate gains better than standard methods.

“The total cost of quality is unknown and unknowable.” - W. Edwards Deming ‐


Cost Benefits from Improvements


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 ‐


Measure Business Performance

Operational Metric; There are many ways to measure your business performance. Here are just a few measures used by some organizations:

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;

• 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

• Revenue• Earnings per Share (EPS)• Profit/earnings ratio (P/E)• Return on assets (ROA)

• Return on net assets (RONA)• Economic value added (EVA• Return on investment (ROI)• Earnings before interest, taxes, deprecation, and amortization (EBITDA)


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.


Impact of a 10% Price increase:

Sales $100 $110 10%Cost of Good Sold 75 75Gross Margin $ 25 $ 35

Selling, R&D, Admin 14 14Operating Profit $ 11 $ 21 91%

A 10% Price Increase Results in a 91% Profit Increase!


Impact of Reducing Cost of Goods

Sales $100 $ 100Cost of Goods Sold 75 67.5 – 10%Gross Margin $ 25 $32.5

Selling, R&D, Admin 14 14Operating Profit $ 11 $18.5 + 68%

A 10% Reduction in CGS Results in a 68% Profit Increase!


Impact of Reduced SG&A Costs

Sales $100 $100Cost of Goods Sold 75 75Gross Margin $ 25 $ 25

Selling, R&D, Admin 14 12.6 – 10%$ 11 $ 12.4 + 13%

A 10% Reduction in SG&A Results in a 13% Profit Increase!


Home Run: Improve Sales, CGS, and SG&A

Sales (UP) $100 $110 + 10%Cost of Goods Sold (DOWN)

75 67.5 – 10%Gross Margin $ 25 $ 42.5

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!


Impact of Leverage

Equity 50

Loan 50Investment $100

A Equity 100

Loan 0Investment $100

B

Investment sold at $110 ; Return on equity:

Revenue 110Total investment 100

$ 10

Return on Equity $10/50= 20%

A Revenue 110Total investment 100

$ 10

Return on equity $10/100=10%

B

Leverage


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.


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

Weaknesses in cost accounting:

• Cost accounting (standard cost) measures average performance and doesnot reflect process variation or design capability – it is related to Cpk. Ineffect, Cpk becomes the target performance for standard cost accounting.

• Cost accounting measures the ‘cost of doing’ but not the ‘cost of notdoing’ ‐ 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 attargeted performance.

• Cpk describes the average cost of the process and does not reflect the‘best day’s performance’ of the process (Cp).


Productivity Investment Dilemma!

Expected Return

Capability Requirement Common Cause Variation = Building the System!

ROI CpCapabilityAcquired Capability Applied

Cpk

Yield

Capability Erosion

Process Analysis

Standard Cost Analysis

Capacity Planning

ROCE

Production Efficiency

These decisions are unique and These decisions are unique and typically are taken

independently of each other –not a good thing to do.

Long-term capital budgeting acquisition decision.

Short-term productivity optimization decision.


What is process capability?

• Process capability (Cp) is a process performance ratio that is used todescribe the ability of a process to meet the expectation of its customersfor performance.

• Process capability is calculated as the voice of the customer (or the widthof tolerance in their agreed‐upon specification) divided by the voice of theprocess (six standard deviations of design performance variation ).

• Process capability is not ‘centered’ around mean performance, andrepresents an absolute ratio of performance – the best that a process canperform based on its designed capability.


Process capability & acquisition decision:

• When capital acquisitions are made, the choice of alternative is based onthe design capability of the system (Cp performance measure) and anexpectation is set that this design capability (or nameplate performance –the performance that is advertised for a process) will be delivered in thereal world.

• Comparison of alternative capital acquisitions is based on an analysis ofthe design capabilities.

• Real‐world performance is always degraded from the design capability –leading to a second indicator of process capability.


Cpk measures current performance:

• Process capability (also indicated as Cpk), is a ratio of performance that isrelated to Cp – only it is referenced to the closest of the upper or lowerspecification limits.

• Cpk represents shifts in performance degradation from designed Cp valuebased 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.


Capital efficiency ratio:

• The capital budgeting analysis was based on the Cp of the design, ratherthan the Cpk of the operating process.

• When daily operations are evaluated the measure used for the capitalbudget is not reflected in routine work – only average performance ofstandard cost is used. The difference between average and target is aloss in capital efficiency.

• This capital efficiency loss can be used to estimate the potential forimprovement in ‘return on capital employed’ based that may be obtainedby moving from the Cpk to Cp performance level.


Delivering Bottom Line Performance:

1.5 2.5 3.5 4.5 5.5 6.5

LS L US LTa rge t

Proce s s Ca pa bility Ana lys is

Within

Overa ll

Designed process capability (Cp)

Achieved process capability (Cpk)

Capital Effectiveness = Capital Employed X Capital Efficiency

Return on Capital Employed (Adjusted) = ReturnCapital Efficiency

Achieved CpkDesign CpCapital Efficiency =


Drive performance gains in entitlements!

• 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.

The financial impact of process capability loss:


LSS projects must yield bottom line results!

Standardize

Measure

Analyze

ModifyDesign Yes

Improve

No

Control

Define

Recognize

Integrate

Kaizen Cycle

Design Cycle

Strategy Cycle

Analysis Cycle

Redesign


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!


Reviewing Black Belt projects:

Yes

Measure Phase

Analyze Phase

BusinessReview

Re‐direct ProjectNo

Financialvalidation of

opportunity & formalproject review

No Re‐direct or RedefineThe BB project

Improve Phase

Control Phase

ManagementReview No Re‐direct or re‐

define the project

Formal ReviewExecutive & financial

validation


How do you spell project success?

• 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!

Defects

Down!

Profits Up!


Thank you! Any Questions?
