Capital decision-making: is your foundry a good investment?

A strategic planner gives advice on modernization and expansion decision-making, offering one approach to determining whether or not investments are worth the money.

How many of you believe, as one skeptical CEO once told me, that owners would be better off investing in Dairy Queen franchises than in their foundries?

How many of you work in companies where "facilities planning" consists of a couple of guys chatting about new equipment over a few lunches or slow Friday afternoons? Do you believe that payback period is an adequate measure of an investment's attractiveness?

How many of you think buying cheap, used equipment and rebuilding it constitutes foundry modernization?

During the past 15 years or so, I've met countless foundry executives who approach facilities decision-making with armloads of wrong-headed ideas and nearly limitless bad habits. One foundry owner I know honestly believes that buying an old molding machine for $100 was one of his greatest accomplishments. Go figure.

Is it any wonder, then, that the industry has often found itself with a glut of bright, shiny new capacity just as the bottom drops out of demand? Changes in our industry must occur to avoid perpetuating our industry's infamous and self-destructive "boom-and-bust" cycle in which we see foundries with brand-new, state-of-the-art equipment go belly up.

An example of a flawed decision-making strategy can be found in the story of Midwest Foundry, Coldwater, Michigan. In an effort to improve its competitive position, Midwest undertook a series of facilities projects that resulted in (essentially) a brand new Disa facility. However, because investment decision-making was focused on what was "best" purely from the operational/manufacturing perspective, management never noticed that big trouble was ahead regarding the "bigger picture" issues of return on investment (ROI), customers, and employees. Their facilities decisions were based on perfectly logical operational criteria but ignored what turned out to be far more important - strategic and financial criteria.

During this time the company suffered a strike and the defection of around half its business, which eventually caused it to close down. If they had done their planning properly, they would have at least considered the state of affairs outside of operations (especially at the customer) and could potentially have prevented the bankruptcy by making needed employee- and customer-related investments (20/20 hindsight!) instead of what may well have been non-essential facilities investments. The company's ROI on its facilities investments was much less than zero; investments in people and customer service may have had the kind of positive return needed to keep the company going.

Timing is Everything

Of course, there is a better way to make facilities decisions - one that ensures investments are in the foundry's best interests as well as in the best interests of the owners. Such an approach also ensures that foundries are a good investment from the only yardstick that really matters - financial return. Now, don't get me wrong. There are excellent non-financial reasons for making investments, but, no matter how compelling an investment appears to be from a strategic or other point of view, nothing (well, almost nothing) can justify investments that fail to provide an adequate rate of return.

Contrary to popular practice, the best investment decisions are those made well in advance of when the capital dollars are actually spent. In other words, foundry managers must be smart and proactive enough to resist the temptations of a juicy new order and keep their heads when business is booming and there's money in the bank. Just because an attractive prospective new order requires a different molding line than your foundry currently runs, buying the new molding line (or accepting the new order, for that matter) is not necessarily a good idea. Similarly, strong business conditions are often the worst time to add new capacity, as everyone else is thinking the same thing and demand, when it changes, will likely decline and pull the rug out from under that investment of yours.

Instead, investments should be timed to coincide with customer requirements, to come on-stream when they are needed most. Further, investments should match up with your foundry's strategic plans; don't invest simply when you can - invest when you should.

In addition to a desire to "do it right," two vitally important prerequisites to facilities decision-making exist. First is the concept of the "base case," which is a scenario wherein no investment is made. A base-case analysis examines the business's short and longer-term financial and non-financial return from "doing nothing" and is an important yardstick against which the merits of new investment decisions should be judged. Development of pro forma financial statements under a no-investment "base case" is integral to sound facilities planning.

Second, short and longer-term target-customer and target-prospect requirements and demand absolutely must be considered. By "requirements," I mean the type of castings they buy as defined by casting size (dimensions and weight), annual volumes, alloy and complexity. Complexity, the only characteristic that isn't self explanatory, means the extent to which the parts are cored, the nature of needed testing and inspection, and the scope of required secondary processing (heat treating, machining, etc.). Demand must be evaluated in tons or pounds as well as dollars, which means forecasting market prices over the investment horizon.

On the one hand, all this means carefully evaluating what target customers currently buy from your foundry as well as what they and target prospects currently buy from your competitors. This information is indispensable in making decisions about needed production capabilities. On the other hand, one must consider both facilities and marketing strategies to project what those target accounts can be reasonably expected to buy from your foundry (and at what price) in the future. This will do much to illuminate decisions regarding needed production capacity.

To Invest or Not to Invest

With this information in hand, you and your management team will be in an excellent position to understand what facilities and equipment are needed to satisfy customer requirements and demand - and hold off the competition - for the foreseeable future. This insight will give rise to answers about facilities and equipment, as well as modernization (no real growth) versus expansion. Typically, the result is a linked sequence of facilities projects aimed at improving your foundry's competitive position. These rather easily address the issue of production capabilities. Great care, however, must be taken when considering the expansion of production capacity, as financial and strategic considerations are often at odds here.

That brings us to the decisive question of whether the proposed investment path is worth the money. Talk all you want about competitive advantage or customer needs, but securing financing from parent companies, financial institutions or the pockets of enlightened company owners will require a hard look at the numbers. And those numbers include discounted cash flow, net ROI and return on assets employed (ROAE). Notice I didn't include payback period. Like price per pound, payback is an outdated role-of-thumb that carries zero weight with the money people and may or may not have anything, ultimately, to do with an investment's attractiveness.

The hard part here is establishing the cost and price foundation for the investment and for the business over the investment horizon (typically 5-10 years). Once a time horizon has been agreed upon, the following four cost and price prerequisites are needed before pro forma financial statements can be prepared:

* investment costs - the purchase price of all equipment and systems as well as the related installation and other "soft" costs;

* operating costs for the base case cost of goods sold, operating expenses, sales general and administrative expenses and taxes for the operation without any new investment;

* operating costs for the investment option - same as above, but for the business that would exist if the investment(s) under consideration are made;

* sales forecast - forecasted tons or pounds, prices and dollar sales under both the base case and investment options.

Also, at this time it's important to list and fully understand the non-financial costs and benefits of each option. For example, these could include:

* synergy with corporate strategy;

* impact on market share;

* learning/intangible start-up costs;

* probability of achieving financial targets (risk inherent in assumptions);

* impact on customer-satisfaction (product quality, delivery performance, etc.);

* impact on your company's image and competitive position;

* potential for business losses due to start-up problems;

* impact on the business' complexity/manageability;

* preferences of key managers and important customers.

Putting It All Together

Pro forma income statements are the next step, which, after all the hard work you've done up to this point, are a relatively simple spreadsheet exercise. Until you get to the bottom line, that is. Once the income stream has been calculated, this information should be used to develop annual and cumulative cash flow projections. The present value of these projected cash flows then should be calculated and combined with rate-of-return data (ROI or ROAE) to provide a complete picture of the investment's financial attractiveness.

The next step is to compare the financial attractiveness of the investment option with similarly calculated returns from the base case. In short, if the business is not significantly better off under the investment option than it would be under the base case, save your money. But what does "significantly better off" mean?

While the analysis of economic return should be the central consideration in deciding whether your foundry, a hot initial stock purchase option, the local bank or a Dairy Queen franchise is your best investment opportunity, money isn't everything. Non-financial considerations can and should come into play before, during and after the number crunching is done and often have a major impact in determining whether your company will be "significantly better off" if the investment is made. However, keep in mind that non-financial considerations should not dominate the proceedings. While they can play an important role in the "better-off" analysis, few non-financial justifications exist for investments that fail to provide an adequate rate of return.

And that brings us back to where we started. Too often in the past, foundry executives let their desire for growth get in the way of sound facilities decision-making to their own and the industry's detriment. Investing for modernization or expansion will, more than anything else and for good or ill, impact the long-term health of your business. CEOs must learn from the past to ensure that history's hard lessons are not repeated.