Darrin J. Wikoff
Today’s economic climate brings with it the challenge of accessing credit for capital investment. In The Ernst & Young Business Risk Report 2010, as shown in Figure 1, access to credit hit number two on the top 10 list of business risks across 14 sectors evaluated in the study. Internationally, asset management professionals are working collaboratively to define new standards that shift the focus away from capital replacement and instead bring visibility to asset performance.
Figure 1: Ernst & Young Top 10 Business Risks, Risk Impact Matrix
Return on assets (ROA) is a leading financial and asset performance indicator used by investors and executives when making decisions that impact the long-term viability of a business. ROA allows for a comparison of like-industry organizations to determine which is the most cost effective at producing a particular product. Typically, in today’s competitive and credit-constrained economy, ROA is a first-pass differentiator between those companies that receive capital investment and those that do not.
ROA is calculated by dividing the company’s net income by the average asset value for a specific fiscal period. Net income refers to the total revenue gained from the sale of goods produced minus the cost of goods sold. Asset value is the average value of all of the company’s assets throughout the fiscal period, as asset value may vary due to capital increases and depreciation. ROA is usually expressed as a percentage, however, some organizations report it as a multiplier of net profit margin to illustrate asset turns.
Stepping Away from Capital Replacement
Over the past 20 years, capital replacement has been the predominant solution used by asset management professionals to address sub-optimal asset performance. As a cost consolidation tactic, maintenance of physical assets is often held to a minimum until capital resources are available to replace the perceived to be “old” asset. In many cases, once the asset is scheduled for capital replacement, preventive maintenance strategies are postponed. Even after capital replacement, some organizations forego maintenance activities until the asset shows signs of “aging.” In the reliability engineering community, we know these practices are reactive, and although they may have a short-term financial benefit to the organization, these practices have a negative long-term impact on ROA.
There are two fatal flaws associated with the capital replacement philosophy as it relates to ROA. First, when we replace a fully depreciated asset, our asset value goes up, causing the company’s ROA to go down. If the organization is impacted by a loss in production volume during the installation of the new asset or incurs extraordinary costs after installation, ROA is doubly affected. The second fatal flaw, and one that is commonly made in pharmaceutical and food and beverage industries, is upgrading technology at the time of replacement. Reliability professionals agree that, in the event that capital replacement is necessary, the organization should strive to utilize 80% of existing technology. With regards to ROA, upgrading technology will inevitably result in an increase in costs, with as much as 60% of that increase accruing in the first two years after installation. When an organization upgrades technology, the cost of maintaining and operating the asset increases as a result of: 1) the need for additional spare parts that are not currently provisioned for under the old technology, 2) the need for training operators and maintainers on the new asset, and 3) inefficiencies experienced as operators and maintainers are becoming familiar with the new asset. While the first two cost factors can be estimated during the final design phase of the capital project, the third is more difficult, and often the most costly. Even though the loss of performance caused by an “old” asset will likely be resolved by the capital replacement, new and even greater process losses will be experienced in the first year after installation in this scenario.
Identifying Performance Losses
ROA, like any other business metric, is a numbers game, one which is poorly played in many manufacturing settings because of the lack of available data for decision making. At the executive level, data is only presented as net income and a financial valuation of assets, with little visibility of what makes up the company’s asset portfolio or how those assets are performing compared to the efficiency of the operating process itself.
Decisions made at this level can have a significant and sometimes adverse impact on physical assets in order to reposition the company’s ROA rating. Even when executives are looking at the assets side of the equation, they are generally focused on reducing the number of assets to compensate for a less than favorable net income. This only creates more pressure on the remaining assets to perform at higher levels. It’s a chaotic cycle. When an organization chooses to consolidate assets, they are forced to run harder and longer with the remaining assets and maintenance strategies are cut short, which further reinforces the perception that assets are aging because they are failing more often. The company finds itself again looking to capital replacement as the only option, undoing the financial gains from the original decision to reduce asset value.
In turn, senior management at the local level tends to be narrowly focused on reducing costs or maximizing production. Obviously, this behavior is created by the focus of executive leaders; however, as a result of inadequate process-related data, the effects of their decisions are similar in that they seldom aim to resolve non-asset related issues. Transforming your company’s ROA valuation today means business leaders will need to have a better understanding of how assets are performing. Cost is just the tip of the iceberg.
When the question arises on how to improve performance, it is important to understand the characteristics of performance. Over the past few years, researchers have analyzed specific industries to better understand these characteristics. Figure 2 illustrates the contributors to less than ideal performance within the food and beverage industry as an example.
Figure 2: Food and Beverage Industry Study of Performance Losses
Here we see that just over 56% of the total losses that impact net income are the result of process inefficiency. Also notable is the fact that equipment or asset-related downtime losses are less than 3 percent.
If we were to continue our examination of process efficiency losses within a food and beverage company using Weibull analysis, we would most certainly discover that variation over an annual fiscal period (e.g. 365 days) is not normally distributed. Using Barringer’s process reliability analysis model, as shown in Figure 3, we can determine the rate of variation, known as the Beta, and the number of production units lost when compared to a “nameplate” value that defines the acceptable level of variation. In Six Sigma terms, a Beta of 50 is acceptable. In the example provided, a Three Sigma target of 25 has been selected as the comparator for this food and beverage company.
In Figure 3, we have two categories of losses, asset-related “special cause” losses and non-asset related “common cause” losses, which are the result of human error, speed reductions and minor process interruptions. Notice that, despite the misleading areas under each category resulting from the varying scale on the X-axis, common cause losses account for 54% of the total process inefficiency.
From these two examples, we can conclude that the company is not receiving optimum earned value from its assets due to both asset-related and non-asset related causes, and that replacing assets as the only improvement strategy will account for less than 28% of the total causes of less than ideal performance, an insignificant figure in the ROA calculation.
Figure 3 - Barringer Process Reliability Analysis of Losses
Return On Asset Reliability
Fewer and fewer companies in 2012 will have the luxury of using capital resources to recover from performance losses, which means your organization will need an alternative strategy to be competitive. Reliability improvement strategies focused on eliminating performance losses are a viable alternative and can have a more favorable affect on the overall financial health of the company. To begin your reliability improvement journey, you will need to identify the performance losses and monetize the impact that reliability improvements will have on the company in order to obtain sponsorship. Instead of focusing your reliability improvement business case solely on cost reduction, tune in to the language of executives and communicate the opportunity in terms of ROA.
Return On Asset ReliabilityTM (ROARTM), developed by GPAllied, is the practice of maximizing the earned value of each asset by analyzing both asset and non-asset related losses from ideal process performance. Instead of using ROA as a lagging indicator to evaluate how viable one organization is over another, ROAR can be used as a leading indicator to better inform business leaders of potential opportunities for improvement without capital investment, and assist in long-term decision making. ROAR illustrates the potential of your reliability improvement strategy by re-forecasting net income gained by minimizing process variation. The ROAR calculation is as follows:
ROAR = (Recovered Net Income + Net Income)/Average Asset Value
Recovered net income in the ROAR calculation is the net sum of the revenue gained by removing variation and producing at the desired level, and the variable cost associated with the production of the additional units since the fixed costs are already captured in the existing net income reports.
Table 1 is an example of how to calculate ROAR in order to define the impact your reliability strategy will have on your organization. In the first line of the table, we see that the average asset value is $1B, from which $350M of revenue is earned. If we assume that the cost of goods sold (COGS) is 65% of revenue, as is typical in many industries, then the net income is $122.5M. Divided by the average asset value for the fiscal period, the result is an ROA of 12 percent.
In this scenario, 20% of the projected units produced were lost due to process inefficiency, equating to $70M. Your reliability strategy is focused on recovering these losses by addressing causes of variation at the process level and maintenance practices that have been ineffective in preventing equipment breakdowns at the asset level. At an estimated variable cost per unit of 30%, the recovered net income is $49M. When we add this recovered value back to the net income and divide again by the average asset value, we get a five point increase in ROA.
However, a five point increase in ROA does not mean much without something to compare it to. Therefore, using the same scenario, Table 2 provides a comparison using a capital expenditures (CAPEX) strategy that is aimed at overcoming performance issues by replacing 5% of the asset base.
Here we have to consider that we are increasing the asset value by $50M during the fiscal period, so our average asset value is going to change. Remember, it is an average between the beginning and end of the period. In the CAPEX strategy, we also have to estimate the change to net income. Besides hopefully generating an increase in revenue, there most likely will be an increase in operating and maintenance costs. In this example, we have conservatively estimated the cost increase to be 8% of the CAPEX asset value. With both the average asset value and net income adjusted, we repeat the ROA calculation. The result is only a one point increase, less favorable than the reliability strategy due to the fact that both asset value and cost increased without a sufficient gain in revenue.
The laws of global competition are in a state of flux and every company is challenged with the crude reality that survivability lies in the hands of financial analysts. The days of proving financial health with an ability to invest capital and build asset portfolios are over. This article demonstrates the danger of a one-dimensional, capital intensive asset performance improvement philosophy and provides an alternative approach to gaining executive interest in your reliability improvement strategy through ROAR. Today’s high-growth company is required to be more innovative in how it addresses performance. Those companies that are focused on eliminating variation and improving the reliability of people, processes and technology are pushing the boundaries of competition. Don’t be left behind waiting on others to invest in the future of your business. Be proactive, communicate the overall company benefits of reliability to top management and take charge of the losses that are within your control.
Darrin J. Wikoff, CMRP, is a Senior Instructor/Change Management Professional with GPAllied. He specializes in Organizational Change Leadership, Business Process Re-Engineering, Reliability Engineering and Work Execution Management. Darrin has nearly 20 years of experience in maintenance and reliability engineering best practices and over 14 years of business leadership experience as both a consultant and small business owner. www.gpallied.com
Order Darrin’s new book Operational Excellence at www.mro-zone.com