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Four financial management tools for manufacturers

Article by Ben Milius, EKS&H March 11, 2018, 10:33 am MDT

Financial tools can uniquely position accounting and finance executives to strategically support the operations of manufacturing and distribution companies. Following are four examples of basic financial management tools their leaders should consider utilizing.

Optimization models

Optimization models support operational decisions between a specific set of varying options, helping guide direction as to which best meets an objective. For example, they can provide clarity to management on the optimal level of inventory to maintain at various distribution sites that maximizes profits and meets customer demand. Other potential uses include supply chain processes, optimal product pricing, cost-cutting opportunities, production scheduling decisions, optimal working capital levels, mix of debt or equity capital financing in investment decisions, and make vs. buy decisions.

Simple optimization models can be performed using Excel's Solver add-in function. The biggest challenge in developing these models is defining the proper inputs that impact a set of decision alternatives. Once the objective function of the model is determined (for example, minimize total costs), it requires mathematical expressions based on the various inputs used to calculate the objective function. Constraints are then determined as equation sets, which limit the objective function between various decision sets. Sophisticated modeling software also exists for complex models, which are commonly outsourced to financial consulting firms.

Ratio analysis

Another tool that improves insights into operational performance is ratio analysis. Ratios can be used to identify operating efficiency, profitability, asset utilization, and financial leverage. Common ratios for identifying strengths and weaknesses in operations include the inventory turnover, days in inventory, operating cycles, yield, throughput, gross margins, lead times, and return on fixed assets.

Calculating the economic order quantity (EOQ) for the purchase of inventory is another useful ratio. According to John Kamauff in his Manager's Guide to Operations Management, "EOQ is the order quantity that represents the lowest total cost of inventory costs and acquisition costs." Each time the procurement department sources materials, costs are incurred; using the EOQ helps operations determine the optimal quantity to order, order timing, and total holding and ordering costs. Along with the EOQ, finance leaders can support operational decisions in calculating inventory stock reorder points, which would indicate the optimal time to source prior to depletion.  

With advancements in big data, finance is more capable than ever of supporting operations with ratio analysis. In fact, many IT systems can do so in real time, providing operations with dashboards of critical ratios. This allows timely detection of operational concerns.

Capital budgeting

To improve capital investment decisions for new production machinery and equipment, capital budgeting is a useful tool. Examples of capital budgeting include the net present value (NPV) method, internal rate of return (IRR) method, payback period, and break-even analysis. The most commonly used method for capital budgeting is the NPV method. The first and often most difficult task of the NPV method is properly identifying the inputs to the model. These include future incremental cash flows, incremental costs, opportunity costs, and the discount rate.

Once these inputs are properly identified, incremental future cash inflows are then discounted to their present value, less any initial investment required. In addition, discounted incremental future cash outflows are subtracted from inflows to arrive at an NPV. If the NPV is greater than $0, then it would indicate a positive return on the investment.

Often the challenge is identifying all opportunity costs and the proper discount rate to use. The most common discount rate used is the weighted-average cost of capital. Other options include using only the required return by either creditors or investors.

Simulation models

Simulation models can best be used to determine future outcomes based on decisions (inputs), often in the form of financial forecasts and/or budgets. If product costing is done using standard costs, simulation models are commonly used to determine the forecasted demand and resulting production and production costs to establish standard rates applied to inventories.  

It is important for finance leaders to develop forecasts alongside operations in understanding operational inputs, such as capital expenditure needs, labor constraints and costs, raw material pricing, equipment repairs and maintenance needs, and supply constraints. This process requires operations managers to make decisions for the longer term, which improves planning. For example, if raw material pricing is forecasted with high volatility and potential price increases, the process of developing forecasts could spur the discussion of whether a hedging strategy should be considered.

Forecasts also allow for sensitivity analysis by directly observing how changing inputs in a model impacts end results. For example, forecasting revenues for a new product line management can observe how incremental price changes may impact profitability or forecasting cash flows may identify future external financing needs. These insights allow operations to better implement business strategies.

Conclusion

No matter how advanced a manufacturer's accounting and finance function is, there are likely additional opportunities to better utilize financial management tools like optimization models, ratio analysis, capital budgeting, and simulation models. The key is to accurately identify appropriate and applicable ratios for comparison and understand the key inputs impacting model outcomes. Once you have those questions answered, the tools do the hard work for you.

EKS&H help manufacturers with a range of issues, including accounting, audit, tax, technology, and transactions. To find out more about how we can help your manufacturing company navigate today's challenges, contact Audit Senior Manager Ben Milius at 303/740-9400 or bmilius@eksh.com.

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