©the mcgraw-hill companies, inc. 2008mcgraw-hill/irwin chapter 2 profitability: business success...

©The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin

Chapter 2

Profitability: Business Success from Operations

Success

2-2

• Operations provides the means to accomplish financial goals.

• Financial return must be good enough, given other alternatives.

• Uncertainty comes from not knowing, in advance, how customers will value outputs . (NPV) Net present value is the discounted cash flow over the life of the investment.

The Link Between Value andInvestment Results

2-3

• Net income:

Net Sales – Cost of Goods sold – Depreciation – Interest - Taxes

Challenge of Net Income “My business made $50,000 last year”

How did I do???

Evaluating Progress Toward “The Goal”

2-4

Return on Equity

It measures the income earned on the shareholder's investment in the business.

Return on Equity =

Net Income

---------------------------

Average Equity

2-5

Evaluating Profitability

• Return on Equity (ROE)– Net Income / Average Equity– Productivity of stockholder investment– Less directly applicable to operations managers because ROA

measures the assets themselves• But ultimately how the company is judged by investors

2-6

Profitability Ratios

Closely linked with income ratios are profitability ratios, which shed light upon the overall effectiveness of management regarding the returns generated on sales and investment.

Gross Profit on Net Sales

Gross Profit on Net Sales Ratio =

(Net Sales - Cost of Goods Sold)

------------------------------------------------

Net Sales

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• Profit Margin

– Income/sales Profit generated per dollar of sales.– Low costs efficient use of operations resources in processes– High sales high levels of value created by those processes

Evaluating Profitability

2-8

• Return on Assets (ROA)– Net Income / Average Assets– Profit per dollar of assets– Efficient use of resources reduces asset needs– Relevant because operations managers control so many

valuable assets

Evaluating Profitability

2-9

Return on Assets

It measures the company's ability to utilize its assets to create profits.

Return on assets =

Net Income

------------------------------------------------------------------- [(Beginning Total Assets + Ending Total Assets) / 2]

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Return on Investment

It measures the income earned on the invested capital.

Return on Investment =

Net Income

--------------------------------------

Long-term Liabilities + Equity

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Fixed Asset Turnover

It measures the utilization of the company's fixed assets.

Sales • Fixed Asset Turnover = -----------------------------

Fixed Average assets

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Turnover of Total Operating Assets

• Turnover of Total Operating Assets Ratio

Net Sales

= --------------------------------

Total Operating Assets

Total operating assets = total assets - (long-term investments + intangible assets)

2-13

Net Sales to Tangible Net Worth

Net Sales to Tangible Net Worth Ratio =

Net Sales

-----------------------------------------

Tangible Net Worth 

Tangible Net Worth = owner's equity - intangible assets

2-14

Operating Income to Net Sales Ratio or Profit from Operations

Margin available to cover interest costs, taxes and dividends

Operating Income to Net Sales Ratio

Operating Income

= ---------------------------

Net Sales

Operating income derives from ordinary business operations and excludes other revenue (losses), extraordinary items, interest on long-term obligations, and income taxes.

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EBIT to Total Assets

• EBIT to Total Assets Ratio =

EBIT

-------------------

Total Assets

• EBIT = Earning Before Interest and Taxes

2-16

Sales to Total Assets

• Sales to Total Assets Ratio =

Total Sales

---------------------

Total Assets

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Asset Utilization

• Asset Turnover, it measures the amount of sales generated by each dollar of asset.

• Asset Turnover =

Sales

----------------

total assets

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Inventory

• Inventory exists because of mismatch between supply and demand. Sometime it is economical to carry large amount of inventory, because:

- it is readily available to meet the demand of the customers when they need it.

- it is cheaper to produce in large quantity

(economies of scale)

- it is cheaper to buy in large quantity (discount)

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Inventory

• Inventory plays a specific role in the firm’s competitive strategy.

- If a quicker response is the goal, they should carry a large quantity to send it to the customer quickly

- If efficiency is the goal, they should produce or buy large quantity. Large scale operation reduces cost.

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Components of Inventory

• Cycle inventory –

Average amount of inventory used to satisfy demand between receipt of supplier shipments. If a demand is 8000 units a month, a company could order 8000 units a month; or it could order 2000 units a week. However, larger quantity means higher carrying cost, and smaller quantity means higher ordering cost.

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Components of Inventory

• Safety stock –

Inventory held for unforeseen demand. There is a trade-off between having too much inventory to take care of any demand, or having no inventory resulting in loss of sales.

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Beginning Inv. + Ending Inv.2

Inventory

• Inventory turnover is the most common inventory productivity measureInventory Turnover =

Cost of goods sold -------------------------

Average Inventory• Average inventory level is basis for productivity

measurement

Average investment in inventory

8000/2 x 265 = $1,060,000 Monthly

8000/4 = 2000/2 x 265 = $ 265,000 Weekly

-------------------------

Difference: $ 795,000

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Example 2.1

Deliveries of 8000 cases monthly (assume all are consumed evenly during a twenty five days during a month)

Cases are valued at $265

• Financial consequences of inventory turnover

Average investment in inventoryMonthly: $1,060,000Daily: $ 84,800----------------------------------Difference: $ 975,200

• What is average level of inventory?

• What is average level of inventory if we change from monthly to daily delivery?

Inventory

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Daily orders vs. MonthlyOrders to Meet 100 unit/Month Demand

Inventory

• Products and components of products sold

• Average inventory level is basis for productivity measurement.

• Inventory turnover is most common productivity measure.

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Days of Inventory

Number of day’s worth of inventory that a company has on hand.

Average Inventory

Days of Inventory = -----------------------------------------------

(cost of goods sold / statement's period)

2-27

Formulas for Measuring Supply-Chain Performance

• One of the most commonly used measures in all of operations management is “Inventory Turnover”

• In situations where distribution inventory is dominant, “Weeks of Supply” is preferred and measures how many weeks’ worth of inventory is in the system at a particular time

valueinventory aggregate Average

sold goods ofCost turnoverInventory valueinventory aggregate Average

sold goods ofCost turnoverInventory

weeks52 sold goods ofCost

valueinventory aggregate Averagesupply of Weeks

weeks52

sold goods ofCost

valueinventory aggregate Averagesupply of Weeks

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Example of Measuring Supply-Chain Performance

Suppose a company’s new annual report claims their costs of goods sold for the year is $160 million and their total average inventory (production materials + work-in-process) is worth $35 million. This company normally has an inventory turn ratio of 10. What is this year’s Inventory Turnover ratio? What does it mean?

Suppose a company’s new annual report claims their costs of goods sold for the year is $160 million and their total average inventory (production materials + work-in-process) is worth $35 million. This company normally has an inventory turn ratio of 10. What is this year’s Inventory Turnover ratio? What does it mean?

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Example of Measuring Supply-Chain Performance (Continued)

= $160/$35 = 4. 57

Since the company’s normal inventory turnover ratio is 10, a drop to 4.57 means that the inventory is not turning over as quickly as it had in

the past. Without knowing the industry average of turns for this company it is not possible to comment on how they are doing competitively in the industry, but they now have more inventory

relative to their cost of goods sold than before.

= $160/$35 = 4. 57

Since the company’s normal inventory turnover ratio is 10, a drop to 4.57 means that the inventory is not turning over as quickly as it had in

the past. Without knowing the industry average of turns for this company it is not possible to comment on how they are doing competitively in the industry, but they now have more inventory

relative to their cost of goods sold than before.

valueinventory aggregate Average

sold goods ofCost turnoverInventory

valueinventory aggregate Average

sold goods ofCost turnoverInventory

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Inventory to Net Working Capital

• It provides an idea of the danger of unfavorable changes in inventory to the excess of current assets over current liabilities.

• Inventory to Net Working Capital =

Inventory

--------------------------------------------

(current assets - current liabilities)

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Local vs. Global Optima – Productivity Tradeoffs

• It is not always possible to maximize productivity everywhere– Tradeoffs are required.

• Example: Inventory vs. Service Levels– Service Level Percent of demand satisfied from stock

Svc. Level

Inv.

0 1000

∞

To increase service level,Inventory levels must be increased.

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Productivity

Output

Productivity = ---------------------

input

2-33

Measurement Improvement

• Two ways to increase productivity: Increase output (numerator), decrease input (denominator), or both.

• For profitability, increase net income or decrease costs (or assets) or do both.

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• Often the greatest resource

• Often the most difficult resource to manage

• Productivity measurement depends on the objective and the behavior desired.

Monthly Performance Data for Sales Force

Possible Productivity Measures for Sales Force

Workforce

2-35

7-38

Definition and Measures of Capacity

Capacity:

Designed Capacity:

Effective capacity or Expected Capacity:

Rated Capacity:

The maximum output of a system in agiven period

The maximum capacity that can beachieved under ideal conditions

Maximum possible output given a mix, schedule difficulties, machine maintenance, quality factors, and so on.

Maximum usable capacity

RC = (Capacity x Utilization x Efficiency)

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CAPACITY

ACTUAL OUTPUT :

the rate of output actually achieved.

EFFECTIVENESS:

EXPECTED CAPACITY

DESIGNED CAPACITY

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7-40

• Measure of planned or actual capacity usage of a facility, work center, or machine

• Measure of planned or actual capacity usage of a facility, work center, or machine

UtilizationnACTUAL OUTPUTDESIGNED CAPACITY

Utilization

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7-41

• Measure of how well a facility or machine is performing when used

• Measure of how well a facility or machine is performing when used

Efficiency ACTUAL OUTPUT

EXPECTED CAPACITY

Efficiency

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• Capacity is the capability to produce output in a given amount of time.

• Utilization: Comparison of time spent actually working against theoretical time available to work• Actual running time/time available

Capacity: Equipment

2-40

Capacity: Equipment

• Efficiency– Efficiency is the comparison of

what actually happened to what “should have” happened

– Actual output/ Standard output Standard = 5400/hour

2-41

Approaches to Incorporating Probabilities in the Decision Making ProcessApproaches to Incorporating Probabilities in the Decision Making Process

• Expected Monetary Value (EMV) approach– Provides the decision maker with a value that represents an average

payoff for each alternative.

• Expected Opportunity Loss (EOL)– The opportunity losses for each alternative are weighted by the

probabilities of their respective states of nature to compute a long-run average opportunity loss, and the alternative with the smallest expected loss is selected as the best choice.

• Expected Value of Perfect Information (EVPI)– A measure of the difference between the certain payoff that could be

realized under a condition of certainty and the expected payoff under a condition involving risk.

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Decision Tree Analysis

• A Decision Tree is a useful tool for organizing decisions by identifying expected revenues associated with alternatives.– They provide a very structured framework for a decision, so that

all alternatives can be understood

– They enable the decision maker to quantify uncertainty

– They allow the decision maker to mix facts and predictions

– They provide the best outcome, given the available information

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Decision Tree Format

Decision trees are used by decision makers to obtain a visual portrayal of decision alternatives and their possible consequences.

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2-45

The Balanced Scorecard

• A management system that maps an organization’s strategic objectives into performance metrics in four perspectives:

Financial, internal processes, customers, and learning and growth.

• These perspectives provide relevant feedback as to how well the strategic plan is executed so that adjustments can be made when needed.

Balanced Scorecard

• Measuring performance beyond financial measures

Balance Scorecard

• Measuring performance beyond financial measures

Four Perspectives in Balanced Scorecard

• Customer Perspective (value-adding view)

Mission : to achieve our vision by delivering value to customers

• Internal perspective (process-based view)

Mission : to promote efficiency and effectiveness in our business process

Four Perspectives in Balance Scorecard

• Financial Perspective (shareholders’ view)

Mission : to succeed financially, by creating value to shareholders

• Learning and growth perspective (future view)

Mission: to achieve our vision by sustaining innovation and changing capabilities through continuous improvement and preparation for future challenges

The Balanced Scorecard

• Framework Consists of:

1. Financial Performance

Objective – how to use strategy to set objects

Measures – what will be measured and how

Target - Stated Target (goal)

Initiatives - Action needed to achieve the goal

The Balanced Scorecard

• Framework Consists of:

2. Customers

Objective – how to use strategy to set objects

Measures – what will be measured and how

Target - Stated Target (goal)

Initiatives - Action needed to achieve the goal

The Balanced Scorecard

• Framework Consists of:

3. Internal Processes

Objective – how to use strategy to set objects

Measures – what will be measured and how

Target - Stated Target (goal)

Initiatives - Action needed to achieve the goal

The Balanced Scorecard

• Framework Consists of:

4. Learning and Growth

Objective – how to use strategy to set objects

Measures – what will be measured and how

Target - Stated Target (goal)

Initiatives - Action needed to achieve the goal