For technical managers, it seems like a “no brainer.” Applying new technologies will make the process better, faster and more consistent. Then the inevitable happens—the bean counters, who don’t know a proximity sensor from a pressure transmitter say, “No money available.”
Keith Campbell, a senior consultant with the Louisiana Center for Manufacturing Sciences, and executive director of the Open Modular Architecture Controls Packaging Working Group, as well as an engineer with many years of experience justifying automation expenditures, says, “Do it in their language, it’s easier to convince them. Remember, finance sets the rules, so speak the language of finance.”
Different languages
This language has terms like cash flows, capital, interest, and, yes, even profit. Campbell, who reveals these definitions later, advises, “You must identify the positive cash flows you create with a new system, and then, using your company’s method for calculating cash flow, do the math.”
Not only is there is a different language, but the problem itself must be evaluated from a different point of view. Peter Martin, vice president of Invensys, a Foxborough, Mass., supplier of process controls and software, says, “When you are justifying automation, it’s important to remember that it’s an accounting problem. It is possible to solve the accounting problem through engineering principles, however. For instance, where is the biggest cost accounting database in manufacturing? It is information from all the sensors in the production process.”
Technical managers are sitting on a gold mine of cost detail that can be used to determine where the manufacturing problems lie, as well as the crucial data that can be used to figure out the best solution—and how to get through the financial maze to approval.
This advice directly leads to the conclusion that bringing a finance person into the automation buying team will reap huge rewards at the justification stage. This person would be involved in the analysis at all stages of the project, and will be well positioned to translate benefits into the correct numbers.
Why is there such an emphasis on financial analysis these days? Steve Loranger, area vice president for Emerson Process Management, an Austin, Texas-based process controls supplier, notes the changing value of automation over the last 25 years. “Automation drivers from the 1950s to 1975 went from pneumatics to electronics by emphasizing speed of operation and labor improvements with limited automation improvements. Drivers from 1975 to 2000 were repeatability and quality. During this time, computers went mainstream, there was improved control and information integration became essential. Now, drivers are economics and business optimization, due to globally integrated manufacturing and activity-based cost accounting.”
A new automation project can be designed to solve any of a number of problems in the plant. The sidebar accompanying this article provides several areas of improvement that can result from the project. Some of the areas can be hard to quantify, but it is essential to try to cost-justify as many as possible.
For example, it may seem hard to quantify safety improvements that result from improved automation. But safety and insurance experts may be able to help document savings that can include anything from avoiding lost work-days to lower insurance premiums. Boston-based Liberty Mutual released its 2003 Fall Workplace Safety Index, and concluded that the financial impact of workplace injuries in the United States is growing faster than the rate of inflation.
Among the higher frequency injuries that may be mitigated by automation are injuries from excessive lifting, pushing, pulling, holding, carrying or throwing of an object, and injuries from bending, climbing, slipping or tripping without falling.
Lifecycle costs
Bill Egert, engineering vice president of Addison, Ill.-based integrator Logic One Consulting, and member of the Board of Advisors for the Robotics International division of the Society of Manufacturing Engineers, advises calculating all of the costs associated with the life cycle of machines. He notes, “Check out costs associated with changes. For instance, on robotics, evaluate the tooling changes needed to support product changeover plus auxiliary equipment such as feeders, conveyors and workstations associated with material handling. One unseen cost occurs if the manufacturer doesn’t have good tolerances, which increases system implementation costs.”
Don’t dismiss employee turnover or morale as a factor that can’t be quantified. Egert reveals, “We had a printed circuit board assembly machine with robots where the component lead straightness was specified. But the manufacturing of one of the components, a relay, was sent to Mexico in order to save costs. Constant employee turnover in that plant caused quality problems including solder buildup or tape missing over a hole. The problems just couldn’t be controlled. This adversely affected assembly, but accounting still swore by the half million dollars of savings.”
Justification is technology independent. The same rules apply to buildings, automation systems and computer systems, and to various scopes such as the entire project, just a portion of a project or even when evaluating competing quotes.
Campbell says the fundamentals of justification include these steps:
* Identify the base case
* Identify alternatives to the base case
* Determine cash flows associated with the alternatives vs. the base case
* Use your company’s financial rules to evaluate the alternatives (payback period, net present value, rate of return, hurdle rate).
The base case is the current state of affairs. Include all the financial data that can be compiled. Then, having identified the correctable problems, document various alternatives to the base case. Quantify all the benefit factors that you can. Calculate the numbers and compare to the company’s financial rules. Those results can then be compared to determine the best alternative to present to management for funding.
Because projects are expected to pay back funds over several years, it is important to find a way to normalize the amounts in order to keep the analysis in proper perspective.
Present value
The first step is to determine the present value, which is defined as the value of all future cash flows discounted at the cost of capital, minus the cost of the investment. Discounted means that a future cash flow is worth less (discounted) than a present cash flow.
So, $100 received three years from now at 8% cost of capital is the same as receiving $79.38 today.
The Net Present Value (NPV) is the present value of all future cash flows discounted at the cost of capital, minus the cost of investment. Cost of capital is a weighted combination of the cost of debt (long term debt and leases after tax) and the cost of equity (preferred and common stock). All future cash flows means that the PVs are summed over some time horizon, often 5 or 10 years. Subtract the cost of the initial investment from the sum of the PVs to get NPV. The greater the NPV, the better the investment.
Where N is the number of years to be analyzed.
What if the company just took the funds and invested them? A valuable comparison is the return due to the business investment versus an anticipated return from automation project investments. The Internal Rate of Return (IRR) is the interest rate that equates the present value of future cash flows to the investment outlay. The IRR assumes that cash flows can be reinvested at a rate equal to the IRR.
The hurdle rate is the minimum rate of return to justify an investment. This includes cost of capital, risk premium (which will include analysis of the track record of the group asking for money, type of investment and allowance for overruns), and other factors such as working capital requirements.
Calculate the cash flows and rates of return for all of the alternatives and then the best solutions will pop out. If the numbers don’t make the hurdle rate, then re-evaluate the benefits.
Emerson’s Loranger discusses the analysis from a slightly different point of view. See the graphic “Connecting The Balance Sheet And The Income Statement.” The balance sheet is where assets and liabilities are tabulated and the income statement is where income and expenses are calculated. The analysis entails comparing the Return on Invested Capital (operating earnings from income statement / invested capital shown on balance sheet) to the weighted average cost of capital, or hurdle rate. The difference is the economic value added.
Analysis is good, but often engineers looking at automation projects become infatuated with new technologies and fail to match the project up with business strategies. As Loranger shows in the Business Planning Framework graphic, technology managers find their comfort zones in evaluating automation technology alternatives. The profit zone for the business, however, lies in meeting or exceeding plant, production and business objectives. So, when looking for projects with the highest probability of approval, make sure that they align with one or more of the objectives in the Profit Zone.
Train managers
Logic One’s Egert offers some additional tips on putting together a justification package. “Get management trained on technical aspects,” he states. “They have lots of knowledge and experience on finance and marketing, but not much on technical aspects. A progressive, smart manager will have those technical people. A manager with technical skills will be able to see some problems coming.” Another problem is management embracing new technology with no strategy for implementing, no urgency for training or no technical champion to embrace and learn the new stuff.
One approach that might change all of the calculations would be to lease new equipment, rather than purchase it. Paul Frechette, president and chief operating officer of Key Equipment Finance, commercial leasing services, a Superior, Colo. unit of Key Corp., says,“80 percent of American businesses lease equipment. They do it understanding that it is use of equipment, not ownership, that creates profits. Leasing from the vendor or from a lessor experienced in the field often yields the best deal, because they understand the value of the residuals (the value of the equipment after the term of the lease is over). The bigger lessors have been doing this for a long time and want repeat business, so they treat the residuals well. Their goal is to become trusted advisors.”
Assistance in evaluating leasing options is available from equipment sales people. Another resource close at hand would be people in the company’s own finance department. They probably are already leasing equipment and have the process figured out.
