- Email: [email protected]
Financial justification of state-of-the-art investment: A study using CAPP
Engineering Management International, 1 (1982) 221-225 Elsevier Scientific Publishing Company, Amsterdam - Printed in The Netherlands
221
FINANCIAL JUSTIFICATION OF STATE-OF-THE-ART INVESTMENT: A STUDY USING CAPP Stephen Evans and Peter J. Sackett School of Engineering,
University
of Bath,
Bath (U.K.)
ABSTRACT Accounting practice heavily influences the investment decisions made in manufacturing and highly profitable state-ofengineering, the-art computer based technologies may lie outside the classical scope of accounting appraisal methods, This work describes the
problems and illustrates a solution to financial justification of these projects. The identification and agreement of effect and objective by both engineers and financial controllers is of paramount importance when clear and direct cost savings are not visible.
INTRODUCTION
tions in manpower or run cost results. The justification for such a system is in the use of information for cost benefit via improved performance and this cannot be quantified easily. In this work the authors isolate pitfalls in justifying state-of-the-art investment and illustrate via a case study an approach which can be adapted to suit particular requirements.
The content and direction of new investment programmes have major implications for an engineering manager; typically a prerequisite of any decision or investment is an exercise to quantify the implications of the programme. However when the exact effect and particularly the cost benefits cannot be calculated, traditional methods may not be applicable. The proposed introduction of unproven (state-of-the-art) tools, methods or processes makes quantification of effect difficult since the data from which we can extrapolate is not relevant to the proposed environment. Just such a problem exists for engineering managers in the field of investment in Computer Aided Engineering (CAE). For instance, a computer based production control system may supply managers with information that previously they had insufficient time or resources to collect; no reduc-
0167-5419/82/0000-0000/$02.75
WHY STATE-OF-THE-ART Most companies accept that, without new products and the investment in time and resources that their introduction requires, competitiveness and market share will be at risk. The same logic applies to manufacturing - waiting for competitors to incorporate new techniques introduces a time lag, possibly lasting several years. During this period you will suffer a penalty in product cost, quality
0 1982 Elsevier Scientific Publishing Company
222
or availability. This view may justify investment in new techniques but not necessarily state-of-the-art (new to everyone) compared to an enhanced (new to your company) approach. However whilst greater risks are involved in state-of-the-art techniques proportionally greater benefits are realisable: a much higher level of benefit than existing systems offer is available, a leap rather than a step; in-house experience will be built up at the learning stage so that benefits flow sooner; company and employee image will improve; a more interesting work environment results which encourages further innovative moves. The counter argument to the use of untried techniques is the raised risk level involved which causes cautious managements to wait to see something working in a similar environment to their own. Risk analysis approaches may be employed and Fatheldin et al. (1978) describe such an approach in a CAE evaluation. However the authors have found that for the investment programmes under consideration here, risk can be reduced by staged implementation procedures and ongoing evaluation. Risk recognition by itself does not tackle the underlying problem of financial justification.
PROBLEMS
IN JUSTIFICATION
The problems encountered in financial justification of state-of-the-art techniques are: l prediction of achievable effect; l translation of predicted effect into financial terms; l use of non-financial objectives. Several years ago Fremgen (197 3) reported that the great majority of American corporations approved investments not justified by classical financial analysis. Homgren (1975) draws attention to “overdependence on an accounting system as being the prime means of motivation and the final word on the appraisal of performance”. Investment applications now being considered
fall outside the physical manufacture or processing of products, and the problems for traditional accounting practices are compounded. For example a proposal to reduce manufacture lead time can use as a base the current cost of work-in-progress and assess other peripheral savings. If the same approach is used to evaluate a Computer Aided Design system on the basis of a specified reduction in lead time we find that no data on cost of design time exists apart from salary payments to staff. These may be negligible compared to the non-financially quantifiable benefits of meeting market imposed requirements for rapid quotations, schemes etc. In this example the objective has been clearly set as reducing lead time by an agreed amount; now, it becomes the role of the justification to show that this can be achieved. We can accurately determine the response of the computer system, the time to draw a certain feature or process an enquiry. To evaluate lead time advantage we need to identify an average drawing, the amount of time saved per drawing, the effect of extra features offered, the constraints on existing practice imposed and the thinking time per design. All these are subjective. Since the prime effect of the system will be to change the working methods of the user and the level of effect on user will determine success, extrapolation from the current status is hazardous. This situation calls for a different and unified approach particularly during the justification phase of a project.
THE UNIFIED
APPROACH
In many U.K. companies finance departments and engineering departments operate as completely separate functions. This often leads to an undesirable feud relationship, since the U.K. financial director will normally have powers of veto over the justification proposal. The nature of the state-of-the-art propositions is that they are based on assumptions which are not considered standard accounting practice so it is necessary to gain
223
approval prior to presenting any final documents. This can be achieved by making the financial manager aware of justification proposals you wish to use as you think of Regular informal meetings should them. be used to raise questions and to describe the methods, objectives and measurements used so that potential points of contention can be discussed and clarified. In particular the balance between purely financial justification and justification by achievement of objectives must be illustrated. It must be communicated that: . the objectives are the best possible and maximise advantage to the company as a whole; and l the proposers believe the new technique will achieve the stated objectives (the primary effects will lead directly to the desired objective). The authors have developed a procedure to achieve this status. THE METHOD Production of written justification for a significant spend project, say flOO,OOO is normally an iterative procedure; here the basic chronological order is set down by stage number.
Stage I Financial department personnel should be introduced to the project at the earliest convenient moment. Stage II Links between primary technique and commercial be clearly documented.
effect of the new objectives should
Stage I I I Level of primary effect must be established. This can only be predicted by the designers of the new technique and care must be taken to ensure that enthusiasm does not become over-
optimism. Restricting the prediction to primary effect helps, but use of mean, pessimistic and optimistic values can be helpful. Stage IV Level of primary effect must be translated to the level of effect on commercial objectives. This is the most difficult stage in which to produce figures that are generally acceptable. It involves discussions with the relevant managers, operators and engineers. Then “gut feeling” has to take over when deciding which prediction or combination of predictions is most sound. Co-operation with finance personnel at this stage will ensure that the predictions become acceptable. Use of optimistic and pessimistic figures is again recommended. Primary effect is the quantifiable, direct impact of a new technique. Primary effects, singly or in combination, lead to secondary effects in an effect-cause-effect-cause pattern which leads directly to the stated objective. Having calculated the effect on commercial objectives it may be that the measurement units are not in financial terms, i.e. in reduced lead time, improved production control data. In this case, if the objectives were specified by company policy, then a justification showing the level of achievable effect related to cost should be presented to the board of directors. Alternatively the objectives can be restated in what may be a more acceptable manner. This involves extending Stage II to cover links between stated objective and some financial measure: for example the sales value of improved response to customer order. Unfortunately further uncertainty is introduced and acceptability of calculated figures declines. At this point justification in purely financial terms begins to fail due to the difficulty of producing realistic and acceptable figures. The concept of advantage may be useful here as a method of making
224
objectives already stated acceptable. Listing advantages accrued by introduction of the new technique can explain the benefits of it more easily than the stated objectives. Quantifying the advantage, if possible, in terms of mean, optimistic and pessimistic values aids the visualisation of the effects. Advantage, in this case, can cover advantage over a former technique employed within the company or over rival companies. the
A CASE STUDY The above procedure was developed during the justification of a computer aided process planning system (CAPP) for a large engineering company. Such a system holds product manufacturing methods and process
information and outputs a manufacture process pfan either generatively or by interaction with an engineer at a terminal. The system stores process plans and distributes them on request to terminals throughout the factory. In addition it communicates with a production control software package to provide plant resource and time requirements for each item, The original objectives for introduction of the CAPP system were shortening of the product design to manufacture cycle time and standardisation and improvement of methods (Sackett and Evans, 1982). These appeared to be clear and no difficulties were envisaged in producing a financial justification. Primary effects and their translation to the stated objectives, according to Stage II, are shown
TABLE 1 Primary effects 1. Direct transfer of data between CAPP and Production Control Software immediately after completion of a process plan. PRIMARY EFFECTS
2. Elimination of paperwork information.
to transmit this
3. Elimination of lengthy manual preparation of process plans.
Cuts out internal posting of forms, production of punched cards, batch input to production controi software. Reduces OBJECTIVE
process
plan to shop floor time.
Shortens product kycletime. 2. Reduces Planning engineer.
clerical engine&s
function
of
have
more
engineers. time
to
i OBJECTIVE
Engineers time spent on improving methods. 3. Process Planning engineer.
OBJECTIVE
Plan Production takes less time. & engineers have more time to
J Engineers time spent on improving methods.
225
in Table 1. Here the objectives can be traced back to the primary effect but various other changes in working practice were caused by these and other primary effects; these were listed as advantages on the justification. Included here were cost savings on data card punching, more reliable issue control and job enhancement for planning engineers. Quantifying the objectives was not successful in that a presentation in financial terms was not fully achieved. The difficulty of evaluating product design to quantify time reductions has been illustrated but quantifying financial implications of method standardisation and improvement seemed insurmountable. The solution was to take one step back from the objectives, towards the primary effect. The new system releases engineering time which can be applied to method standardisation and improvement. Engineering managers believed that the value of engineers time exceeded their payroll rate. So savings in engineering time could be used to provide an enhanced cash value for method standardisation and improvement. This procedure gave a payback of less than three years for design, implementation and run cost of the system. This was vetoed by the finance department due to distrust of this approach and inadequate traceability of cost data savings. This highlights the communication barrier between engineering visualisation of physical effect and finance visualisation of balance sheet entries. The financial manager was eventually convinced of the soundness of this approach. Approval for introduction of the CAPP system was achieved when the combination of cost savings, achieved objectives and ad-
vantages were communicated exceed cost incurrence.
as sufficient
to
CONCLUSION Quantifying in financially acceptable terms that which engineers know to be good practice has never been easy. New technologies are placing increased reliance on engineering justification and it is not a simple task. The approach described emphasises communication between all the parties involved, quantification of as many factors as possible and agreement on the effects and the level of effect achievable. In the case study outlined, the process of reaching this status led to a much improved, widespread appreciation of the advantages to be gained from the successful implementation of the CAPP system. Peripheral areas of the company outside the mainstream of impact were involved and their enthusiasm aided the justification procedure and bodes well for the forthcoming implementation. REFERENCES Fatheldin, M., Rathmill, K. and Leonard, R., 1978. An investment appraisal for computer aided draughting in a manufacturing company, MATADOR Conference, University of Birmingham, U.K. Fremgen, J.M., 1973. Capital budgeting practices: a survey, Management Accounting (May): 11. Horngren, C.T., 1975. Accounting for Management Control, 3rd edn., Prentice-Hall, London, p. 619. Sackett, P.J. and Evans, S., 1982. Implementing computer aided process planning, International Journal of Operations and Production Management, 2(2): 21.
221
FINANCIAL JUSTIFICATION OF STATE-OF-THE-ART INVESTMENT: A STUDY USING CAPP Stephen Evans and Peter J. Sackett School of Engineering,
University
of Bath,
Bath (U.K.)
ABSTRACT Accounting practice heavily influences the investment decisions made in manufacturing and highly profitable state-ofengineering, the-art computer based technologies may lie outside the classical scope of accounting appraisal methods, This work describes the
problems and illustrates a solution to financial justification of these projects. The identification and agreement of effect and objective by both engineers and financial controllers is of paramount importance when clear and direct cost savings are not visible.
INTRODUCTION
tions in manpower or run cost results. The justification for such a system is in the use of information for cost benefit via improved performance and this cannot be quantified easily. In this work the authors isolate pitfalls in justifying state-of-the-art investment and illustrate via a case study an approach which can be adapted to suit particular requirements.
The content and direction of new investment programmes have major implications for an engineering manager; typically a prerequisite of any decision or investment is an exercise to quantify the implications of the programme. However when the exact effect and particularly the cost benefits cannot be calculated, traditional methods may not be applicable. The proposed introduction of unproven (state-of-the-art) tools, methods or processes makes quantification of effect difficult since the data from which we can extrapolate is not relevant to the proposed environment. Just such a problem exists for engineering managers in the field of investment in Computer Aided Engineering (CAE). For instance, a computer based production control system may supply managers with information that previously they had insufficient time or resources to collect; no reduc-
0167-5419/82/0000-0000/$02.75
WHY STATE-OF-THE-ART Most companies accept that, without new products and the investment in time and resources that their introduction requires, competitiveness and market share will be at risk. The same logic applies to manufacturing - waiting for competitors to incorporate new techniques introduces a time lag, possibly lasting several years. During this period you will suffer a penalty in product cost, quality
0 1982 Elsevier Scientific Publishing Company
222
or availability. This view may justify investment in new techniques but not necessarily state-of-the-art (new to everyone) compared to an enhanced (new to your company) approach. However whilst greater risks are involved in state-of-the-art techniques proportionally greater benefits are realisable: a much higher level of benefit than existing systems offer is available, a leap rather than a step; in-house experience will be built up at the learning stage so that benefits flow sooner; company and employee image will improve; a more interesting work environment results which encourages further innovative moves. The counter argument to the use of untried techniques is the raised risk level involved which causes cautious managements to wait to see something working in a similar environment to their own. Risk analysis approaches may be employed and Fatheldin et al. (1978) describe such an approach in a CAE evaluation. However the authors have found that for the investment programmes under consideration here, risk can be reduced by staged implementation procedures and ongoing evaluation. Risk recognition by itself does not tackle the underlying problem of financial justification.
PROBLEMS
IN JUSTIFICATION
The problems encountered in financial justification of state-of-the-art techniques are: l prediction of achievable effect; l translation of predicted effect into financial terms; l use of non-financial objectives. Several years ago Fremgen (197 3) reported that the great majority of American corporations approved investments not justified by classical financial analysis. Homgren (1975) draws attention to “overdependence on an accounting system as being the prime means of motivation and the final word on the appraisal of performance”. Investment applications now being considered
fall outside the physical manufacture or processing of products, and the problems for traditional accounting practices are compounded. For example a proposal to reduce manufacture lead time can use as a base the current cost of work-in-progress and assess other peripheral savings. If the same approach is used to evaluate a Computer Aided Design system on the basis of a specified reduction in lead time we find that no data on cost of design time exists apart from salary payments to staff. These may be negligible compared to the non-financially quantifiable benefits of meeting market imposed requirements for rapid quotations, schemes etc. In this example the objective has been clearly set as reducing lead time by an agreed amount; now, it becomes the role of the justification to show that this can be achieved. We can accurately determine the response of the computer system, the time to draw a certain feature or process an enquiry. To evaluate lead time advantage we need to identify an average drawing, the amount of time saved per drawing, the effect of extra features offered, the constraints on existing practice imposed and the thinking time per design. All these are subjective. Since the prime effect of the system will be to change the working methods of the user and the level of effect on user will determine success, extrapolation from the current status is hazardous. This situation calls for a different and unified approach particularly during the justification phase of a project.
THE UNIFIED
APPROACH
In many U.K. companies finance departments and engineering departments operate as completely separate functions. This often leads to an undesirable feud relationship, since the U.K. financial director will normally have powers of veto over the justification proposal. The nature of the state-of-the-art propositions is that they are based on assumptions which are not considered standard accounting practice so it is necessary to gain
223
approval prior to presenting any final documents. This can be achieved by making the financial manager aware of justification proposals you wish to use as you think of Regular informal meetings should them. be used to raise questions and to describe the methods, objectives and measurements used so that potential points of contention can be discussed and clarified. In particular the balance between purely financial justification and justification by achievement of objectives must be illustrated. It must be communicated that: . the objectives are the best possible and maximise advantage to the company as a whole; and l the proposers believe the new technique will achieve the stated objectives (the primary effects will lead directly to the desired objective). The authors have developed a procedure to achieve this status. THE METHOD Production of written justification for a significant spend project, say flOO,OOO is normally an iterative procedure; here the basic chronological order is set down by stage number.
Stage I Financial department personnel should be introduced to the project at the earliest convenient moment. Stage II Links between primary technique and commercial be clearly documented.
effect of the new objectives should
Stage I I I Level of primary effect must be established. This can only be predicted by the designers of the new technique and care must be taken to ensure that enthusiasm does not become over-
optimism. Restricting the prediction to primary effect helps, but use of mean, pessimistic and optimistic values can be helpful. Stage IV Level of primary effect must be translated to the level of effect on commercial objectives. This is the most difficult stage in which to produce figures that are generally acceptable. It involves discussions with the relevant managers, operators and engineers. Then “gut feeling” has to take over when deciding which prediction or combination of predictions is most sound. Co-operation with finance personnel at this stage will ensure that the predictions become acceptable. Use of optimistic and pessimistic figures is again recommended. Primary effect is the quantifiable, direct impact of a new technique. Primary effects, singly or in combination, lead to secondary effects in an effect-cause-effect-cause pattern which leads directly to the stated objective. Having calculated the effect on commercial objectives it may be that the measurement units are not in financial terms, i.e. in reduced lead time, improved production control data. In this case, if the objectives were specified by company policy, then a justification showing the level of achievable effect related to cost should be presented to the board of directors. Alternatively the objectives can be restated in what may be a more acceptable manner. This involves extending Stage II to cover links between stated objective and some financial measure: for example the sales value of improved response to customer order. Unfortunately further uncertainty is introduced and acceptability of calculated figures declines. At this point justification in purely financial terms begins to fail due to the difficulty of producing realistic and acceptable figures. The concept of advantage may be useful here as a method of making
224
objectives already stated acceptable. Listing advantages accrued by introduction of the new technique can explain the benefits of it more easily than the stated objectives. Quantifying the advantage, if possible, in terms of mean, optimistic and pessimistic values aids the visualisation of the effects. Advantage, in this case, can cover advantage over a former technique employed within the company or over rival companies. the
A CASE STUDY The above procedure was developed during the justification of a computer aided process planning system (CAPP) for a large engineering company. Such a system holds product manufacturing methods and process
information and outputs a manufacture process pfan either generatively or by interaction with an engineer at a terminal. The system stores process plans and distributes them on request to terminals throughout the factory. In addition it communicates with a production control software package to provide plant resource and time requirements for each item, The original objectives for introduction of the CAPP system were shortening of the product design to manufacture cycle time and standardisation and improvement of methods (Sackett and Evans, 1982). These appeared to be clear and no difficulties were envisaged in producing a financial justification. Primary effects and their translation to the stated objectives, according to Stage II, are shown
TABLE 1 Primary effects 1. Direct transfer of data between CAPP and Production Control Software immediately after completion of a process plan. PRIMARY EFFECTS
2. Elimination of paperwork information.
to transmit this
3. Elimination of lengthy manual preparation of process plans.
Cuts out internal posting of forms, production of punched cards, batch input to production controi software. Reduces OBJECTIVE
process
plan to shop floor time.
Shortens product kycletime. 2. Reduces Planning engineer.
clerical engine&s
function
of
have
more
engineers. time
to
i OBJECTIVE
Engineers time spent on improving methods. 3. Process Planning engineer.
OBJECTIVE
Plan Production takes less time. & engineers have more time to
J Engineers time spent on improving methods.
225
in Table 1. Here the objectives can be traced back to the primary effect but various other changes in working practice were caused by these and other primary effects; these were listed as advantages on the justification. Included here were cost savings on data card punching, more reliable issue control and job enhancement for planning engineers. Quantifying the objectives was not successful in that a presentation in financial terms was not fully achieved. The difficulty of evaluating product design to quantify time reductions has been illustrated but quantifying financial implications of method standardisation and improvement seemed insurmountable. The solution was to take one step back from the objectives, towards the primary effect. The new system releases engineering time which can be applied to method standardisation and improvement. Engineering managers believed that the value of engineers time exceeded their payroll rate. So savings in engineering time could be used to provide an enhanced cash value for method standardisation and improvement. This procedure gave a payback of less than three years for design, implementation and run cost of the system. This was vetoed by the finance department due to distrust of this approach and inadequate traceability of cost data savings. This highlights the communication barrier between engineering visualisation of physical effect and finance visualisation of balance sheet entries. The financial manager was eventually convinced of the soundness of this approach. Approval for introduction of the CAPP system was achieved when the combination of cost savings, achieved objectives and ad-
vantages were communicated exceed cost incurrence.
as sufficient
to
CONCLUSION Quantifying in financially acceptable terms that which engineers know to be good practice has never been easy. New technologies are placing increased reliance on engineering justification and it is not a simple task. The approach described emphasises communication between all the parties involved, quantification of as many factors as possible and agreement on the effects and the level of effect achievable. In the case study outlined, the process of reaching this status led to a much improved, widespread appreciation of the advantages to be gained from the successful implementation of the CAPP system. Peripheral areas of the company outside the mainstream of impact were involved and their enthusiasm aided the justification procedure and bodes well for the forthcoming implementation. REFERENCES Fatheldin, M., Rathmill, K. and Leonard, R., 1978. An investment appraisal for computer aided draughting in a manufacturing company, MATADOR Conference, University of Birmingham, U.K. Fremgen, J.M., 1973. Capital budgeting practices: a survey, Management Accounting (May): 11. Horngren, C.T., 1975. Accounting for Management Control, 3rd edn., Prentice-Hall, London, p. 619. Sackett, P.J. and Evans, S., 1982. Implementing computer aided process planning, International Journal of Operations and Production Management, 2(2): 21.