Link btwn Oper & Finance

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1 Link btwn Oper & Finance 2016 Fall - SOM Lecture Topic 3 Dohoon Kim Value Equation Why firms? or why invest? (economic) Value creation Economic Value (EV) = investment x (ROIC WACC) ROIC (Return On Invested Capital) WACC (Weighted Average Cost of Capital) WACC does not change rapidly ROIC EV LB, flow time management, inventory control, product diversity, for increasing ROIC

2 Issues How to measure?, What measures?, Operational efficiency? performance improvement In this chapter (Ch.6) ROIC tree or KPI tree Evaluate process improvement Case analysis Paul Downs started making furniture in 1986, in a small shop in Manayunk. Over the years we have outgrown 4 other shops and we now operate a 20,000 sf shop (see below) in Bridgeport, PA. Much of our work is residential, but we also do a lot of office furniture, including desks and conference tables. We complete 125 commissions per year, consisting of about 500 separate pieces of furniture.

3 Production facility Machines valued: $350k Annual depreciation: $60k Overall facility is utilized at 100% right now Show rooms and factory: $150k for rent Indirect costs: marketing ($100k), management ($180k), finish ($60k) Inventory: $50k WIP and $20k raw material Suppliers need to be paid 1 month before receiving the wood Work force 12 cabinet makers each working about (220 8hours/day) Pay (wage): $20 per hour A worker needs about 40 hr. per unit of furniture (workcell) as labor content Work Cell Spend about 15% of time on set-ups (build fixtures, program machines, etc.) Labor utilization around 90% (idle time resulting from waiting for available tools)

4 End Product Requires 30kg of wood Wood costs: $10 per kg (before scrap) 25% scrap Customer pays Average price is $3,000 per unit 50% down for pay-inadvance Lead-time: customer gets her furniture 3 months later Creating ROIC (Value, KPI) Trees Volume VALUE Growth ROIC WACC Manufacturing costs per unit SG&A costs per unit Labor hours Yield Indirect labor Material Setup Training Job Invested capital per unit Breaks Develop ROIC tree Link financial measures to potential value drivers in operations In operations, performance typically focuses on ROIC Develop several versions as there is no right answer Explore multiple sub-trees

5 ROIC Tree Examples Some Formulas ROIC = Return (Rt) / Invested Capital (IC) = { Rt / Revenue } x { Revenue / IC } DuPont model Rt / Rv = net profit margin (or net profit ratio) Rv / IC = turnover ratio of capital (simply, capital turnover) (cf. Inventory turnover) Note: Rv = R x Price (P) Rv / IC = (R x P) / IC Further breakdown Net profit (Rt) = Rv Fixed cost (Flow rate (R) x Variable cost) Rt / Rv = 1 Fc / Rv (R x Vc) / Rv = 1 Fc / (R x P) (R x Vc) / (R x P) = 1 Fc / (R x P) Vc / P In sum, now we can express ROIC in terms of R, Fc, Vc, & P

6 Summary We do not consider P as a control variable Vc ~ R ~ Fc ~ First ROIC Tree Price (P) Fixed cost (Fc) Net margin Variable cost (Vc) ROIC x Capital turnover Flow rate (R) Price (P) Capital invested (C) Flow rate (R)

7 Further Breakdown In our example, flow rate (R) = Process Capacity (why?) R (= Capacity) = total available time process time (per unit furniture per worker) Total available time (per year) = no. of workers x working hour (annual) Process time per unit = working time + idle time or = labor content (LC) / (1 idle % of LC) Idle time = waiting time + set-up Fc = direct labor + marketing + indirect labor + other indirect costs (rent, depreciation, ) Why (even direct) labor is classified as Fc? Indirect labor (overhead labor cost): administration and finish Further Breakdown (conti.) Fc (continued) Types of depreciation: real depreciation vs. depreciation for tax (saving) we take the former Break down capital turnover PP&E and Working Capital PP&E: Plant, Property, Equipment Working Capital Cf) (in financial statement) WC = current (or liquid) assets current liabilities [ usually, w/o cash (& equivalent) in CA] Inventories: raw material + WIP current assets Prepayment current assets (cf. account receivables) Unearned revenue current liabilities (cf. account payable)

8 ROIC Tree: Figure 6-5 Invested Capital (Fig. 6-6) Invested Capital PP&E + Working Capital Inventory + Pre- Payments Unearned Revenue Raw Materials + WIP Total $ spent on wood Time of pre-payment Revenues x % Down-payment Time of down-payment Flow Rate x Material costs

9 Building ROIC Tree Value Drivers Value drivers are (operational) variables in the ROIC tree that have a big impact on ROIC Identify value drivers based on sensitivity analysis in Excel Typical value drivers are different case-by-case If operation currently is capacity constrained (i.e. has high demand), everything that creates additional capacity is powerful utilization / downtime production yields set-up time / other improvement of Overall Equipment Effectiveness (OEE)

10 Value Drivers (continued) If operation currently is demand constrained (i.e. has insufficient demand), everything that gets more $ s out of a customer is powerful variety / customization after-sales service / support innovation But, (again) no general rule exists: your insight is needed Amazing Example What if we can reduce the setup time by 5% (for e.g., 15% 10%)? Affects many things in the ROIC tree See Excel file Cf. Figure 6-7 has some (minor?) errors Note: it does not match with the Excel template provided by me!

11 Impacts of Setup Note: this is a capacity-constrained system (i.e., big demand) Once we recover the fixed cost, we get additional profit as one flow unit is added to the system fig.6-8 High fixed cost industry will enjoy this benefit E.g.) network service industries like hotel, franchise restaurant, airline, telecom, electricity, transportation, Economics of Setup How?

12 Airline Example Unit: Revenue Passenger Mile (RPM) On a route A: 200 passengers, distance = 447 mile RPM = 200 x 447 = 89,400 RPM Supply measure: Available Seat Mile (ASM) (next slide) Then, airlines try to transform ASM into RPM Load factor = RPM / ASM (cf. utilization rate) See ROIC tree Productivity = Revenue (Rv) / Cost Labor productivity = Rv / Labor cost How the Airline Industry Works: Philadelphia (PHL) to Seattle (SEA) on a Boeing Distance: 2,378 miles (nonstop) Seats on airplane: 137 Available seat miles (ASM): 137 x 2,378 = 325,786 seat miles 120 passengers are on the plane paying an average of $200 for their ticket Revenue passenger miles (RPM): 120 x 2,378 = 285,360 RPM Load factor: RPM/ASM = (percentage of seats sold) Yield: Revenue per RPM = (120 x 200) / 285,360 = 0.08 $/RPM Main cost categories are Labor expenses Fuel expenses Landing fees SGA

13 Bottom-up / Inside-out Analysis vs Top-down / Outside-in Analysis Revenue RPM ASM Load Factor Number of planes ASM per plane Yield ($/RPM) EBIT Labor cost Wages per employee Employees per ASM ASM Return on Invested Capital Cost Fuel cost Other cost Cost per gallon Gallons per ASM ASM Other expenses per ASM ASM Capital Fixed capital Working capital Number of planes Capital per plane Other capital Sources of Performance Why did SouthWest do so well (to 2001)? Pick three hypotheses and locate them in the tree (only simple tree is shown before)

14 Labor Productivity Productivity measure Transformation efficiency Flow rate = RPM Load factor Process time US Air has more pricing power SW outperforms US Air in these metrics Using Productivity Ratios Revenue / Cost = Revenue / Output x Output / Capacity x Capacity / Cost Operational yield Transformation efficiency 1 / unit cost of capacity Revenue / labor costs = Revenue/RPM x {RPM/ASM x ASM/Employee} x Employees/Labor costs USAir: 2.43 = * 0.70 * 0.37 * SW: 3.31 = * 0.69 * 0.53 * Labor productivity advantage of SW is driven by (a) fewer employees per ASM and (b) lower wages Note: There exists a $25k per year difference in wages (= (1/ /67.01) x 4000) Revenue / fuel costs = Revenue/RPM x RPM/ASM x ASM/Gallons x Gallons/fuel costs USAir: 6.21 = * 0.70 * 52.3 * 0.86 SW: 3.31 = * 0.69 * 60.2 * 1.21 Fuel productivity advantage of SW is driven by (a) fewer gallons per ASM and (b) cheaper fuel Note: There exists a $0.33 per gallon difference in fuel prices (= 1/0.86 1/1.21)

15 Sizing the Pie: How to Value the Financial Performance Improvement From an Improved Productivity Ratio Cost reduction required to break even $2,444M $284M $198M Cost reduction required to become SW profitable $108M $35M $1,804M Current (2000) USAir Op Expense at ASM Savings in wages if SW wage rate is paid Savings in wages if SW productivity is achieved Savings in fuel if SW fuel prices are paid Savings in fuel if SW efficiency is achieved New Ops expense Strategic Trade-offs No differentiation between the major US carriers Efficient frontier: Southwest introduced the high efficiency strategy in the US Note: all numbers are exchange rate adjusted Note: all numbers are exchange rate adjusted Ryanair has pushed this to the extreme in Europe following Choose clean strategies, especially for Lufthansa and Ryanair and drive improvement towards the frontier and beyond