OM and Finance Interface

Chapter 5

These slides are based in part on slides that come with Cachon & Terwiesch
book Matching Supply with Demand http://cachon-terwiesch.net/3e/. If you
want to use these in your course, you may have to adopt the book as a textbook
or obtain permission from the authors Cachon & Terwiesch.
1
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 Learning Objectives
 Return on Invested Capital (ROIC)
 Linking operational decisions to ROIC

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 Paul Downs started making furniture in 1986, in a small shop in Manayunk.
Over the years, his business outgrew 4 other shops and is now operating a
33,000 square foot shop (see next page) in Bridgeport, PA.

Much of our work is residential, but we also do a lot of office furniture, including
desks and conference tables. We complete 125 commissions per year,
consisting of about 500 separate pieces of furniture.

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 Production facility
Machines valued about $350 K,
depreciation $60 K p.a. (per annum)
Overall facility is utilized at
100% right now

Rent: $150 K for show rooms and factory

Indirect costs: Marketing $100 K, $180 K management, $60 K finish (quality control)

Inventory: $50 K WIP and $20 K raw material on average at any time

Prepayments: Suppliers need to be paid 1 month before receiving the wood.

Pay 1 month Receive

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 Work force
 12 cabinet makers
 Each works about 220 days and 8h/day
 Each makes $20 per hour

A worker
 Needs about 40 hours per unit of furniture
 Works in cells
 Spend about 15% of time on set-ups (build fixtures / program machines)
 Labor utilization around 90% (idle time resulting from waiting)

End Product
 Average price is $3 K per unit
 Requires 30 kg (kilogram) of wood
• Wood costs about $10 per kg
• 25% scraped, especially during cutting

Each customer pays 50% down and

gets her furniture 3 months later

Pay 50% 3 months Receive

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 Return On Invested Capital (ROIC)

ROIC=Return / Invested Capital Return ≈ Profit

or,
ROIC = Return / Revenue * Revenue / Invested Capital

Return Revenue Fixed Costs Flow Rate x Variable Costs

  
Revenue Revenue Revenue Revenue
Fixed Costs Flow Rate x Variable Costs
 1 
Flow rate x Price Flow rate x Price
Fixed Costs Variable Costs
 1 
Flow rate x Price Price

Revenue Flow Rate x Price


Invested Capital Invested Capital
utdallas.edu/~metin
 Return On Invested Capital (ROIC)
Price
ROIC = Return / Revenue * Revenue / Invested Capital
Fixed cost
Return
Revenue
Return / Revenue requires Margin branch Flow Rate
Price, Fixed costs,
Flow rate, Variable cost
Variable Cost
ROIC
Flow Rate

Revenue / Invested capital requires

Price, Flow rate, Invested Capital
Revenue Price
Invested Cap.
Asset branch

Invested Capital
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 Developing Margin Branch of ROIC
Direct labor cost is not
allocated to products on Number of workers
the basis of wood.
Available
It is treated as fixed cost. Hours
Direct Hours worked per year per worker
Price Labor
Hourly wage rate
Marketing
Management
Fixed Indirect
Costs Labor
Finishing / QA
Other Rent
Overhead
Depreciation

Return Number of
Revenue Demand workers
Available
Margin branch Flow
Hours
Rate Hours worked per
Process year per worker
Capacity
Actual production time
(activity time) Wait time

Hours per Time needed before

Table production time Set-up time

Price of wood

Var Cost Kg per table

Wood per table

Fixed Costs and Process Capacity
Scrap loss
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 Flow rate=Min{Demand, Process Capacity}

Number of
workers

Available
Hours
Hours worked per
year per worker
Process :

Capacity
Actual production time
(activity time)
Hours per Wait time
Table +
Time needed before +
production time
Set-up time 9
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 Fixed Costs
Number of
workers
Available
Hours

Direct Hours worked per

Labor year per worker
+

Marketing Hourly wage rate

+
Fix Management
Costs Indirect +
Labor
Finishing / QA
+

Rent
Other +
Overhead
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Depreciation 10
 Summarizing Margin Branch of ROIC
Number of workers

Available
Hours
Direct Hours worked per year per worker
Price Labor
Hourly wage rate
Marketing
Management
Fixed Indirect
Costs Labor
Finishing / QA
Other Rent
Overhead
Depreciation

Return Number of
Revenue Demand workers
Available
Margin branch Flow
Hours
Rate Hours worked per
Process year per worker
Capacity
Actual production time
(activity time) Wait time

Hours per Time needed before

Table production time Set-up time

Price of wood

Var Cost Kg per table

Wood per table

utdallas.edu/~metin Scrap loss 11

 ROIC - Margin Branch

D B
1760=220*8

53.33=40/(1-0.25)

A, B, D all include
set up time
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 Sales Per Year

1,760=8*220

Unit price
3,000
Number of
workers 12
Sales per Hours of labor available
year 1,188,000 per year 21,120
Time per worker
Flow rate tables per year 1760
per year 396
Labor content
per table 40
Hours of labor Setup % per
per table 53.33 table 15%
% idle time
per table 25
Wait time %
per table 25%

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 Total Cost Per Year

Rent150,000
Marketing100,000
Indirect cost per Finishing 60,000
year 570,900
Management 180,000
Depreciation 80,000

Total cost per Hours available

year 1,140,900 per year 21,120
Labor cost per
year 422,400
Wage rate
per hour 20
Direct cost per
year 570,900
Flow rate tables
per year 396
Material cost per Wood price
year 148,500 per kg 10
Material cost BOM per
per table 375 table 30
Wood per
table 37.5
Scrap per
table 25%

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 Invested Capital
PP&E (Plant, Property, Equipment)

Raw Materials

Invested +
Inventory +

Capital
WIP
+ Flow Rate

Total $ spent on
(required) wood=148.5 K pa
Working Pre- Material costs
:
Capital Payments
Time of pre-payment=0.083 years

Asset: Inventory and Prepayments

Liability: Unearned Revenue
Revenues = 1188 K pa
Unearned
Revenue % Down-payment = 50%
:

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Flow Time of down-payment = 0.25 years15
 ROIC - Asset Branch

D
A, B, D all include
set up time
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utdallas.edu/~metin
utdallas.edu/~metin
 After Break Even Point
Margin=Price-Variable cost
Dollars
Revenues

Fix costs = $992,400

Break even Current Volume Flow Rate

volume volume After
378.06 improvement
=992,400/2625
2625=3000-375

Paul Downs price is $3000 and variable cost is $375. Post break-even margin is $2625.
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 Southwest and Other Airlines (Delta or US Airways)

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 Number of planes

ASM
ASM per plane
RPM
Load Factor
Revenue

Yield
($/RPM)
EBIT
Wages per employee
Labor Employees per ASM
cost
ASM
Cost
Cost per gallon
Return on Fuel Gallons per ASM
Invested cost
Capital ASM

Other expenses per ASM

Other
cost
ASM
Capital Number of planes
Fixed
capital Capital per plane
Other capital

RPM: Revenue per passenger miles.

ASM: Available seat miles.
Working
capital Take OPRE 6377 in Falls for more.

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 Southwest and Other Airlines (Delta or US Airways)
Cost reduction $2,444M $284M
required to break
even
Cost reduction $199M
required to
become SW $108M
profitable $35M $1,804M

Current (2000) USAir Savings in wages if SW Savings in wages if SW Savings in fuel if SW fuel Savings in fuel if SW New Ops expense
OpsExpense at 17212 wage rate is paid productivity is achieved prices are paid efficiency is achieved
ASM
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 OM-Finance Interface:
WalMart’s Supplier Alliance Program (SAP)
goods WalMart Invoice paid by WalMart in 60-90 days
Supplier
invoice
Factoring: Invoice is sold to a factor (any SAP: Invoice is sold to a Walmart’s partner
bank) by the supplier. bank (Wells Fargo or Citigroup) by an
approved supplier.
 Supplier immediately receives cash
that is less than the face value of the  Supplier receives cash in 10-15 days
invoice. that is about the face value of the
invoice.
 If the supplier’s credit rating is low,
the supplier receives less cash.  WalMart’s high (AA) credit rating
pulls up the amount of money the
 The debtor (WalMart ) pays the supplier receives.
factor.

 Supplier does not need WalMart

approval for factoring.
WalMart program started on Nov 2, 2009. Before that, CIT, provider of credit to small
and mid size suppliers, declared bankruptcy. Similar program is in place at Kohl’s since
July 2009. KOHL’s SAP is offered to 41% of suppliers, 11% signed on since then. 23
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 OM – Finance and OM - Accounting Interface

 Operating capital / credit restrictions

 Timing of the advances from customer and to supplier
 Commodities and risk in prices; forward contracts
 Bankruptcy, insolvency risks (own and partners)
 Repercussions from mergers and acquisitions

 Cost, time (and carbon footprint) data from accounting

 Cost allocation to be decided
 Accounting allocates
 OM decides
 Can we decide without allocating?

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 OM Attempts to Understand Finance
Should Finance Understand OM

 Finance deals a lot with stock markets

 Stock price should be in line with OM metrics
 High inventory turnover  High stock price
 High efficiency  High stock price
 High quality  High stock price
 Stock prices are not related to OM metrics
 Gap between Wall street (finance) and Main street (OM)
 Linking Finance and Operations in Retailing. M. Fisher, V. Gaur, A. Raman.
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1290209

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 Summary
 Return On Invested Capital (ROIC)
 Linking operational decisions to ROIC

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