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OM and Finance Interface
Chapter 5
These slides are based in part on slides that come with Cachon & Terwiesch
book Matching Supply with Demand http://cachon-terwiesch.net/3e/. If you
want to use these in your course, you may have to adopt the book as a textbook
or obtain permission from the authors Cachon & Terwiesch.
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Learning Objectives
Return on Invested Capital (ROIC)
Linking operational decisions to ROIC
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Paul Downs started making furniture in 1986, in a small shop in Manayunk.
Over the years, his business outgrew 4 other shops and is now operating a
33,000 square foot shop (see next page) in Bridgeport, PA.
Much of our work is residential, but we also do a lot of office furniture, including
desks and conference tables. We complete 125 commissions per year,
consisting of about 500 separate pieces of furniture.
3
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Production facility
Machines valued about $350 K,
depreciation $60 K p.a. (per annum)
Overall facility is utilized at
100% right now
Rent: $150 K for show rooms and factory
Indirect costs: Marketing $100 K, $180 K management, $60 K finish (quality control)
Inventory: $50 K WIP and $20 K raw material on average at any time
Prepayments: Suppliers need to be paid 1 month before receiving the wood.
4Pay Receive1 month
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Work force
12 cabinet makers
Each works about 220 days and 8h/day
Each makes $20 per hour
A worker
Needs about 40 hours per unit of furniture
Works in cells
Spend about 15% of time on set-ups (build fixtures / program machines)
Labor utilization around 90% (idle time resulting from waiting)
End Product
Average price is $3 K per unit
Requires 30 kg (kilogram) of wood
• Wood costs about $10 per kg
• 25% scraped, especially during cutting
Each customer pays 50% down and
gets her furniture 3 months later
5Pay 50% Receive3 months
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Return On Invested Capital (ROIC)
ROIC=Return / Invested Capital
or,
ROIC = Return / Revenue * Revenue / Invested Capital
Price
Costs Variable
Price x rate Flow
Costs Fixed1
Price x rate Flow
Costs Variable x Rate Flow
Price x rate Flow
Costs Fixed1
Revenue
Costs Variable x Rate Flow
Revenue
Costs Fixed
Revenue
Revenue
Revenue
Return
Capital Invested
Price x Rate Flow
Capital Invested
Revenue
Return ≈ Profit
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ROIC
Return
RevenueMargin branch
Revenue
Invested Cap.Asset branch
Price
Fixed cost
Flow Rate
Variable Cost
Price
Flow Rate
Invested Capital
Return On Invested Capital (ROIC)
Return / Revenue requires
Price, Fixed costs,
Flow rate, Variable cost
Revenue / Invested capital requires
Price, Flow rate, Invested Capital
ROIC = Return / Revenue * Revenue / Invested Capital
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Fixed
Costs
Direct
Labor
Other
Overhead
Number of workers
Hours worked per year per worker
Rent
Depreciation
Available
Hours
Hourly wage rate
Indirect
Labor
Management
Finishing / QA
Marketing
Return
Revenue
Margin branch
Price
Flow
Rate
Var Cost
Process
Capacity
Available
Hours
Hours per
Table
Number of
workers
Hours worked per
year per worker
Actual production time
(activity time)
Time needed before
production time Set-up time
Wait time
Demand
Price of wood
Wood per table
Kg per table
Scrap loss8
Developing Margin Branch of ROIC
Direct labor cost is not
allocated to products on
the basis of wood.
It is treated as fixed cost.
Fixed Costs and Process Capacity
detailed on the next two pages
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Process
Capacity
Available
Hours
Hours per
Table
Number of
workers
Hours worked per
year per worker
Actual production time
(activity time)
Time needed before
production time
Set-up time
Wait time
:
+
+
Flow rate=Min{Demand, Process Capacity}
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Fix
Costs
Direct
Labor
Other
Overhead
Number of
workers
Hours worked per
year per worker
Rent
Depreciation
Available
Hours
Hourly wage rate
Indirect
Labor
Management
Finishing / QA
Marketing
+
+
+
+
+
10
Fixed Costs
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Fixed
Costs
Direct
Labor
Other
Overhead
Number of workers
Hours worked per year per worker
Rent
Depreciation
Available
Hours
Hourly wage rate
Indirect
Labor
Management
Finishing / QA
Marketing
Price
Flow
Rate
Var Cost
Process
Capacity
Available
Hours
Hours per
Table
Number of
workers
Hours worked per
year per worker
Actual production time
(activity time)
Time needed before
production time Set-up time
Wait time
Demand
Price of wood
Wood per table
Kg per table
Scrap loss 11
Summarizing Margin Branch of ROIC
Return
Revenue
Margin branch
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ROIC - Margin Branch
53.33=40/(1-0.25)
D
A
B
A
C
B
A, B, D all include
set up time
1760=220*8
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Sales Per Year
Wait time %
per table 25%
Setup % per
table 15%% idle time
per table 25
Labor content
per table 40Hours of labor
per table 53.33
Hours of labor available
per year 21,120
Unit price
3,000
Sales per
year 1,188,000Time per worker
per year 1760
Number of
workers 12
Flow rate tables
per year 396
1,760=8*220
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Total Cost Per Year
Scrap per
table 25%
BOM per
table 30Wood per
table 37.5
Wood price
per kg 10Material cost
per table 375
Flow rate tables
per year 396
Wage rate
per hour 20
Hours available
per year 21,120Labor cost per
year 422,400
Material cost per
year 148,500
Direct cost per
year 570,900
Indirect cost per
year 570,900
Rent150,000
Marketing100,000
Finishing 60,000
Depreciation 80,000
Management 180,000
Total cost per
year 1,140,900
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Invested
Capital
PP&E (Plant, Property, Equipment)
(required)
Working
Capital
Inventory
Unearned
Revenue % Down-payment = 50%
Revenues = 1188 K pa
Raw Materials
WIP
Flow Time of down-payment = 0.25 years
Pre-
Payments
Total $ spent on
wood=148.5 K pa
Time of pre-payment=0.083 years
Flow Rate
Material costs:
+
+
+
:
15
Invested Capital
Asset: Inventory and Prepayments
Liability: Unearned Revenue
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ROIC - Asset Branch
D
C
D
A, B, D all include
set up time
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Flow RateBreak even
volume
378.06=992,400/2625
2625=3000-375
Current
volume
Volume
After
improvement
Fix costs = $992,400
RevenuesDollars
19
After Break Even Point
Margin=Price-Variable cost
Paul Downs price is $3000 and variable cost is $375. Post break-even margin is $2625.
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Southwest and Other Airlines (Delta or US Airways)
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Return on
Invested
Capital
EBIT
Capital
Revenue
Cost
Fixed
capital
RPM
Yield
($/RPM)
ASM
Load Factor
Labor
cost
Number of planes
ASM per plane
Wages per employee
Employees per ASM
ASM
Fuel
cost
Cost per gallon
Gallons per ASM
ASM
Other
cost
Other expenses per ASM
ASM
Number of planes
Capital per plane
Working
capital
Other capital
21
RPM: Revenue per passenger miles.
ASM: Available seat miles.
Take OPRE 6377 in Falls for more.
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Current (2000) USAir
OpsExpense at 17212
ASM
$2,444M $284M
$199M
$108M$35M $1,804M
Savings in wages if SW
wage rate is paid
Savings in wages if SW
productivity is achieved
Savings in fuel if SW fuel
prices are paid
Savings in fuel if SW
efficiency is achieved
New Ops expense
Cost reduction
required to break
even
Cost reduction
required to
become SW
profitable
22
Southwest and Other Airlines (Delta or US Airways)
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OM-Finance Interface:
WalMart’s Supplier Alliance Program (SAP)
WalMartSuppliergoods
invoiceInvoice paid by WalMart in 60-90 days
Factoring: Invoice is sold to a factor (any bank) by the supplier.
Supplier immediately receives cash that is less than the face value of the
invoice.
If the supplier’s credit rating is low, the supplier receives less cash.
The debtor (WalMart ) pays the factor.
Supplier does not need WalMartapproval for factoring.
SAP: Invoice is sold to a Walmart’s partner bank (Wells Fargo or Citigroup) by an approved supplier.
Supplier receives cash in 10-15 days that is about the face value of the
invoice.
WalMart’s high (AA) credit rating pulls up the amount of money the
supplier receives.
WalMart program started on Nov 2, 2009. Before that, CIT, provider of credit to small
and mid size suppliers, declared bankruptcy. Similar program is in place at Kohl’s since
July 2009. KOHL’s SAP is offered to 41% of suppliers, 11% signed on since then.
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OM – Finance and OM - Accounting Interface
Operating capital / credit restrictions
Timing of the advances from customer and to supplier
Commodities and risk in prices; forward contracts
Bankruptcy, insolvency risks (own and partners)
Repercussions from mergers and acquisitions
Cost, time (and carbon footprint) data from accounting
Cost allocation to be decided
Accounting allocates
OM decides
Can we decide without allocating?
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OM Attempts to Understand Finance
Should Finance Understand OM
Finance deals a lot with stock markets
Stock price should be in line with OM metrics
High inventory turnover High stock price
High efficiency High stock price
High quality High stock price
Stock prices are not related to OM metrics
Gap between Wall street (finance) and Main street (OM)
Linking Finance and Operations in Retailing. M. Fisher, V. Gaur, A. Raman. http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1290209
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Summary
Return On Invested Capital (ROIC)
Linking operational decisions to ROIC
