Correlating manufacturing and financial performance
A key aspect of the new performance measures is how manufacturing is more directly connected to financial performance and vice versa. The illustrative example in this section best illustrates this tight connection and how manufacturing performance improvements are reflected in financial performance.
Assume a manufacturing company with the following baseline numbers:
» Revenues: $50m
» Direct Materials: $20m (40% of Throughput)
» Operating Expenses: $26m
» Total Assets: $30m - Includes $10m Inventory
Using the above numbers, the baseline Financial Performance Measures are:
» Net Profit: $4m (50-20-26)
» Return on Assets: 13.33% (4/30)
» Cash Flow: $4.5m (50-20-26+0.5) assume $0.5m non cash amortization charge.
Scenario #1:
Manufacturing Performance Improvements:
» Throughput: Improves by 5%
» Inventory: Unchanged
» Operating Expense: Unchanged
Business Impact:
» Revenues Increase to $52.5m
» Direct Materials Increases by $1m (40% of $2.5m additional Throughput)
Improved Financial Performance:
» Net Profit: $5.5m (52.5-21-26) - 37.5% increase
» Return on Assets: 18.33% (5.5/30) - 37.5% increase
» Cash Flow: $6m (52.5-21-26+0.5) - 33.3%
The most interesting observation of this scenario is that a modest increase of 5% in Throughput without any change to Inventory or Operating Expense, is amplified as significant financial performance improvements. The basic numbers for these comparisons are reasonably realistic and not idealistic or hypothetical.
Scenario #2:
Manufacturing Performance Improvements:
» Throughput: Unchanged
» Inventory: Reduced by 20%
» Operating Expense: Unchanged
Business Impact:
» Assets Decrease to $28m (20% of $10m is $2m less Inventory)
» Operating Expense Decreases by $0.5m (25% Inventory carrying cost for $2m less Inventory*)
Improved Financial Performance:
» Net Profit: $4.5m (50-20-25.5) - 12.5% increase
» Return on Assets: 16% (4.5/28*) - 20% increase
» Cash Flow:
» Year 1*: $7m (50-20-25.5+0.5+2.0) - 55.6% increase.
($2m in inventory savings is additional cash not spent.)
» Year 2+: $5m (50-20-25.5+0.5) - 11% increase
* Illustrative purposes only - entire reduction of inventory & carrying costs may not be realized in first year.
Again a modest and realistic manufacturing improvement by decreasing Inventory results in significant financial performance improvement.
Scenario #3 - combination of 1 & 2:
Manufacturing Performance Improvements:
» Throughput: Improves by 5%
» Inventory: Reduced by 20%
» Operating Expense: Unchanged
Business Impact:
» Revenues Increase to $52.5m
» Direct Materials Increases by $1m (40% of $2.5m additional Throughput)
» Assets Decrease to $28m (20% of $10m is $2m less Inventory)
» Operating Expense Decreases by $0.5m (25% Inventory carrying cost for $2m less Inventory*)
Improved Financial Performance:
» Net Profit: $6m (52.5-21-25.5) - 50% increase
» Return on Assets: 21.43% (6/28*) - 61% increase
» Cash Flow:
» Year 1*: $8.5m (52.5-21-25.5+0.5+2.0) - 89% increase.
($2m in inventory savings is additional cash not spent.)
» Year 2+: $6.5m (52.5-21-25.5+0.5) - 44.4% increase
* Illustrative purposes only - entire reduction of inventory & carrying costs may not be realized in first year.
The combination of two relatively modest manufacturing performance improvements results in dramatic financial performance. Note that OE is only consequentially decreased due to Inventory reduction - no specific OE reduction is assumed in the illustration. The advantage of using these 3 key manufacturing performance measures is to focus production management on what really matters and connect to financial performance measures that support the overall business goal of making money.
From a Manufacturing perspective it is relatively straightforward to determine performance improvement:
» Was more product shipped and sold? (Throughput)
» Did Inventory levels decrease relative to Throughput?
» Was there a real reduction in Operating Expense - not just calculation, but money saved?
Affirmative answers to each question and all 3 combined indicates manufacturing performance improvement. You can have exceptional utilization and efficiency rates, but unless these three performance measures are improving, there is no improvement that makes a positive impact on the business.
Tell me how you measure my performance and I will tell you how I will behave
Recommendations for practical manufacturing performance measurement and management
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