SME CPMod5 CPProcess 3Apr06

Improving BSO Services and SME Performance Through Cleaner Production: 

Improving BSO Services and SME Performance Through Cleaner Production [DATE] [SPEAKERS NAMES]

Module 5: The CP process and tools/techniques for CP implementation: 

Module 5: The CP process and tools/techniques for CP implementation

Outline for this module: 

Outline for this module FIRST, we discuss. . . operational inefficiency and associated costs THEN: the process for implementing Cleaner Production: Getting started Tools for identifying CP opportunities Prioritization and profitability assessment of CP options Implementation and measurement i.e., “the costs of waste” 1 2 3 4 Cost identification; Process mapping; Others. Basic financial analysis tools

5.1: Operational inefficiency & associated costs: 

5.1: Operational inefficiency & associated costs Module 5: The CP process and tools/techniques for CP implementation

Slide5: 

Remember, CP is a tool for improving business efficiency 

What is efficiency?: 

What is efficiency? What is waste? Efficiency=the reduction of waste ? “Waste is any material or energy leaving the facility. . .” Proactive definition Less strict definition “. . .not as part of the product.” “… without first being used as efficiently as possible.”

Slide7: 

Definitions of waste vary, but ALL companies generate waste as part of their operations. !

Many forms & sources of waste: 

Many forms & sources of waste Allowance  breakage  contaminated solids  core loss  customer returns  damage  drainings  dust  evaporation  furnace loss  greenhouse loss  hidden losses  leakage  overfill  non-conforming material  packaging  process loss  rework  second quality  stock loss  washings  Waste comes in many forms. . . . . .and has many different sources

Slide9: 

What are the costs associated with waste and energy loss? ?

The “cost crocodile”: 

The “cost crocodile” The true cost of waste can be like a crocodile, with only a small part visible See “the cost iceberg” in: Bierma, TJ., F.L. Waterstaraat, and J. Ostrosky. 1998. “Chapter 13: Shared Savings and Environmental Management Accounting,” from The Green Bottom Line. Greenleaf Publishing:England.

Costs of waste are often underestimated: 

Costs of waste are often underestimated For every $1 of waste cost measured, another $2 - $3 of cost are “hidden” in the accounting records, or are not on the books at all Companies typically underestimate how much waste really costs them, sometimes by several orders of magnitude This applies even to big, well-managed companies too! For example. . .

Cost of animals “dead on arrival” : 

Cost of animals “dead on arrival” The “Nutrimeat” abbatoir purchases animals at the farm gate and transports them to the abattoir. About 1% are “dead on arrival” (DOA) from the stress of transport. These animals are incinerated. CASE STUDY DOAs are waste. What is the cost?

Cost of waste ink: 

Cost of waste ink Southwire” estimated the average disposal cost of a drum of hazardous waste ink as US$50 Upon closer inspection, the true cost was discovered to be US$1,300 per drum: CASE STUDY Unnecessary waste represents inputs that were purchased unnecessarily. !

Assessing the costs of waste: an essential part of the CP process: 

Assessing the costs of waste: an essential part of the CP process All waste has a cost—but the cost of some types of waste is far more significant than others. Reducing waste saves these costs—but may also require initial investment and effort Therefore, assessing the costs of waste is essential to: Identify the key problems that CP can address Evaluate whether CP measures are good business decisions. or ?

Slide15: 

How do we best identify the true costs of waste? ? This is discussed later in this module. . .

Slide16: 

5.2: The Cleaner Production Process (Overview) Module 5: The CP process and tools/techniques for CP implementation

Getting oriented: 

Getting oriented The CP process is not an “extra.” It is just good management. WHY? The CP process produces… Improved information for management (understanding of production costs and of the true cost of waste) Prioritization of improvement opportunities and analysis of their profitability Understanding of technology options Which should be INTEGRATED with the business planning process (more on this in a later section)

The Cleaner Production Process: 

The Cleaner Production Process Step 1: Getting organized (setting goals, assembling a team) Step 2: Identification of opportunities (review costs, analyse using process mapping, materials balance, root cause analysis, options generation techniques) Step 3: Prioritization and evaluation Step 4: Implementation Step 5: Measurement and review Our focus today

The CP process is a cycle: 

The CP process is a cycle Identification of Opportunities Prioritization and Evaluation Implementation Measurement and Review Getting Organized

GettingOrganized: 

Getting Organized First, think about who should be involved in the CP process. ID oppor- tunities Prioritize Evaluate Implement Measure, review Get organized 1 Think first in terms of functions, not individuals Functions are the same in almost all organizations, big or small. . .

GettingOrganized: 

Getting Organized ID oppor- tunities Prioritize Evaluate Implement Measure, review Get organized 1 Each function may have a role to play in CP! Basic organizational functions 

GettingOrganized: 

Getting Organized ID oppor- tunities Prioritize Evaluate Implement Measure, review Get organized 1 In small organizations, single individuals often perform many functions: (“wear many hats”) sales accounting owners manager Prod’n Shipping Handout: “Cleaner Production Team”

GettingOrganized: 

Getting Organized So now. . . Assemble your team. ID oppor- tunities Prioritize Evaluate Implement Measure, review Get organized 1 Set challenging CP goals, ensuring they are aligned with business objectives Essential for success: Identify a leader for the CP process: Get management support Identify potential barriers to the CP process (e.g., institutional) and identify solutions Identify external resources (e.g., CP centers, technical assistance) Seek input from personnel at all levels AND

Identifying CPOpportunities: 

Identifying CP Opportunities OVERVIEW: Assess costs to identify areas for efficiency improvement Use process mapping as a tool to understand flow of materials, energy, and waste If necessary, use Root Cause Diagnosis to figure out WHY a problem exists Use option generation techniques to identify possible CP solutions 2 ID oppor- tunities Prioritize Evaluate Implement Measure, review Get organized We will learn about each of these tools 

Prioritize & evaluate: 

Prioritize & evaluate OVERVIEW Determine the value of each CP option based on: Profitability (costs versus savings) Risk and cash-flow issues Level of commitment needed Alignment with business objectives For projects needing capital investment, conduct a project profitability assessment 3 ID oppor- tunities Implement Measure, review Get organized Prioritize Evaluate CP options are evaluated with the same criteria as any business investment

Implementation: 

Implementation OVERVIEW Establish a concrete yet attainable schedule with check-in points; action plan Assign responsibilities Allocate necessary resources Work with employees who will be affected, getting feedback from them regarding the initiative 4 CP implementation is just like implementing any other change in a business.  ID oppor- tunities Prioritize Evaluate Implement Measure, review Get organized

Measurement & review: 

Measurement & review 5 OVERVIEW Collect data before/after to measure and document success Periodically review your CP initiatives in conjunction with your business plan Goal: Continuous improvement! ID oppor- tunities Prioritize Evaluate Get organized Implement Measure, review

Slide28: 

5.3: Step 2 of the CP Process: Identification of CP opportunities FOCUS: cost accounting Module 5: The CP process and tools/techniques for CP implementation ID oppor- tunities Prioritize Evaluate Implement Measure, review Get organized

Slide29: 

WHY COST ACCOUNTING? Remember: Assessing the costs of waste is essential to identifying the problems that CP should address 

Cost categories: 

Cost categories In any enterprise, there are three broad categories of costs: The cost of production inputs Materials, energy, labour, capital, etc. The costs of management of materials, energy, & waste Waste handling, regulatory compliance, supply chain requirements, waste treatment and disposal, non-product losses, etc. Less tangible costs Production throughput, product quality, company image, liability, etc Handout: “Costs checklists”

Problematic accounting practices. . .: 

Problematic accounting practices. . . Waste imposes costs in all three categories But problematic accounting practices hide its true costs “Hidden” in the accounting records Misallocated from overhead accounts Mis-classified as fixed when they are really variable, or semi-variable Not found in the accounting records at all Costs can be. . . (Can you think of others?)

Problematic Accounting Practices:Hidden costs of raw materials: 

CASE STUDY Manufacture of Plastic Rear Panels for Automobiles per accounting records actual MATERIAL LOSSES (as % of input) Adapted from: Rooney, Charles. “Economics of Pollution Prevention: How Waste Reduction Pays.” Pollution Prevention Review.Summer 1993. Engineering specification allowed 50% waste; accounting records only showed waste/loss in excess of specification How did this happen? Problematic Accounting Practices: Hidden costs of raw materials

Problematic Accounting Practices:Hidden costs of raw materials: 

Problematic Accounting Practices: Hidden costs of raw materials CASE STUDY “PLS” packaging company (printing and assembly of potato chip bags) We will learn more about the PLS company in our practical exercises The amount of raw materials used The amount of final product shipped  Accounting records show: ! Accounting records do NOT show: The amount of solid scrap waste generated The amount of any other lost raw materials

Problematic Accounting Practices:Misallocation of costs: 

Problematic Accounting Practices: Misallocation of costs EXAMPLE Consider 2 identical production machines with different utilization. How should you allocate a total electricity cost of $100/day between the units? If investing in a more efficient unit, replace/upgrade unit 2 first!  GOOD: ! BAD: Unit 1 100 units/hr 2 hours/day Unit 2 100 units/hr 8 hours/day $50/day $50/day $20/day $80/day

Problematic Accounting Practices:Misallocation of costs: 

Problematic Accounting Practices: Misallocation of costs In accounting, costs initially assigned to overhead accounts (e.g. utilities) are usually allocated back to processes, products, or projects using an allocation basis such as: The Concept An incorrect allocation gives incorrect cost signals! Correct allocation is needed to accurately target CP efforts, and support better internal decision making. Quantity of raw materials used Production volume Machine hours Labor hours Floor space As in the previous slide: ! !

Problematic Accounting Practices:Mis-classification of fixed vs. variable costs: 

Problematic Accounting Practices: Mis-classification of fixed vs. variable costs Fixed costs are costs that do not vary with production level or other factors Variable costs are costs that are costs that do (or can) vary with production level or other factors Equipment depreciation Rent Permanent labor Loan Interest Raw materials use Casual labor Energy use Water use

Problematic Accounting Practices:Mis-classification of fixed vs. variable costs: 

Problematic Accounting Practices: Mis-classification of fixed vs. variable costs The goal of Cleaner Production is to reduce variable costs (or prevent end-of-pipe fixed costs) Therefore, it is important to correctly distinguish between fixed and variable costs when identifying and estimating costs to support CP efforts “If CP efforts will reduce a cost — then it is variable!”

Problematic Accounting Practices:Mis-classification of fixed vs. variable costs: 

Problematic Accounting Practices: Mis-classification of fixed vs. variable costs A cost considered “fixed” at one firm may be considered “variable” at another firm ! ! Future “fixed” costs are not fixed yet—CP applied now may reduce the size and cost of equipment that you may have to purchase in future !

Problematic Accounting Practices:Missing costs: 

Problematic Accounting Practices: Missing costs In general, two types of costs may be entirely missing from the accounting records: Future costs Less tangible costs permit and other environmental fees lost sales due to returned products Lost sales due to failure to meet customer spec Equipment replacement Cost to reputation of product quality problems Lost profit from product quality problems Etc. Future depreciation costs of new equipment Handout: “Assessing Contingent and Less-Quantifiable Costs” For example For example (variable) (fixed) lost sales due to returned products

Ease of identifying/estimating costs: 

LESS HIDDEN MORE HIDDEN Ease of identifying/estimating costs In general, as you go down this list, costs are more likely to be hidden or difficult to quantify. (but every case is different!) Equipment purchase, direct materials, energy, labour Waste disposal Recycle/rework, treatment, waste handling Regulatory compliance, other indirect costs Less tangible costs

Slide41: 

So, now we know all the problems of cost accounting. But how do we actually get started? ? 

The basic “recipe” for quantifying the cost of waste: 

The basic “recipe” for quantifying the cost of waste First, check the general ledger & production records to obtain all available information about costs and quantities of inputs and outputs The general ledger contains only external transactions, not internal flows between departments or production steps. It will show inputs purchased and goods sold. However, physical quantities (kg, litres, kwh) of inputs purchased are often not recorded. Production records contain the volume of goods produced Sometimes, they include information such as physical quantities of inputs used and number of rejected products. 1

The basic “recipe” for quantifying the cost of waste: 

The basic “recipe” for quantifying the cost of waste Match cost & quantity information to the process diagram: assign costs & quantities to all inputs assign quantities to all wastes Calculate the total cost of each waste, which includes the cost of purchased inputs from which the waste is made the labor expended on these inputs costs of managing the waste (labor, treatment costs, etc.) . 2 3 Process diagrams are our next topic. This is the hard part—but doing is easier than explaining We will LEARN BY DOING with practical exercises. 

Potential sources of cost data: 

Potential sources of cost data Internal data sources External data sources Original records in other departments Activity-based costs* Non-product outputs/ product losses* Employees Industry colleagues or trade associations Vendors and consultants Business partners (e.g., insurance firm) Government (e.g. environment agency) *only relatively sophisticated SMEs will have this information Often the general ledger and production records don’t provide all needed information. So where do you look?

Slide45: 

Group exercise– Cost accounting at the PLS company [45 minutes] (see handout)

Basic PLS Process: 

Basic PLS Process STEP 1: PRINTING STEP 2: LAMINATING STEP 3: SLITTING Plastic film Printed Plastic (Interim Product) FINAL PRODUCT Laminated Sheets (Interim Product) Aluminum film Scrap Scrap Scrap To incineration Plastic film

Slide47: 

5.4: Step 2 of the CP Process: Identification of CP opportunities FOCUS: process mapping Module 5: The CP process and tools/techniques for CP implementation ID oppor- tunities Prioritize Evaluate Implement Measure, review Get organized

Process mapping: 

Process mapping Process maps are: the schematic depiction of a production process They divide a process into basic steps and list inputs and outputs for each step Midland Metals Foundry Process Map

Process mapping: 

Process mapping Process maps are constructed in a particular way: Interim product (from previous work step) Material & energy inputs (product & non-product materials) Non-product loss Interim/final product (to next work step) Work Step Product materials: become part of the product Non-product materials: not incorporated into product Non-product loss material or energy that is lost as scrap, waste, or emissions

Process mapping: 

Process mapping Process maps. . .  Are a key tool for understanding the production process Makes relationships between operations visible and lead to a systems view of the business Can be used to keep track of both quantities of inputs and outputs AND costs Are extremely useful for helping communicate CP opportunities to management & all departments   Making a process map is therefore an essential part of the identifying CP opportunities. 

Don’t all facilities already have process maps?: 

Don’t all facilities already have process maps? NO. Micro-enterprises rarely have any process documentation. Small enterprises usually keep separate documentation by department or machine. There is rarely documentation that makes connections between all process steps. ! Sophisticated SMEs may have information in the form of Flow charts, Value stream maps, Process and instrumentation diagrams, Machine configurations, Arrow diagrams, Box diagrams, Floor plans, etc. All are complex; none replace a basic process diagram! Handout: “Understanding a Process with Process Mapping”

“Nutrimeat”: 

“Nutrimeat” CASE STUDY Enterprise Profile: country sector employees production Philippines Abattoir 90 (regular & contract) market 300-700 animals/day Export- quality products produced to high hygiene standards

Process mapping: “Nutrimeat” : 

Process mapping: “Nutrimeat” CASE STUDY Transport Animals delivered in trucks; Trucks are washed Holding & Inspection Animals are held in pens & inspected. Condemned animals are separated and killed. fuel Animals dead on arrival Faeces, urine, contaminated water Condemned animals water Live animals Live animals Faeces, urine, contaminated water water Incineration Wastewater treatment

Process mapping: “Nutrimeat” : 

Process mapping: “Nutrimeat” CASE STUDY Evisceration & Splitting Abdomen cut open & viscera removed Breastbone split Heart/liver/lungs removed; Head removed Carcass cut into two along the spine Hide removed Energy (to sterilize equipment) Wastewater Water Intestines, edible organs Hides Inedible offal & Parts Stunning & Bleeding Animals are first stunned or killed, and then bled Carcass blood Faeces, urine, contaminated water Water Disinfectant Wastewater treatment Carcass Disinfectant Condemned parts Incineration

Process mapping: “Nutrimeat” : 

Process mapping: “Nutrimeat” CASE STUDY Chilling Carcasses refrigerated overnight water wastewater Energy (for refrigeration) Cutting & boning Carcasses are cut into pieces for retail, some bones removed Packaging Energy (to sterilize equipment & refrigeration) water Bones fat Meat Carcass Energy (to sterilize equipment & refrigeration) water Leaks of refrigerant fluids (Ammonia, CFCs Wastewater treatment

Process mapping: “Nutrimeat” : 

Process mapping: “Nutrimeat” CASE STUDY Incineration Condemned animals and parts Rendering Parts and scraps are rendered for tallow ? Waste treatment processes Secondary production processes And what other processes? ? ? ? ? ? ? ? ? Some secondary production processes

Slide57: 

Process mapping + cost accounting revealed 3 key areas for efficiency improvement: Result of the Nutrimeat CP assessment CASE STUDY 1 2 reducing “dead on arrival” animals Finding alternatives to incineration Housekeeping measures to reduce water use 3

Slide58: 

Group exercise– Process mapping at the PLS company [45 minutes] (see handout)

Slide59: 

5.5: Step 2 of the CP Process: Identification of CP opportunities FOCUS: Root cause analysis & CP options generation Module 5: The CP process and tools/techniques for CP implementation ID oppor- tunities Prioritize Evaluate Implement Measure, review Get organized

Causes of inefficiency?: 

Causes of inefficiency? Now, you have Gathered cost information Made a process map As a result: you understand the costs of waste & have identified key inefficiencies/ problems. But: no solution is possible without understanding the CAUSE of the problem(s). Sometimes, the cause of the problems is clear. Sometimes it is not ! 

Slide61: 

If the “root cause” of a problem is not clear, what do we do? ? Root cause analysis

A tool for Root cause analysis: The fishbone diagram: 

A tool for Root cause analysis: The fishbone diagram A fishbone (causes tree) diagram is it divides all causes into four categories: Possible causes in each category are then systematically identified. Materials is a simple tool for identifying the true causes of a problem. Machines People Methods Again, doing is easier than explaining

Root cause analysis: The XYZ bakery: 

Root cause analysis: The XYZ bakery A CP analysis of a bakery identifies BURNED BREAD as the main problem. Burned bread is a waste with high costs! Cost of inputs (flour, yeast, sugar, etc.) Cost of labor to make the bread Cost of fuel for the oven Lost profit And. . . If the incidence of burned bread is reduced, the business can expand without buying a bigger oven! CLASS EXERCISE Identifying CP options requires understanding the cause of the burned bread problem.

Root cause analysis: The XYZ bakery: 

We start by identifying XYZ’s: Root cause analysis: The XYZ bakery CLASS EXERCISE materials machines people methods Flour + Oven + ?? Employees Bread recipes + ??

Root cause analysis: The XYZ bakery: 

Now, we draw our “causes tree”. . . Root cause analysis: The XYZ bakery CLASS EXERCISE Burned bread Machines Material People Methods Oven Pans Door seals poorly so oven heats unevenly Some pans are blackened . . .and identify possible causes in each category.

Root cause analysis: 

Root cause analysis Sample causes tree

Root cause analysis: : 

Once you have identified possible root causes, how do you know which one(s) are real? In a real situation, those who know the process best should participate in making the “causes tree” Questions can be resolved by talking to employees and observing the production process Root cause analysis:

Root cause analysis: final notes: 

Root cause analysis: final notes Keep in mind the 80/20 rule (20% of causes account for 80% of problems), so focus on the big issues and avoid dwelling on smaller items Often, people focus on the obvious solution rather than best solution. Identifying root causes helps to identify solutions that solve the problem at the source.  

Slide69: 

Once we understand the root cause, we look for a CP option to address it Sometimes the CP options are obvious. Sometimes they are not. ! 

Slide70: 

If the CP options to address a problem are not clear, what do we do? ? Generate CP options

Generating CP options: 

Generating CP options Two basic approaches External Internal Looking for outside solutions via research, technical assistance Generating solutions internally with internal expertise & creative thinking can save effort! existing alternatives used elsewhere are often documented in case studies or available through technical assistance providers BUT… don’t be limited to external solutions. They may not be the best for your situation.

Generating CP Options internally: 

Generating CP Options internally General idea: get people with knowledge of the process to think creatively about solutions. Focus on generating a large number of options THEN worry about assessing if they are feasible or practical Employing worker knowledge and a little creativity can lead to impressive results. Your team should feel confident that they can generate equally or more effective solutions compared to “external experts.”  Experience shows:

Generating CP Options internally: 

Generating CP Options internally Two approaches to encourage creative thinking “BRAINWRITING” – ask each member of the group to WRITE DOWN possible solutions (Often works because people tend to write more than they say) “PROVOCATION” – Encouraging wild and outrageous suggestions Have some provocative solutions to initiate the session May trigger an unusual but effective solution

Slide74: 

5.6: Step 3 of the CP Process: Prioritization and Evaluation Module 5: The CP process and tools/techniques for CP implementation ID oppor- tunities Implement Measure, review Get organized Prioritize Evaluate

Review: Where are we in the CP process?: 

Review: Where are we in the CP process? Implement Measure & review 1 2 3 4 5  We have assembled our CP team  We have identified a number of CP opportunities Now, we must EVALUATE & PRIORITIZE these opportunities Which will we address first? Second? Which are not worthwhile? Why? Get organized Identify CP opportunities Evaluate &Prioritize

Principles and strategies for prioritizing CP opportunities: 

Principles and strategies for prioritizing CP opportunities FIRST Do financial analysis = evaluating cash flow and profitability implications of the CP options Remember, even if a CP option does not require capital, it will require management attention— this is in limited supply! Therefore, prioritization must be strategic! ! THEN Prioritize, based on financial information & business priorities.

Principles and strategies for prioritizing CP opportunities: 

Principles and strategies for prioritizing CP opportunities Remember the “Pareto Principle” (or the “80/20 rule”) DO prioritize both short-term & long-term opportunities. . . BUT, implement “low hanging fruit” FIRST How do you prioritize strategically? Consistently, about 20% of improvement opportunities provide approximately 80% of cost savings. Look for this 20%! CP opportunities that are easy and low-cost to implement, and which provide appreciable cost savings almost immediately. Use these immediate successes to build support for longer-term CP efforts. LOW-HANGING FRUIT are

A typical “pareto” (80/20) result: 

A typical “pareto” (80/20) result Sources of non-product loss Total cost* by source *total cost=purchase, disposal & management costs of material purchased but disposed of as waste A & B account for about 80% of the total costs of non-product loss

Overview of the remainder of this section: 

Overview of the remainder of this section In the remainder of this module, we will: Introduce basic concepts of financial analysis Cash flow analysis Profitability Indicators Introduce some decision-making tools to assist in prioritizing CP opportunities  

Financial analysis: Getting started: 

Financial analysis: Getting started The same process is used for assessing any business project, especially capital investments Characterizing the project’s impacts on cash flow is always the first step. Cash flows are used to calculate profitability indicators Reminder: financial analysis = evaluating the cash flow and profitability implications of the CP options.

Financial analysis: Getting started: 

Financial analysis: Getting started Two basic types of financial analysis Incremental Stand-alone Compares the cash flows of the proposed project to the “business as usual” cash flows Considers only the cash flows of the proposed project Most projects require incremental analysis! In incremental analysis, you only need to estimate the cash flows that CHANGE compared to business as usual

Basic concepts: 

Basic concepts CASH FLOWS Cash outflows (COSTS; negative) + Cash inflows (REVENUES & SAVINGS; positive) = NET CASH FLOW: (Elements of cash flows)

Basic concepts: 

Working capital “the total value of goods and money necessary to maintain project operations” Salvage value the resale value of equipment or other materials at the end of the projects Basic concepts CASH FLOWS includes items such as: Raw materials inventory; Product inventory; Accounts payable/receivable; Cash-on-hand Definitions of special terms

Slide84: 

Timing CASH FLOWS Annual Operating Costs Annual Tax Payments Annual Financing Payments Initial Investment & Working capital Year 1 Year 2 Year 3 Annual Revenues/Savings Project Start Working Capital Salvage Value INFLOWS OUTFLOWS Project END

Cash flow for a CP Project at the PLS company: 

Cash flow for a CP Project at the PLS company CASE STUDY Enterprise Profile: location sector product size Southern Africa Packaging Laminated film for food packaging SME We return to the PLS company. . .

Cash flow for a CP Project at the PLS company: 

The camera will detect problems with the manufacturing process and stop the process automatically Will reduce the amount of scrap/rejected product CASE STUDY CP Opportunity: Quality control camera Cash flow for a CP Project at the PLS company Costs & Savings

Quality control camera at the PLS company: 

Quality control camera at the PLS company Using the costs and savings, we can figure the net cash flow each year on an incremental basis. I.e., this is how cash flow changes compared to business as usual CASE STUDY For analysis purposes, we assume the project ends at year 3 & the salvage value of the camera is recovered

Slide88: 

In our PLS example, total investment = $100K & annual savings = $40K Would you recommend this investment? ?

Profitability assessment: interpreting cash flows over time: 

Profitability assessment: interpreting cash flows over time There is no simple answer to this question. HOWEVER, using PROFITABILITY INDICATORS will help with the decision A profitability indicator, or “financial indicator” is a single number that characterizes project profitability. Common profitability indicators: Simple payback Return on investment (ROI) Net present value (NPV) Internal rate of return (IRR) !

Profitability indicators: Simple Payback and Return on Investment: 

Profitability indicators: Simple Payback and Return on Investment These indicators incorporate The initial investment cost The first-year cash flow Simple Payback (in years) Initial Investment Year 1 Cash Flow = ROI (in %) Year 1 Cash Flow Initial Investment =

Profitability indicators: Simple Payback and Return on Investment: 

How are ROI and simple payback used? Profitability indicators: Simple Payback and Return on Investment In larger companies, the simple payback or ROI calculated for a project are usually compared to a company rule of thumb called a “hurdle” rate: A project must meet the “hurdle rate” to be considered by management. Our company may rule is that project payback must be 3 years or less. Which means ROI must be 33% or MORE.

Quality control camera at the PLS company: 

In our PLS case, what is simple payback and ROI? Quality control camera at the PLS company CASE STUDY PAYBACK= INVESTMENT/YEAR 1 SAVINGS = $100K/$40K = 2.5 yrs ROI= YEAR 1 SAVINGS/INVESTMENT = $40K/$100K = 40%

Slide93: 

ROI & Simple Payback have a problem. They do not account for the time value of money ! What do we mean?

The time value of money: 

The time value of money If we were giving away money, would you rather have: $10,000 today? $10,000 three years from now? ? ? !

The time value of money: 

The time value of money $10,000 today, thanks $10,000 today, thanks! WHY?

The time value of money: 

The time value of money There are 2 reasons for answering “today” Inflation Investment opportunity Both are the source of the “time value of money” (TVM)

The time value of money (TVM): 

The time value of money (TVM) Money loses purchasing power over time as product/ service prices rise, so: A dollar today can buy more than a dollar next year Inflation Investment opportunity A dollar that you invest today will give you more than a dollar next year — having the dollar now provides you with an investment opportunity investment $1 today $1.10 a year from now This year Next year $1 $1.05 How much does it cost?

TVM and profitability assessment: 

TVM and profitability assessment When you invest in a capital project, you have: An initial investment happening NOW A series of cash inflows IN FUTURE YEARS, that pay back the initial investment over time   So, it is important to take the TVM into account when you are estimating project profitability !

TVM: Present value of future cash flows: 

TVM: Present value of future cash flows Typically, we take TVM into account by converting all FUTURE cash flows to their PRESENT values The idea is to DEPRECIATE future cash flows at a particular annual rate, the discount rate The calculation is exactly the opposite of calculating bank interest

TVM: Present value of future cash flows: 

TVM: Present value of future cash flows Present Valuen = Future Valuen (1 + d)n The value of the cash flow in year n The value of the cash flow for year n at “Time Zero,” i.e., at project start-up d = the discount rate n = the number of years after project start-up Handout: “Performing NPV calculations”

TVM: Present value examples: 

TVM: Present value examples Discount rate (d): 10% 20% 30% 40% Years into future (n) 1 .9091 .8333 .7692 .7142 2 .8264 .6944 .5917 .5102 3 .7513 .5787 .4552 .3644 4 .6830 .4823 .3501 .2603 5 .6209 .4019 .2693 .1859 10 .3855 .1615 .0725 .0346 20 .1486 .0261 .0053 .0012 30 .0573 .0042 .0004 .0000 What is the present value of $1 in the future? Present value factors* *Note: present values can be calculated easily with present value factors

Profitability indicators: Net Present Value (NPV): 

figure the present value of the net cash flow for each year of the project. And then add all these present values together, we obtain the NET PRESENT VALUE (NPV) Profitability indicators: Net Present Value (NPV) 1 2 If we: NPV is calculated for a particular project lifetime. It does not consider cash flow beyond that time period If NPV > 0, the project is profitable If NPV < 0, the project is not  

Quality control camera at the PLS company: 

Quality control camera at the PLS company CASE STUDY In our PLS case, what is the NPV? All figures in 1000s of dollars It depends on the discount rate! (and the time period)

TVM: choosing discount rates: 

TVM: choosing discount rates Discount rates make a big difference to profitability! How do we choose the right one? When borrowing money: the discount rate is AT LEAST the cost of capital (i.e., bank interest plus loan fees) When investing one’s own money: inflation + rate of return on alternative investments + risk premium = discount rate

Profitability indicators: Internal rate of return (IRR): 

Profitability indicators: Internal rate of return (IRR) IRR is The IRR tells you what discount rate makes the project just barely profitable IRR is similar to NPV in that it considers both the time value of money and all future year cash flows the discount rate for which NPV = 0, over the project lifetime.

Quality control camera at the PLS company: 

Quality control camera at the PLS company In our PLS case, what is the IRR? CASE STUDY By inspection, IRR is between 25% and 30% Exact calculation: IRR=28.6% IRR must be calculated iteratively Financial calculators and spreadsheets calculate IRR automatically 

Comparing profitability indicators: 

Comparing profitability indicators

Do financial indicators tell everything about financial feasibility?: 

Do financial indicators tell everything about financial feasibility? NO. Considering the individual circumstances of the enterprise is critical! For example, considering NPV or IRR is not helpful if: ! The firm has no significant cash reserve and cannot obtain financing, OR Can obtain only a very a small amount of financing (NPV and IRR do not indicate SIZE of project.) In these cases, improving cash flow in the short term is the only option

Slide109: 

“Experience shows that for the smallest enterprises, simple payback of a year or less is a good rule of thumb.

Prioritizing CP options: 

Prioritizing CP options Now, we have evaluated the potential CP opportunities from a financial perspective. However, financial considerations are only one element of deciding to implement a project How do you weigh all these considerations? ? Technical Financial Organizational Regulatory

Slide111: 

A number of decision-making aides for prioritizing CP options exist However: Decision-making aides can’t make a decision for you! They can only facilitate systematic consideration of the issues involved.  ! Some examples

Decision-making aides for prioritizing CP optionsThe Criteria Matrix: 

Decision-making aides for prioritizing CP options The Criteria Matrix The criteria matrix forces a systemic comparison of options according to specific criteria. Determine a score for each cell on a 1-5 scale: 1: poor/expensive/difficult 5: excellent/not costly/easy Add the score in each category to determine “winners” Criteria are examples only—choose criteria that reflect the particular circumstances

Decision-making aides for prioritizing CP optionsForced pair analysis: 

Decision-making aides for prioritizing CP options Forced pair analysis In forced pair analysis, options are compared systematically in pairs. The result is a best to worst ranking of options. Let’s say B is best. So B moves to the top of the list 1 A B 1 C D Let’s say we have 4 CP options, A-D 2 First, compare A & B 3 B A C D Now, compare A & C 4

Decision-making aides for prioritizing CP optionsForced pair analysis: 

Decision-making aides for prioritizing CP options Forced pair analysis 1 If C is better than A, the new order is If A is better than C, the order remains B C A D B A C D Now, compare D to A Compare C to D In either case, D will move “up the list” until it loses in comparison to another option. 5 6 BUT OR

Slide115: 

Remember, implement “low hanging fruit” FIRST 

Slide116: 

5.7: Step 4 & 5 of the CP Process: Implementation and Measurement/Review Module 5: The CP process and tools/techniques for CP implementation ID oppor- tunities Get organized Prioritize Evaluate Implement Measure, review

Review: Where are we in the CP process?: 

Review: Where are we in the CP process? Measure & review 1 2 3  We have assembled our CP team  We have identified a number of CP opportunities Now, we must IMPLEMENT our CP priorities and measure our progress Get organized Identify CP opportunities Evaluate &Prioritize  We have evaluated and prioritized these opportunities Implement 4 5

Action plans: the basis of implementation: 

Action plans: the basis of implementation Implementation requires an ACTION PLAN. Implement 4 responsibilities resources Specify BOTH who will coordinate & who will carry out specific tasks Identify the resources required for implementation milestones goals Specify WHAT will be implemented and the performance improvements that will result metrics Specify how goals and milestones will be measured Set out specific implementation steps & WHEN they should be achieved Key elements of action plans

Action plan matrix: 

Action plan matrix Summarize your action plan in a matrix: In larger organizations, the matrix is used to obtain management sign-off/approval

Why measure and review?: 

Why measure and review? Measurement and review has two objectives: Measure & review 5 Keep implementation on-track Monitor performance Monitor the MILESTONES in the action plan. Where milestones are being missed, the coordinator must know & take action! Once the CP project is implemented, measure its actual performance against its goals. Performance monitoring should CONTINUE and become a part of business as usual.

Make monitoring of CP implementation business as usual: 

Make monitoring of CP implementation business as usual Energy is 50% of our production cost. We implemented good housekeeping and equipment modifications to improve energy efficiency. Now, the production department reports kWh of electricity used per kilogram of product to management each month.  Monitoring supports continuous improvement In fact, we have a continuous improvement goal of reducing kWh/kg by 5%/year.

REVIEW of module 5: 

REVIEW of module 5 Waste is inefficiency and imposes many costs on businesses. Its true cost is often hidden. Via the CP process, we identify the true costs of waste, prioritize problems and CP options, and implement these priorities systematically.