It's easy to get caught up in the weeds of statistics and tools but remember the ultimate goal of Six Sigma is to make money and increase profits.
The projected financial savings must be analyzed by the Project Manager in conjunction and validation from a Controller or a financial representative.
A project does not have to contribute to ROI or directly increase revenue to qualify as a Six Sigma project. Many forms of soft savings related projects include customer scorecard improvements, loyalty, satisfaction, risk avoidance, and cost avoidance. The reduction of risk, while hard to measure, can increase profit.
Some of the guidelines below may fall under both categories of hard and soft savings in different percentages. Each company may categorize them slightly different. It is important to understand and adhere to your company reporting guidelines.
Before a project begins, a preliminary estimate of the hard and soft savings must be determined and agreed upon by the BB/GB, financial representative, and the MBB or representative of Upper Management.
The GB/BB should possess a firm understanding of financial relationships, variances, and projected impact of their project. The reported savings may be audited therefore tracking accuracy is critical. It is equally important to analyze the financial savings and costs by financial reporting period.
Why is the removal of "waste" important?
The primary objective in the removal of waste (Lean Manufacturing) is to reduce the amount of time in the Order Production Cycle where starts at the time from of receipt of an order (often in the legal form of a Purchase Order) to the time of receipt of payment. In other words, reduce or compress the cash conversion cycle.
The goal is to get paid for an order a close to the time as you have to spend money to make that product or service. In some cases, you may be able to get prepaid.
The quicker a payment is received, the lower the cost of borrowing for the company and gives the company an opportunity to invest or otherwise apply that money. This can lead to further hard and/or soft savings.
Some examples of savings are shown below but each company likely has it's own definitions, policies, and procedures for handing financial reporting.
Hard savings means there is a direct flow to the Profit and Loss statement (P&L).
Soft Savings do not have a direct impact on the P&L.
Some projects may have a problem
statement that involves improving working capital or cash flow. Almost
every Six Sigma project has some impact on working capital.
Some areas to be aware of the could help your project deliver a bigger reward is to improve these areas that impact working capital.
One calculation to determine the impact from a change in payment terms is shown below:
Supplier A was at N45 (net 45 days) and the annual spend is $15,000,000 and your team
negotiates N60 terms then the calculation is as follows:
An additional $616,438 of cash (working capital) is available to put towards debt or fund other investments that wasn't before.
If that money is put towards paying down debt, then the hard savings may be estimated by taking the savings * your company's WACC.
Assume the WACC is 10% for your company then the hard savings can be estimated at $61,438.
The is a simplistic estimate. Each company will have specific guidelines and exceptions. This information is intended to spawn ideas for your team to deliver more results.
Keep in mind sometimes payment terms may be negotiated lower thus negatively impacting cash flow in favor of a piece price reduction that is more than overall favorable.
financial reporting is necessary to show the impact on the P&L of a
respective business unit, facility, and entire company.
Each company will need to define the rules and guidelines for accountability, accuracy, and consistency.
The plan should include:
times many departments are accountable for generating savings and Six
Sigma is certainly one of them (others may be Supply Chain and Human
Since teams are meant to be cross functional, there will be instances where teams have members of two or more of these departments and all are looking to report savings. There should be a policy with examples to guide the savings distribution process.
There should be a database with all projects and their status relative to their FINANCIAL contribution: For example, a project may be closed but the company allows savings to be reported for 12 months since the first month of savings.
If the savings grow over time then and uniform distribution of the full savings rate per month * 12 should be given credit.
Cost Accounting places a strong emphasis on reducing costs, (aka cutting expenses) and this is often leads to decisions that reduce headcount, trimming of employee benefits and a myriad of squeezes that are not the goal of Six Sigma or Lean Manufacturing and actually give these programs a bad reputation.
Lean Manufacturing focuses on the Theory of Constraints, or removing bottlenecks to increase throughput and thus increases Sales (revenue) or make available capacity to take on more sales and growth. Then the company can devote that cost-cutting energy and devote it to growing the "top line" which is sales.
Cutting expenses is limited at some point. A company can only trim so much and often they cross a tipping point where the risk and losses long term exceed any short-term gain. The most damaging correlation a company can be perceived to have is one where improvements from Lean Manufacturing or Six Sigma programs results in headcount reduction (or even overtime reduction).
If the employees, or stakeholders, perceive that these programs reduce their personal or family quality of life in any way, then the program is not likely to succeed...very simple.
The top line growth is seen as being unlimited and is where the competitive advantages can reside. Therefore, the most commonly ask question by company leaders is how to grow the top line which includes increasing throughput with minimal investment or increase in operating expenses.
Three key words:
In Throughput Accounting, there are a few basic formulas used:
Net Profit = Throughput − Operating Expenses
Productivity = Throughput / Operating Expenses
Investment Turns = Throughput / Investment
Return on Investment = Net Profit / Investment
You can see how they are all tied together which an emphasis that increases in throughput drive the most potential for the company.
Calculating FV is an important concept to project a future amount based on inputs of expected interest rate, number of time periods, beginning amount, and payments for the period. (assumed constant over each period).
FV is the value of a current asset (or amount of money) at some point in the future based on an assumed growth rate. There are two commonly used formulas:
1) The basic formula for simple interest (not compounding) is
FV = I * (1 + (R * T))
The time interval could be 'months' or any time interval as long as they are the same units for R and T.
What is the FV of a $10,000 investment after 8 years that earns 5% simple interest annually?
FV = 10,000 * (1 + (0.05 * 8))
FV = 10,000 * (1 + 0.4)
FV = 10,000 * 1.4 = $14,000
2) The basic formula for compounding interest is shown below:
FV = I * (1 + R)T
Using the same example for 1) but using compounding interest. What is the FV of a $10,000 investment after 8 years that earns 5% compounding interest annually?
FV = 10,000 * (1 + 0.05)8
FV = 10,000 * (1.05)8
FV = 10,000 * 1.477 = $14,770
The final result between 1) and 2) is an increase of $770 over eight years as a result of compounding interest (i.e. earning interest on the interest earned from the previous time period) each year instead of solely simple interest.
More advance example
The following is more complex example done in Excel with the following assumptions:
The answer is $109,198. The ability to run scenarios with money that is freed up from a project is useful to help make investment decisions.
This obviously has a very practical use in personal lives as well. The above example is similar to a savings plan for a child's college tuition.
The picture below shows the basic formula and how to enter into Excel.
If you want to find I (or the Present Value PV), simply rearrange the formula above:
I = FV / (1+r)n
ROI is possibly the most commonly used calculation to determine payback but there are several more and variations. We'll keep it simple here. There will likely be questions on a Six Sigma certification exam (especially for Black Belts) about some key financial metrics
One version of calculating ROI is:
ROI = Net Investment / Investment Cost * 100%
ROI = Net Profit (Income) / Investment Cost * 100%
where the net profit (income) is expected earnings
ROI = (FVI - IVI) / Investment Cost * 100%
FVI = Final value of Investment
IVI = Initial value (or cost) of Investment
At a high level, think of it as the
(AMOUNT GAINED - AMOUNT SPENT) / (AMOUNT SPENT) * 100%
Return on Assets (ROA)
ROA = Net Income / Total Assets * 100%
where the net income is the expected earnings from the total value of the assets applicable on the project.
Assume Company A has net income of $50,000 and Company B has net income of $45,000 over the same period of time. Company A has total assets of $1,000,000 and Company B has only ¾ of the Company A assets. Which Company has a higher ROA?
Company A ROA = $50,000/$1,000,000 = 5%
Company B ROA = $45,000/$750,000 = 6%
Calculating the NPV of each project is one method used to evaluate projects ability to deliver to the company's financial expectations. Like any metric, the results needs to be faced with reality. Sometimes are project may be high risk and the potential return can't be justified.
We won't get into the details around the formula shown below since it can be complicated and done in various ways. Leave this up to the Finance representative for the team.
You should know that a POSITIVE NPV is generally worth approving for a given cost of capital.
This is different than IRR where the NPV is set to a value of zero and the internal rate of return, r, (IRR) is calculated and compared to other projects.
The IRR is calculated to determine an investment's internal rate of return which is denoted by r in the formula above. The word 'internal' infers that the calculation does not include external factors such as the WACC, financial risk, or inflation.
The value, r, which represents the internal rate of return, (aka interest rate or discount rate) is solved for in the formula below when the NPV is set to a value of 0.
IRR values for several projects of often compared to each other by a company. Those with the higher IRR are expected to have the best financial benefit.
The basic equation is above however we won't cover an example, just understand these basic concepts of NPV and IRR.
Projects that have a 10% IRR may be sufficient for one company but not another. Each company has it's own acceptability criteria but higher IRR the better the return.
Projects that have an IRR that is higher than the company's ROI are to be prioritized since they can boost the company's overall ROI after the project is implemented.
The Payback Period (PP) represents the amount of time for the project to pay off the initial and incremental investments.
The formula can be quite complex if considering the time value of money, taxes, interest, and cash inflows or further expenses beyond the payback period.
For the sake of keeping it simple, we will ignore those factors in the example below and this example should represent what you might encounter on a certification exam.
PP = (Initial + Incremental Invested Amount) / Cash Inflow
The Cash Inflow is typically expressed in $ that the project is expected to save per YEAR or per MONTH.
Calculate the PP for a project that requires a $50,000 investment up front plus $10,000 per month for the first 5 months. The projected savings are $12,000 per month starting in the sixth month after the initial investment.
PP = (($50,000 + ($10,000 * 5)) / ($12,000)) + 5 months*
PP = ($100,000 / $12,000) + 5 months
PP = 8.33 months + 5 months = 13.33 months
Therefore, the first positive full month will be the 14th; the PP = 14 months
*5 months is added since the savings start at the 6th month.
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