Financial analysis towards lean & six sigma

Financial Analysis towards Lean
& Six Sigma

By Michael R. Buechler

1

The History of Finance

„It is not the business of economist to tell the brewer how to
make beer.“
‐ Alfred Marshall ‐

Financial Analysis by Michael R. Büchler

2

What is Finance?
We can define a moderd finance group as managing a firm’s long‐term and day‐to‐day monetary
operations and strategy. Its size varies based upon total employee head count, total revenue,
industry, and overall business strategy.
Purpose; The finance „group“ provides sound fiscal process, policies, planning and strategy. The
finance group is responsible for incoming and outgoing payments, budgeting, planning and
analysis, asset management (fixed & liquid), tax management, general accounting, and treasury
management. Some finance groups may also be responsible for payrole (HR Function), internal
audit and compliance, risk management and travel/expense administration, in many cases these
functions are outsourced (internal & external).
History; Finance in its modern form really dates from the 1950s. The hugh body of research in
finance over the last sixthy years falls naturally into two main streams. And no, we don’t mean
here „asset pricing“ and „corperate finance“ moreover we can call them business school
approach to finance and the economics department approach. This is purely a „notional“
statement, not physical – based on faculties field rather than its location.


3

Science Arises from the Discovery of Identity amid Diversity
William Stanley Jevons (1 September, 1835 – 13 August, 1882)
British economist and logician

A General Mathematical Theory of Political Economy (1862)
Pure Logic; or, the Logic of Quality apart from Quantity (1864)
Elementary Lessons on Logic (1870)
The Match Tax: A Problem in Finance (1871)
A Primer on Political Economy (1878)

„It seems perfectly clear that Economy, if it is to be a science at all, must be a mathematical science.
There exists much prejudice against attempts to introduce the methods and language of mathematics
into any branch of the moral sciences. Most persons appear to hold that the physical sciences form
the proper sphere of mathematical method, and that the moral sciences demand some other
method—I know not what.“


4

Classical Dictum of Economics
Alfred Marshall (26 July, 1842 – 13 July 1924)
British Economist
The Pure Theory of Foreign Trade: The Pure Theory of Domestic Values (1879)
Principles of Economics (1890)

To someone trained in the classical traditions of economics by the great Alfred Marshall stands out: „It is not
the business of the economist to tell the brewer how to make beer.“
The characteristic economics department approach thus is not micro, but macro normative. The models
assume a world of micro optimizers, and deduce from that how market prices, which the micro optimizers take
as given, actually evolve.


5

Unreliable Estimates Trough Computional Algorithm
Merton H. Miller (May 16, 1923 – June 3, 2000)
American economist
Co‐author of the Modigliani–Miller theorem (1958)
The Theory of Finance (1972)

„For the variances and covariance's, at least, past data probably could provide at least a reasonable starting point. The precision of

such estimates can always be enhanced by cutting the time interval into smaller and smaller intervals. But what of the means?
Simply averaging the returns of the last few years, along the lines of the examples in the Markowitz formula won’t yield reliable
estimates of return expected in the future. And running those unreliable estimates of the means through the computational
algorithm can lead weird, corner portfolio’s and hardly presume benefits of diversification.“
„For the micro normative wing was concerned with finding the „cost capital,“ in the sense of the optimal cut‐off rate for
investment when the firm can finance the project either with debt or equity or some combination of both. The macro normative
or economies wing sought to express the aggregate demand for investment by corporations as function of the cost of capital that
firms are actually using as their optimal cut‐offs, rather than just the rate of interest on long‐term government bonds.“
„The Modigliani‐Miller (M&M) proposition, in short, like the efficient markets hypothesis, are about equilibrium in the capital
markets – what equilibrium looks like, and this is way neither the efficient markets hypothesis nor the M&M proposition have
ever set well with those in the profession who see finance as essentially a branch of management science.“


6

Markovitz Mean‐Variance Model
The business school or micro nomative stream in finance;
Harry M. Markovitz (August 24, 1927‐ )
American economist
Harry Markowitz Model (1952)
"Portfolio Selection". The Journal of Finance (March 1952)

Markowitz makes the powerful algebra of mathematical statistics available for the study of portfolio selection;
„The immediate contribution of algebra to the famous formula for the variance of sum of random variables; that is, the weighted
sum of the variance plus twice the weighted sum of the covariances.“
This is a common formula used by finance during the last fifty years and that formula shows among other things, that for the
individual investor, the relevant unit of analysis must always be the whole portfolio, not the individual share. The risk of individual
share cannot be defined apart from its relation to the whole portfolio and in particular, its covariances with the other
components.
Covariances, and not mere numbers of securities held, govern the risk‐reducing benefits of diversification!

7

Capital Asset Pricing Model
Transforming the Markowitz business model into an economics department model
William F. Sharpe (June 16, 1934 ‐ )
American Economist
Portfolio Theory and Capital Markets (1970 and 2000)
Asset Allocation Tools (1987)
Fundamentals of Investments (2000)
Investments (1999)

„The CAPM implies that the distribution of expected rates of returns across all risky assets is a liniear function of a single variable,
namely, each asset’s sensitivity to or covariance with the market portfolio, the famous beta, which becomes the natural measure
of a security risk. The aim of sience is to explain a lot with little, and few models in finance or economics do so more than CAPM“
„The CAPM not only offers new and powerful theoretical insights into the nature of risks, buts also lends itself admirably to the
kind of in‐depth empirical investigation so neccessary for development of new field like finance.“
„Besides the market factor, two other pervasive risk factors have by now been identified for common stocks. One is a size effect;
small firms seem to earn higher returns than large firms, on average, even after controlling for beta or market sensitivity. The
other is a factor, still not fully understood, but that seems reasonably well captured by the ratio of a firm’s accounting book value
its market value. Firms with high book‐to‐market ratios after controlling for size and for the market factor.“
„That a three‐factor model shown to describe data somewhat better than a single factor CAPM should not detract in any way!“

8

Fischer Black
Myron S. Scholes (July 1, 1941 ‐ )
Canadian‐born American financial economist

Robert C. Merton (31 July, 1944 ‐ )
American economist

Fischer‐Black Formula 1997
(Black–Scholes model)

Fischer‐Black Formula 1997
(Black‐Scholes‐Merton formula)

„Options mean, among other things that for the first time in its close sixty‐year history the field of finance can
be build, or rebuild, on the basis of „observable“ magnitudes.“
„The Fischer Black reminded us, estimating variances is orders of magnitude easier than estimating the means
or expected returns that are central to the models of Markowitz, Sharpe or Modigliani‐Miller. The precision of
an estimate variance can be improved, as noted earlier, by cutting time into smaller and smaller units – from
week days to days to hours minutes. For means, however, the precision of estimate can be enhanced only by
lengthening the sample period, given rise to the well‐know dilemma that by the time a high degree of precision
in estimating the mean from past data has been achieved, the mean itself has almost surely shifted.“


9

Managing for Finance

... a taste of more to come


10

Instinctive Identification for Todays Finance Professionals

„The common perception of risk even today focuses on the
likelihood of losses – on what the public thinks of as the
„downside“ risk – not just on the variability of returns.“
‐ Merton H. Miller‐


11

Show me the Money!
Earnings Before Interest and Tax
How profitable is our business, and how do we need to understand on how we need to callculate its profitability?

Revenue minus expenxes, excluding tax and interest is called EBIT and is also referred to as "operating earnings", "operating
profit" and "operating income", as you can re‐arrange the formula to be calculated as follows:

EBIT =

Revenue ‐ COGS ‐ Operating Expenses ‐ Depreciation & Amortization

In other words, EBIT is all profits before taking into account interest payments and income taxes. An important factor contributing
to the widespread use of EBIT is the way in which it nulls the effects of the different capital structures and tax rates used by
different companies. By excluding both taxes and interest expenses, the figure hones in on the company's ability to profit and thus
makes for easier cross‐company comparisons.
EBIT was the precursor to the EBITDA calculation, which takes the process further by removing two non‐cash items from the
equation (depreciation and amortization).


12

Economic Profit
Economic Value Added ‐ EVA
Definition of „Economic Value Added – EVA“
•

A measure of a company's financial performance based on the residual wealth calculated by deducting cost of capital from
its operating profit (adjusted for taxes on a cash basis). (Also referred to as "economic profit".)

•

This measure was devised by Stern Stewart & Co. Economic value added attempts to capture the true economic profit of a
company;

= Net Operating Profit After Taxes (NOPAT) ‐ (Capital * Cost of Capital)


13

Non Performing Asset – NPA
Definition of „Non‐Performing Asset – NPA“
A classification used by financial institutions that refer to loans that are in jeopardy of default. Once the
borrower has failed to make interest or principal payments for 90 days the loan is considered to be a non‐
performing asset.
Also known as „non‐performing loan.“
Non‐performing assets are problematic for financial institutions since they depend on interest payments for
income. Troublesome pressure from the economy can lead to a sharp increase in non‐performing loans and
often results in massive write‐downs.


14

Managing for Accounting


15

The 1922 treatise of Managing Accounting

„The essential basis for the work of cost accountant – without it, there could
be no costing – is the postulate the value of any commodity, service, or
condition, utilized in production, passes over into the the object or product
for which the original item was expended and attaches to the result giving it
its value.“
‐ William Paton ‐


16

Introduction to Financial Accounting
•

Financial accountancy (or financial accounting) is the field of accountancy
concerned with the preparation of financial statements for decision makers, such
as stockholders, suppliers, banks, employees, government agencies, owners and
other stakeholders.

•

Financial capital maintenance can be measured in either nominal monetary units
or units of constant purchasing power. The central need for financial accounting is
to reduce the various principal‐agent problems, by measuring and monitoring the
agents’ performance and thereafter reporting the results to interested users.

•

In short, financial accounting is the process of summarising financial data, which is
taken from an organisation’s accounting records and publishing it in the form of
annual or quarterly reports, for the benefit of people outside the organisation.
Financial accountancy is governed not only by local standards but also by
international accounting standard.


17

Principles of Financial Accounting
Financial accounting is based on several principles known as Generally Accepted Accounting Principles
(GAAP), International Financial Reporting Standards (IFRS) and Accounting Regulatory Committee
ARC, International Accounting Standards/IAS
These include the business entity principle, the objectivity principle, the cost principle and the going‐
concern principle.
Business entity principle: Every business requires to be accounted for separately by the proprietor.
Personal and business‐related dealings should not be mixed.
Objectivity principle: The information contained in financial statements should be
treated objectively and not shadowed by personal opinion.
Cost principle: The information contained in financial statements requires it to be based on costs
incurred in business transactions.
Going‐concern principle: The business will continue operating and will not close but will realise assets
and discharge liabilities in the normal course of operations


18

Benefits of Financial Accounting

•

Meeting legal requirements: accounting helps to comply with the various legal requirements. It is mandatory for
joint stock companies to prepare and present their accounts in a prescribed form. Various returns such as income
tax, sales tax are prepared with the help of the financial accounts.

•

Protecting and safeguarding business assets: Records serve a dual purpose as evidence in the event of any
dispute regarding ownership title of any property or assets of the business. It also helps prevent unwarranted and
unjustified use. This function is of paramount importance, for it makes the best use of available resources.

•

Facilitates rational decision‐making: Accounting is the key to success for any decision making process. Managerial
decisions based on facts and figures take the organisation to heights of success. An effective price policy, satisfied
wage structure, collective bargaining decisions, competing with rivals, advertisement and sales promotion policy
etc.. all owe it to well set accounting structure. Accounting provides the necessary database on which a range of
alternatives can be considered to make managerial decision‐making process a rational one.

•

Communicating and reporting: The individual events and transactions recorded and processed are given a
concrete form to convey information to others. This economic information derived from financial statements and
various reports is intended to be used by different groups who are directly or indirectly involved or associated with
the business enterprise.


19

Limitations of Financial Accounting
One of the major limitations of financial accounting is that it does not take into account the non monetary facts of the
business like the competition in the market, forex trades etc. Some of following limitations of financial accounting have
led to the development of active based costing accounting:
•

Unclear operating efficiency: financial accounting will not give you a clear picture of operating efficiency when
prices are rising or decreasing because of inflation or trade depression.

•

Shortcoming not spotted out by collective results: financial accounting reflects the net result only. It does not
indicate profit or loss of each department, job, process or contract. It does not disclose the exact cause of
inefficiency i.e. it does not tell where the oppurtunity is because it discloses the net profit of all the business
activities. Furthermore, loss or less profit disclosed by its profit and loss accounts is a signal of imbalanced
businesses, the exact cause of such performance is not identified.

•

Price fixation: financial accounting, costs are not available as an aid in determining prices of the products,
services, production order and lines of products.

•

Provides only historical data: financial accounting is mainly historical and counts cost already incurred. As
financial data is summarised at the end of the accounting period it does not provide day‐to‐day cost information
for making effective desions on real time approach and will not help to indicate future evaluation.

•

Limted analysis on cost of losses: It fails to provide complete analysis of losses due to defective material, idle
time, idle plant and equipment. In other words, no distinction is made between avoidable and unavoidable
wastage.


20

International Accounting Standards
•

Accurate and reliable financial information is the lifeline of commerce and investing. Presently,
there are two sets of accounting standards that are accepted for international use namely, the U.S.,
Generally Accepted Accounting Principles (GAAP) and the International Financial Reporting
Standards (IFRS) issued by the London‐based International Accounting Standards Board (IASB).
Generally, accepted accounting principles (GAAP) are diverse in nature but based on a few basic
principles as advocated by all GAAP rules. These principles include consistency, relevance, reliability
and comparability.

•

Generally Accepted Accounting Principles (GAAP) ensures that all companies are on a level playing
field and that the information they present is consistent, relevant, reliable and comparable.
Although U.S. GAAP is only applicable in the U.S., other countries have their own adaptations that
are similar in purpose, although not always in design.

•

IFRS are International Financial Reporting Standards, which are issued by the International
Accounting Standards Board (IASB), a committee compromising of 14 members, from nine different
countries, which work together to develop global accounting standards. The aim of this committee
is to build universal standards that are translucent, enforceable, logical, and of high quality. Nearly
100 countries make use of IFRS. These countries include the European Union, Australia and South
Africa. While some countries require all companies to stick to IFRS, others merely try to synchronize
their own country’s standards to be similar.


21

Active Based Costing
Do we count all our activities during our business transactions?

In contrast to traditional cost accounting systems, ABC systems
first accumulate overhead cost for each organizational activity,
and then assigns the cost of the activities to the products,
services or customer causing that activity.
ABC’s active analysis are most critical for identifying appropriate
process output measures of activities and resources, their effects
on the costs of making a product or providing a service.
Traditional cost accounting systems often allocate costs based on
single‐volume measures. Using single‐volume measures seldom
meets the cause and effect criterion desired in cost allocations.
ABC system have the flexibility to provide special reports
facilitating management decision making towards costs of
activities undertaken to design, produce, sell and deliver a
company’s products or services.

Activity‐based costing records the costs that traditional cost accounting does not do!

22

Implementation of ABC
According to Ray H. Garrison and Eric W. Noreen there are six basic steps required to implement an ABC system:

6. Prepare and
distribute
management
reports

5. Assign cost to cost
objects using the activity
rates and activity measure
previously determined

4. Calculate
activity rates

1. Identify and
define activities and
activity pools

2. Directly trace costs
to activities (to the
extent feasible)

3. Assign costs to
activity pools

Managerial Accounting, 9th Edition by Ray H. Garrison, Eric W. Noreen and E.W. Noreen (1999)


23

Accountable for Financial Accounting ...

“Hold everybody accountable? Ridiculous!”
‐ W. Edwards Deming ‐


24

Balanced Scorecard


25

Optimum Quality Costs and Zero Defects: Are They Contradictory Concepts?

„A program of continuous improvement does not necessarily introduce increased
costs as the quality level approaches 100%“
‐ Arthur M. Schneiderman ‐


26

BalanceScoreCard

•

History; The first balanced scorecard was created in 1987 at Analog Devices, a mid‐sized
semiconductor company by its „forgotten“ contributer Arthur  M. Schneiderman former VP Quality
at ADI and now been recognized as „first generation“ balance scorecard also know as the half‐life
concept.  The concept then was popularized by Robert Kaplan and David Norton in the early 1990s.

•

Purpose; A strategic planning and management system used extensively in business and by
organizations worldwide. Benefits of the system include increasing focus on results, aligning
business activities with organization strategy and improving performance and communications.
The balanced score card proposes that the organization should be viewed from four perspectives,
with metrics developed, data collected and analysed  or each of them. These four perspectives are:
Financial, Customer, Internal Business Processes and Learning and Growth.


27

Optimum Quality Cost
Juran defines three quality zones relative to the point of minimum total quality cost. The „zone of improvement
project“ lies below the optimum quality level, while the „zone of perfectionism“ lies above it. Between them,
and of the minimum, lies the „zone of indifference.“

•

Quality costs depend on incremental, not
total, elementary costs. At the optimum,
nothing in general can be said about the
relative levels of prevention and failure
costs.

J.M. Juran Quality Control Handbook 1979


28

Optimum Quality Level
The zone of perfectionism is what most troubles proponents of zero defects, for here Juran suggests relaxing
prevention efforts and allowing increased defect rates. Furthermore, he identifies the boundary of the zone of
perfectionism as lying typically , at the quality level where failure costs amount to 40 % of the total cost. Translating
the rules of thumb, this translates into a defect level only half that which exists in the zone of improvement.

•

The is no mathematical requirement that the
optimum occurs at q < 100%. There may be no
optimum in the range of q = 0 to 100%. There
might be a minimum rather than an optimum,
and it could very well be at q = 100%.


29

Never‐ending Eliminating Waste ‐ Muda

Schneidermann, Quality Progress (1986)

The Japanese word for continuous improvement is Kaizen. Innovation is perhaps an alternative method to
compare improvement. While innovation is characterized by costly major events, kaizen represents
inexpensive and almost imperceptible continuous improvement.

30

The Half‐Life System
Quality Improvement Process
•

Among QIP we can define defects as; rework, yield loss, unnecessary reports, cycle times in
services, design and administrative processes, unscheduled downtime, inventory, employee
turnover, absenteeism, lateness, unrealized human potential, accidents, late deliveries, order lead
time, setup time, cost of poor quality and warranty costs.

•

The basic flaw in goal setting is that specific goals should based on means that will be used to
achieve them. Means are rarely known at the time goals are set. The usual result is that if the goal
is too low, we will underachieve the potential. If the goal is to high, we will underperform
expectations. Rational goals with means of prediction is what can be achieved if standard means for
improvement were used!

•

For each increment of time that equals half‐life, the defect trops by 50%. For example, if the initial
defect level was 10%, and the defect half‐life was six months, then after the first six months, the
defect level would be down 5%, after the next six month 2.5%, and so on.


31

Assemble Problem Solving

Continiual problem solving shows the PDCA cycle as
diffrent points along the clock face. This formulation
emphasized that a quality program is not something an
organization does for a year or two to correct some
problems and then moves on to something else. Rather,
the QIP emodied a continual problem‐solving
commitment in which the half‐life method served as the
speedometer for measuring how fast the organization was
traveling around the PDCA cycle.


32

The 7 Steps


33

The Half‐life


34

Implementing the Half‐Life Concept
1.

The corporate Scorecard is divided into five panels. The top panel, Financial Performance, presents information to
stockholders.

2.

The second panel, QIP indicators, presents data how „we“ look to customers and employees. The measures, such
as lead time, on time delivery and employee turnover, indicate whats importand and what needs to be improved.

3.

The third and fourth panels present measures of internal performance. These measures are drive the external
measures shown in the first two panels.

4.

The fifth panel shows how well we are doing in introduction new products and achieving the stratgic goals.

This set of concept was proposed by Schneiderman in 1990


35

Evolution of the First Balanced Scorecard: 1991


36

Kaplan & Norton’s Balance Scorecard
Kaplan & Norton's writing on the subject in the late 1990s:

Kaplan development of the Balance Scorecard 2010:

1.
2.
3.
4.

1.
2.
3.
4.

Translating the vision into operational goals;
Communicating the vision and link it to individual performance;
Business planning; index setting
Feedback and learning, and adjusting the strategy accordingly.

Balanced Scorecard for Performance Measurement
Strategic Ojectives and Strategy Maps
The Strategy Management
Future Opportunities

Kaplan and Norton recognized that any comprehensive measurement and management system had to link operational performance
improvements to customer and financial performance. Kaplan & Nortons BSC, while incorporating Analog’s operational improvement
metrics, also incorporated metrics for innovation, employee capabilities, technology, organizational learning, and customer success. And
unlike the stakeholder perspective, Kaplan & Norten placez shareholder value as the highest‐level metric, with all the other stakeholders
reflected in how they contributed to the company’s success in maximizing long‐term shareholder value.

37

Economic Value Added/Shareholder Value
Integrating Shareholder Value with the Balance Scorecard
• As the BSC emerged in the 1990’s just as two other ideas – Economic Value Added (EVA) and Activity‐Based Costing.
• EVA and other shareholder value metrics address two defects in traditional financial reporting of copporate performance;
earnings per share or „bottom line“ performance measure and capital used to generate the income and earnings.
• To avoid this problem is to divide net income by some measure of invested capital to calculate a return on investment (ROI).
Either by increasing the net income or by decreasing invested capital.
EVA corrects both the over‐invested and the under‐
invested problem by subtracting cost of capital from the
net income;
Net Sales
‐ Operating expenses
= Operating profit (EBIT)
‐ Taxes
= Net Operating profit after tax (NOPAT)
‐ Capital charges (Invested capital x Cost of Capital)
= Economic Valua Added

EVA cannot articulating a strategy and complementary
processes. The BSC /shareholder expands value approach
by defining drivers of revenue growth; objectives and
measures for customers, customer value proposition,
internal business process for innovation and customer
relationships, needed infrastructure investments in
people, systems and organizational alignment.
Robert S. Kaplan HBS 2001 No. B0101C


38

Activity‐Based Costing Model
Activity‐based costing was developed to correct another defect in financial system. Activity‐based costing provides an analytic
model that represents how individual products and customers use different quantities of servicces supplied by indirect and
support resources.
The first step of an ABC model, resources drivers
link expenses of resources supplied to activities
and processes performed (GL).
Assigning resources expences to activity and
process cost provides the first link between ABC
and the BSC
Three parameters – cost, quality and time –
usually define the performance of any process
Quality and time are realatively easy to measure
as they are based on physical measurement. Cost
however, is an analytic construct, not something
tangible that can be measured by manual force
Only an ABC model can accurately trace
organizational expenses to a manufacturing,
distribution, service delivery or process
development.
Robert S. Kaplan HBS 2001 No. B0101C


39

Putting a Balance Scorecard to Work
Linking measurments to a strategy is the heart of a successful scorecard development process. The
three key questions to ask here;

1. If we succed with our vision and strategy, how will we look different?
• to our  shareholders and customers?
• in terms of our internal processes ?
• in terms of our ability to innovate and grow?

2. What are the critical sucess factors in each of the four  scorecard
perspectives?

3. What are the key measurement that will tell us wheter  we’re addressing
those success factors  as planned?


40

Supply Chain and Finance


41

Financing the Chain

"In investing, what is comfortable is rarely profitable."
‐ Robert Arnott ‐


42

General Background on Credit Conditions
The Eco‐System Approach

•

SCF is an approach for enhancing working capital for both buyers and sellers in a transaction – using an
intermediary tool that links buyers, sellers and third‐party financing entities – thereby reducing supply
chain risks/costs and strengthening business relationships.

•

Simply shifting the burden from one party to another can add significant risk to the supply chain
including customer loss, business continuity risk, supplier viability risk, material cost inflation,
deterioration support, and other issues. Supply chain finance provides an opportunity to collaborate and
create benefits for each side of the transaction.

•

In favour to buyers using superior credit rating to lower overall financing costs within the supply chain
by reducing risk for the supplier in return for an extension of credit terms, thereby enhancing the buyer’s
working capital position.

•

SCF potentially fits best in situations the buyer has access to capital at a lower cost than seller and/or
where the buyer has a significant time gap between inventory purchases and cash receipts from sales.


43

Supply Chain Financing – How it works

How it works; While reducing the amount of capital tied up in Accounts Receivable and minimizing investment
in inventories are fairly straightforward keys that will unlock the value in your supply chain, extending Accounts
Payable terms carries the potential for significant risks – supplier instability, impact to business continuity, and
eroded service among them.
To manage and minimize the overall risk inherent in extended payable approaches, leading companies are
turning to SCF, a powerful tool that allows companies to extend the payables cycle in a manner that adds value
to both parties. Buyers hold cash liquidity longer and achieve a more stable supply chain, while sellers gain
quicker access to lower‐cost cash and enjoy improved business continuity. Cash forecasting effectiveness is
enhanced and buyer‐seller relationships are strengthened.
Bottom‐line; For companies that have a strong credit rating relative to their suppliers and are willing to explore
alternative working capital strategies, SCF is a powerful tool that brings benefits to multiple parties across the
supply chain.


44

Shouldn’t all suppliers be squeezed?
Reason why SCF is needed
A comparison of accounting data of industrialized
nations shows that median accounts receivable
ranged from 14% to 33% of sales in 2006.

„If buyers squeezes its supplier on their days
paymement outstanding – the gap for the supplier is
immense and can lead to poor cost of quality.“
Trade across industries*


45

Trade Credit Strategies
Options how to pay Outstandings
Three trade credit strategies
1. Win‐win
2. Follow
3. Squeeze
Depth interviews (Seifert, Springer Volume 10, 2011) indicate that roughly two‐thirds of companies still apply a
single trade credit strategy;


46

Trade Credit Strategies


47

The Win‐Win Approach
The win‐win approach in particular receives much attention from treasury, going beyond the simple adaptation of
payment terms, finance professionals have combined financial insights with electronic payment platforms and created
reverse factoring solutions.

•

Reverse factoring are solutions based on factoring – transactions which suppliers sell receivables to factors for
immediate cash. Because the receivables are sold rather than pledged, tratitional factoring is different from
borrowing – there are no liabilities on the suppliers’ balance sheet.*

•

Reverse factoring, however, is different in three important aspects. First, since the technique is buyer‐centric,
factors do not have to evaluate heterognous buyer portfolios and can charge lower fees. Scecond, since these
buyers are usually investment grade companies, factors carry less risk and can charge lower interest rates. Third,
as the buyers participate, factors obtain better information and can release funds easier.

The first question managers should think about what kind of relationship they want to build. Is the supplier a strategic partner? Is
the customer a key account? Will this partner be around for more than a year? Understanding the partners cost of Capital?
Second, if the relationship is of a more transactional nature, mangers determine their company’s competitive position. Third,
even if the company is in a strong position, it should still consider its cost base

Industry observers predict that reverse factoring solutions will evolve over the coming years to create more
value to suppliers


48

Traditional Factoring

4
Buyer
Portfolio

Bank,
Factoring
Company

1

Supplier

2

3
Example case

First, suppliers sells goods to buyer with accounts payment e.g. 14days. Second, buyers accepts goods
however squeezes accounts receivable to e.g. 45 days (The big player approach) Third, supplier has 31
days neededs to be finance either by equity or loan, e.g. from bank or factoring company. Fourth, bank
or factoring company will check buyers credit‐rating and lend the outstanding payment to supplier
with equivalent interest. This approach is time intensive, expensive and has a negative impact on the
whole supply chain finance for all parties.

49

Reverse Factoring

As a process, reverse factoring is slightly more complicated than traditional factoring. Citibanks’s process, for example, involves
seven steps. First, the buyers sends a purchase order to the supplier and notifies Citibank. Second, the supplier delivers and
presents documents to Citibank. Third, Citibank checks the documents and notifies the buyer, Fourth the buyer approves or
rejects. Fifth, Citibank notifies the supplier of the buyer’s acceptance. Sixth, if the supplier requests early payment, Citibank
credits the supplier’s account. Finally, when the invoice is due, Citibank debits the buyer’s account.

50

Break‐Even‐Time


51

Break‐Even‐Time

„You cannot manage what you cannot measure. What gets
measured gets done!“
‐ Bill Hewlett ‐


52

Are we Fit for its Purpose
Companies lose an extentual amount of money after tax when the deliever late and on overspend on
developing new products. More and more manifactures are learning that the time required to develop a new
product has more influance on its success than its costs.
It is common belief in management practice in todays markets that on of the most effective ways to shorten
development cycles is through the collaborative work of cross‐functional development teams. Common
language has little collabartion and suffers throughout a companies hierarchy.
We can define questions like; what features do customers want? How do features translate into sales? Is the
technology available to develop the features? Will the product be manufacturable at the desired price. We
need to measure on what we are doing what we agree must be done! A metric which would encourage
collabration among different function.
Hewlett‐Packard is using a metric called „Return Map.“ The map includes the critical elements of product
development – the investment in product development and the return or profits from that investment. The
map also shows the breakeven time to develop the product, introduce it and achieve the returns.
The greatest virtue perhaps is the goal and measure for all the the functions and thus shifts the teams focus
from „who is responsible“ to „what needs to get done!“ Even more important is to estimate and re‐estimate
the time and money it will take to complete the overall project success!

53

To be on the Spot of the Market
The Return Map is intended to be
used by all functional managers
and business team.
Basicially it is a two demensional
graph displaying time and money
on the x and y axes respectively.
The x axis is divided into three
segments
–
Investigation,
Development and Manufacturing
& Sales.
Purpose of investigation is to
determine the desired product
features, the products cost and
prize the feasability of the
purpose technolodgieas and the,
plan for product development and
introduction.


54

The Tean Plotes Estimates
Basic Elements
Investment
Line;
total
product
development effort from beginning to
manufacturing and sales release.
Sales Line; Sales volume over a given
time.
Profit Line; volume of sales and the
price of product in market place.
The critical lines are are systematically
plotted on the Return Map include new
produc investement equity, sales equity
and profit equity. Each of these are
plotted by money and time.


55

BET – New Metrics
The map tracks – equity and months –
R&D and manufacturing investment, sales,
and profit.
Break‐Even‐Time (BET), is the key metric.
It is defined as the time from the start of
investigation until product profits equal
the investment in development.
Time‐to‐Market (TM), is the total
development time from start of
Manafacturing phase to Manufacturing
Release.
Break‐Even‐After‐Release (BEAR), is the
time from Manufacturing Release until
investment cost are recovered in product
profit.
Return Factor (RF), is a calculation of
profit equity divided by investment equity
at a specific point in time after a product
has moved into manufacturing and sales

56

Making the Most of the Return Map
The effectiveness of the Return Map involves all three major functional areas in the development and
introduction of new products. The map captures the link between the development team and the rest of the
company and the customer.
•

Interfunctional teams using the Return Map most appropriately during the investigation phase by
generating estimates for final map including investment, sales, and profit.

•

Too often the burden is placed on R&D during the initial project phase – to generate schedules,
functionality and cost goals.

•

Empasizing the missed forecast generated for the Return Map in the Investigation phase should be view
valuable information.

The Return Map can be used to provide a visual perspective on sales forcast and expect profits given any
number of hypothetical secenarios.


57

Forcasting Financial Performance


58

Forcasting Financial Performance

„Your net worth to the world is usually determined by what
remains after your bad habits are subtracted from your good
ones“

‐ Benjamin Franklin ‐


59

How to Choose the Right Forcasting Technique
The selection of a method depends on many factors – the context of the forecast, the relevance and availability
of historical data, the degree of accuracy desirable, the time period to be forecast, the cost benefit (or value of
the forecast to the company, and the time available for making the analysis.
1.
2.
3.

What is the purpose of the forcast – how is it be used?
What are the dynamics and componenets of the system for which the forcast will be made?
How important is the past in estimating the future?

Three general forcasting types to be used and once
the proble has been formulated, the forcast will be
in a position to choose a method!


60

Beyond the Data
Three technique by Chambers, Mullick and Smith (HBS 1971):
Qualitative techniques; these are primarily used when data are scarce – for example, when a product is first
introduced into a market. Use of human judgmenet and rating schemes to turn qualitative information into
quantitative estimates.
Time series analysis; these are statistical techniques used when several years’ data for a product or product line
are available and when relationsships and trends are both clear and relatively stable.
Causal models; when historical data are available and enough analysis has been performed to spell out
explicity the relationships between the factor to be forecast and other factors (such as related businesses,
economic forces, and socioeconomic factors), the forecaster often constructs a causel model.

„Tools designed to predict and shape what consumers want have been around for decades. But as with so
many information technologies, they did not begin to take off until the 1990s“ ‐ Davenport, MIT 2009 ‐


61

What People Want ... And How to Predict It
„Consumers began to come to fruition in the late 1990s, when Amazon.com Inc pioneered the widespread
commercial use of predictions with collaborative filtering.“ This software made recommadations and making
correlations with other products that he or she might like!
Predictions of what products will be successful for creators and distributors of cultural content are less
common. It is easist after the product has developt, when its attributes are clear and there are some indicators
of its popularity. Using regression anlysis will give primary predictions e.g. on how many dvd copies need to be
produced.
Consider the dilemma faced by consumer trying to „keep up.“ The likely agree with the sentiment expressed by
the New York Times media critique;* „Like most Americans, I am overwhelmed by the velocity of everydaylife
and the volume media that goes with it.“

Just as a consumer products company wouldn’t dream of launchig a new product without first testing it with
consumers, no company will launch any expensive‐to‐create offering without putting it to some form of
systematic prediction


62

The effect of inflation

•
•

•

The annual rate of inflation is a statistic that measures the rise in prices for
consumer goods and services.
Inflation represents “price creep” and illustrates the degree of impact on
your buying power and therefore on your ability to enjoy a fixed standard
of living as your real purchasing power (amount adjusted for inflation)
decreases over time.
The impact of inflation is shown by:
New Price (t) = Base Price (1 + inflation rate)t


63

The effect of inflation

New Price (t) = Base Price (1 + inflation rate)t

1 0 7  1 0 0 (1  . 0 7 )

114.49 = 100 1 + .07 

For one Year
2

1 2 2 .5 0  1 0 0 (1  .0 7 ) 3

For two Years
For Three Years

If we assume the inflation rate to be 7% then these three totals will be
required to buy the same item in the given periods.


64

Cash Flow Management

•

A cash flow (CF) is a continuous stream of payments which shifts the equations
for FV and PV. For instance you need to choose between purchasing a piece of
equipment or leasing it at a monthly rate.

•

There are many factors that enter into this type of question such as the amount
of payment required on the lease, the alternative use of capital for other projects
and the ability to make a large down payment. The way this type of problem
should be worked is to determine if the present value of the leasing payment cash
flow is greater than or less than the current purchase price.

•

Future cash flows may be discounted to account for the effect of inflation (called
discounted cash flow – DCF or cost of money is factored‐in)


65

Internal Rate of Return (IRR)
•

This is a metric that assesses the value of alternate investment proposals to
determine their relative worth to the organization.

•

When this is set as a minimum acceptable return for a project, then this becomes the
“hurdle rate” which must be exceeded if the investment is going to proceed.

•

The cost of capital (COC) is the after‐tax return rate a business must achieve in order
to exceed the capital investment that a company could make in the market at large.

•

If CFn refers to the cash flow of a Project in the nth year of that project (t = total
length), then solving the following equation for r (rate) will provide the IRR:

CFn
Project Cost =  (1+ r)n
n=1
t


66

Calculating IRR in Excel
Tool: Excel > Insert > fx Function > Financial > IRR
Example: Calculate the internal rate of return after five years for the following investment project. The initial
investment requirement is $700,000 and the expected return (net expenses) for the next five years is:
$120,000, $150,000, $180,000, $210,000 and $260,000 (Cash Flow)

Answer: 8.66% = This rate should be compared with cost capital. If its higher than project than project should
be accepeted

67

Present Value (PV)

•

Description: the concept of present value (PV) is illustrated by the principal on a
loan. Interest (I) is the amount of money that you are charged for the use of the
principal. Future Value (FV) is the sum of principal (P) and the amount of interest
that is accrued over a period of time. The cumulating value of interest (accrual) is
the effect of two factors: Time (t) that money is used and the Rate (r) of interest that
is charged.

•

Instructions:

•

Applications: FV1 = PV (1 + r), for one year at simple interest
FVt = PV + PVrt, over time at simple interest)

•

Compound interest would change to: FVt = PV(1 + r)t

•

Example: What is the monthly payment on a loan of $18,000 which must be paid on
a monthly basis over 5 years at a simple interest rate of 8%? [HINT: Payments = FV /
N payments].

PV + I = Future Value
Money now + Interest = Money later


68

Present Value – Example

An individual wishes to determine how much money she would need to put
into her money market account to have $100 one year today if she is earning
5% interest on her account, simple interest.
The $100 she would like one year from present day denotes the C1 portion
of the formula, 5% would be r, and the number of periods would simply be
1.
Putting this into the formula, we would have;
When we solve for PV, she would need $95.24 today in order to reach $100
one year from now at a rate of 5% simple interest.

69

Future Value (FV)

Future values may be established using one of the following three
formulae, depending on the compounding period (n):
FV = PV ( 1 +r)n assuming n compounding periods for 1 year.
FV = PV ( 1 + r)nt assuming n compounding periods for t years.
FV = PV ert assuming continuous compounding for t years.
(2.71828 raised to (Rate x Time) .07 x 2 = .14)=1.15
100 x 1.15=115


70

Future Value (FV)

r

FV  PV  1  
n


n

10

 .10 
FV  100  1 

12 


10

 .10 
FV  100 1 
  108.29
 12 

71

Future Value (FV)

r 

FV  PV 1  
n


nt

12 5

.1 0 

FV  100 1 

12 

.1 0 6 0
F V  1 0 0 (1 
)
12
F V  1 0 0  1 .6 5  1 6 5

72

Net Present Value (NPV)
•

•

Net present value is more complex than IRR in that it requires a rate at
which each payment in the cash flow will be discounted and it depends on
the value used as the discount rate.
NPV is the difference between the discounted cash flow for a project at
the selected rate and the cost of the project (initial investment cost).  The
formula is similar to that of IRR, except that you are providing the “r”
rather than solving for it.
NPV =  CFn (1 + r ) ‐n

•

If NPV = 0, then the rate provided was the IRR.  If NPV < 0, then the sum of
the present values of the cash flow is less than the initial investment or
there is a loss on the project.  If NPV > 0, then the sum of the present cash
flows is greater than the IRR and you have made a profit on the project.


73

Calculating NPV in Excel
Tool: Excel > Insert > fx Function > Financial > NPV
Example: Calculate the net present value of the following investment. The initial investment requirement
is $10,000 and you are expected to receive an income stream for the following three years of $3,000,
$4,200, and $6,800. Assume that the annual discount rate is 10% for this period.

Answer: $1,188.44

74

Cost of Quality


75

Cost of Quality ...

„Quality is free. Its not a gift, but it’s free. What costs money are
the unquality things – all the actions that involve not doing jobs
right the first time.“
‐ Philip Crosby ‐


76

Cost of (Good‐Poor) Quality
The concept of quality goes back to the early 1950’s. It was inroducted in Juran’s Quality Control Handbook to
show cost as function of quality expressed as conformance precentage. Costs quality category can be put in
four diffrent groupings:
Prevention; the cost of all activities specifically designed to prevent poor quality in products or services
Appraisal; the costs associated with measuring, evaluating, or auditing products or services to asssure
conformance to quality standards and performance requirements.
Internal failure; costs resulting from products or services not conforming to requirements or customer/user
needs. These occur prior to delivery or shipment of the product, or the furnishing of a service, to the customer.
External failure; costs resulting from products or services not conforming to requirements or customers/user
needs. External failure costs occur after delivery or shipment of the product, and during or after the furnishing
of a service, to the customer.

We can define the first two categories as the cost of good quality and the last two as cost of poor quality the
sum of all categories are called total quality cost!


77

Be aware of the Hidden Peak ...

„I never saw a wreck and never have been wrecked, nor was I
ever in any predicament that threatened to end in disaster.“
‐ Captain Edward Smith ‐


78

The Tip of the Iceberg!
Rejects

Maintenance and service

Rework and sorting
Opportunity cost if sales
greater than plant capacity
Improvement program costs
Lost customer loyalty
Process control

Scrap

Warranty claims
Materials Obsolescence
Additional labor hours
Quality engineering and
administration
Expediting
Excess inventory
Supplier control
Longer cycle times

Quality audits
Cost to supply chain

Cost to customer

Inspection/test (materials, equipment, labor)

79

What should your project achieve?
Define

Measure

Analyze

Redesign

Modify
Design ?

Yes

No

Improve

Control

80

Account for the Cost of Quality
While calculating for cost of quality is straightfoward the execution of calculation may not always be! Hidden
factors are either buried in accounting costs or not consider at all!
•

•

Current accounting system measures:
– Scrap
– Warranty expense
– Inspection cost
– Labor overtime
Current system does not measure:
– Rework
– Lost sales
– Customer dissatisfaction or reputation loss
– Engineering and product development errors
– Production downtime
– Bill of materials inaccuracy
– Rejected raw materials

Total Quality cost
is minimized
when perfect
quality is
achived, hence
drive for zero
defects

Defects found by customers are
the most expensive of all!


81

Old theory of quality‐cost trade‐offs:
Quality Investments result in diminishing returns where further increases in quality are off‐set by
additional cost of achieving this quality performance. After this point an economic trade‐off must be
made to achieve additional quality performance by compromising with higher product cost.
Cost of Prevention:

Cost of Quality:
Failure analysis
Scrap
Rework
100% sorting
Re‐inspection
Re‐test
Warranty
Downgrading
Allowances
Overtime
Expediting
Inventory

Defect Rate
Cost of Control

Point of Diminishing
Economic Returns
from
Quality Investments

Process control
Training
Inspection
Testing
Audits
Redesign
Automation

99% Good = 4 

Failures

Cost

The cost of quality must be defined and presented in the language of the management – money!

82

New Model of Optimum Quality Cost
1.
2.
3.
4.

Attack on failure costs direct in attempt to
drive them to zero
Invest in „appropriate“ prevention activities to
bring about improvement
Reduce appraisal costs according to results
achieved
For further gain coninuously evaluate and
redirect prevention

Four premises strategy;
•
•
•
•

For each oppurtunity there is a root cause
Preventing instead of firefighting
Do it right the first time with zero defects
Prevetation can save you alot costs


83

Cost impact of a 3 quality performance:
Defect Level
5 to 7% of
Output

Level of
Internal Defects

Poor quality casts a
long cost shadow!

Poor Quality
Costs 20 to 40%
of Cost of Goods

Cost of
Goods Sold

84

This Problem Thrives in Functional Silos!
Finance
Records
Sales

Finance
Performance
Credit Check

Engineering

 Errors in cost
estimates
 Hard to assemble
design
 Outmoded
technology
 Expensive
components

Sales &
Marketing

Materials ‐
Procurement

 Errors in demand
forecast
 Product features
do not meet
expectations

Finance
Sends
Invoice

Finance
Pays/AP

 Inaccurate BOM
 Supplier’s
Defects
 Excess lead times
 Delayed
shipments

Manufacturing

Distribution

 Scrap
 Excess/ Obsolete
 Rework
 Wrong mix
products options
 Downtime
 Overtime
 Excess inventory
 Excess Capacity
 Excess/Obsolete
 Warranty & other
product liabilities
 Customer frustration
 Defective products

Defects exist in and between the functions!

Finance
Counts
Inventory

Sales &
Marketing
 Customer
frustrations
 Defective products
 Warranty & other
product liabilities

85

Quality costs are not equal inside goalposts
What is the total cost of poor quality to society?
Lower
Control
Limit

Mean

Upper
Control
Limit

Region of
Desired
Performance

Region of
Customer
Complaints

Region of
potential
loss to the
customer!
Region of
Customer
Complaints

Region of
Specified
Performance

Region
of
Questionable
Performance

Region
of
Questionable
Performance

Lower Specification Limit

Target Value

Upper Specification Limit
86

Value Rules in the Taguchi Loss Function:

Nominal‐the‐Best
Ao
T‐Do
Smaller‐is‐Better

Larger‐is‐Better

Do
=
=
=

Y

Less
Defects

More
Defects

Less
Defects

Ao

T
Ao
Do

T
More
Defects

Y

T+Do

Ao
Do

Y

Target
Cost of Repair or Replacement
Functional Limit

87

How to increase hidden factory efficiency?
What can you do to improve?
Reduce
all work
process
variation!

Eliminate
non‐value
added
work!

Eliminate
Scrap!

Good Sigma Level
High Classical Yield
Calculate
rolled
throughput
yield!

Reduce
Testing!
Work
Reduce
cycle time
and
set‐ups!

No
Does the
Customer
Detect
Defects?
Yes

Eliminate
Rework!

But, what is the
COQ?

Corrective
actions
are taken

Steward
process
outcomes

Manager’s Theory
‘O’ = no worries!

Look into the ‘hidden factory’ operations!

Apply ‘lean thinking’ to your routine work activities!

88

New view on quality performance:
Quality improvement is achieved not by adding inspectors, who are not very efficient, but by
improving the process to eliminate the root cause(s) of poor quality, so problems are resolved
once‐and‐for‐all, not replicated in the next generation of new products.

Defect Rate
Cost of Control

Emphasis of improvement
Cost

Failures

3
4
5
6

89

Relationship of COQ and Sigma level:
Flawless execution is the least costly way to great results!
Cost of Quality

Yield (PPM)

Long‐Term Sigma

30‐40% revenue

308,537

2

20‐30% revenue

66,807

3

15‐20% revenue

6,210

4

10‐15% revenue

233

5

less than 10% revenue

3.4

6

The goal is not perfection, but flawless execution to competitive level. Customers define the
market‐driven competitive performance level.

90

Objectives for managing with COQ:
•
•
•

COQ is used to identify Six Sigma projects for improvement and provide a financial measure of
improved performance.
Over time, reduction in COQ shows managements commitment to continuous improvement of its
work processes.
The goal in managing with COQ is to drive the failure costs to zero; to invest in the most appropriate
prevention activities, and to reduce appraisal costs as permanent process improvement is
implemented and results achieved.

One company’s improvement journey:
Prevention
15%

Appraisal
35%

Failure
15%

Appraisal
35%

Time
Failure
50%

Total = 17% of sales

Prevention 50%
Total = 2.5% of sales


91

Getting to improved bottom‐line results:
“The total cost of quality is unknown and unknowable.”
- W. Edwards Deming ‐
•
•
•
•
•
•
•
•
•

Process control is a pre‐requisite for error‐free quality results.
Cost of quality (COQ) increases as s a result of poorly controlled processes.
Process control can be measured in terms of yield (PPM and sigma).
Therefore, there is a direct correlation between yield (PPM and sigma) measurements
and COQ.
COQ for an average company typically exceeds 20% of sales revenue.
COQ accumulates across the value chain from supplier through production to
distribution.
In almost every company where the COQ is unknown it is safe to estimate that it
exceeds the company’s profit margin!
Most improvement programs are not tied directly to bottom‐line results, so gains are
sub‐optimized and improvements are not accurately reflected in the company’s
accounting statements which only show aggregate results.
Activity‐based costing helps illustrate gains better than standard methods.


92

Cost Benefits from
Improvements


93

Driving for Change and Results

“One of the great mistakes is to judge policies and programs by
their intentions rather than their results.”
‐ Milton Friedman ‐


94

Measure Business Performance
Operational Metric; There are many ways to measure your business performance. Here are just a
few measures used by some organizations:
•
•
•
•
•
•

Maket share
Productivity
Customer Satisfaction
Present margin/operating profit
Service Quality
Business growth

•
•
•
•
•
•

Product reliability
Defects and scrap
Time to market
Order‐to‐cash cycle
Delivery time
Inventory levels

Business Metric; A key factor that distinguishes Six Sigma and Lean from previous quality related
efforts is the attention newer methods receive from top‐management. One primary reason is the
conversion of improvement results into „equity“ financial measures;
• Return on net assets (RONA)
•
• Economic value added (EVA
•
• Return on investment (ROI)
•
• Earnings before interest, taxes, deprecation, •
and amortization (EBITDA)

Revenue
Earnings per Share (EPS)
Profit/earnings ratio (P/E)
Return on assets (ROA)


95

Summarizing in Finance
There are three ways to summarize financial statements, profit and loss (P&L) statement, balance
sheet and cash flow statement.
Lets start with profit and loss statement;
A P&L statement shows a company’s outcome for a defined period of time
– How much money/revenue a company brought in;
– How much it spent/expenses and cost;
– And difference between; revenue ‐ expenses and cost = net income;
– Cost of Goods Sold (COGS);
– Gross margin / gross profit;
– Research & Development (R&D);
– Selling, General and Administartion (SG&A);
– Nonreccuring entries
– Income tax epense
Lets have a look at some of these measure in our next slides.

96

Impact of a 10% Price increase:

Sales
Cost of Good Sold
Gross Margin

$100
75
$  25

$110
75
$  35

Selling, R&D, Admin
Operating Profit

14
$   11

14
$  21

10%

91%

A 10% Price Increase Results in a 91% Profit Increase!


97

Impact of Reducing Cost of Goods

Sales
Cost of Goods Sold
Gross Margin

$100
75
$ 25

$ 100
67.5 – 10%
$32.5

Selling, R&D, Admin
Operating Profit

14
$ 11

14
$18.5 + 68%

A 10% Reduction in CGS Results in a 68% Profit Increase!

98

Impact of Reduced SG&A Costs

Sales
Cost of Goods Sold
Gross Margin

$100
75
$  25

$100
75
$  25

Selling, R&D, Admin

14
$  11

12.6 – 10%
$ 12.4 + 13%

A 10% Reduction in SG&A Results in a 13% Profit Increase!

99

Home Run: Improve Sales, CGS, and SG&A
Sales (UP)
$100
Cost of Goods Sold (DOWN)
75
Gross Margin
$  25

$110

+ 10%

67.5
$ 42.5

– 10%

Selling, R&D, Admin (DOWN)
14

12.6

– 10%

Operating Profit

$   11

$  29.9

+ 272%

10% Improvement in Each Item Results in a 272% Profit Increase!


100

Impact of Leverage
Leverage
A

Equity

50

B

Loan
50
Investment  $100

Equity

100

Loan
0
Investment $100

Investment sold at $110 ; Return on equity:
A

Revenue                     110
Total investment      100
$  10

Return on Equity   $10/50= 20%

B

Revenue
110
Total investment      100
$ 10

Return on equity  $10/100=10%


101

The Balance Sheet
A balance‐sheet shows an organizations assets, liabilities, and equity. The balance sheet is split in
two sections assets and liabilities & equities;
The two sides need to be balanced, hence the name
balcnace sheet. The balance sheet shows the value
of a business improving or declining over time.


102

How Improvments Contribute to Financials
Given the financial reports and measures that have been described, Six Sigma and Lean initatives
can contribute to either the P&L statement or the balance sheet!

Profit & Loss Statement

Balance Sheet Statement

Improvment areas:
• Revenue & cost; increase revenue and
decrease cost
• Hard savings from bottom‐line or top‐line;
Reduction in operation or production costs,
reduction in transaction costs, reduce
headcount and increase throughput

Improvment areas:
• Increasing cash or decreasing inventory
and their associated costs
• Soft savings;
Cashflow improvement, cost and capital
spending, reduce of cash tied up in inventory
or decrease spending of capital, increase
customer satisfaction, increase employee
satisfaction etc.

Cash Flow
While hard savings are generally related to the P&L statement soft savings are linked to the balance
sheet, both of them can be link to cash flow. Cash flow indicates how effectively the business is
managing to juggle income and expenses, and its ability to meet its current expenses.

103

Weaknesses in cost accounting:

•

Cost accounting (standard cost) measures average performance and does
not reflect process variation or design capability – it is related to Cpk. In
effect, Cpk becomes the target performance for standard cost accounting.

•

Cost accounting measures the ‘cost of doing’ but not the ‘cost of not
doing’ ‐ measures the cost of the in‐line processes, but not the cost of off‐
line or corrective action when the process is not able to operate at
targeted performance.

•

Cpk describes the average cost of the process and does not reflect the
‘best day’s performance’ of the process (Cp).

104

Productivity Investment Dilemma!
Capability Requirement

Common Cause Variation = Building the System!
ROI

Expected Return

Capability
Acquired

Cp

Long-term capital budgeting acquisition decision.

Capability Applied
Capability Erosion
Cpk
Process Analysis

These decisions are unique and
typically are taken
independently of each other –
not a good thing to do.

Standard Cost Analysis
Capacity Planning
Yield
Production Efficiency

Short-term productivity optimization decision.

ROCE
105

What is process capability?

•

Process capability (Cp) is a process performance ratio that is used to
describe the ability of a process to meet the expectation of its customers
for performance.

•

Process capability is calculated as the voice of the customer (or the width
of tolerance in their agreed‐upon specification) divided by the voice of the
process (six standard deviations of design performance variation ).

•

Process capability is not ‘centered’ around mean performance, and
represents an absolute ratio of performance – the best that a process can
perform based on its designed capability.


106

Process capability & acquisition decision:

•

When capital acquisitions are made, the choice of alternative is based on
the design capability of the system (Cp performance measure) and an
expectation is set that this design capability (or nameplate performance –
the performance that is advertised for a process) will be delivered in the
real world.

•

Comparison of alternative capital acquisitions is based on an analysis of
the design capabilities.

•

Real‐world performance is always degraded from the design capability –
leading to a second indicator of process capability.


107

Cpk measures current performance:

•

Process capability (also indicated as Cpk), is a ratio of performance that is
related to Cp – only it is referenced to the closest of the upper or lower
specification limits.

•

Cpk represents shifts in performance degradation from designed Cp value
based on observed process performance.

•

Cpk indicates the performance of a process in routine operation.

Note: Cpk provides a short-term estimate for more than a point estimate
use either an average Cpk or Ppk to capture the long-term performance
loss.


108

Capital efficiency ratio:

•

The capital budgeting analysis was based on the Cp of the design, rather
than the Cpk of the operating process.

•

When daily operations are evaluated the measure used for the capital
budget is not reflected in routine work – only average performance of
standard cost is used. The difference between average and target is a
loss in capital efficiency.

•

This capital efficiency loss can be used to estimate the potential for
improvement in ‘return on capital employed’ based that may be obtained
by moving from the Cpk to Cp performance level.


109

Delivering Bottom Line Performance:
Proce s s Ca pa bility Ana lys is
Ta rge t
LS L

Capital Efficiency =

Designed process
capability (Cp)

US L

Within
Ove ra ll

Achieved Cpk
Design Cp
Achieved process
capability (Cpk)

1.5

2.5

3.5

4.5

5.5

6.5

Capital Effectiveness = Capital Employed X Capital Efficiency
Return on Capital Employed (Adjusted) =

Return
Capital Efficiency
110

Drive performance gains in entitlements!
The financial impact of process capability loss:
•

Business invests capital to improve efficiency, effectiveness and economic
performance – driving profitable productivity.

•

Capital investment must be evaluated using contribution that is made to
business performance (e.g., return on the capital employed (ROCE)).

•

Capital investments purchase process capability – they buy an expected value
of process performance (variation) as compared to specified or desired
performance (tolerance).

•

This ratio of variation‐to‐tolerance is an entitlement based on the investment
and is called a process capability index (Cp).

•

Processes rarely operate at their design ideal and a shift in performance from
this target is typically observed and this is expressed as a different process
capability ratio (Cpk).

•

The gap between Cp and Cpk represents the improvement opportunity that
available from a specific work process.

•

The return difference represents a potential financial benefit.

111

LSS projects must yield bottom line results!
Recognize

Strategy Cycle
Define

Analysis Cycle

Measure
Analyze

Redesign

Modify
Design

Yes

Design Cycle

No

Improve

Kaizen Cycle
Control

Integrate

Standardize


112

Where is the prize?
•

The return‐on‐project is not always immediately evident to the
neophyte Black Belt.

•

It is important to “squeeze” each aspect of the return from every
process nook!

•

Consider leverage opportunities: where can this process learning be
applied quickly to achieve a gain?

•

Remember to count the “non Six Sigma” projects that you identified
for the process team to attack.

•

Count a full year’s benefit as the project return.

•

Divide the return into non‐recurring and recurring benefit categories to
clearly illustrate the “annuity” effect.

•

Find the gold in related processes that are disclosed after your
investigation ‐ go for the next best project!

113

Reviewing Black Belt projects:

Improve Phase

Measure Phase

Business
Review

No

Re‐direct Project

Management
Review

No

Re‐direct or re‐
define the project

Analyze Phase
Control Phase
Financial
validation of
opportunity & formal
project review

No

Re‐direct or Redefine
The BB project

Yes
Formal Review
Executive & financial
validation


114

How do you spell project success?
Defects

Down!

•

The process owner and executive sponsor agree that the Six Sigma
project has delivered the claimed return‐on‐project.

•

The Black Belt has demonstrated all required tools for their first project
and has identified a second project to pursue.

•

You feel confident in your ability to take on new challenges!

Profits Up!


115

Thank you! Any Questions?


116

Financial analysis towards lean & six sigma

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