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Nerve of the war, knowing how to justify the gains of an approach of Excellence is essential for the success of this one. Here are the keys to success.

Introduction

Most of the time, Lean projects will ask to invest a few Euros or hundreds of Euros in tool kits … this does not require very specific justification. On the other hand, Lean 6 Sigma activities take time and sometimes require larger investments. This time has a cost that must be justified by the management.

Identify the gains from Lean Six Sigma activities

It is important to distinguish 2 types of earnings :

  • Thes « Hard Dollars » : 
    these are the gains that directly impact the accounting: reduction of the costs of production, reduction of the rejects … They are easy to identify and to measure.
  • The « Soft Dollars » :
    These are gains that are difficult to measure and are not directly reflected in accounting: compliance with standards, removal of the need for investment, reduction of absenteeism, reduction of non-quality…

 Example of non-quality gains

No Internal quality

No external quality

Cost of detection

Cost of prevention

Waste (material loss and accounting added value), the cost of retouching (additional material consumption, staff costs, etc.) and management costs (storage, handling, declarations, derogations…)

Costs incurred when the product is returned by the customer (reprocessing, fine, refund, late payment…)

Cost implemented to check the conformity of products (sampling, auto-control…)

Human investment and committed equipment to reduce nonconformities.

 

Understandably, to justify investments in Lean 6 Sigma, it is better to show the Hard Savings. This is the challenge of agents of change. In our various articles on tools, you will find the elements to identify the gains (See example Excel document in articles 5S, SMED).
These gains make it possible to calculate indicators for financial services :

Return On Investment

The ROI, « Return Of Investment », 
indicates the time after which an investment is profitable. For example, if the gain of your project is a saving of 1000 $ per month for an investment of 5000 $, your ROI is 5 months.

The financial service will validate your investment according to this ROI. It depends on the amount, but most often companies have clear rules: “for an investment of less than 10,000 $, you must have a 12-month ROI »…

Before going to see them with the flower in the rifle with lots of good intentions and good ideas, it is highly recommended to collect these rules to “& guide ” your actions and your tracks to dig.

The disadvantage of this indicator is that it does not take into account the flow of money once the breakeven point has passed. Therefore, we only compare projects against this threshold and most often favor a short-term vision of an investment..

Net present value

1. Current Value Concept

The net present value concept is based on the fact that ” a Dollars today is not equivalent to a Dollars tomorrow  “knowing that in principle we will have a preference for the present.

Typically, an investment (F) of 10,000 $ today for a profit of $ 1,000 in one year, the net value of the project is not 1,000 $. The value will depend on parameters that we indicate below.

L’intérêt d’actualiser les données est de :

  • To be able to identify which project is the most advantageous.
  • Know if the project meets the expectations of returns set by the capital contributors. 
  • Take into account the risk. 
  • Respond to a purely financial logic: ” Do you have to go into debt to build your house right away or save first ? »

This current value is calculated via a rate (t%) which represents the price of time. The interest rate represents the rate at which one can lend against the promise of future repayment, which by convention is expressed on an annual basis. It is this rate that will convert our current sum into a future sum.

Thus, 1 $ today will be worth (1 + t%) in one year, and therefore 1 / (1 + t%) today (so-called value discount rate ). Over a year, the current value is :

Example :

For an interest rate of 7%, 1 $ today will be worth 1.07 $ in one year, but reported today, 1 $ in a year is worth 1 / 1.07 = $ 0.93 Today 

In other words: in a year, I will repay $ 1 of my loan, but today, this $ 1 has a real value of $ 0.93.

2. Identify the rate

Our rate t%, will be calculated according to 2 parameters:

    • The interest rate i% : it represents the price of time gross »
    • The risk r%: it is commonly called “ risk premium “, it is added to the interest and is representative of the risk related to the project.

We deduce the rate :

t% = i% + r%

A company chooses a rate between 7 and 15%. It is recommended to ask the financial service for this data and make estimates before presenting the project.

According to the i% rate, the financial thinking process is different :

    • For a high i%we are looking for rapid profitability. We have a short-term vision, we want to limit risks and investments most often.

       

    • For a low i% : we are ready to wait to make money, we are in a long term vision and we accept more investment.

To compare the projects correctly with one another and make a relevant choice, the same i% will be used for all projects. On the other hand, we will adjust the r% according to their respective risks (uncertain gain, difficulty of implementation…).

It should be noted that the rate generally used is 4% for short or medium term projects and 2% for long term projects (more than 30 years).

3. Calculate Net Present Value

Net Present Value allows us to translate a stream sequence into a single current value, that is, at the time of decision making.

With :

  • Fn : cash flow year n (the “Cash Flow “), in plain language what your project has reported.
  • t% : Rate applied on the investment.

4. Investment choice

From this Net Present Value, we will be able to make a decision on the project. We have 3 possibilities :

VAN < 0

Project not profitable, it is not interesting to invest on this project unless argument other than purely financial (security…).

VAN = 0

We are at break-even point . The project is not financially attractive, but there may be other interests (well-being of employees…).

VAN > 0

Profitable project. The investment is interesting because it pays us more than it cost us. Unless another project is even more interesting or more priority, we invest in it.

Example

It has been identified that to increase productivity and keep up with demand, you need to invest in a new Just-In-Time line. The investment is 150,000 $ and will meet the objectives.

To demonstrate the validity of this project, we will calculate the net present value. The financial service indicates an interest rate of 7% and a risk assessed at 3%. We obtain the following results :

The net present value, however, remains an evaluation tool that relies on information that is difficult to predict and that requires anticipation capabilities, in particular forecasting the discount rate. The rate at one year is not necessarily the same at 10.

Also, future flows (gains) are estimates. There will be several scenarios: Optimistic and Pessimistic.

Profitability Index (PI)

The profitability index is the ratio between the present value of the cash flow and the amount of the investment. Clearly, it is a rate of return of the project. The decision rule is as follows :

  • Index > 1 : the project is profitable, we can accept it.
  • Index < 1 : the project is not profitable, except ” contra-indication ” it will not be accepted.

Internal rate of profitability (TRI)

The Internal Rate of Return makes it possible to identify the value of t% (seen above) for which our project has a NPV of 0.

It is therefore the rate of return of the project. The higher this rate, the more profitable it will be and vice versa.

To calculate it, use the Excel solver. Indicate :

  • The net present value as a goal at 0
  • By changing the value of the Global Rate

Updated recovery time (DRA)

The discounted payback period is defined as the period after which the company recovers its initial outlay from discounted cash flows (thus different from ROI, since discounted flows are considered).

Other notions

For the agent of change, other notions are to know to better understand the financial aspects and better communicate :

  • Market Share : This is the percentage of product sales to the market as a whole. For example, 20% of the market share indicates that our company has 20% of total sales for the reference market. 
  • Margin : Margin is the difference between the sales price and the cost price, the latter depending on the calculation method.

It should also be noted that to go further in the process of justifying earnings, you can also use the Cost / Benefit Analysis.

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