FINANCE for the NonFinancial Professional

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FINANCE for the Non-Financial
Professional
Tuesday, November 11, 2008
ISM Northeast Wisconsin,
Inc. Welcome to the Numbers Games
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Todays Learning Segments

• Segment 1
• Exploring the Documents, Terms, and
• Terminologies
• ________________________________
• The Importance of Understanding Financial
  Terms and Terminology
• Communicating with Senior Management
• Working with Suppliers
• Exploring Basic Financial Documents
• and Terminology

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Todays Learning Segments

• Segment 2 Understanding Cost- Based
  Principles
• __________________________________
• Understanding the Cost-Based Principles
• Supply Chain Costs
• Cost Versus Price
• Costing Methods
• Types of Contracts
• Inventory Overhead

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Todays Learning Segments

• Segment 3 Using Financial Tools Cost
  Management to Improve the Bottom Line
• __________________________________
• Special Factors that Impact True Cost
• Moving Away from Hit-Or-Miss Cost Savings
• Documenting our Value to the Organizations
  Bottom Line
• Reports to Explore for Decision-making

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Segment 1 Exploring the Documents, Terms, and
Terminology
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The Importance of Understanding Financial
Terminology

• Communicating with senior management
• Collaborative partnerships with finance
• Documenting of supplys value to the organization

• Working with suppliers
• Supplier selection criteria
• Comparison of suppliers abilities and
  efficiencies
• Total cost of ownership
• Real costs

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The Why
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Exploring Basic Financial Documents and
Terminology

• Three essential documents
• Income statement (Profit and Loss Statement)
• Shows the activities that have occurred since
  the last income statement was issued
• Balance Sheet
• A snapshot of the financial status of the
  organization at a particular time
• Shows what the organization owns and what the
  organization owes
• Statement of Cash Flows
• Shows the organizations cash movements

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The Income Statement




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Balance Sheet
ASSETS LIABILITIES Current Assets Current
Liabilities Cash 230,000 Accounts Payable
1,000,000 Accounts Receivable 1,100,000 Notes
Payable 300,000 Inventories 640,000 Provision
Federal Tax 100,000 Prepaid Expenses
46,000 Total Current Assets 3,000,000 Total
Current Liabilities 1,400,000 Fixed
Assets Long-Term Liabilities Gross plant,
building Mortgage 500,000 equipment
3,000,000 Notes Payable 50,000
Less depreciation 1,000,000 Long-Term
Liabilities 550,000 Net Fixed
Assets 2,000,000 Total Liabilities
1,950,000 Total Assets 4,016,000 Net
Worth Stock 1,500,000 Retained
Earnings 566,000 Total Net Worth 2,066,000 To
tal Liabilities/Net Worth 4,016,000
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What Do These Mean?

• Revenue
• Sales
• Customers spend
• Cost of sales
• Direct costs
• Variable costs
• Labor and materials
• Gross profit
• Gross margin
• Variable profit
• Profit after costs of sales
• Operating profit
• EBITDA (earnings before interest, tax,
  depreciation/ amortization)
• Interest
• Payments to banks and others for capital borrowed
• Debt finance

• Profit on ordinary activities before tax
• Profit before tax
• Tax on profit on ordinary activities
• Payment to IRS/ Inland Revenue
• Profit for financial year
• Net profit (bottomline)
• Dividends
• Payments to shareholders
• Retained profit
• Value added to the balance sheet
• Goes into PL reserves
• Increase in shareholders equity

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What Do These Mean?

• Current Assets
• Something of value that the organization owns
• Cash and other assets that can reasonably be
  expected to be converted to cash or sold or
  consumed in the near future through the normal
  operations of the business
• Inventories
• Materials stored by organization for future use
  in assembly and/or manufacturing or sales to
  customers
• The organization owns these materials, pays
  taxes on them, and carries insurance to cover
  them
• Current Liabilities
• Money that is owed by the organization to
  creditors
• Debts that will be paid within the fiscal year

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What Do These Mean?

• Fixed Assets
• Assets that are held longer than a year
• Long-Term Liabilities
• Debts to be paid in the future longer than a year
• Depreciation
• The annual charge against earnings to write off
  the cost of an asset, like a machine or building,
  over its useful life
• It is a bookkeeping entry, and it does not
  represent any cash outlay
• As long as existing equipment remains in place,
  its rate of depreciation is an ongoing fixed
  expense
• Net Worth
• What an organization is worth
• Includes moneys retained in the business to date
  (retained earnings)
• Stockholders investments

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Ratios

• Leverage ratios the extent that debt is used in
  a companys capital structure
• Liquidity ratios short term financial situation
  and solvency

To Assess Solvency
To Assess Cost Reduction Potential

• Profitability ratios return on revenue and on
  capital employed in the business
• Activity ratios operational efficiency and use
  of assets

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Leverage Ratios
Total debt / total assets x 100 1,950,000 /
4,016,000 .486 x 100 48.6
Debt to Total Assets
Data Needs Balance Sheet Total Liabilities
Total Assets

• Key Issues
• Measures the percentage of total assets provided
  by creditors

• Other Leverage Ratios
• Times interest earned
• Cash debt coverage ratio

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Profitability Ratios
Gross Profit / Sales 55,011,767 / 10,685,117
5.15
Gross Profit Margin

• Data Needs
• Profit Loss Account
• Gross Profit (Sales less Cost of Goods Sold)
• Sales

• Key Issues
• Low may indicate
• a highly competitive market, direct goods cost
  increases or inefficient manufacturing / service
  delivery and vice versa
• they are failing to cover their fixed costs

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Liquidity Ratios
Current Ratio
Current Assets/Current Liabilities 3,000,000
/1,400,000 2.14

• Data Needs
• Balance Sheet
• Current Assets
• Current Liabilities

• Key Issues
• Indicates ability to meet short term liabilities.
  A result of less than 1 may be cause for concern,
  depending on the immediacy of s/term liability
• Relative analysis and trends are important. A
  worsening trend may be an early sign of
  difficulty.
• A result of 2 or more may indicate high debtors /
  stocks inefficiency a potential source of
  funds to support improvement initiatives

• Other Liquidity Ratios
• Acid-test (quick) ratio
• Current cash debt coverage ratio
• Receivables turnover

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Activity Ratios
Inventory Turnover
Cost of Goods Sold / Inventory 5,673,350 /
640,000 8.86

• Data Needs
• PL and Balance Sheet
• Cost of Goods Sold (Direct costs)
• Inventory (stock) on hand

• Key Issues
• Indicates a companys raw material stock turnover
  P.A.
• A result of 12 in a supplier would mean that the
  raw material purchased in a month is all
  converted into sales
• Relative analysis and trends are
  importantrelatively poor inventory turns could
  indicate excess inventory.

• Other Activity Ratios
• Average Collection Period
• Days Payable

• RD Spend
• Sales/Empl. Average Salary

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Cost of Goods/Sales/Service

• Direct Materials
• Direct labor
• Overhead
• General and administrative expenses
• Cost of Goods/Service/Sales
• 40-60 of every sales dollar in a manufacturing
  organization

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Cost of Money/Capital

• Return on investment that a company must achieve
  to maintain its current market value
• Investment 640,000
• Cost of Money_at_10 64,000
• Investment 540,000
• Cost of Money_at_10 54,000
• Cash release 10,000
• Company X
• Borrowing rate 7-10
• Cost of Capital 12-18
• Carrying cost 18

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Opportunity Cost

• The loss that is incurred when money is not being
  used to make money
• 10,000 invested at 5 500
• 10,000 cash available to implement other
  processes or products that generate efficiencies
  or additional cash flows

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Return on Investment (ROI)

• Savings/Investment
• Cash Flows Into Organization/Investment
• 5,000 Savings/50,000 Investment 10
  ROI

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Earnings Per Share

• 100,000 shares outstanding
• Before savings
• 629,235/100,000
• 6.20 per share

• 250,000 savings
• Increase to net profit for the year (bottom
  line)
• 629,235 250,000
• 879,235/100,000 shares
• 8.79 per share
• 2.59 increase 42 increase per share

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The Purchasing Multiplier

• 250,000 savings
• 12 profit margin
• 250,000 savings/12 profit margin
• 2,083,333 in additional sales
• Gross Sales 10,685,117
• 2,083,333/10,685,000 19.5 increase in sales

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Finance for the Non-Financial Supply Professional
Segment 2 Understanding Cost-Based Principles
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Segment 2 Agenda

• Understanding the Cost-Based Principles
• Supply Chain Costs
• Cost vs. Price
• Costing Methods
• Types of Contracts
• Inventory and Overhead

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A. Total Supply Chain Resources

• Total Cost Management
• Utilization and Scale Curves
• Soft cost analysis
• Postponement

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What is Total Cost Management?

• Holistic approach to procurement focus is on
  total spend/cost rather than line item savings /
  price reduction
• Process that drives accountability of spend
  across the organization (vertically and
  horizontally) and expands to include the entire
  supply chain
• Includes
• Data visibility/access
• Supply base structuring
• Strategic sourcing and contracting
• Supplier performance and development
• Linkage to Business unit/functional strategies
• Partnered/jointly managed projects
• Benefit Capture rather than transactional
  reporting
• Efficient procurement processes

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Total Cost Management

• Volume discounts
• Inventory
• Transportation
• Timing of purchases
• Inspection
• Handling
• Lease vs buy
• Supply Chain costs

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The Utilization Curve

• A formula that assists supply professionals in
  determining whether to give a supplier a greater
  volume of the business
• The formula answers the question
• Does spreading fixed costs across a greater
  volume of units lower the per unit cost
  significantly to warrant putting more business
  with the supplier
• Formula for Utilization Curve
• Average unit cost Variable cost Fixed Cost
  Unit Quantity
• A scale curve measures the effect of cost per
  unit at full utilization as capacity increases

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B. Cost Versus Price

• Pricing How suppliers set price
• What items are price-based versus cost-based
• Direct costs
• Indirect Costs
• Fixed costs
• Variable
• Semi-variable

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Supplier Pricing Models

• Demand-based
• Image
• Promotional
• Segmentation

• Market-based
• Market share
• Market skimming
• Market penetration
• Market competition
• Block pricing
• Cost-based (unit price x ) unit price
• Margin pricing
• of quoted price
• Rate-of-return
• Price volume model

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Cost versus Price Based

• Cost based
• Nonstandard items and services
• Situations where it is difficult to determine if
  a price is fair and reasonable

• Priced based
• Set by law or regulation
• Catalog price
• Market price

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Direct Costs

• Those costs that can be identified with specific
  products or service
• Cost of Goods/Sales Model
• Direct Materials 100,000
• Direct Labor 60,000
• Suppliers use as a basis to allocate their
  overhead
• A reduction in the direct costs is generally
  worth more to a purchaser than a major reduction
  in the suppliers profit margin
• A reduction in direct costs is a a win-win
  opportunity

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Indirect Costs

• Fixed costs
• Costs that tend to remain constant regardless of
  the volume of operating activity
• The cost decreases as a cost-per-unit, or average
  cost decreases, when output levels are increased
• Variable
• Those costs that are expected to fluctuate in
  direct proportion to changes in the level of
  operational activity
• Semi-Variable
• Those costs that displa6 both fixed and variable
  characteristics

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The Income Statement




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Sample Balance Sheet
ASSETS LIABILITIES Current Assets Current
Liabilities Cash 230,000 Accounts Payable
1,000,000 Accounts Receivable 1,100,000 Notes
Payable 300,000 Inventories 640,000 Provision
Federal Tax 100,000 Prepaid Expenses
46,000 Total Current Assets 3,000,000 Total
Current Liabilities 1,400,000 Fixed
Assets Long-Term Liabilities Gross plant,
building Mortgage 500,000 equipment
3,000,000 Notes Payable 50,000
Less depreciation 1,000,000 Long-Term
Liabilities 550,000 Net Fixed
Assets 2,000,000 Total Liabilities
1,950,000 Total Assets 4,016,000 Net
Worth Stock 1,500,000 Retained
Earnings 566,000 Total Net Worth 2,066,000 To
tal Liabilities/Net Worth 4,016,000
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C. Costing Methods

• Activity based costing
• Life cycle costing
• Total cost of ownership
• Life of the product contracts
• Target costing

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Costing Methods

• Activity Based Costing
• Focuses on the activities being performed and
  then determines the best way to directly charge
  or allocate more realistic proportions of costs
  to various products and services

• Life Cycle Costing
• Special requirements of equipment
• Space expansion
• Transportation
• Packaging
• Spare Parts
• Maintenance over the life of the equipment
• Disposal costs

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Net Present Value
Estimated savings per year for life of
equipment 5000 Life of equipment 5
years Cost of capital 8 Net present value
factor 3.993 3.993 x 5000 19,965
savings
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Time Value of Money
Discounted Cash Flow (DCF) A method of
evaluating long-term projects that explicitly
takes into account the time value of money.
10
10
10
10
10
10
10.00
9.00
8.10
7.29
6.56
5.90
Net Present Value (NPV) Present value of cash
inflows less present value of cash outflows.
In the above example the net present value of the
60 payments is 45.85
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Return on Investment
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The Impact of Depreciation

• Cost of Equipment 10,000
• Life of Equipment 5 years
• Scrap Value 1,000
• 10 for this example
• Depreciation per year 20
• Formula for Straight-line depreciation
• 10,000 scrap value at the end of the life of
  the equipment
• 10,000 - 1,000 9,000 x 20 1800

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The Impact of Depreciation
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Total Cost of Ownership
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Costing Methods

• Target Costing A process whereby organizations
  calculate the allowable cost (i.e.target cost)
  for buying/producing the product or service they
  offer to sale by first determining the acceptable
  selling price in the marketplace and the
  organizations internal margin on the
  product/service
• Target Cost
• Estimated Selling Price-Desired Profit Margin
• Targeted Selling Price 480
• 20 profit margin 96
• Target cost 384

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Types of Contracts

• Fixed Price Contracts
• Firm fixed price
• Fixed price with adjustment/escalation
• Fixed price with re-determination
• Fixed price with incentive
• Firm fixed price per unit level of effort
• Fixed price with downward price protection
• Find more on contract type definitions in
  Section _, Page_ of the workbook

• Cost Reimbursable Contracts
• Cost plus a fixed fee
• Cost plus percentage of cost
• Cost plus an incentive fee
• Cost plus award fee
• Cost without fee
• Cost sharing

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Inventory Cost Methods
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Overhead Allocation MethodsThe Unknown Cost
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Finance for the Non-Financial Supply Professional
Segment 3 Using Financial Tools Cost
Management to Improve the Bottomline
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Segment 3 Agenda

• Special Factors that Impact True Cost
• Moving Away from Hit or Miss Cost Savings
• Documenting Supply Managements Value
• Analyzing Supplier Finances
• Reports for Decisionmaking

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A. Special Factors

• Inflation/Deflation
• Interest rates
• Taxes
• Sarbanes-Oxley
• SEC regulations
• Transactional Costs
• Carrying Costs
• Trade-off decisions

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Carrying Costs

• Opportunity Cost
• Overhead
• Handling
• Computer Space
• Taxes/Insurance
• Obsolescence and Damage

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Transactions
Purchase Order Receiving Invoice
Payment Incoming Inspection Freight
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Currency Fluctuations

• E1,000,000 contract
• E1,000,000/
• E1.5/1.00
• 666,666.66
• E1,000,000/
• E1/1.00
• 1,000,000
• E1,000,000/
• E2/1.00
• 500,000

• 666,666.66 contract
• 666,666.66
• E1.5/1.00
• E1,000,000
• 666,666.66/
• E1/1.00
• E666,666.66
• 666,666.66
• E2/1.00
• E1,333.333.32

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B. Moving Away From Hit-or-Miss Cost Savings

• Cost improvement
• Spend management
• Cost avoidances
• Cost containment
• Release of cash for the business

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Critical Activities in Cost Management
1.CostImprovement
2.CostContainment
5.Active CashProduction

3.Price Forecasting
4.Buyer Performance Measurement
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Cost Management Methods

• Set demanding goals give them business
  visibility
• Form sourcing strategy and supplier management
  teams
• Apply the practices, tools and techniques
• Source plans
• Portfolio and competition analysis
• Market and supplier analysis
• Purchase Price and Cost Analysis (PPCA)

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Planning a Cost Improvement Program The Process
Analyze the total expenditure
Step 1
Step 2
Prioritize the attack
Step 3
Develop individual expenditure action plans
Step 4
Monitor progress and report results
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Proactive Cost Containment
Allocate expenditure categories to portfolio
positions
External market price increases pressures
Forecast impact
Prioritize cost containment campaign and set
individual objectives
Improve inter-functional, inter-site and
inter-business cooperation
Strengthen information base
Condition suppliers
Deter increases
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C. Documenting Supply Managements Value to the
Organization

• Bottom Line
• Cost per unit
• Cost of goods/sales
• Gross profit
• Operating Income
• Earnings per share

Pick One
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ExampleCost Savings, Sales, EPS
Cost Savings
Earnings / Share
Sales
1.6mm
3 cents
3.6mm


Cost Savings Cost savings from
Procuri event. (2004)

• Sales
• To create EBIT of 1.6
• You would have to sell an
• Addn. 3.6mm (1.6mm
• 45 profit margin 3.6)

Earnings Per Share Annual Savings
Before tax 1.6 Shares Outstanding 48.1
EPS 3 cents
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Communicating Value

• Customer satisfaction measures
• Security
• Reputation
• Internal collaboration
• Workforce measures
• Availability measures
• Operational measures

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Supplier Financial Analysis

• Bottomline
• Gross Profit
• Operating Income
• Inventory Turns
• Number of Days to turn Inventory to Sale
• Number of Days open/Inventory Turns
• 360 days/8 45 days
• Current Ratio
• Quick Ratio
• Current Assets less Inventory/Current Liabilities

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The Income Statement




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Balance Sheet
ASSETS LIABILITIES Current Assets Current
Liabilities Cash 230,000 Accounts Payable
1,000,000 Accounts Receivable 1,100,000 Notes
Payable 300,000 Inventories 640,000 Provision
Federal Tax 100,000 Prepaid Expenses
46,000 Total Current Assets 3,000,000 Total
Current Liabilities 1,400,000 Fixed
Assets Long-Term Liabilities Gross plant,
building Mortgage 500,000 equipment
3,000,000 Notes Payable 50,000
Less depreciation 1,000,000 Long-Term
Liabilities 550,000 Net Fixed
Assets 2,000,000 Total Liabilities
1,950,000 Total Assets 4,016,000 Net
Worth Stock 1,500,000 Retained
Earnings 566,000 Total Net Worth 2,066,000 To
tal Liabilities/Net Worth 4,016,000
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Payment Terms

• The terms of our payment to our suppliers or from
  our customers to us.
• Net 30 means we have 30 days from the date of
  invoice
• 2 10 means we get a 2 discount from the invoice
  if we pay in 10 days

Investment
Early Payment
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D. Reports to Explorefor Decision making

• Purchase Price Index
• ISM Report on Business
• DB
• ICE

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Hedging

• Accept premise that the market rules
• Hedging transfers risk
• Hedge by taking equal and opposite position in
  market by forward buying when a sale is made
• Locks in profit margin and protects against sharp
  changes in price that could cause income loss
• Avoids speculation

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Hedging Example
Sell Branded Coffee To restaurant chain
customer 1-year100,000 lbs. _at_ .85 cash
Buy Green Coffee On current market 100,000 lbs. _at_
.85 cash

• Profits are locked
• Future green coffee market changes do not impact
  this transaction
• Why did we do this?

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Sarbanes Oxley Compliance Plan
Q1 2004
Q2 2004
Q3 2004
Q4 2004
Q4 2003
Beyond
Release Revised Procurement Policies and
Procedures And Sarbanes-Oxley Control Document
Response
Communication and internal compliance readiness
assessments
Initial testing of controls by Internal Audit
External audit of controls By PWC
Company Wide 100 compliance target
Company Wide - Annual self assessment of
performance
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Buying Strategies

• Forward Buying
• Multiple Suppliers
• Partnership
• Speculative
• Buying
• Inventory stocking

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Now, How About You?

• __________________________________________________
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