Evaluation of Investments in Manufacturing
Assessing Strategic And Economic Criteria
Strategic criteria assess whether the proposed investment is consistent with the business strategy and the manufacturing strategy. Three strategic criteria check elements of these strategies.
Step 1: Strategic Criterion 1
Is the Investment Appropriate for the Business Strategy?
Is the Investment Appropriate for the International Manufacturing Strategy?
Is the Investment Appropriate for the Production System?
Step 2: Strategic Criterion 2
How Will the Investment Affect the Market Qualifying and Order Winning Outputs and the Network Outputs?
Three economic criteria assess the financial benefits of the proposed investment. They account for benefits that are realized in the future, and so are not known with certainty.
Step 3: Economic Criterion 1
How Safe Is the Investment?
Step 4: Economic Criterion 2
How Profitable Is the Investment?
Step 5: Strategic Criterion 3
What Effect Will the Investment Have on Each Manufacturing Lever? Is There Sufficient Manufacturing Capability to Make the Required Adjustments to Each Lever?
Step 6: Economic Criterion 3
How Robust Is the Investment?
The assessment process stops when a proposed investment fails to satisfy a criterion. In this case, the proposed investment is rejected. If all six criteria are satisfied, the proposal is accepted. When a proposal is rejected, insights developed during the assessment process can be used to develop a new and better proposal.
Step 1: Strategic Criterion 1
The first criterion is an assessment of a proposed investment's fit with a company's business strategy, international manufacturing strategy, and factory manufacturing strategy. The criterion is assessed by asking three questions.
a) Is the Investment Appropriate for the Business Strategy?
A company's business strategy (Chapter 13) is the plan used to establish a market position, conduct operations, attract and satisfy customers, compete successfully, and achieve its goals. How successfully a company executes this plan determines the company's profitability. Proposed investments in manufacturing must fit with, and contribute to, a company's business strategy. Proposed investments should help a company execute business strategy.
The elements of business strategy are goals, product-market domain, and basis of competitive advantage. Proposed investments in manufacturing should help a company achieve its goals. For example, market share, volume growth, and long-term profits are important goals in many German and Japanese companies. These companies assess proposed investments in manufacturing for their ability to increase market share and volume and generate long-term profits.
A company has competitive advantage when it has an edge over competitors in attracting customers and defending itself against challenges. There are many sources of competitive advantage. A company's business strategy specifies which sources the company will emphasize. Proposed in vestments in manufacturing should help a company develop and sustain its sources of competitive advantage.
b) Is the Investment Appropriate for the International Manufacturing Strategy?
A company with international operations follows a particular international manufacturing strategy, uses a particular manufacturing network, and assigns roles called factory-types to its factories (Chapters 10, 11, 12). Proposed investments in manufacturing must be consistent with this international manufacturing strategy and must not pull the company, network, or factories in unintended directions (Situation 17.3).
A company competing on the basis of low cost and fast delivery needed to increase production capacity to meet a projected increase in sales in each of the next five years. Two proposed investments in manufacturing capacity were under consideration. The first was to build a small factory with enough capacity to satisfy requirements for one year. The second was to build a large factory with enough capacity to satisfy requirements for five years.
The company chose to build the small factory because the shorter payback period was very attractive to the comptroller and the company's banker.
One year later, the company needed to increase capacity again. Since, the cash flows were similar to the previous year, the company chose to build another small factory. One year later, the company built its third small factory, and before long the company had five small factories.
Shortly afterward, the company realized there was excessive duplication of activities in the five factories. In addition, the cost to handle and transport material between factories was high, and scheduling and control were difficult. In hindsight, the company wished it had built one large factory.
The company's mistake was failing to realize that investments in manufacturing are related to each other and to the business strategy. A small factory is an attractive investment when it is treated as a stand-alone investment and unattractive when treated as one investment in a sequence of many. Small stand-alone factories we re not consistent with the company's business strategy. One large factory, organized into focused factories-within-a-factory, was consistent. The company should have rejected the initial proposal to build a small factory because it did not satisfy strategic criterion 1; the investment was inappropriate for the business strategy.
Domestic and foreign governments sometimes offer land, tax breaks, assistance in hiring and training employees, and other handouts to persuade international companies to take over ailing businesses or locate factories in distressed areas. Companies that do not have clear business strategies or assess proposals using only economic criteria sometimes make poor business decisions by accepting these offers.
3) Is the Investment Appropriate for the Production System?
Manufacturers have access to many soft and hard technologies. None should be considered until after manufacturing has been focused (Chapter 15). Then, those appropriate for the production system in use are considered.
The amount of new technology should also be assessed. This assessment considers whether a company is a technology leader or a technology follower. Companies with capability at or above the adult level can be technology leaders, whereas companies with capability near the industry average level are technology followers. Technology followers should not adopt new technologies until others have adopted them, and the benefits are well known.
Some proposed investments are for equipment to produce new products. These proposals often mistakenly do not consider all stages of the product life cycle: development, growth, shakeout, maturity, saturation, and decline (Chapter 16). Some only consider high volume production during the maturity and saturation stages. By overlooking the investment needed during other stages, proposals can force a factory to use inflexible, high-volume equipment when flexible, low-volume equipment is needed. This makes it difficult to provide market qualifying and order winning outputs at each stage of the product life cycle.
Step 2: Strategic Criterion 2
How Will the Investment Affect the Market Qualifying and Order Winning Outputs and the Network Outputs?
The proposed investment is assessed for its ability to close the gap between current and target levels of factory manufacturing outputs (cost, quality, performance, delivery, flexibility, and innovativeness) and network manufacturing outputs ( accessibility, thriftiness, mobility, and learning). The proposed investment can be accepted if it helps manufacturing meet its targets. It should not be accepted if it provides unneeded outputs.
Step 3: Economic Criterion 1
How Safe Is the Investment?
This step is the first economic check. [1 ]It assesses the effect of uncertainties external to the proposed investment. For example, what if new opportunities appear in the future that are more attractive than the proposed investment, or what if problems develop that change a currently attractive investment into an unattractive investment? It is customary to assume that the longer it takes for an investment in manufacturing to start generating a profit, the greater the risk posed by external uncertainties.
The payback period is a measure of this risk. It is the time required for an investment to return earnings equal to the cost of the investment. The shorter the payback period, the sooner the company will recover its money. The shorter the payback period, the sooner the company can invest its money in other projects.
Most companies require that the payback period for an investment be less than a specified maximum period. The maximum period depends on the type of investment, the scarcity of funds, and the rate of change of products and processes in the industry. For example, in the early 1980s, most companies in the semiconductor industry required paybacks of less than two years for investments in manufacturing equipment. Companies were growing rapidly, investment funds were in short supply, and the rate of change of products and processes was high. In the late 1970s, many companies in the automotive industry accepted paybacks of up to five years on investments in energy conservation projects. This lengthy payback period reflected the feeling that energy prices would remain high, so these projects would remain attractive regardless of external uncertainties.
Step 4: Economic Criterion 2
How Profitable Is the Investment?
The second economic criterion assesses the ability of the proposed investment to generate profits. An investment is profitable when the net cash flows it generates exceed the cost of the investment. Three measures of profitability are return on investment, internal rate of return, and net present value.
A shortcoming of ROI is that it does not consider timing of cash flows. Obviously, the sooner positive cash flows are received, the better. Internal rate of return and net present value remedy this shortcoming.
Internal rate of return (IRR) is the discount rate that equates the present value of the stream of cash flows with the initial investment. Net present value (NPV) is a current dollar amount equivalent to the stream of cash flows. NPV discounts the value of future cash flows to reflect the time value of money. NPV uses a discount rate that has three properties:
? It is the rate of return required for an investment with a particular amount of risk.
? It is the rate of return a company could expect to receive elsewhere for an investment of comparable risk.
? It exceeds the company cost of investment funds.
Regardless of which measure of profitability is used, companies require that the profitability of a proposed investment exceeds a minimum value. The minimum value depends on the profitability of other investments that are available to the company.
Step 5: Strategic Criterion 3
What Effect Will the Investment Have on Each Manufacturing Lever? Is There Sufficient Manufacturing Capability to Make the Required Adjustments to Each Lever?
This step examines the adjustments to manufacturing levers (in the production system and in the manufacturing network) needed to implement the proposed investment. This step also assesses the company's ability to make these adjustments. A company with a high level of manufacturing capability can better make difficult adjustments for difficult investments than a company with a low level of capability.
This step also assesses the proposed investment in light of a company's track record for implementing investments in manufacturing. One measure in this track record is the fraction of potential benefit s a company has realized from past investments in manufacturing. To document the track record, a company must have a process for completing post audits of accepted proposals for investments in manufacturing. Investment proposals outline tasks to be done and benefits that will be gained. Post-audits check the important tasks and benefits in these proposals after the investments are completed to determine what tasks have been completed and what benefits have been realized.
Post-audits establish track records that verify the reliability of proposal writers and provide useful information for assessing future proposals. When post-audits are not done, proposal writers are tempted to exaggerate benefits and downplay costs to help their proposals get accepted.
Step 6: Economic Criterion 3
How Robust Is the Investment?
The final step in the assessment process is a sensitivity analysis to determine how sensitive the profitability of the proposed investment is to uncertainty in the important variables. Examples of important variables are costs, the life of the investment, and the size and timing of cash flows. Uncertainty that, when resolved, produces lower costs and larger, earlier cash flows is not a problem. A problem is uncertainty that may result in an investment that is not safe (economic criterion 1) or profitable (economic criterion 2).
Three values—optimistic, most likely, and pessimistic—are estimated for each important variable. The probability that each value will occur is also estimated. Then, a measure of profitability, such as NPV, is calculated for these data, and results are displayed on a graph. This is a straightforward task when modern spreadsheet software is used.
Summary
Confusion and frustration often surround the process of evaluating investments in manufacturing. A systematic approach that takes account of strategic and economic concerns should be used. The approach presented in this chapter consists of a sequence of six checks or criteria: three strategic and three economic. The strategic criteria assess whether the proposed investment is consistent with business strategy and manufacturing strategy. The economic criteria assess the safety, profitability, and robustness of the proposed investment.
Safety, profitability, and robustness are well-known concerns in financial management.Measures exist for each, but no single measure combines all three. Many companies use payback period to measure safety, internal rate of return to measure profitability, and net present value to measure robustness.
For more Information
* Hoshin Kanri, Kanban for the Supply Chain, Product Lifecycle Management, Manufacturing Planning and Control. Product Development System, Manufacturing Management Books. *
Assessing Strategic And Economic Criteria
Strategic criteria assess whether the proposed investment is consistent with the business strategy and the manufacturing strategy. Three strategic criteria check elements of these strategies.
Step 1: Strategic Criterion 1
Is the Investment Appropriate for the Business Strategy?
Is the Investment Appropriate for the International Manufacturing Strategy?
Is the Investment Appropriate for the Production System?
Step 2: Strategic Criterion 2
How Will the Investment Affect the Market Qualifying and Order Winning Outputs and the Network Outputs?
Three economic criteria assess the financial benefits of the proposed investment. They account for benefits that are realized in the future, and so are not known with certainty.
Step 3: Economic Criterion 1
How Safe Is the Investment?
Step 4: Economic Criterion 2
How Profitable Is the Investment?
Step 5: Strategic Criterion 3
What Effect Will the Investment Have on Each Manufacturing Lever? Is There Sufficient Manufacturing Capability to Make the Required Adjustments to Each Lever?
Step 6: Economic Criterion 3
How Robust Is the Investment?
The assessment process stops when a proposed investment fails to satisfy a criterion. In this case, the proposed investment is rejected. If all six criteria are satisfied, the proposal is accepted. When a proposal is rejected, insights developed during the assessment process can be used to develop a new and better proposal.
Step 1: Strategic Criterion 1
The first criterion is an assessment of a proposed investment's fit with a company's business strategy, international manufacturing strategy, and factory manufacturing strategy. The criterion is assessed by asking three questions.
a) Is the Investment Appropriate for the Business Strategy?
A company's business strategy (Chapter 13) is the plan used to establish a market position, conduct operations, attract and satisfy customers, compete successfully, and achieve its goals. How successfully a company executes this plan determines the company's profitability. Proposed investments in manufacturing must fit with, and contribute to, a company's business strategy. Proposed investments should help a company execute business strategy.
The elements of business strategy are goals, product-market domain, and basis of competitive advantage. Proposed investments in manufacturing should help a company achieve its goals. For example, market share, volume growth, and long-term profits are important goals in many German and Japanese companies. These companies assess proposed investments in manufacturing for their ability to increase market share and volume and generate long-term profits.
A company has competitive advantage when it has an edge over competitors in attracting customers and defending itself against challenges. There are many sources of competitive advantage. A company's business strategy specifies which sources the company will emphasize. Proposed in vestments in manufacturing should help a company develop and sustain its sources of competitive advantage.
b) Is the Investment Appropriate for the International Manufacturing Strategy?
A company with international operations follows a particular international manufacturing strategy, uses a particular manufacturing network, and assigns roles called factory-types to its factories (Chapters 10, 11, 12). Proposed investments in manufacturing must be consistent with this international manufacturing strategy and must not pull the company, network, or factories in unintended directions (Situation 17.3).
A company competing on the basis of low cost and fast delivery needed to increase production capacity to meet a projected increase in sales in each of the next five years. Two proposed investments in manufacturing capacity were under consideration. The first was to build a small factory with enough capacity to satisfy requirements for one year. The second was to build a large factory with enough capacity to satisfy requirements for five years.
The company chose to build the small factory because the shorter payback period was very attractive to the comptroller and the company's banker.
One year later, the company needed to increase capacity again. Since, the cash flows were similar to the previous year, the company chose to build another small factory. One year later, the company built its third small factory, and before long the company had five small factories.
Shortly afterward, the company realized there was excessive duplication of activities in the five factories. In addition, the cost to handle and transport material between factories was high, and scheduling and control were difficult. In hindsight, the company wished it had built one large factory.
The company's mistake was failing to realize that investments in manufacturing are related to each other and to the business strategy. A small factory is an attractive investment when it is treated as a stand-alone investment and unattractive when treated as one investment in a sequence of many. Small stand-alone factories we re not consistent with the company's business strategy. One large factory, organized into focused factories-within-a-factory, was consistent. The company should have rejected the initial proposal to build a small factory because it did not satisfy strategic criterion 1; the investment was inappropriate for the business strategy.
Domestic and foreign governments sometimes offer land, tax breaks, assistance in hiring and training employees, and other handouts to persuade international companies to take over ailing businesses or locate factories in distressed areas. Companies that do not have clear business strategies or assess proposals using only economic criteria sometimes make poor business decisions by accepting these offers.
3) Is the Investment Appropriate for the Production System?
Manufacturers have access to many soft and hard technologies. None should be considered until after manufacturing has been focused (Chapter 15). Then, those appropriate for the production system in use are considered.
The amount of new technology should also be assessed. This assessment considers whether a company is a technology leader or a technology follower. Companies with capability at or above the adult level can be technology leaders, whereas companies with capability near the industry average level are technology followers. Technology followers should not adopt new technologies until others have adopted them, and the benefits are well known.
Some proposed investments are for equipment to produce new products. These proposals often mistakenly do not consider all stages of the product life cycle: development, growth, shakeout, maturity, saturation, and decline (Chapter 16). Some only consider high volume production during the maturity and saturation stages. By overlooking the investment needed during other stages, proposals can force a factory to use inflexible, high-volume equipment when flexible, low-volume equipment is needed. This makes it difficult to provide market qualifying and order winning outputs at each stage of the product life cycle.
Step 2: Strategic Criterion 2
How Will the Investment Affect the Market Qualifying and Order Winning Outputs and the Network Outputs?
The proposed investment is assessed for its ability to close the gap between current and target levels of factory manufacturing outputs (cost, quality, performance, delivery, flexibility, and innovativeness) and network manufacturing outputs ( accessibility, thriftiness, mobility, and learning). The proposed investment can be accepted if it helps manufacturing meet its targets. It should not be accepted if it provides unneeded outputs.
Step 3: Economic Criterion 1
How Safe Is the Investment?
This step is the first economic check. [1 ]It assesses the effect of uncertainties external to the proposed investment. For example, what if new opportunities appear in the future that are more attractive than the proposed investment, or what if problems develop that change a currently attractive investment into an unattractive investment? It is customary to assume that the longer it takes for an investment in manufacturing to start generating a profit, the greater the risk posed by external uncertainties.
The payback period is a measure of this risk. It is the time required for an investment to return earnings equal to the cost of the investment. The shorter the payback period, the sooner the company will recover its money. The shorter the payback period, the sooner the company can invest its money in other projects.
Most companies require that the payback period for an investment be less than a specified maximum period. The maximum period depends on the type of investment, the scarcity of funds, and the rate of change of products and processes in the industry. For example, in the early 1980s, most companies in the semiconductor industry required paybacks of less than two years for investments in manufacturing equipment. Companies were growing rapidly, investment funds were in short supply, and the rate of change of products and processes was high. In the late 1970s, many companies in the automotive industry accepted paybacks of up to five years on investments in energy conservation projects. This lengthy payback period reflected the feeling that energy prices would remain high, so these projects would remain attractive regardless of external uncertainties.
Step 4: Economic Criterion 2
How Profitable Is the Investment?
The second economic criterion assesses the ability of the proposed investment to generate profits. An investment is profitable when the net cash flows it generates exceed the cost of the investment. Three measures of profitability are return on investment, internal rate of return, and net present value.
A shortcoming of ROI is that it does not consider timing of cash flows. Obviously, the sooner positive cash flows are received, the better. Internal rate of return and net present value remedy this shortcoming.
Internal rate of return (IRR) is the discount rate that equates the present value of the stream of cash flows with the initial investment. Net present value (NPV) is a current dollar amount equivalent to the stream of cash flows. NPV discounts the value of future cash flows to reflect the time value of money. NPV uses a discount rate that has three properties:
? It is the rate of return required for an investment with a particular amount of risk.
? It is the rate of return a company could expect to receive elsewhere for an investment of comparable risk.
? It exceeds the company cost of investment funds.
Regardless of which measure of profitability is used, companies require that the profitability of a proposed investment exceeds a minimum value. The minimum value depends on the profitability of other investments that are available to the company.
Step 5: Strategic Criterion 3
What Effect Will the Investment Have on Each Manufacturing Lever? Is There Sufficient Manufacturing Capability to Make the Required Adjustments to Each Lever?
This step examines the adjustments to manufacturing levers (in the production system and in the manufacturing network) needed to implement the proposed investment. This step also assesses the company's ability to make these adjustments. A company with a high level of manufacturing capability can better make difficult adjustments for difficult investments than a company with a low level of capability.
This step also assesses the proposed investment in light of a company's track record for implementing investments in manufacturing. One measure in this track record is the fraction of potential benefit s a company has realized from past investments in manufacturing. To document the track record, a company must have a process for completing post audits of accepted proposals for investments in manufacturing. Investment proposals outline tasks to be done and benefits that will be gained. Post-audits check the important tasks and benefits in these proposals after the investments are completed to determine what tasks have been completed and what benefits have been realized.
Post-audits establish track records that verify the reliability of proposal writers and provide useful information for assessing future proposals. When post-audits are not done, proposal writers are tempted to exaggerate benefits and downplay costs to help their proposals get accepted.
Step 6: Economic Criterion 3
How Robust Is the Investment?
The final step in the assessment process is a sensitivity analysis to determine how sensitive the profitability of the proposed investment is to uncertainty in the important variables. Examples of important variables are costs, the life of the investment, and the size and timing of cash flows. Uncertainty that, when resolved, produces lower costs and larger, earlier cash flows is not a problem. A problem is uncertainty that may result in an investment that is not safe (economic criterion 1) or profitable (economic criterion 2).
Three values—optimistic, most likely, and pessimistic—are estimated for each important variable. The probability that each value will occur is also estimated. Then, a measure of profitability, such as NPV, is calculated for these data, and results are displayed on a graph. This is a straightforward task when modern spreadsheet software is used.
Summary
Confusion and frustration often surround the process of evaluating investments in manufacturing. A systematic approach that takes account of strategic and economic concerns should be used. The approach presented in this chapter consists of a sequence of six checks or criteria: three strategic and three economic. The strategic criteria assess whether the proposed investment is consistent with business strategy and manufacturing strategy. The economic criteria assess the safety, profitability, and robustness of the proposed investment.
Safety, profitability, and robustness are well-known concerns in financial management.Measures exist for each, but no single measure combines all three. Many companies use payback period to measure safety, internal rate of return to measure profitability, and net present value to measure robustness.
For more Information
* Hoshin Kanri, Kanban for the Supply Chain, Product Lifecycle Management, Manufacturing Planning and Control. Product Development System, Manufacturing Management Books. *
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