Overall Equipment Effectiveness. Robert Hansen C.
with the company decision-makers because it is the best way to demonstrate the effectiveness of manufacturing operations using the language of corporate financial managers.
“The return on the total assets available to a firm is probably one of the most useful measures of the firm’s profitability and efficiency. Return on assets, sometimes called the productivity ratio, is calculated by dividing the year’s operating income (income before deducting interest expense and income tax expense) by the average total assets employed during the year.
Because the return for a year is earned on assets employed throughout the year and assets may vary during that time, we compute the return on the average amount of assets. We obtain the approximate average by summing the beginning and ending asset total and dividing by two.
If the percentage is a true index of productivity and accomplishment, it should not be influenced by the manner in which the company is financed. Therefore, we use income before interest charges as a measure of the dollar return in the numerator.... The return on assets is useful for comparing similar companies operating in the same industry. It also aids management in gauging the effectiveness of asset utilization...”3
As indicated above, ROA is determined before interest and tax expense, and this approach will be used for the following analysis. In some references, “income” is defined as before interest, but after tax expense. (If this definition were applied, a tax constant is applied and the rate of improvement is the same ratio.)
The definitions for Direct Material, Direct Labor and Factory Overhead are provided in section 3.1.
As before, to examine the specific impact of improved OEE, the effects of inventory levels will be removed from the typical accounting spreadsheets by assuming the beginning and ending levels are constant for finished goods, work in progress and raw materials. Inventory value is a portion of factory assets, which becomes a part of Average Total Assets.
R.C. Hansen’s Factory will have Operating Income (Earnings Before Interest and Taxes) as developed in the earlier sections of this chapter, and use the results as input for the ROA equation. As before, the operating income categories and values are similar to an example provided in the accounting reference. If your factory figures are proportioned differently, you will need to modify the values to develop your own base case.
Again, in R.C. Hansen’s Factory base case, the parameters were 1,000,000 units sold at a net price of $100 each for a net sales of $100 million. The Factory worked full out at 320 scheduled days or 7680 hours.
Assume the same breakout of the financial figures as provided in section 3.1. (figures in Millions) The definitions of categories was discussed on page 49.
If the values in the various categories vary with your situation, you should modify the example using your figures to develop your specific business case analysis.
The operating income is the numerator for the ROA equation. The denominator is the average of end of fiscal year report of total assets for the two most recent years. This may be directly available from your financial analyst. In the case of R.C. Hansen’s Factory, assume base case ROA is 10 percent, therefore, Total Average Assets for the analysis time period is $9 million divided by 10 percent or $90 million.
Assume Total Average Assets consists of the following breakdown.
Total Asset proportions for a number of manufacturing industries have a 50 – 50 percent split between these two categories. If your company has a different proportion you can modify the formula as necessary. The proportion impacts the denominator of the ROA equation.
This is the base case value to compare the “what if” values against. The review comparison would be, “What would ROA have been if OEE were improved?”. Compare this to the need to add capital projects to provide more product.
As before, assume we have used the simple methodology to determine the combined Factory OEE of 60 percent. As in section 3.1, the ideal rate (R = 217 units per hour) can be determined by knowing the scheduled hours (7680 hours), OEE (.60) and the amount of good product produced (1,000,000 units).
All of the above parameters form case D, the base case ROA. The relevant business cases will be the examination of what ROA would have been with an improved OEE for two different scenarios. These would be 1. ROA if the same amount of product is produced and 2. ROA if the factory can sell everything it can make in 320 scheduled days.
3.5 Case E: Higher OEE with the Same Sales, ROA
This section will examine the base case scenario with OEE improved from 60 to 66 percent, a 10 percent increase, and we schedule to make and sell the same amount of product. With sales being constant, the variable part of the Total Average Assets stays the same ($45 million) as does the amount of Direct Materials used.
The marketing product is the improvement benefit in ROA. Requiring fewer hours to produce the units for sale and computing the financial impact resulting from this decrease generates this improvement.
With OEE at 0.66, the output rate is 66 percent of the ideal rate which is 217.0 × 0.66 = 143.2 units/hr. and the required scheduled time is one million divided by 143.2 or 6982 hours. The reduction of scheduled hours is 7680 − 6982 hours = 698 hours.
As before, assume 96 of the 698 hours are used for targeted OEE education and projects. The rest (602 hrs) are truly saved in reduced scheduled time and the Direct Labor expense for case D is computed.
A greater expense reduction in Direct Labor may occur if the reduced hours are overtime hours.
The financial parameters for Case D, now reflecting fewer factory hours and constant Total Average Assets follow: (figures in Millions)
Total Average Assets remain the same as in the base case ($90 million) because the amount of units and sales were the same as the base case. Therefore, ROA for case E is:
Thus, a 10 percent improvement in OEE has led to a 21 percent improvement in ROA:
This rate of improvement in ROA becomes the marketing product part of the business case in selling an aggressive OEE strategy. Remember that we allocated hours for initial training and projects within the financial plan.
3.6 Case F: Higher OEE, Selling Everything Produced, ROA.
Case F builds on the previous scenario with OEE improved from 60 to 66 percent (a 10 percent increase). It also assumes that we schedule to make and sell everything we can for the same production schedule of 7680 hours (320 days).
From Case E, we know that the output rate with 66 percent OEE is 143.2 units/hr. At that rate and 7680 hours, the Total Number of Good Units Made is 143.2 units/hr × 7680 hours or 1.10 million units. At a net price of $100 per unit, Total Sales are now $110 million.
The marketing product in case F is the improvement benefit in ROA resulting from increased sales.
With increased sales, a number of parameters will vary in both Operating Income and in Total Average Assets. Also, as in case E, we will provide for 96 Direct Labor hours for planned OEE education and targeted improvement projects.