PRODUCTIVITY & GROWTH

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1 Productivity Financial Tools There are a number of financial tools that can be used to measure the financial performance and potential contribution of improvement projects to the productivity of a business. Some of the more commonly used tools are: Value Added Break-Even analysis Net Present Value Analysis Product Contribution Project cash curve Ratio Analysis Planning and budgeting Cash Cycle management Value added calculations In order to sustainably increase profits Value Added must be increased through higher productivity. Value Added shows the net wealth created by a business and is the difference between sales and the outside purchases of materials and services used to make those sales. It highlights the distribution of Value Added to those that have contributed to it, including labour, interest, depreciation, profit and tax, as well as any amounts put aside. Value Added is calculated the same way for goods and services and is a useful tool for communicating performance and motivating employees. < Creation of > Added Value < Distribution of Added Value > SALES VALUE ADDED PURCHASES Eg. materials, expenses, etc. PROFIT LABOUR COST DEPRECIATION INTEREST TAX DIVIDENDS RETAINED EARNINGS

2 Break-even analysis Break-even analysis highlights what volume or percentage of capacity is breakeven. Break-even analysis shows the interplay of different configurations of investment compared with variable costs. It shows what will happen if a business invests in more productive assets and increases fixed costs in order to reduce variable costs, like direct labour, materials and energy. Break-even analysis may show a business must sell more to break-even on an investment but it can make more money beyond this point. Break-even analysis can also be used to look at different product lines. Overheads are often spread across all the output from a business and by using break-even analysis it is possible to split out specific overheads used for particular product lines. It may show a particular product line is not carrying its weight and something needs to be done about it. However, if a product line is dropped its contribution to fixed costs will be lost, and the fixed costs will need to be either eliminated or absorbed by the remaining product lines, making their costs higher. Other alternatives may also be considered such as finding more profitable markets for the product line or redesigning the product to lower its cost, etc. Break-even analysis graph $ B/E SALES Variable Cost Fixed Cost B/E Volume Net present value (NPV) analysis It can be hard to tell if long-term projects are attractive by just looking at a profit and loss statement. It is better to look at cash flow (cash in, cash out), but this can still be hard to judge because money earned in future is worth less than money today. Net Present Value (NPV) is a central tool of Discounted Cash Flow (DCF) and takes into account the time value of money in assessing the benefits of long-term projects. NPV is the present value of expected future cash flows and is used to show whether a project will make a positive return and how much. The Discount Rate used is the rate of return that can be earned in the markets for similar risk. Therefore, businesses often use their weighted average cost of capital for the discount rate. However, it can be argued that a higher discount rate could be used to account for risk, opportunity costs and other factors. NPV > 0 shows the investment will add value to the firm and should be accepted NPV < 0 shows the investment will subtract value from the firm and should be rejected It should be noted that most computer spreadsheet applications provide a NPV formula builder function.

3 Product contribution Where a business has capacity constraints a product contribution versus capacity matrix can be a useful way to look at capacity trade-offs based on the contributions received from different product lines. High CONTRIBUTION Low High Do More Increase Price CAPACITY UTILISATION Decrease Price Reduce or Scrap Low Project cash curve When undertaking large projects it is important to use realistic estimates of the time and amount of cash needed to get to payback and avoid running out of cash or needing to go back for more. Projects must be managed well to get from project start to payback in as short a time as possible. Being on time can be more important than being on budget. Research shows early to market new product development results in higher sales and longer sales. Time to market is often more important than cost, because of the opportunity cost of lost margins and lost cash generation. At the start of a project it is important to understand what a lost week or month in delay will cost the company and to monitor this. It is very important to identify potential risks during the planning stage so that significant risks can be mitigated and delays avoided. Businesses should avoid taking on too many large projects at the same time and digging too big a cash flow hole. Projects can be staggered and the cash flows from successfully completed projects used to help fund further projects. Beware of becoming emotionally involved in projects. Remember the definition of sunk costs and kill failures.

4 Ratio analysis Ratio analysis can be used to measure performance and trends: Key Productivity Levers Increase sales Indicators Sales per employee Labour productivity Output Increase output per unit cost of production Value added-to-sales ratio Profit margin Profit-to-value added ratio Input Optimise use of labour Labour cost competitiveness Labour Cost per employee Optimise use of capital Sales per dollar capital Capital intensity Capital productivity Margin Asset Financial Return on Shareholder Funds (Return on Sales) (Asset Turnover) (Return on Assets) (Gearing) (Net Worth) X Net Sales Total Assets = X = Net Sales Total Assets Total Assets Net Worth Net Worth Planning and budgeting Planning and budgeting is used for sanity testing and looking at financial trends. Annual budgets are best built from the bottom up. That is, by using sales forecast to determine volumes and the material, labour and purchases needed. Budgets are used to ask: What did we do last month? What did we do last year? How are we tracking to budget YTD? What are we forecasting? Three years is a good time period for planning, since five years can become speculative and two years is too short.

5 Cash cycle management Businesses often focus on how much money they are making. But it is just as important to focus on how fast it is made. It is important to know a business s Cash Conversion Cycle (CCC). That is, how fast cash out of a business is converted into cash in to a business. Margin and profit is made every time inventory turns over. The more stock turns a business achieves the less inventory it needs to carry and the more gross profit it makes. Also, money previously tied up in slow moving stock is liberated for use in value adding activities and growing the business. Cash Conversion Cycle = Days Inventory + Days Debtors (Sales outstanding) Days Creditors (Purchases outstanding) It is a good to measure and graph these figures over time Cash Conversion Graph Days $000 s Month Ideally CCC should be reducing or steady over time. For mature businesses the CCC give an indication of how well managed a business is and how hard it is working its cash. For young growing businesses CCC is a good indication of the sustainability of its growth. It should be noted that CCC may be affected by seasonal factors.

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