Process Improvement
Process Improvement
Improving productivity is a never-ending goal in factories and service facilities. Corporations spend millions each year to cash in on savings made possible by advances in information, production, and distribution technologies. They spend additional millions to educate and train their workforces, includ- ing tuition reimbursement programs to send employees to universities to learn better management tech- niques. They also spend millions to convert to processes that reduce the adverse effects of toxic wastes on the environment.
Capital Budgeting: Applications ❧ 423
Case Study: Bracken Manufacturing For the past two years, Bracken Manufacturing has produced a major component for one of the automobile
models built by the Redford Motor Company. The two companies recently signed a long-term contract for the procurement of 800,000 units each year for the next three, beginning at the end of the current year. The contract provides that Bracken will upgrade its manufacturing processes with the twin goals of (1) reducing the unit variable cost of production, and (2) improving quality so that fewer units fail to satisfy performance specifications and end up as scrap.
Bracken is considering two process improvements, designated A and B, to improve the output from the final assembly area of its plant. Table 13-2 gives information for the current process and the two options.
Table13-2
Investment Cost and Unit Variable Cost for Final Assembly Process
Investment
Unit Variable Cost
CurrentProcess
NA
ProcessA
ProcessB
Units from final assembly are inspected 100 percent. Those that pass inspection are shipped to Redford Motors, whereas those that fail to pass inspection are either reworked or scrapped, depending on the cause for failing to pass inspection. Reworked units are sent back for a second inspection and are either accepted, sent back for being reworked a second time, or scrapped. The cycle is repeated for a maximum of three reworkings. Any units that fail to pass inspection after the third reworking are scrapped. It costs $25/unit for inspection and an average of $95 to rework a unit that has failed to pass inspection. Because of toxic materials used in the units, scrapping costs $5/unit.
Table 13-3 gives the probabilities for being accepted and shipped to the customer after inspection, for being sent to rework after inspection, and for being scrapped after inspection. For example, for the current production process, there is a 75 percent probability that units will pass inspection after final assembly or after rework. There is a 20 percent probability that a unit will be sent for reworking after inspection, and a 5 percent
probability that a unit will be scrapped after inspection. (In other words, for every 100 units that go to inspec- tion, 75 units are accepted, 20 units are reworked, and 5 units are scrapped.) After the third rework, all 25 percent that fail to pass inspection are scrapped.
Table13-3
Transition Probabilities from Inspection Current Process
Process B From
Process A
To To Inspection Customer Rework Scrap Customer Rework Scrap Customer Rework Scrap
To
To
To
To
To
To
To
1to3 75%
0% 15% (Continued)
424 ❧ Corporate Financial Analysis with Microsoft Excel ®
The three-year contact helps Bracken raise capital to buy the new equipment to improve its production facility; for example, it can borrow at a lower rate of interest from banks because of the assurance their loan will be repaid. As part of the incentive for process improvement, the contract provides that savings will be shared. Bracken will retain 75 percent of the amount by which it is able to reduce the variable cost of production and pay back the other 25 percent to Redford.
1. Determine the after-tax rates of return for the two new processes. Use a three-year period for financial analysis. Use the MACRS method with a seven-year lifetime for the equipment, and assume that the equipment will be put into operation during the first quarter of Bracken’s fiscal year. You may also assume that the market value of the equipment will be the same as its book value at the end of three years. Use a cost of capital of 13 percent and a tax rate of 40 percent for the incremental income that Bracken will earn from the investment.
2. Prepare a chart that provides separate curves for the change in the net present values of the investments in Process A and Process B over the three-year lifetime of the contract. 3. Which process should Bracken choose? Why?
Solution: Figure 13-14 shows the flow of units from final assembly through the cycles of inspection, rework, delivery to customers, and scrap cycles of the current process. It traces the flow from final assembly to inspection and then to (1) good products that can be shipped to customers, (2) defective products that are reworked and sent back to be inspected again, and (3) defective products that are scrapped.
Figure13-14
Flow of Products from Final Assembly, with Transition Probabilities for the First Three Inspection Rounds with the Current Process
Final Assembly Rework
To Customers
To Scrap
Figure 13-15 is a spreadsheet solution for part 1 of the problem. The challenge in solving this case study is to determine the financial benefits from the process improvements being considered. Part of this challenge is handling the costs of inspecting, reworking, and scrapping units.
1. The first step calculates the variable costs of producing good units with the current assembly process. This analysis is shown in the top of Figure 13-15.
(Continued)
Capital Budgeting: Applications ❧ 425
Figure13-15
Total Annual Costs and Unit Variable Costs
1 BRACKEN MANUFACTURING 2 Old assembly process with 800,000 good units/year to customer
3 Transition Probabilities 4 from Inspection
7 Rounds 1 to 3
8 After 3rd rework
9 Assemble-Inspect-Rework-Scrap Cycle Analysis
10 Number of Units
Variable Cost Analysis
12 Round Inspection
Unit Cost Cost 13 1 854,701
Total annual variable cost = $ 324,854,701 18
Variable cost of a good unit = $406.07 19 New assembly process A with 800,000 good units/year to customer ($1,000,000 investment)
20 Transition Probabilities 21 from Inspection
24 Rounds 1 to 3
25 After 3rd rework
26 Assemble-Inspect-Rework-Scrap Cycle Analysis
27 Number of Units
Variable Cost Analysis
29 Round Inspection
Unit Cost Cost 30 1 830,694
Total annual variable cost = $ 323,673,451 35 Annual saving in variable cost from new assembly process A =
$ 1,181,250 36 Annual payback to customer (25% of annual saving) =
Total annual cost = $ 323,968,763
Variable cost of a good unit = $404.96 39 New assembly process B with 800,000 good units/year to customer ($5,000,000 investment)
40 Transition Probabilities 41 from Inspection
44 Rounds 1 to 3
45 After 3rd rework
46 Assemble-Inspect-Rework-Scrap Cycle Analysis
47 Number of Units
Variable Cost Analysis
49 Round Inspection
Unit Cost Cost 50 1 819,057
Total annual variable cost = $ 313,705,542 55 Annual saving in variable cost from new assembly process B =
$ 11,149,159 56 Annual payback to customer (25% of annual saving) =
Total annual cost = $ 316,492,831
Variable cost of a good unit = $395.62
(Continued)
426 ❧ Corporate Financial Analysis with Microsoft Excel ®
Figure 13-15 is divided into three modules. Each calculates the variable costs for producing 800,000 good units of product. The top module calculates the costs for the current assembly process, the middle module calculates the costs for Process A, and the bottom module calculates the costs for Process B. Each module is organized in the same manner. In each module, the number of good units supplied to the customer is 800,000 (Cells C17, C34, and C54), as required by Bracken’s contract with Redford.
Enter a trial value (e.g., 100,000) in Cell B13 for the number of units that move from final assembly to the first round of inspection. To calculate the number of units that move from the first, second, and third rounds of inspection to customers, rework, and scrap, enter =$B13*C$7 in Cell C13 and copy to C13:E15. Change this entry to =$B16*C8 in Cell C16 and copy to D16:E16. The number of units that move from rework to inspection on each round is entered as =D13 in B14 and copied to B15:B16. Calculate the totals by entering =SUM(B13:B16) in Cell B17 and copying to C17:E17.
The next step is to use Excel’s Goal Seek tool to determine the number of units from final assembly (i.e., the number of units from inspection on the first round in Cell B13) needed to end with 800,000 units of good products to customers (the value in Cell C17). Figure 13-16 shows the Goal Seek dialog box with the settings. The result in Cell B13 is 854,701 units. (Excel’s Solver tool can be used as an alternative to the Goal Seek tool.)
Figure13-16
Goal Seek Dialog Box with Settings to Determine the Number of Units from Final Assembly to Produce 800,000 Units of Good Product with Bracken’s Current Assembly Process
The annual variable cost for producing 800,000 units of good product with Process A, and the resulting unit cost, are computed in Cells G13:I18. The total cost includes the cost of assembling 854,701 units, inspecting 1,066,667 units, reworking 211,966 units, and scrapping 54,701 units. These values are calculated in Cells B13, B17, D17, and E17 and transferred to Cells G13:G16. Cells H13:H16 have data values for the unit costs for assembling with Process A, inspecting, reworking, and scrapping. Multiplying the number of units by the unit costs gives the total costs; that is, the entry in I13 is =G13*H13 and the entry is copied to I14:I16. The total cost is calculated in Cell I17 by the entry =SUM(I13:I16). The variable cost of a good unit is calculated by the entry =I17/C17 in Cell I18.
The analysis for Process A is made in the same manner. Cells A2:I18 are copied to the lower portions of the spreadsheet and edited with the new transition probabilities and unit costs. Excel’s Goal Seek tool is used to determine the number of units to inspection from final assembly that must be made to produce 800,000 good units. Three rows are added for calculating the annual saving with the new assembly process, the annual payback to Bracken’s customer, and Bracken’s total annual cost for producing 800,000 good units. To compute the first of these for Process A, enter =I17-I34 in Cell I35. To compute the second, enter =0.25*I35 in Cell I36. To compute the third, enter =I34+I36 in Cell I37. The variable cost of a good unit for Process A is then calculated in Cell I38 by the entry =I37/C34. The analysis for Process B is made in the same manner.
(Continued)
Capital Budgeting: Applications ❧ 427
2. Figure 13-17 calculates the net present value, internal rate of return, and modified internal rate of return at the end of three years for investing in the process improvements. The chart at the bottom shows changes in the net present values of the two processes with years from the investment, then one year, as compared to almost two years for Process A.
Figure13-17
Capital Budgeting Analysis for Process Improvement at Bracken Manufacturing
59 BRACKEN MANUFACTURING Evaluation of Bracken’s after-tax rate of return on investment in
60 the new assembly process 61 Analysis period is 3 years, with MACRS depreciation
62 Cost of Capital
63 Tax Rate
Year-End Before-Tax Incremental Cash Flows Generated 66 by the Investments in New Processes
69 Depreciation (MACRS, 7-Year Life, 1st Quarter)
73 Taxable Income
Year-End After-Tax Incremental Cash Flow Investment 79 in New Process
82 Evaluation of Process A
86 Years to break even
87 Evaluation of Process B
91 Years to break even
Process B
Process A
NET PRESENT
YEAR
(Continued)
428 ❧ Corporate Financial Analysis with Microsoft Excel ®
The first step in this series of calculations is to enter the year-end before-tax incremental cash flows generated by the investments in the new processes. The entries in Cells B67 and B68 are the negative values of the investments. The incremental savings are calculated by entering =$I$35-$I$36 in Cell C67 and copying the entry to D67:E67, and by entering =$I$55-$I$56 in Cell C68 and copying the entry to D68:E68.
Depreciation is calculated by using the MACRS schedule for seven-year property and the mid- quarter convention for putting the equipment into service in the first quarter (Table 11-2). Taxable income, tax, and after-tax cash flows are calculated in the same manner as before.
Once the after-tax cash flows have been determined, the NPV, IRR, and MIRR functions are used to calculate the net present value, internal rate of return, and modified internal rate of return. The reinvestment rate for calculating the modified internal rates of return is assumed to be the same as the cost of capital. The years to break even item is determined by interpolating between the NPV values at the ends of years 1 and 2 (which are the last year for a negative NPV and the first year for a positive NPV for both processes).
3. Bracken should choose Process B because of its higher NPV and MIRR. The return on the investment of $5 million in Process B at the end of 3 years is an MIRR of 54.73 percent. Process B breaks even in just slightly more.
Improving quality requires management attention and often involves costs. Yet it is a truism that “Quality doesn’t cost. It pays!” Increased profits can far outweigh the cost of investing in quality. Nevertheless, quality can be a “hard sell” to executives focused on short-time profits.
A firm’s industrial engineers make analyses such as those for the Bracken case to justify recommen- dations to do what is needed to improve quality. This type of analysis encourages financial managers to recognize rather than overlook the benefits from improving production processes and the savings possible from quality control—despite an increase in manufacturing costs.
The Bracken case study illustrates several points that astute executives have learned in implement- ing the “Just-in-Time” (JIT) philosophy correctly. By giving its supplier a three-year contract, rather than doling out short-term purchase orders, Redford Motors has made it possible for Bracken to go to its lenders and borrow money to make the large investment needed to improve its production process. The arrange- ment provides incentives to both buyer and supplier. Both share the cost savings.
Note also the impact of quality control. Although the investment for Process B is five times as much as for Process A and has the same unit cost for final assembly ($340/unit) as Process A, it reduces the number of units that must be produced, inspected, reworked, and scrapped in order to end up with same 800,000 units per year to Redford Motors. Doing it right the first time has a huge payoff!
A note in Business Week points out: “Because most top managers were weaned on finance or market- ing, manufacturing often gets short shrift when capital budgets are drawn up. Consultants find that manufac- turers routinely funnel millions into reducing costs, yet pinch pennies when it comes to the factory, where investment can bring big gains in productivity and profits.” (Business Week, November 23, 1998, p. 137)
Business Week’s comments apply as much to service facilities as to factories. I daresay none of us is with- out examples we can cite from our experience of the costs of shoddy service. In fact, as the example illustrates, the benefits from quality control can far outweigh the costs for having to repeat and repair—and often losing customers. Quality costs and benefits are an important part of financial analysis for capital budgeting.
Capital Budgeting: Applications ❧ 429