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Harvard Finance Simulation Pre-Reading
Harvard Finance Simulation Pre-Reading
There is a deadline to submit decisions for each decision Earnings before interests and taxes (EBIT): measures the
round, after which all decisions from all teams are processed profit your company generates from its operations.
by the system, resulting in a new situation. This new situation
Retained earnings1: this is the sum of your profit and losses
depends on team decisions and the sensitivity of the
since your company inception.
algorithm the game is based on.
Return on capital employed (ROCE): measured by
Teams are assessed against a set of metrics called ‘winning comparing EBIT2 with Capital Employed3, this metric
criteria’. The winning team will be the one ranking highest identifies how efficiently your team is using capital to
across the largest number of criteria, after the last decision. generate profit. See section ‘Return on capital employed
(ROCE)’.
2
1
If Profitt=1 = €500 and Profitt=2 = -€500, then REt=2 = €0 EBIT = Revenue –Expenses
3
Capital Employed = Fixed Assets + Working Capital
Requirement = plant value + inventory value (in this game)
Share price, which is the value of your company shares on ─ The number of days of credit they grant to
the stock exchange. It will be covered in the section ‘Share customers.
Value’.
Note that you are currently developing the same products
Employee morale, a measure of your employees’ as your competitors, and you need to create an appealing
engagement and satisfaction, covered in section ‘Employee value proposition if you want to attract customers and grow.
morale’.
According to observers, forecasts of the future economic
At the end of the game, winners will be defined based on conditions point towards light improvements in the short
how high each team has ranked for each of these criteria, in run.
comparison with their competitors.
Build a successful business model
At the start of each decision, you will be able to check your
current ranking for each criterion, directly in your web-based All teams start with the same metrics, producing the same
interface. products and selling the same number of products.
Exercise: Without looking, which of the following is NOT a The business units are fully independent: each has its own
winning criterion for this game? Sales & Marketing division, R&D department, and production
plant.
─ ROCE ─ EBIT
Here is an overview of your sales revenue, EBIT (Earnings
─ Sales Revenue ─ Employee Morale Before Interest and Taxes) and capital employed at start4.
As mentioned earlier, your team will make decisions for EBIT -236 464
Product A and Product B. The most recent industry analyses
Capital Employed 2146 7666
indicate that both markets should evolve at the following
rates: To reach market leadership, you need to set up a sound
business model:
Market Product A Product B
─ Creating value for customers, thereby attracting
Current market
+10% -5%
growth demand, and delivering on demand.
Product A is thought to be in the early stage of its lifecycle, ─ Creating value for your organization, by offering
whereas Product B is in a more mature stage. products at a price that allows you to be profitable.
However, teams can significantly influence the size of the You will be building a value proposition that is the result of
markets – the volume of demand – for both products based your decisions in
on:
─ R&D expenses,
─ The prices they charge given the performance of produced and plant capacity investments),
4
Numbers might slightly change depending on the number of
participating teams.
─ Pricing In other words, the quantities of products (A and B) that will
be sold by your company at the end of each decision round,
for each of your business units. Said decisions will incur costs
will depend on
and expenses.
─ The number of items available for sale
Meanwhile, consumers will assess your value proposition
─ The attractiveness of your value proposition, based
against that of your competitors and make a purchasing
on your R&D, selling efforts (= marketing), customer
choice on that base. If your value proposition is more
payment terms and price.
appealing, you will generate a sales revenue, which in turn
─ Results from previous years, because of customer
impacts your EBIT (Earnings Before Interest and Taxes).
loyalty.
Administrative and
selling budget Important is therefore to understand what matters to your
COMPETITION
R&D budget (potential) customers to avoid spending cash on elements
THE VALUE CUSTOMERS
PROPOSITION VALUES
that do not drive demand (e.g., investing a lot into
Manufacturing
1. Which business line is not profitable at start? Note that this customer is always happy to delay their
2. What are the seven types of decisions you will make payment or pay in installments: a brand that takes that into
to build your value proposition? consideration will be praised for that.
Impact on demand
must be taken to build effective marketing and R&D ahead
for → to an Product A Product B of the competition.
increase in
Price Sharp decrease Light decrease Customers are very loyal in that they do not easily look
Administrative and elsewhere for a supplier, should a company fail to deliver.
Increase Sharp increase
selling budget
This customer profile is usually comfortable financially and
R&D Sharp increase Increase
does not react strongly to installment payment options.
Number days of
Sharp increase Light increase
credit increase
Exercise: Without looking, for which product line does
Failure to deliver
Sharp decrease Light decrease
on demand demand:
Sensitivity of customers to various elements
1. react very much to price?
Your success in attracting customers to buy your products 2. react very much to administrative and selling
will depend on how well you cater to their expectations. budget?
3. react not so much to R&D?
4. accept some delay in delivery?
What customer expectations mean for you provided with an estimate of the total production costs, the
production budget.
Fixed customer sensitivities
The total production costs consist of a combination of fixed
One common misconception is the belief that you can ‘force’ and variable costs and are influenced by several factors.
one of your customer segments to become sensitive to an
𝑇𝑜𝑡𝑎𝑙 𝑝𝑟𝑜𝑑𝑢𝑐𝑡𝑖𝑜𝑛 𝑐𝑜𝑠𝑡
aspect, even if they were not sensitive to it at start: this
= 𝐹𝑖𝑥𝑒𝑑 𝑐𝑜𝑠𝑡
approach does not work.
+ (𝑉𝑎𝑟𝑖𝑎𝑏𝑙𝑒 𝑐𝑜𝑠𝑡 𝑝𝑒𝑟 𝑢𝑛𝑖𝑡
For example, even if you invest a lot on administrative and × 𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑢𝑛𝑖𝑡𝑠 𝑝𝑟𝑜𝑑𝑢𝑐𝑒𝑑)
selling budget and R&D for Product A, the customers of that
The fixed costs include all the elements for which you spend
segment will not become less sensitive to price.
money, regardless of whether you produce or not. It includes
Creating products that best meet your customers’ salaries, insurance payment, rent, set up cost, etc.
expectations seems to be the best thing to do. Yet, you
The variable costs include all elements for which money is
might need to accept some trade-offs when integrating
spent only when you start producing. Raw materials and
your profit objective, your product portfolio strategy, and the
input to production, packaging, electricity, etc. are part of the
‘total’ customer sensitivities. As an example, you may want to
variable costs.
develop a simpler product to better compete on prices.
In FOF, there is no obligation to produce items at every
Lost orders decision round, so you might decide to just produce zero
Another point to keep in mind in the simulation: any order items. However, by not using this plant, the fixed costs will
that you receive and for which you do not have enough still be incurred, which will have an impact on your income
For example, if you receive orders for 30 Product B items but Unit cost (≠ variable cost per unit), is computed as follows:
you only have 28 to sell, you will completely lose 2 orders. 𝑇𝑜𝑡𝑎𝑙 𝑝𝑟𝑜𝑑𝑢𝑐𝑡𝑖𝑜𝑛 𝑐𝑜𝑠𝑡
𝑈𝑛𝑖𝑡 𝑐𝑜𝑠𝑡 =
𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑢𝑛𝑖𝑡𝑠 𝑝𝑟𝑜𝑑𝑢𝑐𝑒𝑑
Therefore, there is no use in overspending in administrative
and selling budget and R&D or to drop prices to boost Several factors contribute to an increase or decrease in unit
demand, if you do not have capacity to deliver: you will just cost for each of the products:
1. Can orders from the ongoing period be delivered at Economies of scale Sharp decrease Light decrease
sensitivities and design a value proposition that caters to Inversely, the longer the payment terms for your suppliers,
said sensitivities – to generate demand. the higher your unit cost. Indeed, suppliers are flexible, but
Yet, when designing a value proposition, you should be they will increase their price if you pay them later. The
mindful of your production costs. Every period, you will variable production cost will increase by the number of days
decide on the quantity of goods you want to produce and be of credit requested, divided by 600 – e.g., if you decide to pay
you supplier 30 days after delivery of the goods, then the
variable production cost will be increased by 5% (30 Business line Product A Product B
days/600). Initial vehicle
72 74
capacity5
Other factors playing a role in the unit cost are the capacity CAPEX intensity $25 $100
used, and the production cost index. Initial plant value $1800 $7400
Depreciation rate 6% 6%
The production cost index is provided at the start of each
decision round and carries information regarding the At each decision round, your plant is depreciated by a certain
evolution of material prices – thereby impacting the amount – 6%. It represents the natural loss of value over time.
production costs. To keep production capacity at the same level, you need to
invest 6% of the plant value at each decision round.
Finally, a cost of non-quality can be incurred because of the
field failure rate (FFR). The FFR is the percentage of If you want to grow your capacity, you can also invest more
malfunctioning items that are sent back to your company, than the depreciation. You need to multiply the CAPEX
starting at 11.6% for both product lines. Intensity by the additional vehicle capacity you want to have.
𝐶𝑜𝑠𝑡 𝑜𝑓 𝑛𝑜𝑛 − 𝑞𝑢𝑎𝑙𝑖𝑡𝑦 The increased capacity will not be available until the
1 following period.
= 𝑆𝑎𝑙𝑒𝑠 𝑟𝑒𝑣𝑒𝑛𝑢𝑒 𝑜𝑓 𝑚𝑎𝑙𝑓𝑢𝑛𝑐𝑡𝑖𝑜𝑛𝑖𝑛𝑔 𝑖𝑡𝑒𝑚 ×
3
5
If you divide plant value ($1834 in Product A) by capex intensity
($23), you find the capacity (73).
─ Minimum inventory available, which measures how much cash you are still
allowed to spend during the period.
Usable capacity is how much of your production capacity
you can really use to produce. This usable capacity is lower The cash available is updated by the system as soon as you
than your theoretical capacity because of maintenance plug in a decision, and it should not fall below 0.
works and differences in skills among your workers. It can be
The cash at end is a forecast based on:
improved by investing in HR & Quality.
At the start of the game, the usable capacity is as follows: - on your decisions such as the amount you spend,
the loans you take or repay, and your facility
Business line Product A Product B investments.
Initial usable
79% 84% - and on the net sales of the period, which can only
capacity
be forecasted. They depend on your decisions but
Minimum inventory is the number of produced items that
also on those of your competitors.
are stored away because of inefficiency in the
manufacturing and in the logistic process. You can promote
If the actual cash position of your company turns out to be
‘Just In Time’ by investing in HR & Quality.
negative – e.g., because product sales volume is lower than
It corresponds to 8% of your production and is automatically expected – after running the simulation, then the Facility
withdrawn. investment will be reduced and – if necessary – an additional
short-term loan will be automatically contracted.
Exercise: Answer the following questions:
Additional
1. How can you reduce the minimum inventory? supplier credit
New
2. Can you use 100% of your production capacity? short term loan Production, Marketing,
R&D, HR & Quality,
additional inventories,
New additional credit to customers
long term loan
Cash at
HR & Quality start
CASH = 0 CASH = 0
quality training program. This investment will have the January 1st During the period December 31st
following impacts:
External sources of funding
Effect of an increase of
HR & Quality Organizations do not always generate enough cash to
→ on
Usable production sustain their growth, and that is why funding sources are
Increase
capacity
very much welcome.
Field failure rate (FFR) Decrease
Minimum inventory Decrease In FOF, your company can resort to two types of loans: a
Effectiveness of R&D, short-term loan, and a long-term loan.
admin. and selling Increase
expenses
The short-term loan has the following features:
Note that the effects of HR & quality start being perceivable ─ it cannot exceed 20% of the previous sales revenue
only from the next period! ─ there is a 12% interest rate
─ it is automatically reimbursed at the start of the next
Finance your growth period
Cash constraints Therefore, this short-term loan can save your decision, but it
can also pose a problem: interest rates are substantial and
The amount of cash that you are allowed to spend every
paying back at the start of the following period will impact
period is limited. As a result, you may not validate your
your cash reserves for said period.
decision if the forecasted cash at end of the period is
negative. Therefore, you will have to monitor the cash The long-term loan has the following features:
─ it is capped at 5 times the Net income of the Share value
previous period or $1000, whichever is the greatest.
Each company has issued 1000 shares at $15 face value at
─ it can be partially or completely reimbursed from
start, and the number of shares will remain unchanged over
available cash, if you decide to, and if your available
time.
cash is positive
The share price, though, will be function of your financial
*Interest rates fluctuate based on your debt/equity ratio.
performance, including
Debt/equity ratio Interest rate
Exercise: Answer the following questions: Exercise: Without looking, which of the following impacts
neither Share Value nor Employee Morale:
1. What will be reduced if my cash is negative
after running the simulation? ─ ROCE ─ EBIT
2. Which loan has the highest interest rate? ─ Sales Revenue ─ ARE
3. When can I pay back my long-term loan? ─ Capacity
─ CO2 Emissions
Utilization
Employee morale
Return on capital employed (ROCE)
Employee morale and share value are two winning criteria
The ROCE is measured by comparing EBIT7 with Capital
for which there is no direct decision: they are impacted by
Employed. It is a winning criterion and plays a central role in
other metrics.
this simulation.
Employee morale can be described as the level of
Simply put, it measures the efficiency and the profitability of
engagement, of motivation of your employees to do their job
your capital investments.
well.
You can influence the ROCE through other decisions, shown
It is a metric based on:
in green in the graph below.
─ job security: the less capacity you use, the less
Reduce Increase Increase
employees you can keep or hire Costs Operating Margin Revenue
7
6
EBIT/Shareholders’ Equity EBIT = Revenue – Cost
NB: W.C.R. stands for Working Capital Requirement and is We are game lovers: from board game to video games, our
composed of the inventory, accounts payable and account team just loves to have fun.
receivables in this simulation.
─ Improving R&D
─ Increasing the Sales Revenue
─ Reducing the price
─ Building additional production capacity
─ Taking a loan (ST, or LT)
─ Increasing the number of days payable
So what now?