UCSD LAMP 2013:Financial Success

Dan Goldzband, CMA• University of California, San

Diego, Extension Division• General Dynamics Global Imaging

Systems, San Diego CA * All opinions expressed are the soley the presenter’s and do not represent

the positions or policies of General Dynamics or the University of California.

Financial Success Overview: Purpose

General: • Provide a useful understanding of the basis of

accounting and finance and how R&D fits into that schema;

• Enable you to communicate more effectively with your company’s financial managers and staff, for your mutual benefit.

Specific: Provide tools to track and analyze your own LAMP project’s performance.

Financial Success Overview: Presentation Outline

• Underlying concepts: finance vs. accounting• Nature and analysis of costs• Projecting project development cost / Using the

Budget & Costing TemplateExercise: Set up Budget & Costing Template

• Evaluating future project or product financial performanceExercises:• Project your team project’s financial performance• Southwest Airlines landing system

Financial Success Overview: Presentation Outline (part 2)

• Evaluating company financial performanceReview Cohu, Inc. financial statementsSelect companies for more rigorous financial statement analysis at 2nd meeting

• R&D case studies:Assignment: R&D case studies to report at 2nd meetingCase Exercise: Gold Peak Electronics (if time permits)

Company Performance Simulation Exercise

I. Underlying Concepts: Finance vs. Accounting

Finance vs. Accounting(dueling definitions)

• Finance: Science of market valuation

• Financial management: Area of management where decisions are based primarily on considerations of value.

• Accounting: Information system used to collect and organize data and provide information regarding an entity’s financial performance and condition.

Finance vs. Accounting(basic work products)

• Accounting: financial statements and various performance analyses derived from them (historical):

Income statementBalance sheetCash flow statement

• Finance: performance projections and valuations (future-oriented):

Cash flow projectionsNPV / Economic value added analysis

II. Nature and Analysis of Costs

II. Cost Definitions -- Part 1• Cost: The amount of resources surrendered

to acquire or create a new resource.• Expense: Amount of resources used or

consumed to deliver goods/services to customers, or carry out the company’s major or central operations (use of either existing assets or new resource)

Note: Costs are recognized as expenses only when they can be matched, either directly or indirectly (i.e., within the same period) against revenues. Only then is the cost resource considered to have been consumed.

Cost Analysis concepts• Cost Object: Anything about which cost data is

collected; the point of reference of cost measurement.• Cost Driver: Any independent factor (variable) that

causes costs to be generated.

Cost Classifications(non-exclusive)

Classification BasisProduct costs vs. period costs Relationship to revenue

generation

Direct vs. indirect Relationship to occurrence of specified activity

Cost behavior: Variable vs. fixed Relationship to volume of activity

Product Costs: accounting treatments according to product

characterTangible product: Product in form of finished goods inventory until actually sold (i.e., reclassified from a cost to an expense)

Examples: Delta Design (Cohu) test handlers, kits and spare parts

GD GIT motors, resolvers and other devices

HP printers

Services: Product in form of service, series of services or other intangible. Cost of providing these services or intangible benefits is expensed as incurred, regardless of how much (or little) revenue results in same period.

Examples: AT&T communication servicesGoogle web-based advertisingSouthwest Airlines transport services

Product Costs: analysisDefinition: Costs pertaining strictly to the creation,

acquisition or generation of the company’s product or services.

Traditional manufacturing model of product costs:

Raw materials+ Direct labor+ Overhead (includes depreciation)

= Product cost

Period CostsDefinition: Costs not related to production activities.

These usually occur as a function of the passage of time, or at least independently of fundamental production or operational activities.

Typical period costs:• Selling costs (advertising, commissions, delivery, support)• General and administrative costs• R&D

Note: What is the fundamental activity of any company?

Product vs. Period Costs (standard P&L format)

Direct vs. Indirect CostsTraditionally applies specifically to product costs

Definitions:• Direct costs: Product costs which can be

related or traced to specific, discrete units of production or services.

• Indirect costs: Product costs which cannot be related or traced to specific, discrete units of production or services, or for which it is impractical to do so.

Direct vs. Indirect Costs(with production as cost driver)

Cost Behavior Patterns• Variable costs: Vary in relation (usually

directly) to the volume of a specific activity/cost driver (usually production or sales)

• Fixed costs: Do not vary directly as a function of same activity. (“Fixed” actually a misnomer—they vary, but not ).

Fixed vs. Variable Costs(contribution margin format P&L)

Specific Cost Classifications

Specific Cost Classifications

Product Costing Tools

• Bill of Materials (BOM)• Routing

Costed Bill of Material

Costed Labor Routing

Key Cost Accounting/Mgt Terms• Standard cost: Pre-determined, per-unit cost for a

component of production or service (material, labor or OH). Used in internal control process as benchmark standard.

• Cost variance: Amount of difference between actual and standard cost.

• Target costing: The process of setting product cost goals at or near start of product development process and designing products to meet those cost goals.

III. Projecting Project Development Cost

Evaluating Financial Performance

Project cost evaluation: • Development cost vs budget• Achieving product target cost

Financial contribution evaluation: • NPV• ROI• Payback

Project Development Costs

Materials and Services:• Materials• Purchased services (consulting)Labor (at burdened rates):• R&D• Overhead

LAMP Project Financial Management Tool:

Budget and Costing Template

• Collect and report project development costs by period

• Project 12 months net income and calculate projected Return on Investment

IV. Evaluating Future Project or Product

Financial Performance

Evaluating Product Financial Performance

• Payback• Return on Investment (ROI)• Net Present Value (NPV, aka Economic

Value Added, or EVA)

Project 1: Sample Assumptions

Investment 750,000

P&L / Cash Flow: $ / unit Qty Ext

Revenue 250 10,000 2,500,000 Variable cost 100 10,000 (1,000,000) Contribution Margin 1,500,000 Fixed Costs (excl Depreciation) (1,000,000) Depreciation (150,000) Op Profit 350,000 Tax @ 35% (122,500) Net Income 227,500 Plus: Depreciation (non-cash expense) 150,000 Annual Cash Flow 377,500

5-year economic life, discount rate: 12%

Timing of Product Financial Evaluations

• At project inception

vs

• Upon project completion

Payback

• Criteria: Time required to recover investment

• Calculation:Investment / annual cash flow

• Scenario 1 Payback:750,000 / 377,500 = 2 years

Return on Investment (ROI)

• Criteria: Financial return

• Calculation:Annual cash flow / Investment

• Project 1 ROI:377,500 / 750,000 = 51%

Net Present Value (NPV)• Criteria: Value added from final product.

• Calculation:Sum of present values of cash flows (negative and positive)

• Project 1 Incremental Value:Investment (750,000)PV of Op C/F’s 1,360,803NPV 610,803

Relative Merits• Payback: Critical to capital

management

• ROI: Ease of understanding and applicable to post-investment performance evaluation

• NPV: Directly addresses fundamental issue of shareholder value

Relative DisadvantagesPayback: Disregards time value of money and

actual value created

ROI: Disregards time value of money and actual value created

NPV: Best used as investment decision rule, not well-suited for post-hoc analysis

Project 2: Sample Assumptions

Investment 1,500,000 P&L / Cash Flow:

$ / unit Qty Ext Revenue 275 10,000 2,750,000 Variable cost 100 10,000 (1,000,000) Contribution Margin 1,750,000 Fixed Costs (excl Depreciation) (1,000,000) Depreciation (150,000) Op Profit 600,000 Tax @ 35% (210,000) Net Income 390,000 Plus: Depreciation (non-cash expense) 150,000 Annual Cash Flow 540,000

7-year economic life, discount rate: 12%

Payback (Project 2)

• Criteria: Time required to recover investment

• Calculation:Investment / Annual cash flow

• Scenario 1 Payback:1,500,000 / 540,000 = 2.78 years

Return on Investment (ROI)(Project 2)

• Criteria: Financial return

• Calculation:Annual cash flow / Investment

• Scenario 1 ROI:540,000 / 1,500,000 = 36%

Net Present Value (NPV)(Project 2)

• Criteria: Value added

• Calculation:Sum of present values of cash flows

• Scenario 1 Incremental Value:Investment (1,500,000)PV of Op C/F’s 2,464,429NPV 964,429

Comparison of Methods and Results

Project 1 Project 2Payback 1.99 yrs 2.78

yrs

ROI 50% 36%

NPV 610,803 964,429

Assignment (right now!)

Project your project’s

• ROI

• Payback

(Suggest you add to final report, refining the estimates as necessary)

Group Exercise

• Read WSJ article: “A Radical Cockpit Upgrade Southwest Fliers Will Feel”

• List every conceivable (and plausible) investment, expenditure or operational change that Southwest will have to make to implement and maintain this system (the negative cash flows in an NPV analysis). Also list any non-obvious possible positive cash flows or benefits.

V. Evaluating Company Financial Performance

Basic Financial Statements• Profit and Loss Statement / Income Statement (presents

economic performance, always 3 years)

• Cash Flow Statement (presents all cash flows, always 3 years)

• Balance Sheet (presents all resources, obligations and aims to arrive at accounting of enterprise value, always 2 years)

The Four Questions

• What is the trend and quality of recent earnings performance?

• What are the trend and drivers of recent operating cash flow performance?

• How has the company been providing for its future, and how is it financing this investment?

• Assess the company’s financial condition and its financial strategy.

Financial Performance

Profitability: Ascertain profitability (net income and other interim income measurements) and trend

Cash Flow: Is the company generating a positive and increasing operating cash flow?

Changes in Components of Performance

• Prepare and review P&L vertical analysis for the 3 years to identify trends and changes in performance drivers

• Identify reasons for changes in operating cash flow.

Investment in the future• R&D (as % of revenues)• Capital expenditures (Cap X) in new

productive assets• Combination of the two, as % of revenues

(combined “plowback ratio”).

Revenue (the fundamental company activity) is the standard basis for performance benchmarking

Financial Strategy & ConditionFour financial activities:

1. Raising capital (from investors)

2. Investing capital3. Returning capital (to investors)

4. Restructuring capital (usually to improve overall cost of capital)

#1, 3 and 4 are the “3 R’s” which indicate a company’s overall financial strategy with respect to its investors

Clues to Financial Strategy & Condition

In C/F statement:• Net financing C/F (positive, negative or

neutral?)• Dividends being paid?• Stock repurchases?• Debt activity (issuances, repayments or both?)

In Balance Sheet:• Change in $ amount of debt or equity• Change in capital structure (debt/equity ratio)