Building a financial perspective into an engineering program

Building a financial perspective into an engineering program P.J.Gregory Department of Mechanical Engineering, Monash University, Clayton Campus, Victoria, Australia (Peter.gregory@eng.monash.edu.au) Abstract Engineers are increasingly expected to place their studies in context, in particular that their role is one of wealth creation in a competitive world. To realise this it is argued that an important component of an industrial engineering program is to provide costing and financial analysis so that industrial engineers have the necessary tools to enable them to place their studies in perspective, and enable them to make decisions which better reflect the needs of their organization. Effective analysis of value stream mapping, just in time, lean manufacturing and inventory management requires an appreciation of costing and financial practice; it is clearly preferred that these studies are carried out as an integral part of the engineering program rather than something that is viewed as an add on activity. The paper looks at the content, Cost Volume Profit (CVP) analysis, overhead analysis, project evaluation and analysis of company financial data, and timing of such studies. Keywords: costing, financial analysis, integration, engineering curriculum 1. INTRODUCTION A study into engineering education by the Institution of Engineers, Australia, identified an issue considered important by large companies employing engineering graduates; that engineering is about wealth creation in a competitive world, so engineers must understand early the context in which they function, economics, finance, accounting, teamwork, and competition - while not losing sight of the need for technical excellence and for environmental responsibility. The study also emphasized the need for engineers to be able to place their studies in context and not view their role simply as problem solvers.[1] This paper addresses a number of the issues identified in the study concerned about changing the engineering culture, in particular the development of financial and accounting concepts within the framework of an engineering degree, specifically for industrial engineers. A number of educational models for the development of financial and accounting concepts exist. One option is to restrict the engineering program to technical issues and rely on postgraduate programs such as the MBA to address the broader issues and in particular the financial and accounting units. Another is to establish double degrees in which students enroll in an engineering program as well as a commerce program. Both these options have their place in the educational spectrum; however it has been observed that enrolling in these options may result in the student being drawn away from engineering practice towards a more general management career especially for the former, and the second is only available to a limited number of students; more particularly engineering students enrolling in an essentially technical degree would miss out or delay their understanding of the issues identified, wealth creation through development and its application of new technology, the reduction of risk or the increase of profit, working in a competitive environment and the importance of not losing sight of technical competence yet ensuring their studies are in the context of today s environment. This paper outlines a framework of incorporating costing and financial analysis into an industrial engineering degree. The approach is to examine the types of problems which industrial engineers will investigate, the decisions that are

made as a result of these investigations, and the costing and financial tools that will support the analysis. Financial skills are important to other engineering disciplines. Whilst there is strong need to develop financial skills amongst all engineers it is felt that at the undergraduate level the need to integrate these skills is most strong in the areas of industrial engineering and manufacturing. As an example consider a study to improve the waiting time at the emergency ward of a local hospital. As a result of a detailed investigation into the administrative and medical processes which take place in the ward the waiting time was reduced from 120 minutes to 90 minutes, a significant improvement. However if the engineer were to reflect on the likely outcome they would recognize that patients would value more highly the service provided by that hospital and so demand for the emergency services would increase. This would entail a further study to review the resources available in the emergency ward and assuming these were made available the financial contribution from the emergency ward would increase. 2. INDUSTRIAL ENGINEERING PROGRAM The industrial engineering and engineering management program at Monash University is a four year engineering degree in which level 1 is common with all other engineering students, level 2 is largely common with mechanical engineering students, level 3 focuses on specific IE skills and level 4 provides opportunity for students to specialize in areas of interest to them, prepares them for work as a professional engineer and includes a number of capstone subjects including a final year industry based project, in which their previous coursework is linked and integrated into a cohesive pattern. As industrial engineers they will be expected to design and improve processes by breaking them into their parts, evaluating each part from the perspective of the customer, and repackage the process by eliminating those activities which do not add value and enhancing those that do add value. To do this effectively they require the engineering/technical skills to analyse tasks, measure work, examine work flows and plant layout and simulate possible process options. This must be done in a customer focused, quality driven environment where they seek measureable improvements in the areas of agile manufacturing, that is the ability for a company s productive systems to be able to respond quickly to changing environmental, economic and competitive conditions in a lean manner, for example organizing production of goods at the right price and quality, structuring services to be reliable and efficient and tracking the movement of goods through suppliers, warehouses and distribution centres. In many of these situations the improved process will result in less time to process, better use of operators, equipment and other resources, improved layout shortening travel time, risk of injury and improved quality and reliability of products and services. These are important measures but increasingly the industrial engineer is expected to quantify the benefits in financial and monetary terms. Costing and financial analysis becomes an essential and integral component of the IE program. At the same time there are many other topics for inclusion in the overall engineering program and it is necessary to be very selective in the choice, content and weighting of each topic. This will vary from degree to degree. In the case of the industrial engineering degree context, product and service costing, and project viability are three critical areas. This paper examines the material covered in these areas and their integration into the engineering component of the degree. 3. ACCOUNTING and FINANCIAL ANALYSIS 3.1 Separation of costs into fixed and variable components Cost volume profit analysis CVP analysis is remarkably simple in concept but extremely important when decisions affect the level of output. For many there is a mindset that the cost of a product is a singular value, as expressed in statements like this pump costs $150 to produce. In reality the cost of a product is made up of two components, a fixed cost which does not vary with the level of output, at least in the short term, and a variable cost which varies directly with output so that at least in the short term a plan to expand output in an underutilized factory will result in no change in fixed costs but a proportional increase in variable costs, resulting in no change in the unit variable cost, a reduction in the fixed costs and a reduction in total cost. CVP examines the relationship between sales revenue, costs and profit with changing levels of output, with Output x Sales price = Unit variable cost x Output + Fixed Costs + Profit

and assumes that sales volume is equal to production output or that there is no change in inventory. The break even point can be identified as the sales required for zero profit. Graphical presentation of this analysis is a valuable communication tool and plays an important role in exploring What if scenarios, for example the effect on profit and the break even point if the company is considering replacing its variable labour with more capital intensive options. Decisions affecting the level of output and the method of operation need to be evaluated in the context of fixed and variable costs. Flexible Budgeting The budgeting process is enhanced when costs are considered in terms of their fixed and variable components enabling actual performance to be assessed in terms of a flexible budget set at revenue based on budgeted selling price and actual quantity and the static budget based on the budgeted units. This becomes particularly important when evaluating performance where it is important to separate output based performance from efficiency based performance to assist in identifying the basis for improvement and also to determine bonuses and rewards for high performing staff. 3.2 Overhead analysis CVP analysis is essentially concerned with one product operations; in most cases the factories produce more than one product and in these situations decisions are often required regarding the relative profitability of the products. Traditionally the product cost has been considered in three parts with the variable cost made up of two costs which can be clearly traced to a specific product, a direct material cost and a direct labour cost, and one cost which cannot be directly traced to a product and is allocated on some arbitrary basis, an overhead or fixed cost. The overhead cost was generally a small component, generally less than 5% of the total manufacturing cost with direct labour about 30%. In these situations it was not very critical to be precise in allocating overhead costs; however in recent times with the increased use of technology and the replacement of manufacturing labour by equipment, overhead costs have increased to about 30-35% of total cost and direct labour cost reduced to about 5%. The ratio of allocated overhead cost to direct labour has changed from about 1: 6, to 6 :1 which means that more care is now needed in the allocation of fixed costs across the product range. Reliance on allocating overhead costs on the traditional method of direct labour can result in misleading information on the cost of manufacturing for different products, possibly resulting in selling prices which under or over estimate the real product cost. In the real competitive world, and especially if a product s selling price is based on a mark up of its manufacturing cost, this can result in some products being wrongly priced below their competitors and others overpriced with disastrous outcomes. In the same way wrong decisions can occur when considering expansion of some products instead of others or making on site or buying in products. A more sophisticated activity based analysis of overhead costs is based on separating the overhead costs into a number of cost pools in which the costs in each cost pool have a common purpose; whilst each cost pool is essentially different from other cost pools. There is no change to the total overhead cost; but instead of one cost pool allocated on the basis of direct labour costs there are a number of homogeneous costs pools each with their own allocation base; for example the overhead costs associated with set ups, the costs associated with quality inspection, with machining, with assembly and with packaging are all collected separately and an appropriate basis for allocation established such as the number of set ups with each product, the time associated with quality inspections for each product etc. This approach ensures that the overhead costs associated with each product are better identified and should result in more accurate estimates of the manufacturing cost for each product. The selling price for most products is determined in part by competitor s pricing, the customer values associated with the product but also on a mark up on manufacturing cost. In such situations the allocation of overhead costs becomes critical. Activity based analysis provides two benefits; it assists in more accurately estimating product costs and so ensuring that decisions relating to expansion, contraction of a product are more based on better data, and secondly the cost allocation base identifies the variable that is driving cost and provides a focus for improving the process, for example the number of setups is more clearly identified and costed against a specific product. In many cases engineers work in a push environment in which a product is first designed, produced and costed with price determined on a cost plus basis. There are also many occasions when competitive factors play a large part in determining price. In these situations the engineer has to work in a pull environment designing the product to meet a particular or target price.

3.3 Financial Analysis Inventory reduction Two of the most obvious tasks within a work improvement program are the reduction of inventory and just in time scheduling by improving process flow and increasing equipment reliability so that inventory is not required as a safeguard against machine breakdown but for many the way in which inventory savings affect company performance is little understood. This can be overcome by providing a basic understanding of the two company reports, the balance sheet and profit and loss statement (or income statement). The balance sheet provides a snapshot on a particular date of a company s use of resources, by identifying current (including cash, debtors, inventory and prepayments, indeed any asset that can be converted into cash within 12 months) and non current assets (including plant, equipment, investments, land etc), current liabilities (principally loans and creditors) and non current liabilities with the balance of assets less liabilities making up the shareholders equity. (Current + Non current ) Assets = (Current + Non current) Liabilities + Owner s equity A reduction in inventory is likely to mean in operating terms less space required for storage, less insurance required, improved quality because problems will be identified more quickly and corrected more quickly; it will also mean in financial terms a reduction in current assets which will improve the company s liquidity as measured by the current and acid test ratios; but because of the identity above, it will also mean either that other assets can be increased or more likely liabilities such as bank loans can be reduced. The reduction in the cost of interest is then observed in the profit and loss statement leading to an increase in the level of profit, so that it is possible to link directly an improvement in inventory management with improved financial performance. Cash conversion cycle This is an important measure also known as the cash management cycle or cash to cash cycle used to measure company liquidity. In concept it is the time taken to convert a dollar s worth of inputs into a dollar s worth of sales. The cash conversion cycle brings together three important metrics, the accounts receivables turnover, the inventory turnover and the accounts payable turnover. This incorporates the days debtors with the days inventory less the days creditors using data in the balance sheet. Investigating ways of reducing the cash conversion cycle becomes an important activity in the continuous improvement cycle. The calculation (Table 1) is illustrated with the following data although it is generally more accurate to use average data for debtors, creditors and inventory based on levels at the beginning and end of the period. 2005 2004 2003 Annual sales 2,960 2,352 1,570 Cost of Goods Sold 2,338 1,834 1224 Average Receivables 419 509 275 Average Inventory 461 592 290 Average Payables 274 334.1 137.1 Accounts Receivable Turnover 7.1 4.6 5.7 Inventory Turnover 5.1 3.1 4.2 Accounts Payables Turnover 8.5 5.5 8.9 Accounts Receivable Collection Period 50.9 77.9 63.2 Inventory Processing Period 71.0 116.2 85.2 Accounts Payables Payment Period 42.2 65.6 40.3 Cash Conversion Cycle 79.7 128.5 108.1 TABLE 1. Cash conversion cycle Cash conversion cycle = Accounts Payables collection period + Inventory processing period Accounts payables payment period In practice the metrics can be used by analyzing trends over time, by comparisons with other similar companies and also by using the liquidity and financial metrics to identify opportunities for process and work improvement.

3.4 Project evaluation Most engineering projects focus on the replacement of existing equipment or the purchase of new equipment where it is necessary to compare the costs associated with the proposal with the benefits that result. There are a number of ways this evaluation can be carried out, sometimes indicating different courses of action. It is essential that these evaluation alternatives are well understood and the features of each alternative method recognized. Desirably the analysis should recognize the realities of the economic environment; that is that future cash flows should be discounted and that taxation, risk and inflation need to be considered. There are two basic discount cash flow techniques [2], firstly the net present value in which the cash inflows and cash outflows are discounted at the appropriate rate of return and the expected monetary gain/loss determined. A positive NPV indicates that the project benefits exceed the cost of capital; that is the return will be higher than if the funds were invested elsewhere. Another measure is the internal rate of return which calculates the rate at which the present value of the discounted cash inflows equals the present value of the discounted cash outflows. In many cases this is an easier measure to comprehend as the internal rate of return can be compared with the cost of capital. However there are a number of assumptions which may not always be valid; the method assumes that future cash flows can be re-invested at the internal rate of return, an assumption which may not always be warranted, and also in some circumstances multiple rates of return are possible. The modified internal rate of return where future cash flows are re-invested at the company s cost of capital, a much more realistic assumption addresses one of these assumptions. When two projects are being evaluated and only one can be implemented then calculating the equivalent annual value, (which is the net present value divided by the annuity factor) is necessary if the projects are of unequal life and if the projects involve different cash inflows it may be necessary to consider the incremental benefits of the investment. These discounted techniques have merit but at times companies will also rely on the payback period, the time to repay the initial investment, particularly if there is uncertainty in the cash inflows in future years, and if the company s cost of capital is high. As well the accounting rate of return is favoured by some companies as the analysis is more in keeping with the way company performance is measured and reported in financial accounts. 4. POSITIONING in the INDUSTRIAL ENGINEERING PROGRAM Ensuring that the industrial engineering students acquire relevant costing and financial analysis depends on the material being presented in a timely manner and integrated into their engineering studies. There are many accounting and finance courses offered in universities but most have differing educational outcomes and expectations of prior knowledge. The Institution of Engineers, Australia emphasized the importance of context, timeliness and providing a complement to the technical engineering studies as a means of making a better engineer. Ideally the costing and financial concepts should be included as a part of every unit, but realistically a unit in the third level based on lectures, problem solving and case studies is appropriate. This provides time in the fourth level for the costing and financial analysis to be incorporated into the capstone units and into the final year industry based project. 5. CONCLUSIONS Costing and financial analysis is an important component of the industrial engineering undergraduate degree; students need to be able to apply the concepts to extend the engineering analysis so that their recommendations are couched in terms of the ultimate user. To do so will show further evidence of a change in culture not just limited to pragmatic problem solver but more actively involved in the process of problem definition, formulation, solution and implementation. Whilst the approach will often be based on identifying problems in the work environment, solving them in operational and financial terms, an important part of the engineer s training is to use costing and financial metrics as indicated in this paper to identify and prioritise opportunities for improvement. The other aspect to address in the costing and financial analysis content is to focus on the decisions that are associated with process improvement and ensure that engineers have the necessary skills to provide all the relevant information to result in the correct decision being made. These concepts can be best developed by firstly introducing the financial concepts in a stand alone unit and then used and applied using case studies to illustrate the concepts and finally by ensuring

that in their final year of undergraduate study students work on projects which require them to address a number of issues so that they have to consider the financial consequences of each option. References [1] The Institution of Engineers, Australia, Changing the culture: education into the future (1996). [2]Don Dayananda, Richard Irons, Steve Harrison, John Herbohn, Patrick Rowland, Capital Budgeting; financial appraisal of investment projects, Cambridge University Press, Cambridge, (2002).