How to increase earnings per share capsim

Simulation Practice Round 1

To get to the data to answer the questions do the following: Dashboard and under Practice Round 1 > click decisions. Launch the web spreadsheet. Click > continue as draft. You don’t have to enter any data just view the data to provide the analysis. View the data under Decisions, Proformas and Reports. My team is the ‘Baldwin” team so only view the data from my team to do the analysis. Just click file exit to exit please do not save. I uploaded some but all supporting files if you need them can be found by going to Dashboard and under Practice Round 1click > Round 0 Reports. I really need this by 9 am EST June 6 2013 If you have any questions, please advise.

Capstone® Debrief Rubric Report

Table of Contents

How to Use This Report ................................................................................................................................ 2

Sample Report ............................................................................................................................................... 3

The Company Rubric ..................................................................................................................................... 4 ROS ............................................................................................................................................................ 4

EPS (Earnings Per Share) ........................................................................................................................... 5

Contribution Margin ................................................................................................................................. 5

Change in Stock Price ................................................................................................................................ 6

Leverage .................................................................................................................................................... 6

Stock Price ................................................................................................................................................. 7

Bond Rating ............................................................................................................................................... 8

Emergency Loans ...................................................................................................................................... 8

Current Ratio ............................................................................................................................................. 9

Inventory Reserves.................................................................................................................................. 10

Plant Purchases Funded .......................................................................................................................... 11

Accounts Receivable ............................................................................................................................... 12

Accounts Payable .................................................................................................................................... 13

Asset Turnover ........................................................................................................................................ 14

Sales to Current Assets ........................................................................................................................... 14

Overall Plant Utilization .......................................................................................................................... 15

Stock Outs (Company level) .................................................................................................................... 15

Bloated Inventories ................................................................................................................................. 16

Overall Actual vs. Potential Demand ...................................................................................................... 16

Cost Leadership ....................................................................................................................................... 16

Product Breadth ...................................................................................................................................... 17

Market Share Overall .............................................................................................................................. 17

Overall Awareness .................................................................................................................................. 18

Overall Accessibility ................................................................................................................................ 18

Overall Design ......................................................................................................................................... 19

Asset Base ............................................................................................................................................... 19

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The Product Rubric ..................................................................................................................................... 19 Positioning .............................................................................................................................................. 19

Age .......................................................................................................................................................... 20

Reliability ................................................................................................................................................. 20

Price Percentile ....................................................................................................................................... 21

Awareness ............................................................................................................................................... 21

Accessibility ............................................................................................................................................. 22

Customer Survey Score ........................................................................................................................... 22

Potential Share/Average Share ............................................................................................................... 23

Actual Share/Potential Share .................................................................................................................. 23

Plant Utilization ....................................................................................................................................... 24

Automation ............................................................................................................................................. 24

Contribution Margin ............................................................................................................................... 24

Days of Inventory .................................................................................................................................... 24

Promotion Budget ................................................................................................................................... 25

Sales Budget ............................................................................................................................................ 25

R&D Utilization ........................................................................................................................................ 25

Overall Product Evaluation ..................................................................................................................... 25

Summary Rubrics ........................................................................................................................................ 26

How to Use This Report

The Capstone® Debrief Rubric Report offers a comprehensive evaluation of a company and its products.

It is prepared as a rubric, with each item in the report scored on a scale of zero to three: • Excellent – 3 points • Satisfactory – 2 points • Poor – 1 point • Trouble – 0 points

There are seven categories ranging from “Margins & Profitability” to individual products. Each line item is discussed below, beginning with how the item was scored.

To make quick use of the report, scan it for zeros. Find the description below to learn why the company earned a zero. We recommend having a Capstone Courier at your disposal as you interpret the results.

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Sample Report

DEBRIEF REPORT 2013 Ferris C42681

COMPANY RUBRIC Points (0..3)

Margins & Profitability Asset Utilization ROS (Profits/Sales) 0 Asset turnover (Sales / Assets) 1 EPS (Earnings Per Share) 0 Sales to Current Assets 1 Contribution Margin 2 Overall plant utilization 2 Change in Stock Price 0 Total (Max 9) 4 Total (Max 12) 2

Ability to raise growth capital Forecasting Leverage 2 Stock outs 2 Stock price 0 Bloated inventories 2 Bond rating 1 Overall Actual vs. Potential Demand 3 Total (Max 9) 3 Total (Max 9) 7

Sound Fiscal Policies Competitive Advantage Emergency loans 3 Cost leadership 0 Leverage 2 Product breadth 3 Current Ratio 3 Market share 2 Inventory reserves 0 Overall Awareness 2 Plant purchases funded 3 Overall Accessibility 2 Accounts Receivable 2 Overall Design 1 Accounts Payable 2 Asset Base 3 Total (Max 21) 15 Total (Max 21) 10

PRODUCT RUBRIC Cake Cedar Cid Coat Cure Ch Cp Cs Overall Primary Segment Trad Low High Pfmn Size 0 Pfmn Size Positioning 1 3 2 2 2 0 1 1 2 Age 3 3 1 3 3 0 2 1 2 Reliability 0 0 0 0 0 0 0 0 0 Price Percentile 0 1 0 0 0 0 0 0 0 Awareness 2 2 3 3 3 0 2 2 2 Accessibility 2 2 0 2 2 0 2 2 2 CustomerSurveyScore 1 0 3 3 3 0 3 1 2 PotentialShare/Avg 1 1 3 3 3 0 0 0 1 ActualShare/Potential 3 2 3 3 2 0 2 2 2 PlantUtilization 3 3 3 2 2 0 0 0 2 Automation 0 0 1 2 2 0 2 2 1 ContributionMargin 0 0 0 0 0 0 0 0 0 Days of Inventory 2 2 2 1 2 0 0 0 1 Promotion Budget 0 0 3 3 3 0 3 3 2 Sales Budget 0 0 3 3 3 0 2 2 2 R&D Utilization 0 0 0 0 0 0 0 0 0 Total (Max 48) 18 19 27 30 30 0 19 16 21

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The Company Rubric

ROS Return on Sales (Profit/Sales) answers the question, “How much of every sales dollar did we keep as profit?”

Excellent ROS > 8% Satisfactory 4% < ROS <=8% Poor 0% < ROS <= 4% Trouble ROS <= 0%

Between 0% and 4%, while the company is at least making a profit, it is not bringing in sufficient new equity to fund growth. The industry is growing at about 15% per year. The industry consumes about 15% more capacity each year, which arrives in the form of plant expansions and new products. Therefore, as the simulation begins, an average company would add about $12 million in new plant each year. If half that or $6 million was funded with bonds, an average company would need about $6 million in new equity. Therefore, if the company does not have the profits, it must either issue $6 million in new stock, or $12 million in bonds, or not grow to keep up with demand. Worse, if it has no profits, its stock price falls, making it difficult to raise equity through stock issues.

This ignores investments in automation, which also require a funding mix of equity and debt.

In the opening round of Capstone® companies have an excess of assets, and that can convert idle assets into productive ones. Therefore, do not worry too much if the company’s profits are low. But after year 3, expect that idle asset cushion to be gone. Profits become critical because those companies with profits can grow, and those without cannot.

What if profits are negative? The company is destroying equity. Its stock price has plummeted, making it more difficult to raise equity. All of the problems described above are now accelerated. In short, trouble.

How can companies improve ROS? Here are a few questions to pose.

1. Can you raise prices? 2. Can you reduce your labor costs? Your material costs? 3. Can you forecast sales better and thereby reduce your inventory carrying expenses? 4. Have you pushed your promotion or sales budgets into diminishing returns? 5. Can you sell idle plant to reduce depreciation? Alternatively, can you convert idle plant into

some other productive asset, like automation or new products? 6. Is your leverage too high, resulting in high interest expenses. (See leverage.)

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EPS (Earnings Per Share) EPS (profits/shares outstanding) answers the question, “What profits did each share earn?” EPS is a driver of stock price, and stock issues are an important source of growth capital.

Excellent EPS > $2 + Round # Satisfactory ($2 + Round #)/3 < EPS <= $2 + Round # Poor $0.00 < EPS < ($2 + Round #)/3 Trouble EPS <= $0.00

In the table, “Round #” refers to the year in the Capstone®. Round 1 is year 1, round 2 is year 2. The market is growing, and so should profits. In Round 5, for example, an excellent EPS would be ($2 + $5) = $7.00 per share, and a satisfactory EPS would be at least 1/3 that or $2.33.

EPS is important for three reasons. First, profits bring new equity into the company. Second, EPS drives stock price, and the company can issue shares to bring in new equity. Third, any new equity can be leveraged with new debt.

An example may help. Suppose the company wants to invest $15 million in new plant and equipment each year for the next three years. If its profits are zero and it issues no stock, the purchases would need to be funded entirely with bonds. But this would drive up interest expense, and worse, eventually the company would reach a ceiling where bond holders would give it no additional debt. The company would stop growing.

In the end, a company’s growth is built upon equity. If it has equity, it can get debt, too.

How can companies improve EPS? Improve sales volume while maintaining margins. EPS is closely linked with the Asset Utilization and Competitive Advantage categories.

Contribution Margin Contribution margin is what is left over after variable costs. Variable costs include the cost of goods (material and labor) and inventory carrying expense.

The biggest expense is the cost of goods. If the contribution margin is 30%, then out of every sales dollar, $0.70 paid for inventory and $0.30 is available for everything else, including profits.

Excellent Contribution Margin > 35% Satisfactory Contribution Margin > 27% Poor Contribution Margin > 22% Trouble Contribution Margin < 22%

Fixed costs are those expenses that will be paid regardless of sales. They include promotion, sales budget, R&D, admin, and interest expenses.

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As the contribution margin falls below 30%, it becomes increasingly difficult to cover fixed costs.

How can a company improve its contribution margin? Guard price and attack material and labor expenses.

Change in Stock Price The change in stock price from one year to the next is an indicator for the long term growth potential of the company.

Excellent > $20.00 Satisfactory > $7.00 Poor > - $5.00 Trouble < - $5.00

If the stock price is increasing, the company will enjoy easier access to new equity via profits and stock issues, which in turn can be leveraged with additional bonds, and the combined capital can fund plant improvements and new products.

If the stock price is falling, it becomes increasingly difficult to obtain new investment capital, either equity or debt. Eventually the company’s ability to make improvements comes to a halt.

Leverage In Capstone® Leverage is defined as Assets/Equity. (It is sometimes defined as Debt/Equity, but in either case, Leverage is addressing the question, “How much of the company assets are funded with debt?”) The higher the Assets/Equity ratio, the more debt is in the mix.

Using Assets/Equity, a Leverage of 2.0 means half the assets are financed with debt and half with equity. Read it as, “There are $2 of assets for every $1 of equity.” A leverage of 3 reads as, “There are $3 of assets for every $1 of equity.”

Excellent 1.8 < Leverage < 2.5 Satisfactory 1.6 < Leverage <1.8 , or 2.5 < Leverage < 2.8 Poor 1.4 < Leverage <1.6, or 2.8 < Leverage < 3.2 Trouble Leverage < 1.4, or Leverage > 3.2

It is easy to see why too much Leverage can cause problems. As debt increases, loans become more expensive. The company becomes high risk, and lenders eventually decline to lend the company money.

On the other hand, companies with a competitive advantage usually have a larger asset base than their competitors. For example, a broad product line implies a larger plant. A highly automated facility implies a large investment. Growing the company’s asset base quickly calls for prudent use of debt.

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Here is an example. Suppose Andrews has assets of $100 million, and Baldwin $125 million. Assume that each team is utilizing their assets productively. An observer will bet on Baldwin because its larger asset base translates into more products or more productivity. Now suppose that Andrews is leveraged at 2.0, and Baldwin at 2.5. If so, they both have $50 million in equity. By leveraging its equity, Baldwin gained an advantage.

Too little leverage can also indicate weakness, provided that investment opportunities exist. Think of it this way. When a company retires debt, it is saying to stockholders, “We are out of ideas for investments. The best we can come up with is to save you the interest on debt.” This will not impress stockholders, who are looking for a high return on their equity (ROE). An investor expecting a 20% ROE will be unhappy learning that their money was used to reduce debt at 10%.

ROS * Asset Turnover *Leverage = Price/Sales * Sales/Assets * Assets/ Equity = ROE. If the company can somehow hold its margins and productivity constant, increasing leverage improves ROE.

If leverage is falling, here are some things to suggest to the company.

1. Decide upon a policy towards leverage. For example, “Our leverage will be 2.5.” Adjust your leverage before saving your decisions. (Issue/retire debt, issue/retire stock, pay dividends.)

2. Find investment opportunities. For example, if the market is still growing, and you are already at a high plant utilization, you will need to add some capacity each year. Or perhaps you can add a new product. Fund these investment opportunities with a mix of debt and equity consistent with your policy.

3. In the latter rounds of Capstone® you are likely to become a “cash cow”. You discover that you have excess working capital that cannot be put to good use. In the real world management might get into new businesses, but in Capstone® there are no such alternatives. In this case, make your stockholders happy by buying back stock or paying dividends to maintain the leverage.

Stock Price Stock price is a function of book value, EPS and the number of shares outstanding. Book value sets a floor, although negative earnings can depress stock price below book. Stock price can also be negatively impacted by emergency loans. In the absence of losses and emergency loans, Capstone’s stock price is primarily a function of past and present EPS.

Excellent Stock price > $40 + 5 * Round number Satisfactory Stock price > $25 + 5 * Round number Poor Stock price > $10 + 5 * Round number Trouble Stock price < $10 + 5 * Round number

In the table, “Round Number” refers to the year in the Capstone®. Round 1 is year 1, round 2 is year 2. The market is growing, and so should profits. As time passes and EPS increases, we should expect stock price to increase.

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Stock price is important because, ultimately, equity drives the company’s ability to raise capital for growth. Even if it never issues a share, a rising stock price means it is accumulating profits as retained earnings. More equity means that it can raise additional debt, and together its mix of debt and equity fuels the company’s growth.

Also see the discussion for EPS and Leverage.

Bond Rating The bond ratings are, from best to worst, AAA, AA, A, BBB, BB, B, CCC, CC, C, DDD. Bond ratings are driven by leverage. As bond ratings fall, interest rates climb on both short term and long term debt.

As the bond rating decays, bond holders become reluctant to give the company additional debt. This sets a limit on the company’s ability to acquire additional assets, particularly automation, capacity, and new products.

Since leverage is a function of equity, the bond rating is in some sense derived from equity. Companies can improve their bond rating by adding equity, either as a stock issue or as profits. The more equity they have, the more debt they can raise, and the bigger their asset base.

Alternatively, companies can improve their bond rating by reducing debt. However, reducing debt also implies shrinking the asset base. While there are always exceptions to the rule, shrinking the asset base in a growing market would be limiting to growth.

Excellent AAA, AA, A Satisfactory BBB, BB, B Poor CCC, CC, C Trouble DDD

Emergency Loans If a company is out of cash on December 31st, a character in the simulation, Big Al, arrives to give it just enough money to bring its cash balance to zero. The company pays Big Al its short term interest rate plus a 7.5% premium. Stock price also falls – how much depending upon the severity of the loan.

Excellent No emergency loan Satisfactory Emergency loan less than $1 million Poor Emergency loan less than $8 million Trouble Emergency loan greater than $8 million

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The great majority of emergency loans are rooted in three mistakes.

1. The company purchased a plant, but did not fund it adequately. 2. The company forecasted too much demand, and when it did not materialize, its inventory

expansion exceeded reserves. 3. The company neglected to fund your current assets adequately, usually because it brought its

current debt to zero.

You can also direct students to the online Team Member Guide, and the Analyst Report, where emergency loans are also discussed at some length.

While painful, an emergency loan that purchased assets is not destructive so long as the assets are useful. After all, the company could have and should have funded the assets with cheaper debt. It now has an asset at its disposal, even though it overpaid for it.

However, there is another cause of emergency loans – sustained negative profits. The company is, well, a zombie, kept in motion by transfusions from the deep pockets of Big Al. The only advice we can offer here is, intervene before the company joins the walking dead. If profits are negative two years in row, intervene to improve margins and reverse the trend.

Current Ratio Current Ratio is defined as Current Assets/Current Liabilities, which in turn is (Cash + A/R + Inventory) / (A/P + Current Debt). From a banker and vendor’s point of view, it answers the question, “How likely am I to get my money back?”

Excellent 1.8 < Current Ratio <= 2.2 Satisfactory 1.6 < Current Ratio <=1.8, or 2.2 < Current Ratio <= 2.4 Poor 1.3 < Current Ratio <=1.4, or 2.4 < Current Ratio <= 2.7 Trouble Current Ratio < 1.3, or Current Ratio > 2.7

Like any asset, current assets are paid for with a mix of debt and equity. The debt is Accounts Payable and Current Debt, which we can think of as “short term funding”. The balance is “long term funding”, and it is probably equity, but it could be long term debt. More precisely this long term funding is Working Capital, which is defined as Current Assets – Current Liabilities.

What should the Current Ratio be? While that is a policy decision, we suggest starting with the debt/equity mix of the entire company. If the mix is 50/50 overall, why would the company have a different policy for Current Assets? If Current Assets are funded half with Current Liabilities and half with equity, then the Current Ratio is 2.0.

Where does trouble begin? A Current Ratio of 1.0 says that Current Assets are funded entirely with Current Liabilities. Bankers and Vendors are very worried, and are likely to withhold additional funding. They do not begin to relax until the ratio reaches 1.3, which in effect says for every $1.30 of current assets they fund $1.00. By 1.6 they remain watchful but are less concerned, and at 1.8 they are happy to lend money or offer credit.

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However, trouble exists at the high side, too. A Current Ratio of 3.0 says that the company has $3.00 of assets for every $1.00 of debt, and therefore $2.00 of current assets are being funded with long term money. But if long term money is tied up with current assets, it cannot be used to fund long term assets – capacity, automation, and new products.

Consider a stockholder. The stockholder knows that he/she gets no return on current assets. Stockholders make no return on Cash, on Accounts Receivable, or on inventory. In some sense they are necessary evils. Stockholders recognize the necessity of current assets, but if they expect a 20% return on their investment, they would rather the company borrow money from a bank at 10% so their money can be invested in wealth producing assets – capacity, automation, and new products. A stockholder wants to see a low Current Ratio, while vendors want to see a high Current Ratio.

It follows from this reasoning that paying current debt to $0 is a mistake. The question companies must answer is, “How much current debt should be in the mix?”

In the real world, bankers will typically fund up to 75% of Accounts Receivable and 50% of inventory. Using this as a rule of thumb, here is a quick method to arrive at Current Debt before a company saves decisions.

1. Drive the proforma financial statements into a “worst case scenario”. In the worst case, the pessimistic unit sales forecast is put into the Marketing worksheet, and the best case unit sales forecast into the Production schedule. In the worst case, the proforma balance sheet ‘s inventory is at a maximum.

2. Looking at the proforma balance sheet, calculate 50% of the inventory and 75% of the Receivables.

3. On the Finance sheet, enter the result as Current Debt for next year.

Companies will discover that if its policy towards A/R is 30 days, its policy towards inventory is 90 days, and it has $1 of cash, then a policy of A/P at 30 days, and current debt at 75% of A/R and 50% of inventory, will give it a Current Ratio of about 2.0.

Inventory Reserves Inventory expansions are the number one cause of emergency loans. This can be further broken down into two root causes – forecasting, and inadequate inventory reserves.

By inventory reserves we mean, “How much inventory are we willing to accumulate during the year in our worst case?” We express this as “days of inventory.”

Suppose the gross margin is 30%. If so, then the cost of inventory consumes 70% of every sales dollar. If sales are $100 million, over the course of a year the company spends $70 million on inventory. In one day it spends $191 thousand. In 30 days it spends $5.7 million. In 90 days $17.3 million.

We are interested in how many days of inventory the company planned to be able to absorb, because if inventory expanded beyond this, it would see Big Al for an emergency loan.

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Excellent 75 to 105 days of inventory Satisfactory 55 to 75 days, or 105 to 135 days of inventory Poor 30 to 55 days, or 135 to 160 days of inventory Trouble Below 30 days or more than 160 days of inventory

To find inventory reserves we determine cash and inventory positions on January 2nd, after all the dust has settled from borrowing, stock issues, bond issues, debt retirement, etc.

Inventory reserves in days = ((Starting Cash + Starting Inventory)/COG) * 365. For example, if starting cash and inventory totaled 30 million on January 2nd, and annual cost of goods is expected to be $120 million, then days of inventory was $30/$120 * 365 or 91 days.

If the company sells its entire inventory, it converts it all to cash. The more inventory accumulated, the more that cash is crystallized as inventory. Eventually the company runs out of cash and turns to Big Al to pay for the inventory that has accumulated in the warehouse.

Companies can develop an inventory reserves policy by considering their worst case forecast for sales. If the inventory policy is 90 days, they can plan the production schedule so that they will have (1 + 90/365) = 125% of their worst case forecast, including any starting inventory.

Companies cannot predict what competitors will do in detail. Therefore, companies plan for the worst and hope for the best.

Trouble is highly likely to occur when inventory reserves are less than 30 days. The company may get away with it, but that requires both precise forecasting and predictable competitors or, more likely, lots of luck.

Trouble appears in a different form when inventory reserves exceed 160 days. Now the company has idle assets, which should either have been put to work or given back to the stockholders.

Plant Purchases Funded Failure to fully fund plant purchase is the number two cause of emergency loans. The error occurs because companies often count on profits or perhaps inventory reductions that do not materialize.

Excellent Fully funded Satisfactory Funding shortfall is within $4 million Poor Funding shortfall is within $8 million Trouble Funding shortfall is greater than $8 million

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Funding sources include:

1. Depreciation 2. Stock issue 3. Bond issues 4. Excess current assets

Depreciation often confuses students. While we do pay cash for expenses like promotion or inventory, we never actually pay cash for depreciation. And yet governments allow businesses to deduct depreciation as an expense, thereby reducing profits and taxes. Why?

Governments want businesses to continue to pay taxes, and they agree that equipment wears out and must be replaced. The purpose of depreciation is to set aside a guaranteed cash flow that can be used for the purchase of new plant and equipment. Teams can successfully argue that cash from depreciation is a valid source of funding.

Stock and bond issues raise long term funds for any investment in the company.

Excess current assets can be defined as “anything greater than the current assets required to operate in our worst case scenario”. For our purposes, we assume that teams need a minimum of 90 days of inventory, 30 days of accounts receivable, and $1 of cash. Of course, teams might want to have deeper reserves, but in applying the rubric to Plant Purchases, we allow companies to apply anything above this minimum to plant purchases. We use the January 1st balance sheet (same as the December 31st balance sheet from last year’s reports) to discover starting current assets.

If the sum of the company’s funding sources is greater than its plant purchases, the company fully funded the purchase. If the shortfall is less than $4 million, it is plausible that its intention was to reduce the current asset base by $4 million. If the funding shortfall is $8 million, it is conceivable albeit unlikely that the shortfall was planned. Anything more than $8 million is cutting deeply into current assets, and will likely result in an emergency loan.

Accounts Receivable The accounts receivable policy affects both demand and the balance sheet. Companies express the policy in days. A 30 day policy means that accounts receivable will be 30/365 * Sales.

Excellent 45 to 60 days Satisfactory 30 to 45 days, or 60 to 75 days Poor 20 to 30 days, or 75 to 90 days Trouble Less than 20 days or more than 90 days

On the balance sheet, if a company expands A/R policy from 30 days to 60 days, it doubles A/R. In effect it gives a loan to customers, and in the process it incurs the additional expense of carrying that loan. For

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example, if accounts receivable expanded from $10 million to $20 million, and the company funded the expansion with short term debt at 10%, it would incur an additional $1.0 million in interest expense.

On the other hand, demand would increase by about 5% from $120 million to $126 million, while fixed costs would remain the same. Profits would increase by about $0.8 million after paying the additional $1 million in interest expense. And, of course, the additional $6 million in sales came out of competitors.

But there is a risk. It is trivial for competitors to copy A/R policies, and if that happens, the increase in demand is neutralized while everyone absorbs the additional $1.0 million in interest expense. The question then is, “Will competitors realize we have expanded our credit terms? All of them?”

Beyond 60 days, the incremental cost in interest exceeds the incremental gain in demand.

As companies shorten A/R policy, they effectively reduce the loan they have made to customers. Cash goes up, interest expense falls. However, customers want credit terms. If the company demands cash payment, demand falls to 65% of its potential.

These relationships are easily explored with the company’s Marketing worksheet. As they vary the A/R policy, they should watch the computer’s demand forecast.

Accounts Payable Accounts payable policy affects both parts deliveries and the balance sheet. Companies express the policy in days. A 30 day policy means that it pays vendors 30 days after it receives a bill.

Excellent 0 to 15 days Satisfactory 15 to 30 days Poor 30 to 45 days Trouble Over 45 days

On the balance sheet, if companies expand A/P policy from 30 to 60 days, it doubles A/P. In effect it extracts a loan from vendors on which its pay no interest. If payables expand from $10 million to $20 million, that means that it could borrow $10 million less from its banker, and if interest rates are 10%, it saves $1 million in interest expense.

However, vendors want to be paid. If they are not paid, they begin withholding parts deliveries. At 60 days, parts deliveries fall 8%. The company pays for the workforce, but it gets 8% less inventory to sell. In Round 1 this translates to about $2.35 million in wasted labor expense, and potentially missed sales from stockouts.

A policy between 0 and 15 days improves production about 2%. This translates to about 84 thousand units that the company in Round 1 that the company would not have had before. In effect, the labor cost on these units is free, a savings of $700 thousand, plus the contribution margin on these units, another $800 thousand.

These relationships are easily explored with the Production worksheet. As the company varies A/P policy, watch the impact upon total Production After Adjustments.

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Asset Turnover Asset Turnover or Sales/Assets answers the question, “For every dollar of assets, how many sales dollars do we generate?” We would like to generate as many sales dollars as possible.

Excellent ATO > 1.3 Satisfactory 1.0 < ATO <=1.3 Poor 0.8 < ATO <= 1.0 Trouble ATO <= 0.8

In Capstone®, 1.0 to 1.3 (that is, $1.00 to $1.30 of sales for every dollar of assets) is considered satisfactory. Anything over 1.3 is excellent. Between 0.8 and 1.0, chances are the company has idle assets.

Consider its starting Traditional product (Able, Baker, Cake, Daze, Eat, or Fast). In Round 0 it could produce 1.8 million units on first shift, yet demand was only 1.0 million units. Almost half the plant was idle. Its Sales/Assets ratio was depressed, dragging down the entire company’s Asset Turnover.

Below 0.8 the company is in trouble. Either sales are depressed, or the assets are unproductive, or both.

What can companies do to improve Asset Turnover? Fundamentally a company needs to increase demand or reduce the asset base. Many of the other items in the rubric drill down into these issues. Consider these questions:

1. Is the plant utilization on any product below 130%? (See plant utilization.) 2. Can the company make its products more competitive? (See Design, Awareness, Accessibility). 3. Are its current assets appropriate for its sales base? (See Sales to Current Assets).

Excellent Asset Turnover >1.3 Satisfactory 1.0 < Asset Turnover < 1.3 Poor 0.8 < Asset Turnover < 1.0 Trouble Asset Turnover < 0.8

Sales to Current Assets This ratio asks the question, “Given our sales base, do we have adequate current assets to operate the company?” Current assets are comprised of Cash, Accounts Receivable and Inventory. In the worst case scenario, cash has dwindled to $1 as inventory expanded. The accounts receivable policy (for example, 30 day terms) is a direct function of Sales.

Given the A/R policy in days, inventory policy in days, and sales, it is easy to calculate whether a company has adequate Current Assets to operate the company. For example, suppose the company projects worst case sales to be $120 million, sets A/R policy to 30 days, and is willing to carry 90 days of inventory. If its gross margin is 30%, then it will spend 70% * $120 million on inventory during the year,

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or $84 million, and a 90 day inventory policy translates to 90/365*$84 = $21 million. Accounts Receivable will be 30/365*$120 million = $10 million. In the worst case the company will have only $1 in cash. Current Assets = $1 + $10 million + $21 million = $31 Million. Sales/Current Assets = 3.8

Excellent 3.5 < Sales/Current Assets <4.5 Satisfactory 3.0 to 3.5, or 4.5 to 5.0 Poor 2.5 to 3.0, or 5.0 to 5.5 Trouble Sales/Current Assets < 2.5, or > 5.5

Too low a ratio risks a visit from Big Al. Too high a ratio indicates idle current assets which should either be put to work or given back to shareholders as a dividend or stock repurchase.

Overall Plant Utilization Overall Plant Utilization asks the question, “Are we working our plant hard?” It is calculated as Total Production / Total Capacity.

Excellent Plant Utilization > 1.7 Satisfactory Plant Utilization > 1.3 Poor Plant Utilization > 0.9 Trouble Plant Utilization < 0.9

It is easy to demonstrate that second shift is nearly always more profitable than first shift. This often surprises students who look at the 50% second shift wage premium and assume that second shift must be something to avoid. But suppose we only run one shift – by necessity it must pay all of the fixed costs – depreciation, R&D, Promotion, Sales Budget, Admin, and Interest. Anything on second shift only pays for the 50% premium on labor.

It follows that we want to run as much second shift as possible. In a perfect world, we would run two shifts, our best case demand forecast would come true, and we would have only one unit of inventory left at the end of the year. On the other hand, if we max out second shift, there is a good chance we could stock out, and stock outs are very costly. Therefore, 170% plant utilization or more is considered excellent and 130% satisfactory.

Stock Outs (Company level) Stock outs are HUGELY expensive. Consider a typical stock out. Demand is 500 thousand. The company stocks out at 400 thousand. The price is $30, and the unit cost is $21. Consider – the 400 thousand that were sold must have paid for all of the fixed costs – depreciation, R&D, Promotion, Sales Budget, Admin, and Interest. Therefore, the missed units would have only have paid for their cost of goods, contributing $900 thousand towards profit, been taxed at 35%, resulting in a $585 thousand net profit.

At the company level, we are interested in how many of the company’s products stocked out. (At the product level below, we will examine the individual stock out.) Chronic stock outs suggest problems with forecasting.

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Excellent No product stocked out Satisfactory 1 product stocked out Poor 2 products stocked out Trouble 3 or more products stocked out

Bloated Inventories We define a bloated inventory as any product that has more than 4 months of sales sitting in the warehouse.

While it is not uncommon to be taken by surprise by a competitor on a single product (perhaps a new product was introduced), if inventories are bloated across several products, the company is having difficulty forecasting demand.

Excellent No product had a bloated inventory Satisfactory 1 or 2 products with bloated inventories Poor 3 or 4 products with bloated inventories Trouble 5 or more products with bloated inventories

Overall Actual vs. Potential Demand The company worked hard to create the demand, but did it meet it?