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Computer integrated manufacturing: a new look at cost justifications.

COMPUTER INTEGRATED MANUFACTURING: A NEW LOOK AT COST JUSTIFICATIONS

The factory of the future is just around the corner. Can you justify its cost?

Have you ever attended a manufacturing trade show and watched a numerically controlled machine that could reduce direct labor and associated overhead costs by 20% to 25%? How about a live demonstration of computer-aided manufacturing/computer-aided design (CAD/CAM) illustrating its flexibility and potential cost savings due to reduced manufacturing cycle times and increased use of standardized parts? Have you attempted to convince top management of the virtues of implementing advanced manufacturing technology? Have your clients asked for advice on the subject?

This article details the importance of computer integrated manufacturing (CIM) for today's manufacturer and describes the traditional cost justification techniques used by CPAs in industry and their advisers in public practice. It also explains how to handle the strategic issues in manufacturing that are subjective and intangible.

WHAT'S CIM?

CIM generally refers to a network of computers and machines run by people to achieve optimal manufacturing productivity. CIM's complexity tends to increase the closer you get to a traditional, complex factory. Conversely, it becomes more simplistic as you move to a continuous factory or just-in-time (JIT) operation.

Exhibit 1 on page 27 lists the pieces of CIM that are waiting to be installed and implemented in a manufacturing operation. According to the National Resource Council, the following potential savings are available from implementing CIM:
Savings Function
5%-15% Reduction in personnel costs
15%-30% Reduction in engineering
 design costs
30%-60% Reduction in overall lead time
30%-60% Reduction in work-in-process
40%-70% Gain in overall production
200%-300% Gain in capital equipment
 uptime
200%-300% Product quality gain
300%-3,500% Gain in engineering
 productivity


Sound intriguing? If these are the benefits your company or your clients want from CIM, the first step is to explore the traditional cost accounting justifications to make that CIM machine a profitable reality rather than an unwarranted expense.

TRADITIONAL JUSTIFICATION METHODS

All approaches used to justify an expenditure of capital for new manufacturing equipment require a quantitative appraisal to determine the financial consequences. In essence, the idea is to discover if cash flow equals benefits less costs. Benefits are the projected annual savings; costs are the recurring operating costs; and the cash flow is the net income after taxes plus noncash charges. The keys are to determine cash flow and how and when it will offset the initial expenditure. The basic questions to ask with every justification method are

* Benefits. What's to be gained from the purchase of advanced manufacturing technology? Will additional sales or savings result? Quantify your answer.

* Costs. What's the upfront cost of the expenditure? What are the recurring costs such as maintenance and other expenses? Again, quantify the answer.

* Opportunity cost. What's the cost to the company for not making this expenditure? For example, if cash can earn 10% after taxes, the cash itself has an opportunity cost of 10%. Thus, if equipment is purchased for cash, the opportunity cost is 10% of the cost used to acquire the items. And the opportunity cost of equipment in use is the profit lost due to the unavailability of the equipment for other purposes.

* Time value of money. What else could the company do with the money? A capital outlay made in one year can't be compared directly with another year because time gives them different values. Thus, the cash flow stream for a new expenditure must be converted to a base year to effectively assign a time value to it. This cost of capital is what the company would pay to use the capital on an alternative purchase and it reflects the rate the firm decides it can receive from pursuing a different project.

There are four basic techniques to determine what the "hard" benefits are from advanced manufacturing technology:

1. Payback period.

2. Return on investment.

3. Net present value.

4. Internal rate of return.

Let's see how each approach works in a basic example: Assume Acme manufacturing wishes to purchase a numerical control stamping machine for $50,500 to help control operating costs. The sophistication of this machine means no new annual operating costs will be incurred. The annual savings resulting from this expenditure are expected to decrease from $25,000 (overtime expenditures) to $4,000 over the four-year life predicted for the equipment. Acme set a 10% discount rate as the minimum return expected on investments. Therefore

Initial cost = $50,500

Annual recurring costs = 0
Annual savings = $25,000 (year 1)
 25,000 (year 2)
 10,000 (year 3)
 4,000 (year 4)
Estimated life = 4 years
Discount rate = 10%


PAYBACK PERIOD METHOD

The payback approach attempts to calculate the amount of time to recover the initial capital outlay for cash flows generated.

Payback = Initial cost/Cash flow

When the cash flows are unequal, the annual cash flows beginning with year one should be added and a determination made as to when the expenditure will be recovered.

$25,000 (year 1)

25,000 (year 2)

500 (1st quarter year 3)

$50,500 initial cost

Therefore, payback is in three years. A general rule is if payback occurs within one-half to one-third of the equipment's lifetime, the purchase should be accepted. In this case, three years is 75% of four years; therefore, the proposal would be rejected.

RETURN ON INVESTMENT

Return on investment (ROI) is a ratio that attempts to determine the financial gain from the project compared with the initial capital costs incurred. ROI = Benefits - depreciation/Initial costs Therefore: Depreciation =

$50,500/4-year life = $12,625 per year

Benefits = Sum of cash flows/Estimated life = $25,000 + $25,000 + $10,000 + $4,000/4

= 64,000/4 = $16,000 per year

ROI/year = $16,000 - $12,625 per year x 100%/$50,500

= 6.7% return on investment

Since 6.7% is less than the minimum requirement set by management of 10% on investment, a proposal using this technique should be rejected.

NET PRESENT VALUE

Net present value (NPV) is a discounted cash flow method that relates the flow of monies and the timing of such investments over the life of the project. NPV attempts to adjust cash flows to base year zero in order to ensure that all funds are compared against the same benchmark. See Exhibit 2 How to calculate net present value of a CIM investment.

In this case, the proposed project recovers all the initial costs; plus it yields an additional $3,133 return. Moreover, under this example, the 10% opportunity cost of the firm's capital is met. Consequently, the proposal should be accepted.

INTERNAL RATE OF RETURN

The internal rate of return (IRR) is that interest rate at which the cash flow stream equals all the costs of the proposed investment. The IRR technique requires a trial-and-error approach that finally hits on the solution. While more difficult to compute than NPV, its intent is to find the maximum rate of interest the project could pay on the investment--and break even. See Exhibit 3 How to calculate the internal rate of return on a CIM investment.

Since the IRR is 13.73%, which is greater than the desired 10% minimum rate of return, the project would be accepted using this technique.

JUSTIFICATION MYOPIA

As shown, these techniques offer the CPA a wide variety of options and result in different conclusions about whether to accept or reject a project. However, if you're using these techniques within your advanced manufacturing technology justification process, beware of their shortcomings:

Payback. This technique gives only an indication of the time needed to recover an investment. The approach tends to consider only cash flows up to the payback period. It fails to look beyond that period to determine what future cash flows will or won't be. The payback method is best used as a device to determine when an investment will be satisfied rather than as an indicator of the potential value of an investment.

Return on investment. ROI takes into account the depreciation of the investment over time and gives the user a better tool than payback. While the ROI approach can place capital expenditures with varying lives on a comparable basis, it doesn't consider cash flows. Thus, it is limited in evaluating long-term, large-scale projects. If ROI comes to less than 15%, time value techniques should be used.

Time value techniques. Both NPV and IRR are better techniques than payback and ROI for justifying advanced manufacturing technology. Both methods consider all hard costs associated with the investment, including the cost of capital. With NPV, the user selects the alternative project that yields the highest net present value. IRR, as an extension of NPV, compares the proposed project's return with the discount rate appropriate for the company. IRR, in essence, ignores the company's current discount rate and determines the rate of return of the total cash flows.

Unfortunately, using these techniques and managing strictly by the numbers does not take into account the strategic importance of the investment to the company. NPV and IRR are geared to long production runs of standard products. Under CIM, however, manufacturing is geared to increased flexibility, improved quality and innovative expansion of products. Thus, accountants must rethink and refine these time-honored cost justification approaches. Besides the hard benefits calculated, each company now needs to add the soft benefits available under CIM.

JUSTIFICATION FOR CIM

The justification process for advanced manufacturing technology in a CIM environment must be viewed differently from the traditional process for three reasons:

1. Project size. CIM investments are projects without end. Investments made today eventually will be replaced by new technology. Most benefits from CIM accrue with time as advances in both hardware and software take hold.

2. Project components. Since CIM requires various successful installations of advanced manufacturing technology, benefits will accrue due to the synergism of various pieces on the shop floor. The integration of advanced manufacturing technology long term is what makes CIM a self-liquidating expense.

3. Identification of CIM soft benefits. The installation of advanced manufacturing technology in a manufacturing environment can provide significant intangible benefits that traditional accounting justification methods don't recognize. These include

* Improved flexibility on the shop floor.

* Reduced manufacturing lead time.

* Faster delivery of new products to market.

* Improved product quality.

* A more skilled and better trained work-force.

* Improved product design.

* Optimal customer service.

While these benefits may be hard to quantify individually, collectively they can both reduce operating costs and stimulate additional sales. The key to these soft benefits is to understand that a CIM environment allows for fewer levels of management and thus better use of corporate assets--both human and mechanical. The result to the company is improved decision making and significant improvement in profitability.

HOW TO GET STARTED

An investment in CIM through the purchase of advanced manufacturing technology must be looked at not merely as an accounting exercise but as a strategic policy decision. Remember, with CIM the traditional cost justification techniques provide only an appropriate starting point. It's important to approach the new manufacturing environment with a different perspective--a perspective that looks at the long-term benefits to the company using CIM. Here are four steps to follow:

1. Investigate CIM alternatives today. There are several advanced manufacturing technology options available that can make an immediate impact on company profits. Investigate them and take appropriate action. Waiting until the state-of-the-art technology becomes completely adopted within a market could cause your company or client to lose competitive advantage.

2. Develop a CIM project team. Pull together a CIM project team that will investigate and report the new technologies in the market. By staying abreast of evolving technology in manufacturing, you can strategically advise how to best allocate funds now for future growth.

3. Realize CIM requires a long-term focus. Always, when introducing CIM into a company, attempt to link together various aspects of the business. Realize the investment of advanced manufacturing technology requires risk, but that risk can be minimized when various aspects of the plant can be integrated into one long-term strategic process.

4. Develop tomorrow's skills today. The skills required for the adoption of CIM or the installation of advanced manufacturing technology need to be available for benefits to materialize. CIM requires a better educated workforce and a commitment by management that training will be budgeted and implemented. Only through the integration of man and machine can CIM be really profitable.

A NEW VISION

The factory of the future is around the corner. Short-term cost accounting justification techniques, while valid in the first half of the century, are losing impact as more and more plants automate their manufacturing process. New techniques must incorporate long-term planning that pulls in the soft benefits available with advanced manufacturing technologies. Without this vision of the future, the factories of tomorrow will be no more than a showcase for the indecisiveness of the past.

EXHIBIT 1

What computer integrated manufacturing can do for the factory

Advanced manufacturing technology will characterize the factory of the future. In this regard, computer integrated manufacturing (CIM) has many applications:

* Order management. Allows for faster delivery and responsiveness to customers and to customer orders through electronic data interchange (EDI). In essence, customers will secure and lock in supplier capacity for the product.

* Computer-aided design (CAD). Allows the computer to assist in minute details and specifications of a customer order or to simulate variations of that order.

* Manufacturing resource planning. Allows the production schedule to be simulated and integrated using one information base to direct the operations on the plant floor to balance supply and demand.

* Computer technology. Allows different hardware and software to be integrated and to communicate with one another. Provides the foundation for both artificial intelligence and expert systems.

* Computer-aided manufacturing (CAM). Allows for factory machinery to be programmed through numeral controls (NC) tape preparation and computer numeral control (CNC).

* Robotics. Allows for the minimization of human activity in the areas of pick/pack, and excessive lifting, transporting and manufacturing operations.

* Automated guided vehicle systems. Allow for driverless forklifts and automated storage and retrieval systems. As JIT becomes more imbedded in future manufacturing disciplines, the role of computerized material-bundling equipment will become more vital.

* Group technology. Allows for the coding and classification system to group various families of parts, to aid in both inventory use and part standardization.

* Vendor scheduling. Allows for improved scheduling of customer orders to improve delivery and internal processing. In the future, orders will be booked directly via EDI into a vendor's upcoming production schedule.

EXHIBIT 2

How to calculate net present value of a CIM investment
 Discounted
 cash flow
Year Savings Costs Cash flow PV of $1 at 10%
0 0 ($50,500) ($50,500) 1.000 ($50,500)
0-1 $25,000 0 25,000 .909 22,727
1-2 25,000 0 25,000 .826 20,661
2-3 10,000 0 10,000 .751 7,513
3-4 4,000 0 4,000 .683 2,732
Total $64,000 ($50,500) $13,500 + $3,133 NPV


EXHIBIT 3

How to calculate the internal rate of return on a CIM investment
 PV of 1 Discounted PV of 1 Discounted
Year Benefits at 10% cash flow at 13.73% cash flow
0 0 1.000 ($50,500) 1.000 ($50,500)
0-1 $25,000 .909 22,727 .879 21,982
1-2 25,000 .826 20,661 .773 19,328
2-3 10,000 .751 7,513 .680 6,799
3-4 4,000 .683 2,732 .598 2,391
Total $64,000 $ 3,133 NPV 0 NPV


JOEL C. POLAKOFF, CMC, CPIM, CPM, is a partner of BDO Seidman in Chicago and the firm's national technical coordinator for manufacturing consulting services. He writes frequently on manufacturing subjects and is a member of the board of advisors of the Corporate Controller and the Journal of Manufacturing.
COPYRIGHT 1990 American Institute of CPA's
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 1990, Gale Group. All rights reserved. Gale Group is a Thomson Corporation Company.

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Author:Polakoff, Joel C.
Publication:Journal of Accountancy
Date:Mar 1, 1990
Words:2638
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