A perspective on foundry profitability.

Much has been written about foundry pricing practices and profitability. Generally, I agree with the implication of most of these articles, that foundries have a long way to go in understanding these issues. What they attempt to relate is that, for this industry, pouring more metal into more molds is an obsession. The idea of making a profit is secondary and something that results from the whole endeavor.

Not all foundries have ignored profitability, but a significant number have done so, as can be seen by industry statistics showing the number of foundries that have been or will be closed, and the rather odd pricing practices that prevail.

A recent article on pricing, for example, makes the point that not every job needs to contribute the same amount to profit. Pricing should reflect what the market will bear, as opposed to a fixed markup or a set price per pound. While I cannot argue with that view in general, it needs to be pointed out that the approach presupposes two important factors about the competition:

* they have an accurate cost model;

* they are conscious of their return on

assets.

While most foundries use some form of a cost model to estimate a job (whether they maintain it effectively or not is another issue), few, if any, use return on assets to determine their minimum acceptable profitability. As I hope to demonstrate, return on assets is the basis for the profitability of any business endeavor.

Return on Assets (ROA)

When you consider the asset side of your balance sheet, those assets expressed in dollars are the total assets that you employ to earn a profit. If those assets were real dollars instead of machinery, inventory, receivables and other items, think of the return you could earn on those dollars if, for example, you invested them in CDs, treasury bonds or some other investment. If you are a foundry without any interest-bearing debt (variations will be discussed later), then the maximum interest rate or rate of return you could earn on the invested dollars (assets) would represent the minimum earnings (profits) you should be receiving by using those same dollars as assets in your foundry. The concept is simple: You do not invest dollars to pour metal; you invest dollars in assets to earn a return, which is called profit.

The use of return on assets as the basis for comparing competing uses of the same dollars converts the balance sheet into one big CD. The formula to compute return on assets is simply annual earnings before taxes divided by the dollars of total assets on your balance sheet. This is the basic concept. In many firms outside our industry, this concept has been highly refined, but that is beyond the scope of this article and most likely beyond the need of most foundries. The logic, however, is simple: Why turn dollars into foundry assets if you are going to earn less than leaving the dollars to work by themselves as financial assets?

We should consider the assets themselves for a minute. In a world of zero technology change and zero inflation, depreciation would return sufficient dollars to replace each piece of foundry equipment as it wears out. This is so because the technology would not change and you would be replacing each piece of equipment with an identical piece at the same cost.

But the real world is very different. Inflation is real, and technology is always changing. Therefore, to use the fixed asset portion of the balance sheet in the calculation of return on assets is going to require making an adjustment to the total asset value. The adjustment has to be made to account for the increase in the cost of replacing the same piece of equipment. If the adjustment is not made, then our return on assets will reflect a return on fixed assets that is slowly wearing itself out and leaves us with a false sense that we are doing well and a bif financial shock when we must replace spent equipment.

The effect of a change in technology is a complex consideration because a change in technology also involves the consideration of DCF-ROI (Discounted Cash Flow/return on investment) calculations in justifying the new technology. This is beyond the scope of this article. However, it is important to realize that both the replacement cost of equipment and cost of new technology usually require making adjustments to the value of fixed assets when computing return on assets.

Real Estate Adjustments

Real estate (land and buildings) adjustments present a different set of considerations because real estate is driven by market forces. Financial people argue that all real estate should be valued at its market value under the theory that this is the value you would have if you converted your real estate to dollars. Therefore, the return should be based upon that value.

In my view, that approach is acceptable for real estate that has appreciated over its purchased cost. But what if the real estate at market value is worth less than the purchase price? it would seem prudent to continue to use the purchase price of the building, less depreciation, plus the cost of the land, so long as the net is equal to or greater than the market value. If the net is less than the market value, then market value would be the realistic basis.

We've talked about the asset basis upon which to determine the return on assets. How about the earning side of the analysis? Here the discussion is between using earnings before taxes or earnings before interest and taxes. Without getting into a long discussion about the effects of interest and debt, it is safe to say that using earnings before taxes will give a reasonable result. A second adjustment is sometimes considered when the depreciation expense is adjusted to reflect adjustments made to the fixed assets. The effect is to lower the earnings number and, hence, the return on assets. Lengthy debates regarding the pros and cons of any adjustment are unnecessary; the important requirement is to be consistent in all calculations. Again, whether someone chooses to make such an adjustment and all the thinking that goes into it is not within the scope of this article.

In the beginning, I hypothesized that the business did not carry debt; therefore the return on assets was compared to the best use the same dollars could be put to regardless of the investment. For simplicity, CDs or treasury bonds were mentioned, but what if a business carries debt as a part of its capital structure? The easy answer is that the return on assets should at least equal what it costs to borrow the debt.

While this is an easy answer, it ignores the fact that debt can be a small or large portion of a foundry's capital structure. There is a technique for determining the weighted average cost of capital. However, if you consider the capital put up by the stockholders to be as valuable as the borrowed funds, then it becomes easy to use the cost of the debt as the minimally acceptable return on assets. A return on assets less than what it costs to borrow deserves close attention.

Benchmarking ROA

Once return on assets is determined and compared to some benchmark, management can then decide if the use of the assets is acceptable or not. If the use of the assets is unacceptable, then a reversal of the process will produce a profit figure that the foundry must meet. By taking the adjusted total assets (whatever method is used) times the desired rate of return on assets, the desired earnings before taxes is obtained. it is from this figure that foundry management must look at its operations and how to conduct its business.

The key elements in this discussion are the determination of a return on assets that reflects the aspects of an ongoing business and a target to measure against, once the return on assets has been determined. We began by suggesting the use of CD rates or treasury bonds as a starting point to measure return on assets. Clearly, this was simply to develop the concept. A pure theorist may say that opportunity cost is the correct measure to use, assuming assets may be converted from one endeavor to another. I think that is unrealistic, but the point is important because assets must earn a return sufficient to keep them in use, or they will wear away, and the business entity then experiences financial problems.

This article is not intended to completely cover this subject, but hopefully it will stimulate discussion as it applies to our industry.