Organizational productivity is calculated as an efficient utilization of labor, materials, and capital versus the revenue received by their conversion and sale. Productivity is calculated as a ratio of outputs to inputs based on inflation and economic adjustments as shown in Figure 7.1. It is calculated as a year-to-year index. Pricing adjustments and changes in international currency exchange rates are incorporated into a productivity index for the current year to ensure that, relative to internal operations, production efficiencies are accurately estimated net of the impact of external factors that are beyond an organization’s immediate control. Figure 7.1 also shows that higher productivity results from simultaneously increasing sales, lowering costs, or a combination of both. Fligher productivity makes an organization more adaptable because it has resources to invest well and a better ability to respond to disruptive changes. It also makes an organization more competitive. High competitiveness enables organizations to dominate their industries.
There are financial measurements that calculate the effectiveness for increasing sales, reducing costs, and managing assets. These are EVA, NOPAT, market value added (MVA), and ROE. These metrics measure the revenue versus the costs incurred to attain it. Revenue and costs are adjusted for macro-economic factors and estimated using a weighted cost of capital. They will not guarantee that future operational performance will be competitive, but they guide an organization toward improving its operational performance by ensuring resources are allocated to productive activities. The interrelationships between financial and operational performance measurements ensure alignment with available capital to increase revenue, reduce costs, or efficiently utilize assets.
NOPAT is another useful measure of organizational efficiency, unless the organization is highly leveraged financially. Higher net operating income drives higher cash flow and increases shareholder ROE. Higher operating income and cash flow enable organizations to invest in technologies such as digitization and automation to further reduce operating expense and increase cash flow. Alternatively, new products and services can be created to gain additional revenue. Evaluating NOPAT relative to the capital invested to create it enables calculation of EVA.
EVA is a measure of how well assets were managed to create the NOPAT metric. Like ROE, it can be distorted by how investments are financed and how assets are valued. Figure 7.2 shows that EVA measures the rate of return on total capital. It is calculated by dividing NOPAT by the total capital used to sustain operations. Capital is calculated as all of the cash
Increasing economic value added (EVA).
invested in net assets over their useful life without adjusting for financing. The cumulative depreciation expense of assets is subtracted from their investment because their value decreases over their useful life. EVA can be increased by increasing profits with the same capital (e.g., inventory, accounts receivable, cash, facilities, and equipment), maintaining the same level of profit using fewer capital resources, or using a strategy that combines both approaches. EVA is also useful for measuring organizational performance because it focuses attention on growing sales, reducing costs, and managing assets better. These actions increase shareholder value by ensuring an investment’s rate of return on invested capital is higher than the cost of that capital. This goal is to ensure capital is not assigned to projects or investments that provide a low return on invested capital. An analogy would be to invest a $100 in a bank that provides 10% interest rather than one that provides just 5%. The higher interest rate is more attractive to an investor. This is the basis for strategic alignment to tactical projects. Projects should be considered in the same way unless they must be undertaken because of laws, regulations, and other influences.
As a side note, G. Bennett Stewart III of Stern Stewart & Company describes a modification of the EVA concept in which an organization’s value creation is based on its market value or MVA. The MVA is calculated by subtracting the costs of capital from an organization’s market value. MVA information on 1,000 corporations is embodied in the Stern Stewart
Performance 1,000 report. However, the MVA method could be impacted by external economic factors such as stock speculation. This could bias an MVA analysis, although an argument could also be made that an organization’s stock is fairly valued by the market based on an expected ROE to stockholders.
ROE shows the return shareholders received from an organization’s operational effectiveness and efficiency. It is influenced by the ways in which assets are financed and valued as well as how expenses are accrued for acquisitions and how some overhead components such as research and development are recorded. In other words, the full cost of these assets may not be accurately accounted for, which would cause distortions of financial performance and, by implication, operational performance and productivity estimates. Higher ROE also favors use of debt rather than cash financing for the acquisition of capital. For this reason, it is often recommended that ROE be estimated using an average cost of debt and equity capital to provide better insight to measure shareholder equity. Productivity is directly correlated to ROE and EVA because they are aggregate measures for how well an organization manages resources and assets to support sales and revenue generation.
The ROE financial model shown in Figure 7.3 is also called a DuPont financial model based on where it was first used in practice. Average cost of debt and equity capital is used in our example. The example applies to the production of both products and services, including supporting operations such as manufacturing, purchasing, accounting, and other processes. The numbers shown in Figure 7.3 are simplified and are not related to the other examples in this chapter. The DuPont model is useful for identifying beneficial improvement projects across an organization. It helps with the evaluation of the right balance of projects to execute strategic goals while avoiding competition for scarce resources. There will need to be operational linkage to these projects when creating project charters. The model also shows how projects are linked to each other financially, as well as shareholder performance measurement (i.e., ROE). This analysis becomes a roadmap for increasing productivity.
The analysis of revenue, costs, and assets helps ensure a linkage between higher-level financial goals and the process improvements necessary to execute them. Project selection and the impact on ROE and productivity can be evaluated by varying the model’s inputs, such as cost of goods sold (COGS), depreciation expense, selling expenses, and general and administrative expenses, or by increasing sales levels or pricing to evaluate the
Return-on-equity (ROE) financial model.
impact of these changes on the model’s higher-level financial and productivity ratios. Analysts can change the levels of these influential financial categories and metrics to evaluate the impact on ROE. The usefulness of this model is in guiding the focus of operational improvement efforts and
Common Financial Ratios
in showing how they impact the higher-level financial metrics. This analysis also helps prioritize and align competing projects that may need the same resources. In summary, a financial model is also useful to improve MVA, EVA, NOPAT, ROE, and productivity year-to-year and to meet or exceed competitive productivity levels.
Table 7.2 lists common financial ratios used to measure operational efficiency. Improvement projects identified using these ratios will be directly tied to EVA, ROE, NOPAT, and productivity. High liquidity implies an organization is not highly leveraged with debt and can self-finance investments in areas such as digitization and automation as well as improvement projects to eliminate current process issues. It also reminds leadership that internal improvement projects need to generate returns higher than the cost of invested capital; that is, it will see higher improvements in its financial metrics (i.e., EVA, ROE, and productivity metrics). High liquidity makes an organization more competitive because it can quickly apply resources to areas experiencing competitive threats or to those where sales can either be increased or operating costs reduced. In other words, high liquidity increases an organization’s adaptability.
Activity ratios show the efficiency with which assets are utilized. Competitive organizations have high activity ratios. As an example, inventory turnover measures how well inventory assets are managed to support sales as approximated by COGS. As an example, for constant COGS, the lower the required inventory invested in raw materials, work in process, and finished goods inventories, the higher the inventory turnover ratio. An inventory turnover ratio can also be calculated for a single product or all products in combination.
But activity ratios can also be misleading. A classic example is running a machine to achieve 100% efficiency, but without incoming demand. The results are high inventory build-up with all the associated issues and low relative throughput rates, which lengthen the lead time from order to cash. Recall the bottleneck example, where a resource should only be activated to match its throughput to a bottleneck. This implies if there is no demand then machines should be idle. This was a paradigm shift in the 1980s because many American manufacturers designed and employed large complicated machines with high throughput rates. These machines needed to be kept busy (i.e., 100% utilized) to generate positive payback. In contrast, Japanese manufacturers such as Toyota employed simple and low-cost machines in parallel that were idle until external demand required they be activated for production. Asset utilization needs to be carefully thought out to ensure no adverse impacts elsewhere in the organization.
Table 7.3 shows the general ledger of a hypothetical profit center for the years 2018 and 2019. This information will be used to demonstrate the usefulness of financial analysis by process improvement professionals to identify improvement projects to increase productivity and competitiveness. The ledger contains a large amount of information that can be used to identify projects. Just by looking at the changes to accounts between 2018 and 2019, there are some positive changes. These include lower inventory investment and a reduction of liabilities. But the negative changes are significant. Shareholder equity and revenue are down in 2019, and labor costs and accounts receivables increased. More detailed analysis will help focus on where operational and other improvements would be useful.
The next step is to create the income statement as shown in Table 7.4 for the year 2019 with income and expenses. This statement is a snapshot
Profit Center General Ledger
2019 Profit Center Income Statement
of a company’s profitability over the specified period (i.e., 2019). It should be noted that an income statement can be impacted by the accounting method used to calculate expenses. As an example, most organizations use an accrual rather than a cash accounting system. In an accrual system, revenues from sales are recorded when they are earned, and expenses are recorded in anticipation of their incurrence. The accrual system contrasts with a cash system in which revenue and expenses are recorded as they occur without an accrual of future expenses. The choice of accounting method has an impact on income for the period under consideration.
Although this income statement can be used to identify projects by increasing revenue or reducing expenses, it needs to be compared to the prior year and percent changes must be calculated to determine negative or positive impacts. Ideally, several years would be used in this analysis. These should be carefully analyzed for their significance. As an example, an expense analysis would compare year-to-year expenses by type. If expenses increased more than the adjusted sales, projects can be used to investigate the root causes and reduce expenses. There could be several projects in any category, and several different projects could be focused across different categories. The advantage of a top-down approach for project identification is that the projects are financially linked to metrics that directly impact productivity. If they are also strategically aligned, then the organization will be more competitive with higher productivity. Alignment implies that projects promote the current strategic goals. These could be revenue increases in certain market segments, inventory reductions for products being obsolesced, direct labor reductions for products or services that have low profit margins, or other types of projects.
Next, we construct a balance sheet of an organization’s profit using information shown in Table 7.5. Components of a balance sheet include assets, liabilities, and shareholder equity. Assets are resources owned by a business that are expected to benefit future operations by creating a revenue stream that exceeds the cost of the asset. The rate of return versus
2019 Profit Center Balance Sheet
the cost of capital invested in an asset is the basis of the EVA calculation shown in Figure 7.2. Asset acquisition, management, and disposal require ongoing evaluation.
Productivity improvement projects are created based on an evaluation for how assets are acquired, managed, and disposed of by an organization. Evaluations can be made to determine if assets should be purchased or leased. Financial models can show the advantages of each approach. Asset conversion, through the sale or leasing of assets to others, frees up cash for investments that could create higher rates of return on investment. This occurs if assets are used or consumed to increase sales or reduce operating costs. Examples include reducing inventory to such a low amount that a facility can be sold or used for other purposes. In addition to reducing asset investment, cost savings are realized by not having to maintain the asset or by paying interest expense to borrow capital. Remote working dramatically can reduce operating expenses associated with fixed assets such as an office building. Expenses such as energy, maintenance, and materials are also significantly reduced by remote work, and employees benefit from reduced commuting expenses. These are disruptive changes to how an organization works. They increase productivity and competitiveness.
Liabilities are debts or obligations to creditors. They reduce the asset value of a business. They include accounts payables, loans, and other debt. Projects can be deployed to reduce liabilities such as late fees or to pay off loans and debt. Examples include refinancing or selling an asset and leasing it from a third party. From a process perspective, these processes (e.g., the accounts payable and others that incur debt) can be simplified and standardized through process-focused projects. The third section of a balance sheet is shareholder equity. This is calculated as assets minus liabilities. It is a measure of a shareholder’s net investment in the business. The relationship between the three balance sheet categories is assets = liabilities + shareholders equity.
Different types of financial analyses are made to examine financial and operational performance and their interrelationships. One type is shown in Table 7.6. It is an evaluation of changes to pricing for three production facilities for the years 2018 and 2019. We see pricing was negative for 2019 relative to 2018 for three production facilities. The negative pricing reflects the fact that there was price erosion of the aggregate products manufactured by all three facilities. The next step would be to evaluate the specific pricing of each product at the three facilities to identify the reasons for the price erosion. There
Evaluating Price Changes
could have been several causes, such as adjustments of warranty issues, price concessions to offset external competition, or other adjustments.
Pricing is important to maintain target profit margin, assuming the COGS is constant. Although competitiveness may be temporarily increased because of higher sales, productivity and longer-term competitiveness will decrease.
Issues associated with negative pricing help identify projects. As an example, warranty problems could have occurred due to design problems, poor user training, or poor production quality. Competitors may have lowered prices, forcing a temporary response. Or for situations characterized by poor product forecasting, forecasted quantities may have exceeded actual demand and created excess inventory or product obsolescence problems, and these products may need to be sold at a lower margin. In summary, there may be many different reasons for price erosion. A root- cause analysis of pricing issues and their elimination will have a positive impact on productivity and long-term competitiveness.
Evaluating Year-over-Year operating Income and Margin
Table 7.7 shows an analysis of operating income and margin. This financial statement is particularly useful for identifying operational improvements to increase productivity. Revenue variation stems from year-to-year changes in sales, inflation, and currency valuations as well as adjustments caused by returns, warranty, pricing changes, and other concessions. Changes to operating expenses are positively impacted by investment such as automation, process improvements, supplier discounts, or other factors that reduce expenses. Negative changes are caused by higher expenses. Many reasons for higher expenses require improvement projects be created to investigate them. Year-to-year changes in expenses are relevant if adjusted to revenue. Their magnitude is also an important criterion for further investigation.
Table 7.7 shows that sales revenue increased by 7% from 2018 to 2019, but operating income decreased by 4% and operating margin by 10% over the basis year 2018. The erosion of operating income and margin
Measurement Net Income
was caused by increases in all the expense categories listed in Table 7.7. The indirect labor and overtime categories had large increases, and the 2019 expenses were large relative to 2018. Projects can be deployed in these higher percentage categories. As an example, the causes for higher overtime and indirect labor cost could be investigated. Analysis and elimination of the root causes for high operating expenses will help improve operating income and margin as well as organizational productivity. An adjustment can also be made to operating income to evaluate it net of taxes and additional income sources. This is shown in Table 7.8. Higher income is important for internal investment, to pay down debt, or to pay dividends, or it can be retained to increase shareholder equity.
The lead time of an order-to-cash process is shown in Figure 7.4. The shorter the order-to-cash lead time, the higher the free cash flow available for supporting operations. In other words, money will be available sooner. Available cash can be used to finance additional production or for other purposes. In contrast, if free cash flow is low, then money needs to be borrowed to finance operations and investments such as equipment, facilities, and other assets, and borrowed money incurs interest expense. In some situations, organizations are highly leveraged because they build inventory, hire employees, or purchase assets. If this investment is not converted into cash, an organization’s financial position deteriorates and productivity decreases. This situation occurred in the automotive industry when the wrong vehicles were made because of poor forecasting or demand did not
Compressing the cash flow lead time.
materialize. In some situations, inventory rapidly becomes obsolete and is never converted into cash. Instead it must be written off the balance sheet as a loss. This reduces competitiveness.
Analysis of its order-to-cash flow lead time enables an organization to understand how its cash is used and to develop strategies to manage it more effectively. This is the velocity flow of invested cash. For some highly efficient organizations, cash flow is optimized to where customers pay for products or services before the supplier pays for the labor, materials, and overhead that were used to create them. Organizations can utilize several strategies to compress their order-to-cash lead time, such as paying suppliers as late as possible or offering customers pricing discounts for early payment. Lead time can also be reduced by simplifying or leaning out supply chain processes.
Table 7.9 shows a cash flow analysis at a single point in time using the information from Table 7.3. The analysis shows cash increased by $1,186,184 in 2019 relative to the basis year 2018. This cash flow increase was based on reductions in inventory investment, the sale of other assets, and increases in depreciation expense that reduced income taxes. This extra cash can be used for capital investment to increase sales revenue or to decrease operating expenses. Improvement projects can also be applied to these processes.
2019 Cash Flow Analysis
There are four methods commonly used to evaluate the investment cost versus benefits from projects: net present value (NPV), internal rate of return (IRR), payback period, and the average rate of return (ARR). These are shown in Table 7.10. When evaluating capital expenditures or other investment decisions, the time value of money is important, as is the interest earned if money were safely invested with a guaranteed rate of return. A dollar earned in the future will be worth less than one earned today for the simple reason that we could earn interest on today’s dollar and external economic conditions such as inflation or currency exchange rates may impact the value of a future dollar. Earning guaranteed interest on money is a logical investment alternative. These concepts are used to evaluate whether cash should be invested in a project for productive purposes.
The NPV method compares the present value of a project’s future cash flows to an initial investment cost. The comparison is made relative to its minimum rate of return compared to a safe investment. The rule is that an investment should be undertaken if its NPV is positive or its return is higher than what could be obtained from a safer investment. It is important to determine a project’s expected cash inflows relative to project risks throughout the life of the project to ensure the NPV is accurate. As an example, in some projects, the cash inflows occur early while in other projects they occur toward the end of the project. Cash flows derived from
Evaluating Potential Investments
the latter scenario will have more risk because external factors have more time to influence the project.
The IRR method evaluates the NPV of a project’s cash inflows and outflows. If the IRR is equal to or greater than the minimum required rate of return, then the project should be undertaken. The minimum required rate of return depends on project risk and the availability of other investment alternatives. When an organization has more investment opportunities than available cash, it may rank projects to invest in those with a target minimum IRR.
The payback method calculates a simple ratio of the initial investment divided by the projects annual cash inflow. It does not consider the time value of money, but it does provide a quick estimate of the project’s costs versus benefits. The ARR calculation divides a project’s cash inflows minus depreciation by the initial investment. The investment alterative having the highest ARR is selected. The time value of money is ignored in the ARR analysis, and income rather than cash flow data is used for its calculation. ARR also evaluates the full useful life of the investment. Organizations usually have finance policies that determine the preferred evaluation method. There may be others that are specific to an organization’s industry.
The example shown in Figure 7.5 calculates productivity using the formulas from Figure 7.1 and the information in Table 7.3. The productivity improvement is shown to be 6.9% when comparing year 2019 to 2018. This implies the organization used less resources to achieve revenue gains by managing its operations effectively. This analysis can be applied to several organizational levels using cost center reports. The advantage is that it provides a direct view of how effectively and efficiently managed organizations use resources to gain incremental revenues. It also helps identify impactful improvement projects to further increase productivity. These would need to be aligned to strategy. Recall that the initial review of Table 7.3 showed some categories increased while others decreased. But by integrating all of the information into the analysis, we can evaluate progress made toward higher productivity and, by implication, competitiveness.
Several of the higher-level financial metrics in Table 7.3 have also improved from 2018 to 2019. This higher productivity is assumed to have occurred through process improvements that increased revenue, reduced cost, and utilized assets more efficiently. The productivity index was also impacted by pricing. As a final observation, productivity is a total supply chain concept. It needs to be calculated throughout a supply chain and optimized based on available labor, capital, technology, and knowledge. Recall that factor productivity was discussed in Chapter 1 from a macro- economic perspective and is like the application of technology and knowledge to improve the use of productive resources (i.e., labor and capital). Productivity evaluations should be made across an organization’s operations as well as the end-to-end supply chain participants. In other words, it makes little sense from a competitiveness perspective to only optimize productive operations but not other operations such as marketing, sales, design, and supporting back office processes.
2019 Productivity analysis.