Now more than ever before, capital assets Plant,

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1 Managing Assets to Improve Profitability BY ROBERT J. MCFARLAND, CPPM, CF, HOOSIERS CHAPTER ITT AEROSPACE/COMMUNICATIONS DIVISION Now more than ever before, capital assets Plant, Property and Equipment (PP&E) should be scrutinized as intensely as all other business processes and systems should be established that ensure that assets are monitored and managed throughout the asset life cycle from acquisition to disposition. Industry is continuously evolving in its endeavor to improve earnings, become world class and to compete in a world market. Accordingly, companies are constantly analyzing functional and operational activities, right sizing the organizations and reducing operating cost. To maintain competitiveness they are redefining strategy, redesigning product, reengineering manufacturing and business processes, out-sourcing business functions, consolidating operating facilities and shifting manufacturing locations to enhance competitiveness and operating results. The objective of each of these activities is the reduction of operating cost, increased earnings and enhanced competitiveness. Each of the changes in the business has an impact on the capital asset requirements. Failure to scrutinize the PP&E in conjunction with these activities and maintain efficient asset management processes may result in lost earnings, missed opportunities or more. Scrutinizing the capital assets will reduce operating costs and increase earnings. Establishing asset management systems and processes that manage the investment rather than contain or control them will sustain the cost reductions and increases in earnings. We must establish processes that ensure management that the PP&E is acquired, maintained and utilized to its highest level to satisfy current and future operational requirements. The magnitude of the investment in PP&E, increased cost of new technology and asset carrying cost make asset management a critical function in today s business environment. Analysis of over 20,000 manufacturer s financial statements shows that the net book value of PP&E represents 29% of total assets and 48% of total capital. Without integrated asset management, the total PP&E investment and consumption of capital will increase significantly. Maintaining high PP&E balances on the balance sheet and constantly acquiring new assets without appropriate retirements and disposition of assets has a significant effect on the organization. As the PP&E balances grow, so too do the asset carrying costs. The growth of the PP&E balances and the asset carrying costs reduces the return on assets, net operation results and shareholder value. Failure to leverage existing PP&E when planning new asset acquisitions results in a continuous strain on the organization s capital. As the investment in PP&E increases, available NPMA 7

2 Experience by several major corporations show that the results of an asset working capital decreases. The net effect of uncontrolled PP&E is an organization with tremendous liability; significant idle, redundant and obsolete assets balances, lower return on assets, weakened earnings and reduced stockholder equity. PP&E has a natural tendency to accumulate over time. New assets are routinely acquired; however, exiting assets are rarely evaluated for disposition. This natural accumulation of PP&E coupled with constant changes in products and processes results in the accumulation of Idle, Redundant and technically Obsolete (IR/O) assets. IR/O will accumulate when new PP&E is acquired to replace existing assets, capitalize on new technology or accommodate changes in strategy, products or processes and existing PP&E is not analyzed for disposition or trade-in. Nonrecurring events have the same tendency to create IR/O assets. The most significant event that results in IR/O assets is a business combination (i.e., merger or acquisition). The result of a business combination always creates new capabilities and a significant amount of IR/O assets. An inevitable fact of business life is that PP&E will be consumed, lost, destroyed and pilfered during the normal course of operations. Consumed, lost, destroyed and pilfered PP&E frequently goes unreported and remains on the balance sheet as assets. Those assets with a capital net book value remain on the balance sheet and continue to be included in the base for property tax and insurance premium assessments until they are fully depreciated. The carrying costs of these assets, property taxes and insurance premiums, are completely unnecessary and avoidable with proper asset management procedures. Additionally, the retention of assets on the balance sheet defers recovery of the investment for both financial and tax reporting purposes. As with the IR/O, the costs associated with the assets no longer at the company do not generate any return. Every company should establish a capital asset management and optimization program. It must be designed to eliminate or reduce the impact of carry cost for assets no longer needed or no longer at the company. This will ensure management that PP&E is in sync with the strategic and operational objectives of the organization and that operating procedures are in place to maintain PP&E records which minimize carrying costs and maximize earnings to the maximum extent. A Capital Asset Management Optimization Program consists of two distinct parts. Part one is the Capital Asset Management Optimization Program and part two is the Capital Asset Management program. The Capital Asset Optimization Program includes development of an asset baseline (inventory) and analysis of asset utilization, carrying costs and requirements. The Capital Asset Management Program consists of the development and implementation of an integrated asset management database. In order to keep all processes in sync you should implement both parts but each part may be implemented independent of the other. Implementation of the optimization program will provide immediate benefits by eliminating assets that are no longer at the company and identifying IR/O assets for disposition and reducing asset carrying costs (i.e., insurance, tax, facilities and maintenance costs). This is best accomplished through a thorough and complete physical inventory. However, without a sustained asset management program, these benefits will undoubtedly be short lived and the assets no longer at the company and IR/O asset population will regenerate itself over time. Implementation of the asset management program will preclude the reoccurrence of assets no longer at the company and IR/O populations enhance the asset management process, ensure management that the operating costs are minimized to the extent possible and that the capital investment is leveraged to the maximum extent possible. Implementation of the asset management program without benefit of the optimization program will defer the program benefits. The elimination of assets no longer at the company and IR/O assets will occur over time rather than as the result of the optimization program. Therefore, the reliability and accuracy of the asset information used by management or strategic and operational planning and future capital investment may be unreliable until the assets no longer at the company and IR/O asset population is identified and disposed of through the course of normal operations. Concurrent completion of both the optimization and the management program will provide the most dramatic and immediate results. There are four options available to management regarding PP&E. The least desirable option is no action. The others include; 1) periodic implementation of the optimization program without the asset management program; 2) implementation of the continuous asset management program without benefit of optimization; and 3) implementation of both the capital asset optimization and management programs. The cycled optimization plan shows the savings of a periodically recurring optimization analysis. This savings pattern shows relatively short-term benefit of the optimization program when implemented without the management program. The savings are lost as the assets no longer at the company and IR/O populations regenerate over time. The continuous management plan, without optimization, shows slower savings realization. The savings benefit is slower because the assets no longer at the company and IR/O assets are eliminated over time through the normal asset management process. However, the savings are sustained as long as the asset management program is maintained. The optimization and management program shows both the dramatic savings of the optimization analysis and the sustained savings resulting from the management program. 8 NPMA

3 optimization program will have a profound affect on organization s profitability. Notwithstanding the benefits of these programs, management should carefully consider the program impact on the organization as a whole. Each of the options (i.e., cycled optimization, continuous management and the combined optimization and management program) will produce net cash saving in the form of reduced costs and tax liability. However, there is a potential for a significant impact on the current period results of operations. The Optimization program will result in a significant write-off of assets for both book and tax purposes. Subject to the condition of your company, the write-off may erode the current earnings. Analysis of several major corporations disclosed that the optimization program eliminated 25% of the net income due to asset write-offs. Inversely, the asset management program produces sustained savings on a consistent basis without the dramatic effect of earnings. Preliminary testing and discussions with stock analysts may help you make the most beneficial decision. Most organizations select the combined optimization and management options and recognize the write-off and tax savings as soon as possible. The results of the combined program have affected current period earnings. However, the stock analysts have recognized the program benefit and the unique nature of the current period charge against earnings. The objective of an asset optimization program is to identify IR/O assets for disposition, eliminate assets no longer at the company and ensure that the asset base is consistent with the strategy of the organization. The asset optimization program is a detailed analysis of the organization s existing asset base, short-term asset acquisition plans and the strategic plan of the organization. Analysis of the existing asset base includes evaluation of utilization, cost of ownership and contribution to current or future operations. If an asset is under utilized, the cost of ownership exceeds the benefits derived from the asset or it does not satisfy current or future capabilities and requirements. It should be dispositioned as quickly as possible to generate the maximum return back to the company. The management program should train all employees to report missing assets for investigation to minimize assets no longer at the company that should be written off. The short-term asset acquisition plan should be compared to the assets identified for disposition to ensure that no assets are released for disposition for which there is a current or future demand. Comparison of the existing assets to the organization s strategy and operational activities is necessary to ensure that only assets which satisfy current and future needs are retained and to determine if under utilized or idle assets will become mission critical to the organization in the near future. After the assets identified for disposition have been compared to the asset acquisition plans internally, they should be compared to the acquisition plans of affiliate organizations. In those instances where one company has an asset identified for disposition that satisfies the asset requirements of an affiliate company, tremendous savings may be realized by transferring the asset requirements of affiliate organizations; the assets should be released for disposition (i.e., sale, scrap or trade-in). Experience by several major corporations show that the results of an asset optimization program will have a profound affect on an organization s profitability. The benefits of writing off assets determined to be no longer at the company and the proceeds from the disposition of IR/O assets frequently exceed expectations. Additionally, redirecting assets to new or alternative uses and deferring additional asset investment has had a significant impact on working capital and future financing requirements. The net effect of the optimization program, in addition to the financial benefits, is management confidence that the asset base is capable of supporting the operational and strategic needs of the organization, the asset base has been reduced to the maximum extent practical, the cost of carrying the assets is as low as possible and the asset information is current and reliable. Effective asset management is a continuous process. It requires constant monitoring of asset locations, utilization, maintenance or calibration, cost benefit analysis, inventorying and financial and tax reporting analysis. The objective of the capital asset management program is to establish and maintain a standardized asset management process across functions. By including all of the functions in the asset management process, management has confidence that those operational departments, asset management, accounting, and tax functions, are synchronized as it relates to the capital assets. A fully integrated asset management program assigns these responsibilities, trains the employees and ensures management that the assets are properly safeguarded. Policies, procedures and processes are established for each stage of the asset life cycle from asset acquisition planning through disposition and establishes the roles and responsibilities of the personnel assigned to use, safeguard and maintain the assets. When performed by dedicated and qualified asset management personnel, the asset management and reporting processes ensure that pertinent and accurate asset information is available to management in a timely manner to support critical business decisions, that the asset population is limited to those items critical to the current operations and strategic goals and the carrying costs are minimized to the extent practical. A well-defined process will enable management to consider the state of the assets in the strategic planning process as well as the day-to-day operations of the organization. Strategic plans that fail to recognize the need for new assets or the obsolescence resulting from a new strategy may have a profound effect on the future of the organization. NPMA 9

4 Assets cost money. From the time of acquisition through and including disposition, assets consume capital. In conjunction with the asset management process, an integrated asset management database should be established and maintained. The asset management databases incorporate all of the relevant asset information including financial and tax capitalization values and depreciation, location, assigned responsibility, utilization, maintenance, calibration and cost of ownership into a single system. The best starting point of an asset database is at the completion of a capital asset optimization program. The asset database provides management with: A Transaction Based Inventory (TBI) process to reduce the cost of physical inventories; An asset utilization program to maximize investment and reduce cost; Database reports necessary to ensure that assets are leveraged to the maximum extent practical; Confidence that assets no longer at the company are identified and written-off in a timely manner; and, Confidence that assets are identified for disposition when they no longer contribute to the organization s strategy, become obsolete or when the cost of ownership exceeds the derived benefits. The asset utilization process is critical to driving costs down and improving profitability from investments made in assets. This requires a change in culture and organizational ownership of assets. Assets must be used to support all company objectives and must be shared to avoid idle non-productive assets. We also need to eliminate the proverbial I am keeping it in case some day I need it. We all know that day rarely, if ever, comes. The asset optimization program gives drive to significant cost savings from improved utilization. For example a company that can improve its utilization of assets from 10% to 20% can provide cost savings approaching the following: 50% Reduction in Capital investment costs; 50% Reduction in Calibration and/or maintenance costs; 50% Reduction in property tax; 50% Reduction in property insurance costs; and, 50% Reduction in the storage and support area requirements. In fact there are many other areas that affect the overall improvement of asset management and the cost of managing our investment. I know some of you will want evidence so here is some documented evidence of two companies who have accomplished this. One is a defense contractor and the other is a hi-tech company. DEFENSE COMPANY Initial Evaluation 24 separate databases/spreadsheets were being managed in addition to the capital asset database Over 30 different labs were working on programs Equipment utilization was measured at 9% Nearly half the equipment was no longer supported by the Calibration lab, putting projects and schedule at risk Test equipment was not standardized across labs and programs, decreasing the likelihood of sharing Engineers were fearful that they would not be in control and would not have equipment to do their jobs Results Utilization nearly tripled, going from 9% to 26% Total Inventory was reduced by 35% Capital expenditures was reduced to 75% of historical norms The inventory of obsolete unsupported equipment was reduced by 50% Lab space was freed up allowing for growth needed by the contractor The capital approval process was streamlined; over 95% of all requests are fulfilled through re-deployments from current inventory ROA increased and cash flow savings exceeded the goal Capital is available to acquire state of the art equipment required to meet increased demands HI-TECH COMPANY Initial Evaluation Assets were costing the company over $10M annually $7M in equipment-related costs $3.5M in engineering productivity impacts Equipment resources were not being effectively managed as Just in Case inventories and reactive processes fueled inefficiencies Implementing and institutionalizing a solution due to logistics, expertise and deep seated and habitual hoarding practices of the engineering products would not be a trivial task Results Utilization more than tripled, reducing the inventory from 19,000 assets to just 11,600 Capital expenditures were reduced from $9.6M to $1.7M Control of assets was dramatically improved: Write-offs were reduced from $800K to less than $8K 10 NPMA

5 Past due calibrations went from 10.5% to 1% Product delivery time was reduced by 20% Significant improvement in efficiency were achieved: Bench-to-Bench calibration time was reduced from 10 days to 2 days Equipment lead-time from user request to arrival of equipment was reduced from 16 weeks to less than 1 day 20 man years of productivity were saved each year The asset disposition process is as important as the acquisition or utilization process. Assets represent both capital and capability to the organization. Delayed acquisition of new assets may inhibit the organization s ability to respond to the marketplace. Inversely, untimely disposition of an asset may have a dramatic impact on current operations or capabilities critical to the organization s strategy. The integration of asset information and reporting should eliminate the potential for adverse impact on the organization resulting from untimely disposition of PP&E. Assets cost money. From the time of acquisition through and including disposition, assets consume capital. Excluding the cost of money associated with the acquisition of an asset, PP&E carrying cost includes property tax, insurance, utilities, calibration, maintenance and facilities. The actual carrying cost of PP&E fluctuates between companies based on a variety of factors. However, a reasonable range of PP&E carrying cost is from $5.00 to $8.00 per $ of net book value. Using a net book value of $ million and an average carrying cost of $6.50 per $ of net book value, the carrying cost of PP&E is $6.5 million annually. Results of recent optimization programs indicate that most organizations have a significant amount of assets no longer at the company, IRO assets on the balance sheet. Subject to the type of industry, these assets represent from 10% to 18% of the net book value of the assets and IRO assets generally constitute 5% of the net book value (NBV) of the assets. Identification and elimination (write-off) of assets no longer at the company and disposition (sales) of IRO assets will have a significant affect on the current and future financial results of an organization. Writing off the assets no longer at the company with a net tax value of $5 million dollars (50% of net book value) will generate a onetime tax savings of $1.65 million dollars, based on an income tax rate of 33%, and reduce annual operating costs by $225,000. The estimated operating cost reduction is based on combined property tax and insurance assessments of $2.25 per $100 of net book value. Identification and disposition of IRO assets will have an equally significant affect on the operating results for different reasons. Factors to consider in the disposition of IRO assets include disposition proceeds, tax benefits and operating costs. Disposing of IRO assets with net book and tax values of $5 million and $2.5 million, respectively, a 10% resale value and a $6.50 per $100 carrying cost will result in one time sales proceeds of $500,000, tax savings of $660,000, and a recurring operating cost reduction of $325,000. Implementation of a proactive asset management program will prevent the future accumulation of assets no longer at the company and IR/O assets. Accordingly, the reduction in property tax, insurance, maintenance, utilities and facilities expenses related to the assets, IR/O property, is a continuous annual savings. Based on the examples used above, recurring annual savings would be equal to $550,000 per year. This savings represents a net reduction in operating cost, a net increase in earnings per share and will ultimately translate into a net increase in the market value of the organization. An additional benefit, which may be realized as a result of effective asset management, is the reduction in new asset acquisitions. Several organizations have learned through utilization and availability analysis that many of the asset acquisitions that have been planned are no longer necessary because the assets planned for future acquisition are currently available within the organization. Therefore, additional asset investment is significantly reduced. One organization recently performed an asset optimization analysis and found available assets, which resulted in cancellation of 50% of the planned acquisitions equal to $250,000,000. Property management has an opportunity to streamline processes and make significant contributions to the company s profitability. In many cases, companies have focused on the acquisition process and failed to manage assets throughout the life cycle. Without managing PP&E throughout the life cycle, asset population grows unchecked, as do the carrying costs. Frequently, once an asset is on the books it stays forever without regard to its physical presence or useful value. The retention of IRO PP&E by some companies has become so overwhelming that they obtain larger facilities to accommodate operations. Others have acquired warehouse facilities to store their IRO assets. The propensity is to retain everything on the off chance that it may be useful in the future. However, at some point the savings to be realized by disposing of the asset will overcome the urge to save it. At this point there does not appear to be an awareness or sensitivity to the savings to be realized. The asset management process and the information generated by the integrated asset management database provides information critical to the day-to-day needs of the organization. It ensures management that the capital investment is reasonable and necessary based on current operational and strategic objectives, that the cost of operations are based on sound business decisions, and that the proceeds from the disposition of assets are maximized to the extent practical. With a structured capital asset management program, the capital asset base is now managed and controlled as effectively as all other disciplines throughout the organization. NPMA 11