Many companies are as lean as possible. Current warehouse and distribution center processes have been stripped of excess labor, meaning that when calculating the labor savings of an investment in automation, the result would not adhere to most companies’ rules required to approve an automation project.
That does not mean automation projects can’t be justified; it just means we have to do a better job at it. Recognizing how to calculate return on investment properly will not only help the process of continuous improvement within a company’s operations, but will also help maximize the possibility of positively impacting the bottom line when deciding if a project is worth the price.
Cost Savings vs. Cost Avoidance
By definition, cost savings means reducing current costs while cost avoidance means reducing the possibility of incurring future costs. When most companies were reacting to the falling economy, the emphasis on automated material handling project justification was cost savings. Typically this was done by installing equipment that replaced existing labor and the associated labor savings would pay for the cost of the equipment in one to three years.
The result of companies laying off workers due to decreased demand or because they implemented automation projects was that they became as lean as possible in order to fulfill their mission, which was a good strategy for most. However, with hardly any labor costs remaining to use cost savings as primary justification, the focus shifted to cost avoidance.
As the worst of the recession passed, distributors have been trying to fulfill orders with their current workforce as well as plan on slow growth scenarios and the associated challenges. As most have experienced, slow growth in an already lean operation without adding labor or automation is a temporary fix. Employees can only work so hard for so long before they throw their hands in the air and give up, which is never a good situation for the employer or employee. Therefore the concept of justifying a project with cost avoidance would be applicable.
For example, I was recently with a customer whose business has been blessed by “hockey stick” growth. He stated that if all of his processes stayed the same and he didn’t introduce automation, he would have to add four employees per shift per every additional 1,000 units produced and shipped. His challenge is simple: the company is expecting to double in volume over the next three to five years. Although this is an extreme situation (a problem we all wish we had), it proves the point that saving expected future expenses should be considered when performing the return on investment calculations.
A Lean DC + Available Capacity= More Profit
Since we have come to accept that the hardest punch from the Great Recession has been dealt and we are back on our feet, then that would mean we also accept the fact that growth, however slow, is in our future. As stated in the above scenario regarding cost avoidance, if the warehouse or distribution center is as lean as it can get, which translates to high productivity and minimal room for added capacity, then the only way to accommodate growth is to add capacity through labor, automation or a combination of the two.
In any scenario that addresses additional capacity, the additional profit resulting from the growth and added capacity should also be taken into consideration when calculating the ROI. The reason is simple: if capacity is not added, then additional sales cannot be realized (this is known as the “you can’t fit 10 pounds of sugar in a five-pound bag” theory).
The Profit and Loss Statement as Justification
By using either Net Present Value (NPV) or Internal Rate of Return (IRR) as justification, a more suitable calculation may be the key to determining the value of a capital project. This might sound like a daunting task, but these variables have already been identified and are fairly easy to understand. However, since we are basing the calculations on future cash flows, the trick is to be conservative in the estimates in order to maintain credibility during the process.
The NPV method is based on the evaluation of the discounted cash flow as a result of the project. To find the NPV, determine the present value of each cash flow, including the negative cash flow resulting from the initial cost of the project and all other cash flows including the cost savings, cost avoidance and additional profits, and then discount them at the project’s cost of capital, r. We then sum these discounted cash flows and determine the NPV. If a project has a positive NPV, then it adds value to the company. The formula for the five-year NPV is as follows where FCFn means Future Cash Flow at the specific year, n, while r is the cost of capital:
The Internal Rate of Return is defined as the discount rate that forces the NPV to equal zero. The purpose for analyzing the IRR is to determine if the discount rate that forces the NPV to equal zero is more than the “hurdle rate,” which is common for companies to be their cost of capital, r. For example, if the cost of capital is 10% and a project’s IRR is 15%, then implementing the project would be a beneficial investment to the company. The formula for the five-year IRR is as follows:
Both of these equations are extremely simple to calculate provided in a spreadsheet using standard commands as long as the variables are known. Every company has their own specific Cost of Capital as the formula to calculate it is complex and is associated with the debt and equity position of the company.
For public companies, the Cost of Capital is published, but for privately held companies it would be extremely difficult to determine, so the conservative estimate would be to use a risk-free rate of return which most people consider to be the 10-year Treasury bill. The higher the Cost of Capital, the harder a project is to justify using NPV since the future cash flows are discounted at the higher Cost of Capital rate.
Material Handling Examples
Lean DC, Inc. (Table 1) is at 100% system capacity and 100% workforce productivity and is extremely lean and efficient in its current operations. It is a $100 million company with a budgeted 1% Return on Sales to give it a $1 million net income. It plans on 2% growth each year for the next five years. In order to accommodate the growth, it is investigating either spending $2,250,000 on a new pick module with a conveyor and sortation system or adding 10 employees per year at $25,000 per year in personnel expenses each. Below represents the cash flows used as the basis for the ROI calculations.
1 No cost savings through reduced labor since already lean.
2 Cost avoidance calculated by adding 10 employees per year at $25,000 per employee.
3 Additional net income is calculated by adding 2% to the previous year’s revenues to account for the growth, and then multiply by 1% return on sales for the net income. Subtract the net income from year 0 in order to determine the additional net income that can be realized with the added capacity to match the demand associated with the 2% growth.
In this example, using a cost of capital of 10% (extremely conservative) would yield an NPV of $190,336 and an IRR of 18.17%. Both of which would seem acceptable for project justification since the NPV is a positive number and the IRR is higher than the Cost of Capital.
As a second example, (Table 2) Lean DC Inc.’s competitor down the street, Grow Slow Distributors, LLC, is at 90% system capacity and 100% workforce productivity and therefore has the ability to receive, store, pick and ship more products, but they would need to add more labor in order to do so. They are also a $100 million company with a budgeted 1% Return on Sales to give them a $1million net income. They plan on only 1% growth each year for the next 5 years. In order to accommodate the growth, they are investigating either spending $1,500,000 on a new pick module with a conveyor and sortation system or adding only 5 employees per year at $25,000 per year in personnel expenses each. Table 2 represents the cash flows used as the basis for the ROI calculations.
In this example, the same conservative Cost of Capital of 10% and the above Total Cash Flows would yield an NPV of ($55,047) and an IRR of 8.72%. Both of which would not be acceptable for project justification since the NPV is a negative number and the IRR is lower than the Cost of Capital.
In summary, just as most aspects of doing business have been altered as a result of the economic situation, so have the means for justifying capital projects in a warehouse or distribution center. Continuous improvement is the only option for distributors to stay competitive; consequently, incorporating automated material handling systems at some point is required. So understanding and utilizing new strategies for providing financially-based justification to CFOs and CEOs might provide the necessary advantage to get the project approved and the business properly positioned for profitable growth.
John T. Phelan, Jr., P.E. is chief operating officer of TriFactor, LLC, a material handling systems integrator based in Lakeland, Fla. He can be contacted at 863-577-2243 or [email protected] For more information visit www.trifactor.com.