Exposure to global competition and ambitious market plans calls for adoption of modern advanced techniques in manufacturing.

The rapid pace of change makes the definition of ‘advanced’ manufacturing technologies (AMT) a moving target. When a new AMT is introduced, the shift in technology demands justification for the huge capital investment required. AMT has generally required leadership taking ‘judgment calls’. At every stage, sourcing, assessing and purchasing new technology involve decisions fraught with uncertainty.
 
Given the magnitude of investment and absence of any iron-clad guarantee of the benefits outweighing the costs, most firms prefer to take the short-term ‘wait and watch’ policy. Yet, there is a risk of another firm implementing the new technology and gaining a larger market share. Meanwhile, over time, with ‘maturity’, yesterday’s AMT is today’s conventional manufacturing technology, leaving some firms ahead in the game. AMT brings strategic, qualitative and quantitative benefits in monetary terms. For instance, in manufacturing automation, involving robotics and automated manufacturing systems, some of the benefits are listed below:

Quantitative
Increase in productivity

Reduction in manpower costs

Reduction in operating costs

Reduction in overhead costs

Quantitative
Process improvement

Quality improvement

Operator comfort

Safety improvement
Strategic

Competitive advantage resulting from quick scale-ups of production volumes, meeting delivery schedulesOperator dependence, long term liabilities and industrial relations issuesTechnological ability of the organisation to expand usage of new technology rapidly when it becomes the key driverRisk abetment - mitigating risk of operator costs, availability, quality for the long term

Conventional capital investment justification budgeting techniques assign a zero value to qualitative and strategic benefits. According to Kaplan, there is no reason to value them at zero in a capital expenditure analysis. Zero is after all no less arbitrary than any other number. Conservative accountants who assign zero values to many intangible benefits prefer being precisely wrong to being vaguely right. Managers need not follow their example. Alternative methodologies have been presented earlier by Kaplan, Sinason and others. An insight into an easy to apply practitioner’s technique, based upon three established principles from these earlier studies:

First principle - investment in AMT is justified when the ‘hurdle rate’ (expected benefit of investment) is equal to the cost of investment (financial + running cost)Second principle - the present manufacturing process (without AMT) needs to be valued lower to factor in the currently absent qualitative benefits, when comparing with the future process under evaluation (with AMT)Third principle - the strategic benefits provided in a future process (with AMT) need to be valued higher, when comparing with the present process (without AMT)
The stumbling block while applying the last two principles is the inability to quantify the concepts of ‘valued higher or lower’. The proposed technique overcomes this by using three concepts from behavioural economics.

‘Loss aversion’ means tendency for people to strongly prefer avoiding losses than acquiring gains. Quantification of the money value of a utility is possible when the decision maker views the loss or discount associated with not having the particular utility. For example, looking at a qualitative feature which has no established market value, it is easier for a respondent to estimate the discount needed for a commodity without that feature, rather than to estimate the ‘additional’ (premium) money he is willing to pay for that feature‘Anchoring’, when faced with a situation where an unknown value is to be estimated, people take recourse to initial anchors as benchmark. Assigning an abstract, absolute value is much more difficult and inaccurate than estimating value relative to a benchmark‘Status quo bias’ refers to the preference for individuals to remain at the ‘status quo’, because the disadvantages of leaving it loom larger than the advantages. Bias in judgment arising from pre-established positions should be removed
To demonstrate the practicability of the above technique for quantifying ‘qualitative’ benefits, some experiments were conducted as a pilot testing project. Respondents were manufacturing and purchasing managers, who typically face the task of justification.

To quantify ‘quality’ benefit, two samples were shown, one manually welded part and another robotically welded. As respondents were not being faced with a decision of investment, the negative impact of status quo bias was eliminated. On asking how much lower price would justify their choice in favour of a machine that produces a part of this quality (the manual welded part) than (robotically welded part) quality? Answers varied from 30 per cent to 50 per cent. Some even answered that if they have an alternative of a machine producing good quality, they will not buy a machine producing substandard quality, no matter how much cheaper. These values represent the ‘discount’ for qualitative benefit.A question was asked in regard to quantify ‘predictability’ in quality that how much discount would they need to justify a machine that produces 97 per cent accurate parts, with 3 per cent parts requiring rework or rejection as opposed to that producing 100 per cent accurate parts? The answers varied from 20 per cent to 50 per cent, contrasted with the premium of justification questions, where answers typically focused on ‘cost of rework / rejection’. The question in context to quantify safety was how much discount would they need to justify a machine that is somewhat unsafe, with a possibility of one accident to worker each year? The response was ‘infinite’. Many of them said that they would not accept an unsafe machine, yet with sufficient stimulation and lowering the perceived risk of the accident to a ‘minor’ accident, estimates lay between 30 to 50 per cent. For many manual processes, one or two minor accidents per annum is commonplace. No matter what the ‘qualitative benefit’, it is always possible to pose a question to allow estimating a ‘discount’ for not getting the benefit. The same technique can be adopted for strategic decisions, which are typically done at corporate management levels. The following questions were presented in the form of a premium for a ‘strategic value’.

To quantify competitive advantage the question was how much higher overall capital investment will justify gaining an advantage that they can respond to a change in the market requirement three months before than their competitor? Corporate decision makers attach a high value (10-30 per cent) for first mover advantage. (3-6 months represent the typical difference in retooling, retraining and ramping up production when there is a significant product change between manual setups and flexible automation with robotics.) In today’s competitive world, this advantage can cause a severe impact on the organisation, justifying a double digit percentage of perceived valueSimilarly, to quantify operator dependence the question asked was how much higher overall capital investment will justify having no uncertainty of human work force availability, skills and industrial relations issues
Given the present scenario of increasing cost and attrition issues, corporate decision makers attach a value of over 20-30 per cent to overcome manual process dependence.

The proposed step-by-step approach is:

Apply first principle:
Tabulate costsInvestmentCost of investment (finance cost-per annum)Running costs-per annumCompute the ‘hurdle rate’ = (finance cost + running cost) / investmentTabulate the predicted benefits– quantifiable, qualitative and strategicCompute quantitative benefits in the form of financial benefit. Compute ROI (benefit / investment)If ROI exceeds the ‘hurdle rate’, investment is justified (even with conventional techniques) - no further analysis requiredIf not, move to second step
Apply second principle:
Estimate discount factors, for absence of qualitative benefits. Use discount factors multiplicatively to arrive at cumulative discount factor (thus 10, 15, 6 per cent discounts should be computed as 0.9 x 0.85 x 0.94 = 0.72 resulting in 28 per cent cumulative discount)Discount the AMT investment amount by this discount, and recalculate the hurdle rate. If the ROI is higher than hurdle rate, investment is justifiedIf not, move to third step
Apply third principle:
Perform strategic analysis. It requires the involvement of corporate managementEstimate strategic value, by asking questions as givenDiscount the investment in AMT further by the strategic value premium, and recalculate the hurdle rateIf the benefits are higher than hurdle costs, investment is justified
Words of advice
Whether as exporters or in competition with imported goods, increasing integration with world markets has one message for Indian firms: wake up to the challenges of a competitive environment and seek strategic investments to improve market stature internationally. The techniques presented allow managers to make a quantitative assessment of the benefits and strategic value of advanced technologies, and take an informed investment decision. By posing challenging questions, managers can evaluate for themselves the true risks of not investing in emerging technology. As Henry Ford succinctly put it, “If you need a machine and don’t buy it, then you pay for it without getting it.” While caution is justified while making large capital investments, the risk of not investing can be ignored no longer!

Source: A&D India

Dated Oct-Nov 2008