Contemporary capital investment

1

EPPA 4213

Seminar Perakaunan Pengurusan

Ainun Haji Abdul Majid

2

Benefits of AMT:

offers opportunities for both flexibility and integration

INVESTMENT APPRAISAL OF AMT

Flexibility refers to the use of AMT for different products

with the facility to switch rapidly between them

its usefulness is not limited to the particular purpose

for which it was purchased

thus, increasing its useful life

Integration refers to the linking of previously separate

functions

eg. linking design to production (CAD/CAM)

3Traditional measurements

are seen as inappropriate . . . .

Focusing attention on savings direct labor costs

Criteria adopted for payback period or discounts

/ hurdle rates are short term analysis

Flexibility and integration are underemphasized

Accounting has been the crucial factor which

militates against adoption of AMT

Therefore, restrict the ability to compete in world

markets

4

Nilai Kini

Bersih

Kadar Pulangan

Dalaman

Kadar Pulangan

Dalaman Diubahsuai

Tempoh

Bayar Balik

Alir Tunai

Terdiskaun:

Kadar

Pulangan

Perakaunan

Alir Tunai Tak

Terdiskaun:

5

1. Payback

ignores time value of money

ignores cash flows outside the pay back period

emphasis on short term

TRADITIONAL TECHNIQUES

3. Internal rate of return (IRR)

optimistic reinvestment assumption

2. Accounting rate of return (ARR)

ignores time value of money

lead to high rate of return (very deceiving)

profits based on historic cost convention is used

to compare investment value

6

4. Net present value (NPV)

Single absolute number

TRADITIONAL TECHNIQUES …2

5. Modified internal rate of return (MIRR)

Advantage: implicit reinvestment assumption at

the rate of cost of capital

Disadvantage: the discount rate used may be too

pessimistic

Might lead to wrong signal as to which project is

financially preferable

7Investment Appraisals Two Projects

Year Project A (‘000) Project B (‘000)

0

1

2

3

4

5

(100)

10

30

60

60

20

(100)

60

60

10

10

10

Payback

Average ARR

IRR

NPV (10%)

3 years

32%

20%

RM32,360

1.67 years

20%

24%

RM24,670

8Modified IRR for Two Projects

Project A (‘000) Project B (‘000)

Year Cash

Flow

Reinvested @

10%

Cash

Flow

Reinvested @

10%

0

1

2

3

4

5

(100)

10

30

60

60

20

14.641

39.641

72.600

66.000

20.000

(100)

60

60

10

10

10

87.846

79.860

12.100

11.000

10.000

Total value of

inflows 213.171 200.806

MIRR 16.4% 14.6%

9Reasons For The Use of Payback

and IRR Techniques

Increasing use of discounted cash flows method (DCF)

in UK and US firms

Use alongside with payback and ARR

REASONS: PAYBACK

Simplicity of calculation and understanding

Help in assessing time-related risk by encouraging

quick returns

Especially when liquidity is a problem

Complementing other more sophisticated methods

10Reasons For The Use of Payback

and IRR Techniques …2

REASONS: IRR

Convenient for ranking projects (while NPV has

got to be converted into profitability index (PI)

Implicit reinvestment assumptions

Calculations does not require prior specification

of discount or hurdle rate

The measure is expressed in percentage terms

rather than absolute figure as in NPV

11CRITERIA IN USE - TRADITIONAL

High discount rates

Kaplan and Atkinson (1989) noted 20%-25% discount

rates in USA

In UK, similar to US

Short payback period

in UK, 75% required payback of 3 years or less

Adjust inappropriately for risk

Increase hurdle rate

reduce payback periods

12Incorrect use of nominal discount rate to

discount current price cash flow

Use of discount rates based on money market rates eg.

returns available to equity holder

Market rate takes accounts of inflation

When inflation high, interest rates rise

Project cash flow should also take account of inflation

If not, it will underestimate the PV of a cash flow

And thus rejecting a profitable projects

Neglecting tax shield effect on debt finance

Interest paid on debt is tax deductible

Reduces the cost of debt

13

Tidak mengambil kira risiko tidak

melabur

Lebih sesuai untuk analisis pelaburan jangka

pendek

jumlah pelaburan besar

jangka masa pulangan adalah panjang

Perbezaan usia

guna / usia

teknologi mesin

14MEASUREMENT IN USE UNDER

AMT ENVIRONMENT

Important factors ie. benefits of AMT must be quantified

either precisely or based on estimation

improvement in quality

greater flexibility

reduced inventory

reduction in floor space

reduction scrap, waste and rework

reduced throughput-time

reduced lead-time

reduced disruption of workflows

improved organisation learning curve

lower warranty and service costs

If too difficult

to

quantify,

they

should be

identified

as

intangible

benefits.

15INVESTMENT APPRAISAL IN JAPAN

Japanese managers include a wider array of

performance indicators (PI)

quality control cost, scrap, rework, warranty,

service costs, wastage, space saving and

machine performance

Western managers appear over-concerned with

quantitative advantages of AMT

Japan: use payback but geared to the long term of

2-5 years (Table 15.1 Ashton et al.)

Western: adopt short-term performance target

16INVESTMENT APPRAISAL IN JAPAN

…2

Japan: emphasized the value of team working and

co-operation

individual performance are assessed along with

group performance

Western: individuals could be responsible for

departmental capital budgets

Japan: evaluate real cost associated with R&D,

software development, training needs (skills

shortages) and vendor support services

Western: impose more financial pressures to support

capital projects and short term performance

17AMT STRATEGY AND

IMPLEMENTATION

Implementation of AMT strategy is company-wide responsibility and not middle-level management’s

LEVEL TERM

Top Management 5 yearsLong-range strategic plan

Director 3 yearsLong-range operational plan

Manager 1 yearsAnnual operational plan

18AMT STRATEGY AND

IMPLEMENTATION …2

Long-range strategic plan (LRSP)

covered a 5 year period

performance criteria includes financial and non-financial objectives

flexibility, quality, better service, reduced waste etc

strong engineering voice (involvement)

Long-range operational plan (LROP)

developed to cover all aspects of implementation

though top down, actually a company-wide

commitment

19AMT STRATEGY AND

IMPLEMENTATION …3

Annual operational plan (AOP)

designed to track the progress of LRSP and

LROP

introduced to monitor expenditure on capital

equipment, labour and overhead

also served to inform senior managers of

necessary changes to original performance

milestones

20TEAM WORKING AND CO-

OPERATION CULTURE

commitment to work as part

of a team

desire to work towards a

shared goal

(not personal financial gain

and promotion)

21TEAM WORKING AND CO-

OPERATION CULTURE …2

Two important cultural explanations:

1. The tradition of lifetime employment

encouraged a long-term view of one’s career goal and

conduct

one loses by leaving to join another rival firms

lose accrued benefits

treated like a junior

retrained like a non-skilled worker

2. Route to promotion is length of service, seniority and loyalty

individualism is unusual

22THE FRAGMENTATION OF AMT

DECISION MAKING

Fragmented approach refers to little

or no cross- fertilization between

functional or hierarchical levels

eg. between senior managers and

engineers

lack of team management

(Refer the following Figure)

23KEY STAGES IN THE INVESTMENT

APPRAISAL PROCESS FOR AMT (UK)

Project Engineer

(Cost proposal)Project

Analyser

Accounts

Manager

Director Europe

Engineering

Manager

Director USA

24KEY STAGES IN THE INVESTMENT

APPRAISAL PROCESS FOR AMT (UK) …2

Project manager devises a cost proposal forecasting the

benefits of investment

The engineering manager then assess the proposed

investment according to its strategic importance

Project analyzer (eg. trainee management accountant)

will scrutinize the proposal

checking the figures and records the expected cost

savings

Accounts manager approves (rubber-stamping)

The whole process may take 9 months - 1 year.

25DIVISIONS BETWEEN

ACCOUNTANTS AND ENGINEERS

ITS IMPLICATIONS:

Accountants may fail to grasp the meaning behind engineering technology

Information may be diluted to facilitate understanding and thus lost its meaning

Leads to poor communication esp. when accountants and engineers occupy separate buildings and uses different canteens

Accountants are remote from production

Restricted in their participation in planning teams due to their narrowly specialized knowledge and skills

26DIVISIONS BETWEEN

ACCOUNTANTS AND ENGINEERS …2

EG. Application of JIT Philosophies:

Japan: perceives JIT as a holistic approach (company-wide) to world-class manufacturing status

UK: sees JIT as an inventory control system

confined JIT implementation to the responsibility of an individual engineering manager

perceives separately from technology decisions

eg preventive maintenance (PM) carried out in isolation from wider manufacturing plan

becomes sole responsibility of maintenance dept.

27PERBANDINGAN APLIKASI PENILAIAN

PELABURAN AMT ANTARA:

JEPUN

Faktor kualitatif

Pulangan jangka

panjang

Tanggung jawab

kumpulan

BARAT

Faktor kuantitatif

Pulangan jangka

pendek

Tanggung jawab

individu

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ANALISIS PELABURAN

AMT

STRATEGIK

29

• Penjimatan Buruh Langsung & Tak Langsung

• Kurang Inventori

• Ruang Tempat

• Tuntutan Waranti

• Masa Pengeluaran Lebih Pendek

• Masa Penyediaan lebih pendek

• Cepat Bertindak Balas Dengan Pasaran

• Meningkatkan Struktur Pasaran

30DCF ANALYSIS OF AMT

- QUANTITATIVE FACTORS

Several costs and benefits may be estimated with faint degree of precision

Direct labor savings as indirect labor increases due to

industrial engineering

maintenance staff

computer support staff

Costs may now be semi variable – step like behaviour


- QUANTITATIVE FACTORS …2

Improved throughput time

increased demand realized per ringgit of incremental investment

impact revenue projections

when process time is the cost driver, less cycle time/unit means units will have less indirect costs attached

cycle time decreases, response time is faster

therefore buffer WIP and FG is not necessary

therefore less financing cost

the opportunity cost of reducing space


- QUANTITATIVE FACTORS …3

Reduction in set up times dues to programmable machine changes

Reduced quality errors due to improved machinery tolerance and product inspection scanners

Reduction in post sale warranty cost

33

Reputasi

Teknologi

Syer

Pasaran

Kedudukan

Persaingan

Inovasi

Produk

PERTIMBANGAN

STRATEGIK

DCF ANALYSIS OF AMT

- QUALITATIVE FACTORS


- QUALITATIVE FACTORS …2

Depreciation on Machinery:

Due to technological change (qualitative),

difficult to predict:

useful economic life

equipment residual values

future operating costs (technological

learning process and technological

change)


- QUALITATIVE FACTORS …3

Real time performance feedback -

intangible benefit

rather than periodic accounting

Instantaneous feedback permits:

immediate identification of problem production

areas

allow corresponding action before entire

damage

prevent the incurrence of production overrun

36STRATEGIC PRODUCTION

ADVANTAGES - FMS

Eg. Should a competitor adopt an FMS, it

enables:

greater product heterogeneity

more customized service

greater product reliability

shorter lead time

If it does not adopt, it will cease to be a

player in the marketplace

37STRATEGIC PRODUCTION

ADVANTAGES – FMS …2

Strategic decisions involve overall corporate goals:

market share

product reliability

customer satisfaction

improved production performance

none of these benefits are readily quantifiable

38INVESTMENT APPRAISAL - CAD

Real justification for CAD is fivefold:

process innovation

product innovation

better quality

ability to undertake complex design work

ease modification/retrieval

Investing in CAD enables greater design

creativity

lead to design products with fewer parts

thus benefits reach all areas of production cost

eg inventory management and product reliability

39INVESTMENT APPRAISAL – CAD …2

Comparing manual and automated design

work:

CAD permits more complex modifications to

be performed in a simpler manner

leads to a greater retrieval rate

reduce design lead times as drawings reach

production much quickly

time-savings in modifications of existing

drawings

able to compete in the domestic and

international market-place

40INVESTMENT APPRAISAL – CAD …3

DCF is not appropriate to capital projects of

this type

Implementing new technology could costs

more than the price of the hardware and

software packages

Eg. training, hours of intellectual effort, pain-

staking attention

If true costs of AMT were known, there would

not be any future investment

41STRATEGIC BENEFITS OF CAD

Case: Simmonds Precision Products

justify investment purely for strategic reason

no attempt were made to quantify them

Strengthening the organisation’s visibility in the

marketplace

enabling production of high quality low cost

production with fewer errors

faster customer turnaround

more integration of manufacturing engineering

42

AMT CAPITAL BUDGETING ANALYSIS

STRATEGIC

• Direct labor savings

• Inventory financing

• Floor space

• Incremental indirect labor

• Spoilage/Warranty claims

• Throughput time/Setups time

• Scrap/rework

• Product heterogeneity

• Number of parts

• Future operating costs

• Residual values/Useful life

• Real-time measures

• Delivery

• Product reliability

•Technological reputation

• Market share

• Competition

• Product innovation

43A CASE EXAMPLE

XYZ Co. produces machine tools.

Considering replacing its boring and drilling

equipment

Near end of physical life and no residual value\

There is 2 options:

Replacing with technology

OR

Replace with FMS

44A CASE EXAMPLE …2

1. An incremental approach consists of replacing

existing components with similar technology with a

10 year life

at a cost of $2.5

million

depreciation

straight line basis

no residual value

for tax purposes

all other fixed costs

are cash expenses

Annual cost and revenue

projections:

Production and sales: 50,000

Price per unit: $35

Cost/unit of raw material: $4

Direct labor: $5

Variable overhead:$3

Fixed overhead: $4


2. An FMS with a 10 year llife

no residual value, straight line write off

Cost $6 million

Installation cost $600,000

Training and start up cost $700,000

Engineering support $800,000

25% reduction in raw material cost (improve quality)

35% reduction in direct labor (automation)

20% reduction in throughput time (increase sales)

15% reduction in variable overhead (reduce material

handling) but will be offset with:

Annual increase in fixed engineering cost of $30,000


Annual increase of fixed electrical cost

$20,000

Reduction in inventory $300,000

Annual fixed cost savings $75,000 (less

financial charges and space)

Discount rate 16%

Marginal tax rate 34%

47CAPITAL BUDGETING ANALYSIS

– Machine Replacement’000

Investment $2,500

Revenues (50,000 x $35) 1,750

Expenses

Full cash cost (50,000 x $16)

Annual depreciation

800

250

Total expenditure $1,050

N.I.B.T. 700

N.I.A.T (@34%) 462

Depreciation add back 250

After tax cash flow 712

Total present value (@4.83) (10yrs,16%) 3,441

Payback = $2,500 / $712 = 3.5 years


– FMS ’000

Investment: CostInstallationStart-upEngineering

Total

$6,000600700800

8,100

Revenues (60,000 x $35) 2,100

ExpensesRaw material (.75x4x60,000)Direct labor (.65x5x60,000)Variable overhead (.85x3x60,000)Fixed overhead (4x50,000)Incremental fixed overheadFixed overhead savedAnnual depreciation

18019515320050

(75)810


Continued


– FMS ’000 …2

Total revenue $2,100


N.I.B.T. 587

N.I.A.T (@34%) 387


After tax cash flow 1,197


Initial inventory liquidation 300

Total return $6.087

Payback = $8,100 / $1,197 = 6.8 years

50REVISED CAPITAL BUDGETING ANALYSIS

– Machine Replacement’000

Investment $2,500

Revenues (50,000 x $35 x .75) 1,312

Expenses

Full cash cost (50,000 x $16)

Annual depreciation

800

250


N.I.B.T. 262

N.I.A.T (@34%) 173


After tax cash flow 423


Payback = $2,500 / $423 = 5.9 years

51REVISED CAPITAL BUDGETING ANALYSIS

– FMS ’000

Investment $8,100

Total revenue $2,100


Less: depr.adjustment (140)

N.I.B.T. 727

N.I.A.T (@34%) 480


After tax cash flow 1,149


Initial inventory liquidation 300

Residual value (@0.386 x $1,400) (recovery upon termination) 540

Total return $6.087

Payback = $8,100 / $1,149 = 7.0 years

52INVENTORY REDUCTION METHODS

Raw Material Work in Process Finished Goods

• Fewer closer

supplier

• Frequent deliveries

• Smaller orders

• Long-term contract

• Supplier inspected

• Improved plant

configuration

• Worker

flexibility

• Increased quality

• Less set ups

• Demand pull

• Reduced cycle

time

• Increased

production

flexibility

53JIT SUMMARY

Traditional Change Result

“Push” raw material release

Pull system Decrease in WIP

Large batch processing

Production cells Shorter cycle times, less space & setup

Uneven work scheduling

WIP Kanban Improved quality

End-of line inspection

Cell responsibility

Less rework

High levels of FG FG Kanban Less FG

Significant material handling

Plant reconfiguration

Less material handling and damage

54“AS IS” vs. “TO BE” Characteristics

AS IS TO BE

Manual scheduling from forcast

Order driven computerised scheduling

Long lead time – monthly buckets (EOQ)

Lead time reduced to hours (day need)

Large inventory ½ month inventory

Manual material handling Automated material handling

Receiving - central Point of use

Standalone testing function Integrated with fabrication and assembly

Continued

55“AS IS” vs. “TO BE” Characteristics …2

AS IS TO BE

Lengthy setup standalone machines

Reduced or eliminated setup flexible random processing

Inspection after the fact Closed loop automatic feedback

Manual tool management Auto tool management

Separate design and processing

CAD/CAM and manufacturing functions integrated

Supplier communications clerical/manual interfaces

On-line communication with supplier

56OPERATING PLAN CHECKLIST

Category

Increased

Productivity

Improved

Quality

Improved

Flexibility

Increased

Throughput

System

Integration

Improved Steel

utilization

x x x

Indirect labor -

rework

x x

Indirect labor –

machine repair

x x x

Management-

office automation

x x

Management –

foreman reduction

x x x

Indirect material-

Rust Proofing

x x x x

Inventory - FG x x

57Multi Attribute Decision Models (MADM)

- Scoring model for a FMS

Attributes Weights Values Confidence Product

1. Strategic

Technological

reputation

12 4 1.0 48

Market share 10 2 0.8 16

Competitive

position

14 3 0.7 29

Product

innovation

8 4 1.0 32


- Scoring model for a FMS …2


2. Quantitative

NPV 30 4 0.9 108

Payback 10 2 0.8 16


- Scoring model for a FMS …3


3. Qualitative

Product

heterogeneity

4 4 1.0 16

Product

reliability

3 2 0.6 4

Response time 3 1 1.0 3

No. of parts 4 0 0.8 0

Real time

measures

2 5 0.9 9

Total 100 281

60

Education

Contemporary capital investment