Calculating automation implementation payback is a subject that continues to gener- ate controversy—and, more often than not, confusion—throughout the manufactur- ing world. Moreover, the issue of how management will justify the vast expenditure of automation against the total needs of the business is still one of the hottest around.
The National Association of Electrical Manufacturers (NEMA) recently reported the results of a survey on automation. Financial payback was classified as very important by 91% of the respondents. What’s more, 78% of another survey felt that “Most businesses in the United States will remain so tied to traditional investment criteria that they will be unable to realistically evaluate the potential of computer-aided manufacturing options.” In other words, businesspeople are using formulas that include only traditional benefits to run the numbers, and as a result they are procrastinating—they are not putting these technologies to work.
In the automation systems business, we have been developing new ben- efit considerations—new manufacturing economics—that go beyond the limited return-on-investment evaluations of the past to take into account the total impact of automation on the entire business. This is because automation technologies do not change the factory floor; they change the entire business in new and important ways.
The point is that businesspeople should be skeptical of conventional wisdom in this area because old guidelines often do not work today. Automation investments represent strategic decisions with far-reaching competitive implications and should be evaluated as such. However, there still are financial calculations that can be made to validate the appropriateness of the investment.
So far we have talked about financial justification with words such as traditional, limited, and conventional. It’s interesting that under the so-called enlightened con- cept of financial justification—which is outlined below—we are learning there really is no black magic involved—no voodoo economics.
In fact, we still use many of the evaluation techniques that have been around for years. We still try to estimate a net present value and a payback period—these are basic decision criteria. In addition, discounted rate of return—some people call it
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internal rate of return—is still an important measurement. The only difference now is that we have to expand our horizons and think more globally. This means that we must project and incorporate, in our calculations, benefits that accrue business- wide—benefits that previously would not be considered at all. It also means that the long-term, macro view is the field of measurement, taking into account the benefits of automation over the long haul.
2.6.1 Benefits
Let’s talk first about businesswide benefits. Up to now, whenever we evaluated the advantages of a plant or equipment investment, we identified potential savings in such terms as lower direct material costs, direct labor reductions, or improved indi- vidual machine utilization. Now, even though these benefits can—and still do—come from automation investments, we find that they pale by comparison to savings being generated in other areas. For example, we can substantially reduce indirect manufac- turing expenses for such things as fork trucks, fork truck drivers, material handlers, and employees in packing and shipping. Further, automation frequently reduces the number of machines required in a factory, and a direct result of this is a reduction in maintenance and perishable tooling costs. At the McDonnell Douglas Missile Assembly Plant, we saw a reduction in the overhead areas of operating supplies and hazardous waste disposal by reducing the so-called touch labor in the SMAW mis- sile encasement department with the implementation of our semiautomated braiding system. This is real savings.
Fewer machines also means that less floor space is required. This, in turn, drives down such related expenses as heat, light, taxes, and insurance.
One of the strongest leverage factors we count on today is quality costs. The positive impact that automation can have on quality will most assuredly affect the costs associ- ated with scrap, rework, warranty claims, quality inspectors, and after-sales service. The ounce of prevention that improved quality builds into our products can therefore lead to across-the-board reductions in these areas—well worth many pounds of cure.
Up to now, we have been talking about lowering costs and expenses that appear on the operating statement. It is also important to leverage the balance sheet. One of the largest single items on any balance sheet is inventory. Therefore, to the extent that inventory can be reduced, cash is made available for other purposes.
We have learned that automation in general—and computer-integrated manu- facturing systems in particular—reduce plantwide manufacturing cycles. These reductions usually free up large amounts of cash—cash that previously was tied up in inventory or work in process (WIP). This, in effect, becomes the down payment for automation.
The payoffs we have talked about so far are quite tangible and easily measured. We call these the ripple effects of automation. Ripple effects are bonus points, if you will: effects such as higher productivity from increased worker satisfaction, higher market share from improved quality, higher market share from faster response time to shifts in marketplace demand. Though these advantages are difficult to measure, they are even more difficult to forecast.
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All these benefits are more than theoretical: they are empirical. They are results that really can be and have been achieved by many companies. General Electric (GE) experienced this initially at one of its own facilities, the Locomotive Products Division in Erie, Pennsylvania. Over several years, GE implemented a large, mul- tiphased project that covered a broad spectrum of automation technologies. The benefits from this project were realized across several areas. Impressive savings were generated in direct material and direct labor costs, while equally important results were obtained in increased capacity, higher product quality, and reduced cash lockup in inventory. These benefits not only leveraged earnings, but also established the foundation for survival in tougher times—the smaller, more competitive world market the locomotive division is dealing with today.
Let’s explore some of the disciplines for using this information in the justifica- tion process. Before we start, a rule: We cannot demand large short-term paybacks. The payback may come in phase three of a three-phase project. History has proven that synergy really does come into play here: When all the phases are complete, the total system benefit is larger than the sum of its individual parts.
The payback computation requires two sets of data. These take the form of a 5- or 10-year pro forma cash flow for the business. The pro forma should be com- piled assuming (1) the automation alternative is undertaken, and (2) a do-nothing or as-is scenario, which requires a candid answer to a very tough question: “What will happen to my competitive position if we don’t automate?” Often, the truth will not reflect the status quo. Instead, it may include a possible erosion of market share because of the likelihood that one’s competitors will not stand still. In this case, the competitor’s lower cost structure and higher quality product will allow it to gain market share.
Once the cash flow has been determined for these two alternative scenarios, the cash flow difference between the two should be used in the automation payoff calculations. For example, a corporation is evaluating whether or not to proceed with a $3 million automation project (see Table 2.1). For starters, we have assumed that the status quo will prevail if the project is not adopted. However, if the proj- ect is undertaken, the income will increase $200,000 each year—and cash flow will increase $2 million in the first year because of inventory reduction, and half a million each year thereafter. The key now is to plug the difference in cash flow into the financial calculations.
The 10-year rate of return on the investment is 24%. If we had mistakenly considered only the operating cost efficiencies and overlooked the inventory reduc- tion, the return would have come out a meager 2%—with the result being project disapproval.
Consider another case. Let’s assume a 5% erosion of market share in a $100 million market if the project is not undertaken. The resulting decrease in sales, net income, and cash flow now magnifies the benefit of automation and generates a discounted rate of return of 62% (Table 2.1). So the lesson to be learned is that inventory reductions and share gains or losses usually have dramatic leverage on the payoff to be earned.
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With regard to the ripple effects we discussed above, we should deal with these softer measurements by means of a sensitivity analysis. Returning to our exam- ple, let’s change it slightly by assuming no $2 million inventory reduction. The discounted rate of return falls to 11% (Table 2.1). Suppose management has set a hurdle rate of 20%. That means the discounted rate of return must be at 20% before the project can be approved. We can easily determine that an additional $200,000 of cash would be needed each year if we wanted a 20% return—and this, in turn, translates into one additional point of market share. Management can then make a gut feel decision as to whether or not this gain in share is feasible—and whether or not to proceed.
TABLE 2.1 Ten-Year Pro-Forma Cash Flow Analysis of Operating Results of a Product Line with and without a $3 Million Investment in Automation. (a) Considers traditional and nontraditional benefits, with no loss of market share without automation. (b) Considers traditional and nontraditional benefits, and assumes a 5% loss of market share without automation. (c) Considers traditional benefits only, and no loss in market share without automation.
(Project DCRR 62%)
(b) (c)
Sensitivity Analysis Operating Results (Millions) No Automation $3.0 Automation Sales/yr. $25.0 $25.0 Net Income/yr. $ 2.8 $ 3.0 Cash Flow/yr. $ 3.0 $ 3.5 (Project DCRR 11%) TRADITIONAL BENEFITS Direct Material Direct Labor Machine Utilization NONTRADITIONAL BENEFITS Less Inventory Indirect Cost Reductions Fewer Machines Less Floor Space
Lower Costs from Higher Quality Ten Year Pro Forma
Ten Year Pro Forma
Operating Results (Millions)
Operating Results (Millions) No Automation $3.0 Automation No Automation $3.0 Automation Sales/yr. $25.0 $20.0 $25.0 $25.0 Net Income/yr. Sales/yr. Net Income/yr. 2.8 $ 3.0 $ 3.5 $ 3.0 Cash Flow/yr. Cash Flow/yr. $ $ 3.0 $ 3.0 $ 5.0 $ 2.0 $ 5.0 (1st yr.) $ 3.5 (yr. 2–10) (a) (1st yr.) (yr. 2–10)
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2.7 SOFTWARE INTERFACES TO ASSEMBLY