Understanding Producer Value

An economic model for justifying equipment asset management and utilization

In today's process and manufacturing environment, intense pressures to reduce expenses, tighter restrictions, and declining resources necessitate new methods to identify opportunities, prioritize and align activities, and measure results. With a comprehensive model, maintenance, or more broadly equipment lifetime optimization, is a prime candidate to simultaneously increase reliability, effectiveness, and corporate profitability.

Technology and practice have developed to a level capable of recognizing most equipment defects in time to prevent failures and minimize unscheduled interruptions in production. However, the measures of effectiveness have tended to remain subjective and intangible: Does equipment operate when needed, are production interruptions and catastrophic failures few and far between, are problems corrected promptly, are operations managers happy?

The concepts of avoided costs and saves, frequently cited as measures to justify advanced equipment management technology and practices, are largely intangible and disconnected from business and financial results. What is the profit impact of a failure that does not occur? More sophisticated companies have gained inter-departmental agreement for an average cost of avoided failures and maintenance actions. While this adds some objectivity, it does not answer the basic question.

There is another challenge. After years of success, the cost of equipment maintenance will stabilize at a lower level. At that point, some managers assume that all of the cost reductions have been harvested, and now the program responsible for these results can itself be harvested by reducing personnel and funding. Can this be true? Are production gains and cost reductions from enlightened equipment management practices permanent, or are sustaining efforts required? This is a very difficult question to answer without measures of performance linked directly to enterprise profitability.

Overall performance measures that combine availability, production output, and lifetime cost are necessary for prioritizing resources and assessing the effectiveness of optimizing efforts. Measures must originate from market conditions and business objectives, point to opportunities for increased profitability, and lead to optimized decisions and greatest value. They must be equally applicable for an entire producer unit as well as individual components.

Several overall performance measures are in use. Maintenance cost as a percentage of replacement asset value (RAV) is often used in benchmarking and as a performance indicator. However, this metric does not consider operating intensity and age of equipment, both of which affect the need for maintenance and its cost. Overall equipment effectiveness (OEE), associated with total productive maintenance (TPM), is another often-used measure of performance. It measures normalized availability, output, and quality, but it does not consider the cost to attain these results.

Asset management
It is clear that a change in mindset is needed. Asset management is being loosely used to describe a more global, enterprise view of equipment optimization. It is directed to increasing the worth, financial return, and value generated by assetsproduction equipment in a manufacturing, process, or production facility. This definition leads to a primary objective of asset management: Managing the means of production (equipment assets) to gain greatest lifetime value.

Does this mean increasing availabilitythe ability to produce more product? Yes. Increasing yield and quality, producing higher margin products? Yes. How about reduced costs? Again, yes. Some call this concept asset utilization. Whatever the name, it is very important to recognize that increased availability, yield, and quality and reducing costs are results rather than actions.

With this perspective, it is clear that sights must be elevated above maintenance costs to all factors that influence the creation of lifetime value. Cost reductions are counterproductive if they lead to diminished financial return through some combination of decreased production availability, output, yield, and quality.

To differentiate efforts for effectively managing producer assets from those of a Realtor, transportation manager, or portfolio manager, more specific terminology is appropriateterminology that defines applicability, a process, objectives, and measures of performance all aligned to gain maximum value from the means of production. The name coined for this discussion is Equipment Lifetime Management.

Equipment lifetime management
Equipment lifetime management (ELM) begins with the recognition that financial measures are the fundamental measures of enterprise success and the specific contribution of processes and programs. ELM extends beyond maintenance to include all factors that determine and influence lifetime cost of ownership. Proper design, installation, and operation are vital elements toward effective ELM and will reduce costs. A recent article asserts that 60 percent of lifetime maintenance costs are expended on preventable problems caused by faulty design, installation, operation, and maintenance practices. Several reports have stated that facilities that work toward highest reliability also enjoy lowest lifetime costs. The two are inseparable.

A clear and credible connection between lifetime cost and profitability must be established for producer equipment assets. Economic Value Added (EVA)* appears to be a better measure of the value creation process than return on investment (ROI). In terms of evaluating the performance of specific functions, EVA appears to be a far better statement of contribution to organization and business objectives than cost-based measures such as maintenance cost as a percentage of RAV.

Success begins with a change in mindset from reducing cost to gaining maximum value and profitability from production and manufacturing equipment. A Producer Value Model (PVM) to measure progress along this path is proposed and explored in the following discussion.

The opportunity
Many members of the maintenance and reliability community have viewed reliability improvements and technology advances such as precision shaft alignment and predictive condition monitoring as ends in themselves. This view, based on technical considerations, may have had merit in the past.

But times are changing. Staff is being reduced. Criteria for success are dominated by bottom line financial results. Without demonstrable financial justification, investments to improve practice and reliability, as well as investments for advanced technology to improve condition assessment and life prediction, have diminishing chances for approval. In the equipment world, engineering judgment is rapidly being replaced by the burden of financial proof. Show me the money has become substantially larger than a catchy line from a popular movie.

Profit center mentality
This argument leads to another concept: the advantages of shifting from a cost-centered to a profit-centered mindset as an essential ingredient of managing equipment for greatest lifetime value. A cost center contains no systemic incentives to optimize. If anything there are institutionalized disincentives to optimize a cost center. Everyone knows the reward for finishing a year under budget. Pressure to reduce costs orients people toward protecting their own tasks rather than toward overall results. A profit center mentality promotes initiative, agility, optimization, and ownership. Investments and added costs are evaluated from the standpoint of results and return. The profit center mentality is clearly superior in a complex manufacturing or process environment.

Many have based justification for improved equipment management technology and practice on ROI. Reported ROI of 7 to 10 for predictive maintenance and other advanced equipment practices is not unusual. The reported average is somewhere around 4 to 5. However, there is a problem. Many companies reporting a high ROI from advanced practices have not observed a corresponding improvement in bottom line financial performance. Some have made this comparison with companies in the same industry they know are not spending an equivalent amount for improved equipment management technology and practice.

Performance gap
Why is there a difference between expectations, common measures, and bottom line results? There are several reasons:

  • Conventional ROI calculations for improved equipment technology and practice typically do not account for market and business conditions. Changes in either or both can have a significant impact on the resulting value.
  • In general, there is no way of linking results to assumptions. Did a given investment produce the expected results and if not, why not? Most enterprises track budgeted versus actual expense for large projects. Very few have the information, tracking, and accounting structure to accurately determine the profit/cost impact of incremental changes such as precision shaft alignment.
  • The best practitioners of equipment management are passionate, often overoptimistic, and may be totally consumed by technical results with little appreciation of, or even interest in, the profit impact of their work. In times past optimistic expectations and subjective benefits were sufficient. This is no longer true. Show me the money is now the way the game is scored.

There is a major requirement for accurate, traceable information, such as mean time between failure (MTBF), or an equivalent, for each individual piece of equipment. The exact reason for a failure, all components involved, and the cost in terms of both operations and restoration are all imperative information that must be sortable by manufacturer, model, component, cause, and other criteria to detect patterns. If improvements are made in materials or alignment practice, there must be a way to match results with expectations. If the two do not agree, information must be available to determine why.

An effective financial model for equipment optimization must include the ability to prioritize the application of resources by financial return within an environment where opportunities far exceed resources. The model must be capable of comparing actual results to expectations, especially when changes and results occur over a considerable period of time. As an example, the full results of a systematic program of root cause failure analysis (RCFA) and defect elimination may not be seen for several years.

The author fully recognizes that many of the concepts presented require a great deal of testing and refinement. The central theme, that any investment for improvements in equipment reliability, practice, and technology must be traceable to bottom line financial performance, is indisputable.

Selecting a financial measure of performance
A financial measure of performance that demonstrates the value of equipment effectiveness must have three attributes:

  • It must be credible to business and financial executives who may have little or no appreciation for the potential contribution of optimizing equipment management technology and practice toward the creation of enterprise value.
  • It must accurately represent the value of increased equipment effectiveness and utilization, taking into account market opportunities for increased production and/or quality and conditions, product margins, and manufacturing performance.
  • It must be an impartial arbiter that indisputably demonstrates the necessity for, priority, and enterprise profit impact of investment to eliminate defects.

Ideally, the financial measure or measures must apply top to bottom within an enterprise. The measure utilized by a senior executive focused on shareholder value must be consistent with and linked to measures utilized by line management, engineers, process operators, craft, and support personnel.

Economic value added
Economic Value Added (EVA) was selected as the representative financial measure to demonstrate the value of equipment effectiveness for three principal reasons:

  • EVA is gaining acceptance as a financial measure of value, changes in value, and performance. EVA promotes ownership and the profit-centered mentality mentioned earlier. It has been stated that EVA is a better indication of value than conventional measures, even cash flow, and strips away many of the standard accounting procedures that may distort and disguise real value and changes in value.
  • EVA will be credible to the business and financial executives that control investment for increasing equipment effectiveness.
  • The information needed to calculate EVA permits calculating other measures, such as return on net assets (RONA) and return on capital employed (ROCE).

It is suggested that value models be constructed for the smallest identifiable producers within an enterprise. Producer is defined as an entity for which the cost of materials and price of finished goods can be calculated. Each unit in a multi-unit power station, chemical plant, or oil refinery is an example. Others include one paper machine in a multi-machine mill and each line in a manufacturing facility. In many cases the output from one unit is the input to another. Under these conditions, the calculation of transfer prices is all-important to assure an accurate, representative picture of value creation.

flow-chartThe producer value model
The accompanying flow chart identifies elements of the proposed producer value model (PVM) and their relationships. Blocks in the lower tier of the chart represent various functional areas. The middle tier illustrates OEE concepts and illustrates how OEE links to sales revenue.

The top tier builds a simplified calculation of EVA, which essentially is after tax operating profit less the cost of capital. The top tier illustrates after tax operating profit consisting of revenue from sales of finished goods minus the cost of raw materials, conversion costs, and taxes, equals after tax operating profit. After tax operating profit, minus the cost of capital calculated from net assets multiplied by an interest rate, produces EVA. The larger the value of EVA, the more value being created. A negative EVA indicates declining value. In a recent presentation, it was stated that a major multinational corporation requires a measure equivalent to EVA greater than 20 percent in good years and no less than 0 in bad years.

Production yield and conversion costs are the links between conventional measures of equipment effectiveness and financial results. Regardless of production effectiveness, an enterprise will not survive long if the cost of finished goods exceeds price.

Within the proposed model, conversion costs are defined as inside the fence costs required to produce a given product. These include utility costs (fuel, electric power, and water) as well as costs of steam and compressed air produced centrally or within a process and distributed throughout a plant. Apportioned administrative costs are another element of conversion costs. The costs of compliance with safety and environmental requirements must be included. Waste disposal is another conversion cost.

Returning to the usage of electric power, it must be recognized that between 50 percent and 85 percent of the lifetime ownership cost of a motor-driven pump is for electricity. Operating efficiency has a double impact: low efficiency will increase power consumption. The added stress due to operating off best efficiency point will result in higher maintenance costs and a shorter life.

Value of operations and maintenance
Operating and maintenance (O&M) costs include salary and wages, fringe benefits, repair parts, and consumables. O&M also produces value. Good operating and maintenance practices have a positive impact on production output through availability, production rate, and quality. By reducing fluid, air, and heat leaks and directing attention to the benefits of operating equipment at best efficiency, good O&M practices reduce utility costs. Likewise, good O&M practices reduce the risk of safety and environmental violations. (One company reported that 50 percent of environmental violations were caused by equipment failures.) By extending life and reducing requirements for replacement and spare parts, good O&M practices also reduce the need for capital, a growing requirement in todays financial environment.

World class enterprises recognize that conversion effectiveness, measured as a reduction in conversion costs, can occur only by a reduction in defects. World class organizations further recognize that trained personnel are imperative toward maximizing conversion effectiveness. Personnel must be trained to question current procedures in order to wring the last drop of efficiency from a given process. They must pay attention to detail such as steam and air leaks, heat loss due to faulty insulation, inadequate lubrication, and pumps allowed to operate well outside of best efficiency.

In a real enterprise, the dispersion of producer value to individual equipment and even component level is complicated by the existence of multiple products and the allocation of shared resources. Some may be intermediate products of another process; all require establishing internal product transfer prices. This demands an accurate allocation of costs between producers and users' activity based accounting.

In addition to demonstrating the value impact of practice and technology within a producer enterprise, the proposed PVM must possess other attributes. The ability to predict EVA for a given investment at any level within the enterprise and then report on effectiveness (results) as the investment is implemented is one. This leads to the ability to determine whether increased production or reduced cost has the greater effect at the profit level. Many will state that a large increase in production is more beneficial than a reduction in costs. Since factors such as market conditions and product margins are considered within the PVM, the calculations will demonstrate whether increased production or reduced cost creates greatest value. ROI is not nearly as good as either a predictor or reporter. A good part of the reason is that assumptions leading to ROI may be difficult to evaluate after the fact. Additionally, conditions may change.

Equipment effectiveness
The PVM permits tracking any given investment and determining whether the investment had the anticipated impact, and if not, why not, including changes in forecast conditions such as market and price variations.

Referring again to the chart, production effectiveness is often measured in terms of overall equipment effectiveness (OEE) associated with total productive maintenance (TPM). OEE is a normalized quantity representing net production yield made up of three terms: availability, production rate, and quality. The values in the numerators lead to production yield. Many companies utilize OEE as a prime measure of equipment effectiveness. Approximately 85 percent or better is considered world class performance.

In the author's opinion, OEE has two significant weaknesses. In terms of OEE, a process can be highly effective, and very unprofitable, if conversion costs are excessive. Additionally, OEE alone does not lead to opportunity or priority. By ignoring market and business conditions it is easy to focus OEE on the wrong activity.

Timed production effectiveness
To incorporate the crucial importance of conversion cost toward enterprise profitability, the author has proposed an expanded OEE-based effectiveness measure: Timed Production Effectiveness (TPE).

TPE = Production output  x timed availability  x conversion effectiveness

TPE applies conversion cost to OEE that has been modified to consider the time window of opportunity driven by market conditions.

Timed availability is defined as the amount of time a facility, system, or component is capable of producing a required result compared to the time windows in which production is scheduled or required. Timed availability imposes three conditions to the calculation of availability:

  1. For a process or facility in which production is sold out, the availability objective is 8,760 hr (1 yr) to create an incentive for minimizing scheduled outages.
  2. For a process or facility in which production is not sold out, and for spared or redundant facilities, systems, or equipment, the target or objective is the actual time in which operation is required.
  3. In the event a system or component failure slows or interrupts production, the interruption does not end for the purposes of calculating timed availability until production is fully restored.

Timed availability thus reflects the full impact of a momentary malfunction that stops or upsets production for an extended period. Timed availability is the most realistic measure of availability for all facilities and components. It is especially valid for those that must be capable of operating at 100 percent during a production time increment less than total calendar time.

Production output is production delivered in specification divided by the production objective. The concept of a production time increment also is applied so that the term reflects output when required to meet scheduled demand.

Since actual output can be greater than scheduled output, production output may be greater than 1. If off-specification production is sold at a lesser price, a constant is applied to account for diminished income. Quality also may be tracked as a separate quantity as in OEE.

Some facilities measure and track the combined timed availability and production output as asset effectiveness. But asset effectiveness is only part of the story. For the full picture, conversion cost must be addressed.

Conversion effectiveness, the third term in TPE, is a conversion cost objective divided by actual conversion cost. Note that the objective is divided by the actual to reflect increasing effectiveness when actual cost is less than objective, the inverse of the terms in OEE. Conversion effectiveness is used to measure the conversion efficiency of a specific component, unit, or facility. All applicable conversion costs, utilities, O&M, administrative, and waste disposal, must be included.

Some companies prefer real over normalized values. If so, the denominator of conversion effectiveness divided by the numerator of production output results in conversion cost per unit of output, a valuable performance measure itself. There are other vital measures that can be derived from TPE provided the information structure is properly constructed.

During several discussions of TPE, participants have mentioned the difficulty of obtaining accurate cost information. Organizations must strive to determine costs, regardless of difficulty. It is imperative to know exactly how much it costs to deliver a given product. Activity based accounting is a must. Lacking this knowledge it is very easy to sell a product at less than the manufacturing cost, very important in today's highly competitive climate where fractions of a cent may be the difference between profit and loss.

Next, it is always the author's reply that regardless of whether accurate cost information is available today, competitive survival mandates it tomorrow. Those who cross the line between guesstimated and actual costs will have an enormous competitive advantage, as well as crucial information with which to assure resources are always applied to highest value activities.

Leveraging conversion effectiveness
Any discussion of the necessity of linking asset effectiveness to enterprise profitability must not neglect the leverage comparison between profit increases gained through increasing conversion effectiveness and production increases. Most process and manufacturing companies operate at a net profit after tax of less than 10 percent. This produces greater than 10:1 leverage in favor of improving conversion effectiveness. In other words, $1 million value gained through increased conversion effectiveness has the same impact on bottom line profit as $10 million of additional production.

When availability is high and production is sold out, improved conversion effectiveness may be the only way to increase profitability. As an example of converting value to production, a consultant brought in to survey the control air system at a large amusement park concluded that air leaks consumed the capacity of one full air compressor. In terms of net profit, air leaks required the equivalent of 10,000 to 15,000 added paid attendance at the park. In a similar calculation at a sold-out chemical plant, the profit equivalent to increasing pump average MTBF by 1 year required an availability of 103 percent.There is also the double-edged contribution of increasing operating and maintenance effectiveness. In addition to the obvious advantages of reducing cost, and the not-so-obvious leverage of increasing conversion effectiveness, there are other major contributions to value illustrated by the upward arrows in the PVM chart. When production is sold out, increasing output by increased availability or quality (yield) contributes significantly to profit. Some companies have been able to avoid capital investment for added production by recovering hidden capacity within existing facilities. In addition, increasing production output with O&M costs held constant results in a per-unit reduction. Thus the double-edged contribution.

Whatever the measurement criteria and benchmarks for conversion effectiveness, they must connect directly to unit objectives and profit and be understood by senior executives. Nothing else will gain support from those who control the funds.

Practitioners of all aspects of equipment management must incorporate financial awareness, prioritization, and tracking of results into their everyday activities. Without this vital dimension potential improvements in technology and practice may never be funded or applied. Instead of enlightened equipment management leading to greatest value there will be a race to the bottom, immediate cost reductions without any long term effects.

The financial model must begin with business and market conditions, demonstrate conclusively the real value of improved practice and technology, prioritize investment opportunities, and track results, even when separated from action by a significant time interval. Furthermore, an ideal financial model must contain provisions for what if examination of assumptions under variations in business and operating conditions. The PVM appears best suited to this crucial task. Only with the awareness provided by an accurate financial model can modern facilities be managed to optimize the only parameter that counts, profitability. MT

John S. Mitchell is president of the Machinery Information Management Open Systems Alliance (MIMOSA). MIMOSA information is available at www.mimosa.org