5.4 Project Financial Evaluation PDF

Introduction to Black Belt
Project Financial Evaluation

Leaders designing the future
Learning objectives: Content
1. Demonstrate how LSS projects can financially I. Background

impact organizations. II. Profit Model
2. Understand the profit model. III. 5 Ways LSS Creates Financial Impact
• Cost Reduction
3. Analyze the 5 ways Lean Six Sigma creates
financial impact. • Increase in Capacity
• Increase in Demand
• Increase in Contribution Margin
• Improvement in Capital Structure
www.leansixsigmainstitute.org Project Financial Evaluation 1
I. Background
▪ In many cases, finance and accounting

provide important yet indecipherable
reports.
▪ Finance rarely addresses leaders’ needs in

understanding the financial impact of the
decisions being made.
It is very important to demonstrate how Lean Six Sigma

improvement projects financially impact an organization.
Project Financial Evaluation 2
1
II. Profit Model
Sales revenue
Profit
$
Value
Total costs
Break-even point
Variable costs
Loss Conversion costs
Volume
Invested capital = Fixed assets + Inventory + Accounts receivable

Dimensions
▪ Horizontal line: Resources (i.e., Conversion costs) These are costs that
remain unchanged regardless of sales volume.
Examples: Resources such as rent, employee salaries, benefits, utilities (water,

electricity, phone, etc.)
▪ Sloped line: Variable costs that change in proportion to the sales volume.
The slope of the line is proportionate to the contribution margin % of
products at different volume levels.
Examples: Materials, transportation, tariffs, etc.
2
How to Calculate Contribution Margin
When you deliver a service or make a product and deduct the variable
costs of delivering that service or product, the leftover revenue is the
contribution margin.
▪ Sales Revenue: $100,000
▪ Variable costs: $25,000
▪ Contribution margin ($): $75,000
▪ Contribution margin (%): 75%
Break-Even Point
Exercise 1 Sales revenue
$
Value Profit
Total costs
Break-even point
Variable costs

Volume
Conversion costs $10,000

Break-even point = = = 20 Units
Price per unit – Variable costs per unit $600 - $100
3
III. 5 Ways Lean Six Sigma Creates Financial Impact
1. Reduction in costs
2. Increase in capacity
3. Increase in demand
4. Increase in contribution margin
5. Improvement in capital structure
Based on: The Value Add Accountant by Jean Cunninngham

1. Cost Reduction
Cost reduction occurs when a company eliminates an existing cost –

meaning, when a company does not incur the expense any longer.
Examples:
• Eliminating or reducing late payment fees
• Eliminating materials used to repair defective products
• Eliminating shipping costs caused by returns or replacements
4
Profit Model: Reduce conversion costs
Exercise 2
Sales revenue
$
Value Profit
Total costs
Break-even Variable costs

point Profit
Potential
Conversion costs (old)
Loss Conversion costs (new)

Volume
Cost savings are translated to potential profits and fewer unit sales are required to cover expenses.
Examples: Cost Reduction
▪ Eliminate or reduce overtime costs by

reducing lead times.
▪ Eliminate or reduce direct costs by not hiring

new personnel after an employee has quit
his/her job, since capacity has increased.
▪ Reduce rent expense by reducing the amount

of space needed to operate.
10
5
Cost Reduction: Energy
▪ Lighting
▪ Office equipment
▪ Heating, air conditioning and
refrigeration
▪ Thermal insulations
▪ Transformers o Perform correlation analysis on energy consumption
o Favorable contracts
▪ Water heaters
o Energy consumption during specific timeframes
▪ Compressed air o Good habits and best practices
o Improve power factor
10% - 20% of total cost is energy-related
11
Mistakes in calculating cost reductions
▪ Although reducing setup time can lead to increases in

available capacity, a key factor that creates value, this
by itself does not necessarily reduce costs.
▪ Similarly, improving layout to reduce the space

needed to conduct operations, also helps increase
capacity, but this by itself also does not necessarily
impact costs.
12
6
Target Cost
ZX12 Product
Product Procurement Process
Current
Kaikaku Kaizen Kaizen
The following table shows Price
Required Profit Margin
$400.00
57.00%
$400.00
57.00%
$400.00
57.00%
$400.00
57.00%
the relationship between Target Cost
Conversion Cost
$172.00
$50.84
$172.00
$49.12
$172.00
$49.12
$172.00
$43.75
Material Cost $155.00 $135.00 $128.25 $128.25
product, procurement and Total Cost $205.84 $184.12 $177.37 $172.00
process improvements and Difference $33.84 $12.12 $5.37 $0.00
achieving the target cost Demand 500 500 500 500
and improving profitability. Sales $200,000 $200,000 $200,000 $200,000

Total Actual $102,920 $92,060 $88,685 $86,000
Total Target Cost $86,000 $86,000 $86,000 $86,000
Gap $16,920 $6,060 $2,685 $0

Profit Margin 48.54% 53.97% 55.66% 57.00%
13
Product or Service profit evaluation

In-class exercise:
Product P Product Q Available resources:
Which product would
you choose to sell?
$90/unit Sales Price $100/unit A – one resource
100 units/wk Demand 50 units/wk B – one resource
C – one resource
D D D – one resource
Purchased 15 min/unit 5 min/unit
part Each resource is available
$5/unit C C B
5 days a week, 8 hr./day
10 min/unit 5 min/unit 15 min/unit
A B A Conversion cost $6,000

DC #1 DC #2 DC #3
DC = Direct Costs
$20/unit $20/unit $20/unit
14
7
Product or Service Profit Evaluation
Product P Product Q
P Q
Price $ 90 $ 100 $90/unit Sales Price $100/unit
Material cost $ 45 $ 40 100 units/wk Demand 50 units/wk
Throughput $ 45 $ 60
D D
Purchased 15 min/unit 5 min/unit
part
$5/unit C C B
A B A
DM 1 DM 1 DM 1
DM = Direct material
15

Supply all demand for Q and use the remaining capacity to produce P Product P Product Q
Sales
Sales Price $100/unit
Quantity Price Subtotal $90/unit
50 units/wk
100 units/wk Demand
Q 50 $ 100 $ 5,000
P 60 $ 90 $ 5,400
D D
Total Sales $ 10,400 15 min/unit 5 min/unit
Cost of Material
Q 50 $ 40 $ 2,000 Purchased
P 60 $ 45 $ 2,700 part C C B
$5/unit 10 min/unit 5 min/unit 15 min/unit
Total cost of material $ 4,700
Conversion Cost $ 6,000
Profit $ (300) A B A
Constraint Used Total Remaining

30 1500 2400 900
DM 1 DM 1 DM 1
16
8
Product P Product Q
Supply all demand for P and use the remaining capacity to produce Q Sales Price $100/unit
$90/unit
Sales 100 units/wk
50 units/wk
Demand
Quantity Price Subtotal
Q 30 $ 100 $ 3,000 D D
P 100 $ 90 $ 9,000 15 min/unit 5 min/unit
Total Sales $ 12,000

Purchased
Cost of Material C C B
part
Q 30 $ 40 $ 1,200 $5/unit 10 min/unit 5 min/unit 15 min/unit
P 100 $ 45 $ 4,500
Total cost of material $ 5,700
A B A
Conversion Cost $ 6,000 15 min/unit 15 min/unit 10 min/unit
Profit $ 300
Constraint Used Total Remaining

15 1500 2400 900 DM 1 DM 1 DM 1
17

Product P Product Q
$90/unit Sales Price $100/unit
100 units/wk Demand 50 units/wk
P Q
Price $ 90 $ 100 D D
Material cost $ 45 $ 40 Purchased 15 min/unit 5 min/unit
Throughput $ 45 $ 60 part
$5/unit C C B
Restriction (min) 15 30 10 min/unit 5 min/unit 15 min/unit
Throughput / min $ 3 $ 2
A B A
DM #1 DM #2 DM #3
18
9
2. Increase in Capacity
▪ An increase in capacity of employees, equipment, and processes also

increases the opportunity to satisfy increased demand with existing
resources.
▪ It is important to note that increasing capacity positively impacts

value creation potential even if these changes are not immediately
reflected in a company’s financial statements.
▪ However, an increase in capacity only translates to actual economic

value creation when further steps are taken to increase profits.
19
Profit Model: Increase Capacity

Exercises 3 and 4
Sales Revenue
Profit
$
Value
Total costs
Break-even
point Variable costs
Profit
Potential
Conversion cost
Loss
Volume

20
10
Examples: Increase in Capacity
Setup time reduction:

▪ Produce more in order to satisfy customer demand without increasing costs.
▪ Reduce batch size which reduces finished goods and WIP inventory.
FG = Finished goods
WIP = Work-in-progress Project Financial Evaluation 21
21

Space reduction:
▪ Reducing the space needed to work creates the opportunity to grow without
having to invest in additional facilities.
▪ The space saved (no longer needed) can be utilized to increase capacity.
• Capacity increased from 30% to 65%
22
11
Reduction in service or product quality

defects:
▪ This reduces the amount of rework.
▪ Time that was previously allocated to

identifying and fixing product or service
defects can now be used to meet
customer needs.
23
Work time reduction:
▪ The essence of Lean Six Sigma is to eliminate

activities that increase work time and
unnecessary costs (non-value-added activities).
▪ Eliminating or decreasing non-value-added

activities allows teams to provide more services
or produce more goods while using the same
amount of time and resources.
24
12
3. Increase in Demand
▪ When there is an increase in demand, both sales and contribution

margin increase as well.
▪ Strategies to increase sales facilitate the implementation of Lean Six

Sigma improvements.
▪ Furthermore, Lean improvements can help attract more customers.
For example: Reducing delivery time encourages customers to make

purchases since value is being created for them without having to incur
additional costs.
25
Profit Model: Increase in demand

Exercise 5
New demand Increased profit
$
Sales revenue
Profit
Value
Total costs
Break-even
point
Variable costs
Loss Conversion cost

Volume
26
13
Increase in Demand
▪ An increase in demand and the additional capacity created by Lean

Six Sigma projects, together increase profits.
▪ The benefits of Lean Six Sigma projects (i.e., increasing speed and
improving quality) increase the level of customer satisfaction, which
in turn increases demand further.
▪ Motivation increases when employees see increases in productivity

without greater stress or having to work harder.
27
How does Lean Six Sigma help increase demand?
▪ Record-time services and deliveries
▪ Excellent quality
▪ Service and product customization
▪ Outstanding customer service
▪ Lower prices
▪ Improved goodwill and company image
28
14
Case Study: Convenience Store Chain
▪ Traditionally used a “Push system”
▪ Changed to a “Kanban system”
▪ Began replenishing sold merchandise

only
▪ Now only pays for what is sold
▪ Optimized store layout and shelf space
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Case Study: Packing Material Supplier
▪ Initial lead time = 42-45 days
▪ Final lead time = 12 days
▪ Increase in capacity
▪ Increase in demand
▪ Increase in price
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15
4. Increase in Contribution Margin
▪ When the price and variable cost relationship increases, profits also
increase (in an upward slope).
▪ Ways to increase contribution margin:

• Increase price
• Reduce required materials
• Reduce variable costs (i.e., commissions, purchased parts, shipping,

etc.)
31
Profit Model: Increase in contribution margin

Exercise 6
Sales revenue
$
Value
Profit
Total Costs
Break-even
point Variable costs (old)
Variable costs (new)

Volume
32
16
How does Lean Six Sigma increase contribution margin?
Increase in value increase sales price:
▪ Develop significant competitive advantages over competitors:

(e.g., outstanding customer service)
▪ Higher-quality products
▪ Low customer complaints
33
Increase sales price:

▪ Lean improvements help eliminate the barriers sales staff face when dealing with
price increases.
▪ For example, develop a strategy for customizing products or services by improving

capacity and increasing speed.
34
17
Reduce [direct] material content used:
▪ Avoid production errors by using only the direct material / resources required.
▪ Collaborate with suppliers to identify areas of opportunity.
35
How does LSS increase the contribution margin?
Reduction in material cost

▪ Constantly hold product design meetings to sustain or improve value by
reducing the cost of components.
36
18
Example: Material Content Reduction
Reduce cost of materials by modifying product designs.
Design for Six Sigma &

Design for Manufacturing
37
Example: Material Content Reduction
Reduce the cost of materials by modifying product designs.
Value Engineering
38
19
5. Improvement in Capital Structure
▪ A reduction in the capital resources required to produce or deliver a certain

quantity of products or services will cause an increase in the Return on Invested
Capital (ROIC).
▪ Lean Six Sigma implementation mainly impacts the following aspects of capital
structure:
• Fixed assets (buildings, equipment, vehicles, etc.)
• Inventory
• Accounts receivable
39
Improvement in capital structure

ROI Calculation Sales revenue
Profit
$
Value
Total costs
Break-even
Volume
Invested Capital= Fixed assets+ Inventory + Accounts receivable

40
20
How does Lean Six Sigma improve capital structure?
Accounts receivable:
▪ Improve the account receivable processes by conducting Kaizen events and

applying continuous flow from the point of receiving the clients’ orders through
the issuance of their invoices.
• Record orders directly into the system
• Poka Yoke is used to eliminate errors when processing orders, collecting data,
issuing invoices, etc. (e.g., bar codes)
41
How does Lean Six Sigma Improve capital structure?
Accounts receivable:
• Issue invoices upon service/product delivery
• Invoice design (mistake-proof)
• Early payment discounts

Consulting Fee
Labor: 5 hours at $75/hr.
Early Payment Discount
Tax
42
21
How does Lean Six Sigma Improve Capital Structure?
Inventory:
▪ Less inventory reduces the need for time-intensive inventory counts.
▪ If WIP inventory is reduced and stabilized, then there is no need for a complex
accounting system.
43

Inventory:
▪ Kanban helps maintain low and stable inventory levels
▪ Lean inventory management
▪ Use 5S to have only what is needed
44
22
Effective payment collection:

• Receiving advance payments
• Collect payments as services/products are delivered to the customer (versus

receiving full payment once a customer receives the full services or
products)
• Prioritize invoices according to payment amounts

• Maintain constant communication with sales personnel
• Have teams dedicated to identifying internal issues and discrepancies
45
Fixed assets: “Everything that needs to be purchased to sustain work.”

Buildings, Computers, Vehicles, Machinery, etc.
Lean companies don’t require big or “monumental” facilities, assets and

equipment. Everything is now purchased and used according to needs.
46
23
Equipment
Production line
Optical comparator
47

5S, continuous flow, Kanban, etc., will help you significantly reduce
space occupied by excess inventory, unused machinery, unnecessary
tools, obsolete materials, etc.
48
24
Traditional Metrics
Sales
Operation margin % Sales Revenue Contribution
Working capital Profit
Return on investment (ROI)
Total costs
$
Value
Break-even
Volume

49
Profit Model
Exercise 7 With reduced costs and
improved contribution margin
Original sales revenue
$
Value
Total cost reduction Profit
potencial
Break-even point
Variable cost reduction
Loss Conversion cost reduction

Volume
Invested capital= Fixed assets+ Inventory + Accounts receivable Project Financial Evaluation 50
50
25
Conclusions
Lean Six Sigma is not magic.
It is a proven way to improve a

company’s financial results through a
customer-focused approach.
Accountants and Black Belts have the

opportunity – and obligation – to use
the profit model as a visual template to
communicate and drive improvements
in their organization.
51
26

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Introduction to Black Belt

Project Financial Evaluation

Learning objectives: Content

1. Demonstrate how LSS projects can financially I. Background

www.leansixsigmainstitute.org Project Financial Evaluation 1

▪ In many cases, finance and accounting

▪ Finance rarely addresses leaders’ needs in

It is very important to demonstrate how Lean Six Sigma

Loss Conversion costs

Invested capital = Fixed assets + Inventory + Accounts receivable

Examples: Resources such as rent, employee salaries, benefits, utilities (water,

Examples: Materials, transportation, tariffs, etc.

Project Financial Evaluation 4

▪ Variable costs: $25,000

▪ Contribution margin ($): $75,000

▪ Contribution margin (%): 75%

Project Financial Evaluation 5

Loss Conversion costs

Conversion costs $10,000

4. Increase in contribution margin

5. Improvement in capital structure

Based on: The Value Add Accountant by Jean Cunninngham

Cost reduction occurs when a company eliminates an existing cost –

• Eliminating or reducing late payment fees

• Eliminating materials used to repair defective products

• Eliminating shipping costs caused by returns or replacements

Project Financial Evaluation 8

Break-even Variable costs

Loss Conversion costs (new)

Examples: Cost Reduction

▪ Eliminate or reduce overtime costs by

▪ Eliminate or reduce direct costs by not hiring

▪ Reduce rent expense by reducing the amount

Project Financial Evaluation 10

Mistakes in calculating cost reductions

▪ Although reducing setup time can lead to increases in

▪ Similarly, improving layout to reduce the space

Project Financial Evaluation 12

process improvements and Difference $33.84 $12.12 $5.37 $0.00

achieving the target cost Demand 500 500 500 500

and improving profitability. Sales $200,000 $200,000 $200,000 $200,000

Gap $16,920 $6,060 $2,685 $0

Project Financial Evaluation 13

Product or Service profit evaluation

A B A Conversion cost $6,000

Project Financial Evaluation 15

Product or Service Profit Evaluation

Constraint Used Total Remaining

Total Sales $ 12,000

Constraint Used Total Remaining

Product or Service Profit Evaluation

Project Financial Evaluation 18

▪ An increase in capacity of employees, equipment, and processes also

▪ It is important to note that increasing capacity positively impacts

▪ However, an increase in capacity only translates to actual economic

Project Financial Evaluation 19

Profit Model: Increase Capacity

Invested capital = Fixed assets + Inventory + Accounts receivable

Setup time reduction:

Examples: Increase in Capacity

• Capacity increased from 30% to 65%

Project Financial Evaluation 22