A Tutorial on Financial Project Justification Methods for the Oil Analysis Professional

Transcription

1 A Tutorial on Financial Project Justification Methods for the Oil Analysis Professional Drew D. Troyer Noria Corporation 2705 E. Skelley Drive, Suite 305, Tulsa, OK, , INTRODUCTION More than any single factor, growth in the oil analysis industry has been limited by the inability of its professionals to effectively propose projects and report results to management using conventional financial language. This is not uncommon in technical disciplines like oil analysis where technicians and engineers have received little or no training on the use of conventional financial project evaluation methods. This tutorial introduces the oil analysis professional to important financial tools and language like Internal Rate of Return (IRR) and Net Present Value (NPV) used to cost justify oil analysis and lubrication management projects that are designed to reduce costs and increase the firm's profitability. As a group, we in oil analysis and lubrication management must learn how to effectively use these tools so we can speak the language of management profitability. Failure to speak on management's terms, typically leaves us disappointed in our ability to obtain support to deploy the "best-practice" projects we are sure will benefit the organization. Let's learn to use these tools to be sure we are in fact making cost justifiable changes and improvements, and to be sure management approves our proposals (if financially feasible) for implementation. FINANCIAL OBJECTIVES AND THE TIME VALUE OF MONEY Our primary reason for employing financial analysis tools is simple; a dollar invested must return the dollar plus yield some acceptable rate-of-return. The necessary rate of return depends upon several macro and micro economic variables. The state of the economy and the business environment combined with the general condition of the industry in which the firm participates are macro-economic issues that affect what constitutes an acceptable rate of return. The financial health of the firm, the aggressiveness of management and the uncertainty surrounding the proposed investment are some micro-economic issues that determine the threshold of feasibility for an investment or a project under review. In summary, the inherent risk of the proposed investment, the current business environment and management's propensity for risk combine to determine the mark a proposed project must cross to be deemed financially feasible. The time value of money is an important financial analysis concept that refers to the general notion that a dollar received or spent today is worth more than that same dollar received or spent at any point in the future. It stands to reason that this is true for two reasons. First, inflation reduces the buying power of a dollar next year compared to that same dollar today. Likewise, a dollar received today can be invested, yielding a positive return. For instance, a dollar received today invested in a 10% yielding stock, bond or savings account would be worth $1.10 the same time next year and $1.21 the following year. Conversely, the receipt of a dollar two years from now is only worth about $0.82. Most people are accustomed to thinking about the time value of money. We put money into savings, stock accounts and mutual funds expecting the value to grow over time. For investment analysis purposes we also have to think in the inverse knowing that money received in the future isn't worth as much as the same amount received today. This notion of the time value of money is a cornerstone of financial management and project feasibility evaluation. In order to estimate the true value of a project under consideration or to compare it to other investment opportunities, we must review cash flows in present value. That means we have to discount future cash flows so we can compare dollars spent today in implementing projects to future cash flows on an apples-to-apples basis. We discount future cash flows using the following general equation: Practicing Oil Analysis

2 PV = Cash Flow/ (1 + k) n Where: PV = Present Value - Today's Value of future cash flows Cash flow = the amount received (or avoided) or the amount spent at a point in time k = The discount rate for a given period (usually inflation adjusted) n = The number of years or periods in the future The variable "k", typically defined by the manager of accounting and finance, represents either the cost to borrow capital or the rate of return management can secure using other "safe" investment opportunities. For large, very stable organizations, capital with which to grow the company is available at a much lower cost than for a small, high-risk organization. The rate may look very high as compared to the prime lending rate or other published interest rates. This is because most financial managers will adjust the "k" factor to reflect inflation. For example, if one wishes to determine the present value of $1,000 received five years in the future where the cost of capital is 10% annually, our equation would read as follows: PV = $1,000/(1 +.10) 5 = $621 So, receipt of $1,000 five years from now is really only worth $621 in today's dollars. This concept will play an important role as we review common financial tools used for project evaluation in lubrication management and oil analysis. The maintenance and reliability professional typically seeks resources (money and/or people) to deploy improvement projects that promise to deliver future value. To accurately assess the value of these projects, we must view the expected cash outlays and expected cash inflows in present value to determine the value of the project. PROJECT EVALUATION DECISION TOOLS Managers need to see projects presented in a way that enables them to assess its financial feasibility. The most common financial management techniques used to evaluate the economic merit of a project are: Discounted Payback Period (DPP) Net Present Value (NPV) Internal Rate of Return (IRR) The three techniques, discussed below in detail, are related, but provide information to management from different perspectives. They are calculated using the same numbers, but produce a different spin on the information and the way in which it is communicated. Discounted Payback Period The DPP compared discounted cash inflows to discounted cash outflows for a project to determine the point at which it produces a "break-even" cash flow. The method enables management to review various projects based upon cash impact, and the time required for the project to reach break-even. By discounting the future cash flows, the cost of capital is reflected in the analysis. Table 1 presents a cash flow table for a project that costs $1,000 up front, and is projected to produce $400 per year in benefit over a five-year period at a cost of capital of 10%. Table 1 - Discounted Cash Flow Table. 140 Practicing Oil Analysis 99

3 In our simple example, the discounted DPP for the project is just over three years. Many managers rely heavily upon this technique because they believe that long planning horizons produce volatile projections. As such, these managers will typically set maximum payback period above which projects will be rejected. They prefer to implement projects that reach black ink (profitability) in short order. A criticism of this method is that it penalizes long-term oriented strategic projects where it takes time for the cash to flow readily. Also, it fails to effectively look at the total value of the project for the life of the project or advise management of the rate-of-return the project delivers. Many organizations have a maximum time frame by which a project must break-even and begin to produce positive cash flow. This is especially true in organizations where "cash is king", meaning management pays special attention to the cash flow streams. Generally, smaller, more volatile organizations are more cash conscious. As a rule, larger organizations tend to have a broader base of cash flow sources. So, the DPP method is favored by smaller organizations while larger firms tend to prefer the IRR or NPV methods. Exceptions to this rule, however, are common. Internal Rate of Return The IRR determines the percentage rate the project returns for the investment. This method, unlike the DPP, the IRR method does not require discounting of the cash flows. Rather, it describes the percentage rate return that is provided by the project. For our simple example, we invested $1,000 on a project that produces $400 per year in positive cash flows over a five-year period producing an IRR of 29% (see table 2). This project yields a return similar to the return generated by investing the $1,000 in a bank account that yields 29% annual return. Table 2 - Internal rate of return calculation. The calculation of IRR is mathematically complex. It represents the sum of the PV calculations previously described for each year of the project where the rate (k) is held variable and the equation is set to zero. By hand, the calculation is a cumbersome, iterative, trial and error process. Fortunately, spreadsheet programs like Microsoft Excel and others simplify calculation of IRR with built-in functions that compute the rate from a defined set of raw cash flow data. Research suggests that managers prefer the IRR method 3 to 1 over other project analysis techniques because it produces a very straight-forward piece of information that simplifies the process of assessing different investment opportunities. The problem with this technique is that it is a relative measure. An investment of one dollar can look as good as an investment of one million dollars from a percent return perspective. Often, very growth conscious firms will prefer the IRR method. If the goal of the organization is grow at 20% per year, the sum of all the firms investments must grow at 20% or greater or greater per year. Any investment that exceeds the 20% mark has a chance of pushing the aggregate growth number up. Growth firms are often willing to assume great risk to invest in projects that will produce this high rate of return. Net Present Value Net present value (NPV) is the sum of all discounted cash flows over the proposed life of the project or investment. The cash flows are discounted to reflect the firms cost of capital or its so-called no risk investment opportunity. The thinking behind the NPV method is simple, the firm must invest in projects and Practicing Oil Analysis

4 opportunities that increase the wealth of its owners. If it invests in a zero NPV opportunity, wealth is unchanged. A negative NPV project destroys wealth. The accuracy of the NPV estimate depends heavily on management's ability to accurately estimate the cost of capital and the life of the project. The cost of capital can waver over the life of the project or investments, affecting the calculated value. Likewise, it is often difficult to determine how long a project or investment will continue to produce value. This method is often favored because it sums up the magnitude of wealth created by the project. Table 1 shows how the NPV works. Unlike the DPP, the NPV is looking at the sum of the discounted cash flows over the life of the investment. In our example, the net present value of the project over the estimated five-year life of the project is $516. The NPV method is unanimously favored by finance academicians. Likewise, large, stable companies favor this method because it communicates how much wealth, over and above the cost of capital or required rate of return, the investment under consideration adds to the organization. Large, stable organizations are typically more interested in the creation of wealth over the long haul than skyrocketing with an extremely high rate of return. Likewise, these firms usually have large and stable cash reserves so they can wait longer than small, volatile organizations for returns to reach break-even on cash flow. Each of the previously discussed methods has its merits and limitations. Different managers within the same organization may prefer one approach over another. Likewise, a manager may heavily weight DPP for one project and IRR for another. As an oil analysis professional, include all three in your business proposal so management can evaluate the proposed project from all angles. ASSEMBLING THE LUBRICATION MANAGEMENT BUSINESS PROPOSAL To many reliability professionals, the idea of developing a business proposal is daunting. However, it is critical to achieving success. Once you understand the techniques, you simply need a recipe for the proposal's assembly. To be effective, the proposal should contain the following elements: Technical summary of the project you wish to implement Brief description of how you expect the proposed project to deliver value to the organization with a break down of cash inflows (up-front and on-going). A brief description of the expected costs to implement the project with a breakdown of the cash outflows (up-front and on-going). A tabulated review of financial impact the project will have on the organization with the expected DPP, IRR and NPV clearly identified. A list of the assumptions you made in evaluating the business aspects of the project Technical Project Summary Generally, managers who make financial decisions like reports that are light on technical details and heavy on financial details. It is the natural inclination of most technical people to produce just the opposite in a report they present to management. Engineers generally develop specific detail in describing the technical nature of a project, then present a very casual financial argument. Reverse this and you will see more projects approved, and done so more quickly. In the summary, you need to generally describe the technical change you wish to implement, but do so in plain language, unencumbered by technical jargon. For example: XYZ company's 10 conveyor drive gear reducers have been the source of tremendous maintenance and lost production costs. An investigation into the root causes of failure has the led the team to conclude that extremely high levels of abrasive contamination is causing abnormal wear in the bearings, leading to failure. We believe that we can substantially reduce the contamination levels in these gearboxes by employing vent breathers, off-line filters and regular monitoring to ensure that our target levels are met. Research in the area suggests that cleaning up from our current contamination levels to the new target -cleanliness levels will yield a 2.5 times life extension in these gearboxes. The above statement is clear, concise, non-technical and adequately summarizes the nature of the proposed 142 Practicing Oil Analysis 99

5 contamination control program. Frankly, most managers don't desire any more information than what was stated above. However, as the technical person on the job, you must be prepared to answer questions of this nature, so be sure to have your ducks in a row. Just because the technical aspects of the project are not detailed in the business proposal to management, technical staff should not take a casual approach toward the project's technical validity. Expected Benefits Financial benefits generated by oil analysis and lubrication management projects can come in two forms and from numerous sources. Benefit Forms Proactive Benefits - Proactive activities like reducing particle and moisture contamination, changing or reclaiming oil and upgrading a lubricant's quality specification actively extend the life of components. By controlling the forcing function or root cause that leads to a failure, you can preemptively reduce the failure rate for a component or system. For example, the relationship between particle or moisture contamination level and mechanical integrity has been widely researched. Tables are available to assist you in determining the affect on component life that results from a change in the contamination level. Predictive Benefits - There is inherent complexity in the valuation of predictive maintenance benefits. The objective for predictive maintenance is to produce a non-event, and the value of a non-event is inherently difficult to quantify. The value of predictive maintenance lies in its ability to provide advance warning so parts and labor can be scheduled, run-time compensatory actions can be taken to "limp" the machine along until a scheduled outage, costly chain-reaction failures can be avoided, etc. In their seminal work " Predictive Maintenance - The Effect on a Company's Bottom Line", Johnson, Maxwell and Hautala provide a framework for assessing this value. This framework should be utilized in the assessment of the predictive maintenance benefits of oil analysis and lubrication management, and referenced in the report to management. Benefit Sources Repair Costs - If a machine presently fails once every year, you can estimate the average costs for parts and labor to restore the machine and present that as an annualized value. For instance, if a machine fails once a year and, on average, requires $5,000 for restoration, the average annual repair cost is $5,000 Downtime Costs - When a mission critical machine is not running, the cash register is not ringing. One can estimate the typical downtime cost associated with a machine's failure and multiply it by the average duration of the lost production time. It is important to look only at the profit of the production in the financial analysis (production loss minus cost of goods sold). Lubricant Costs - Often, changes in lubrication management and oil analysis reduce the consumption of lubricants. Savings estimates should include lubricant costs, labor and disposal costs. Energy Consumption Costs - Usually, improving lubrication involves reducing friction. By comparing energy consumption during normal operation before and after the changes with an amp meter, these savings can be effectively estimated. Quality Costs - Often, percent defect is reduced through good management of lubrication quality. This is especially true in applications like molding, machining, rolling and casting where the precision of hydraulic control is affected by the lubricant's quality. Increased Production - In some cases, properly lubricated machines simply produce more. For example, contamination or varnish can slow the cycle time of a molding machine, reducing its output. Likewise, proactive and predictive lubrication analysis and management may enable management to turn production up a notch or two with greater confidence that reliability will be assured. Risk-based Costs - Insurance, safety risk, environmental damage and other risk-based costs should be assessed on a case-by-case basis and included in the evaluation. In this part of the report, clearly and concisely state the expected benefits of the organization in a fashion that enables management to compare the current state of affairs to the proposed state of affairs. The exam- Practicing Oil Analysis

6 ple in table 3 is an easy to read table that provides all the facts related to the proposed project to implement contamination control on the 10 conveyor gearboxes. Table 3 - Summary of the projects benefits In the example on table 3, the benefits associated with the proposed contamination control project is expected to be $60,000 per year for the 10 gearboxes. This value proposition will be compared against the costs to implement and manage the project. While the emphasis of the present paper is on the hard, financial benefits, no business proposal to management is complete without an assessment of the qualitative, or "soft", benefits the proposed project produces. Often, it is the soft benefits that get management on-board and create a sense of urgency to implement the project. Some of these soft benefits include: Happier employees Increased sense of self-worth among employees Improved teamwork More interesting or satisfying work Higher employee retention rate Improved plant or company image with senior management, within the industry or within the community Increased safety and environmental friendliness All things simply seem to go better when the machines are reliable Expected Costs This section should summarize for management where the costs will originate. Some costs occur up-front, other costs are recurring, still others occur periodically. Periodic costs can either be assessed in the year they are actually expected to occur, or averaged as is done for system repair parts and labor in our example. Table 4 summarizes the expected up-front and on-going costs associated with the example project. Table 4 - Summary of the project's costs 144 Practicing Oil Analysis 99

7 Tabulating the Project's Value Once all the costs and benefits are figured, the project needs to be brought together into an easy to read table like table 5 Table 5 - Financial analysis for the proposed contamination control project Table 6 - Summary investment analysis for the proposed contamination control project. Tables 5 and 6 clearly define the business impact of the proposed project over the expected life of seven years. Here are some key elements of the data presented in the two tables: The increased revenue and decreased costs are neatly defined. The expected costs to implement and manage the project over the planned life of seven year are clearly identified. The net cash flow is developed by subtracting the out-flows from the in-flows. The net cash flow is the basis of the financial analysis. The cash flows are discounted to reflect the time value of money. A cost of capital, or "k" factor of 10% was selected for this project. It is likely the accounting or finance department can give the operational "k" value for your organization. The net cash flow is simply multiplied by the discount factor for the given year Practicing Oil Analysis

8 or period to arrive at the net discounted cash flow value. Table 6 provides a summary of the net present value (NPV), internal rate of return (IRR) and discounted payback period (DPP) that is concisely located in a small table for management to review at a glance. The example project paid back the initial investment in less than one year, even with the cost to borrow money at a 10% interest rate factored out. Over the expected life of the project, the IRR was 111%. That means that management would have to invest the $27,000 to implement the project in an account or stock that produced 111% annual interest to equal the return produced on this investment. Likewise, the NPV of the project is an attractive $119,000, meaning that that over its life, this project will add $119,000 in value to the organization. The planned life is something you will have to guess at. In our example, reducing contamination levels will provide ongoing financial yield. Sometimes, however, it is difficult to be sure that the services of the assets in question will be required beyond 5, 7 or 10 years. This is a judgment call you must make relative to your organization's specific situation. Defining Your Assumptions As previously discussed, making decisions under uncertain conditions is the job of a manager. By providing a proposal that distills everything into dollar figures, you have to make assumptions. For example, you must assume that the research that suggests that the life of a gearbox can be extended by a factor of 2.5 times if it is cleaned up applies to your gearboxes. Likewise, you must assume your estimates of the value of the benefits and the costs to implement and maintain are correct. As long as the assumptions are logical and well thought through management will usually accept them, sometimes with revision. It is, however, imperative that an exhaustive list of assumptions be included in the business proposal. CONCLUSION By learning the language of business and finance, and by developing the skills to present a project for approval to management in a format to which they are accustomed, your project approval rate will increase dramatically (assuming that the projects you propose deliver real value to the organization). Likewise, you will enter meeting with management with the confidence that comes from knowing the project you are proposing is profitable. When more of these high value projects get implemented, you and the entire reliability team will be adding value to the organization. Adding value to your organization is an experience that is both personally and professionally rewarding. References: 1. Brigham, E and L. Gapenski (1988) Financial Management - Theory and Practice, The Dryden Press: Hinsdale, IL. 2. Johnson, B., H. Maxwell and D. Hautala (1999) "Predictive Maintenance - The Effect on a Company's Bottom Line Performance", Proceedings from the Practicing Oil Analysis '99 Conference, Noria Corp.: Tulsa, OK. 3. Fitch, J. and D. Troyer (1998) Learning Oil Analysis Level II Course Book, Noria Corp.: Tulsa, Oklahoma 146 Practicing Oil Analysis 99