As heat treaters, it is critical to be able to justify the purchase of new heat-treatment equipment to management by being able to prepare a return-on-investment (ROI) analysis. This will ensure we continue to modernize our heat-treat shops. However, the heat treater often needs help understanding how to do this. Let’s learn more.
A mistaken belief by many heat treaters is that as a furnace reaches the end of its useful life – typically somewhere between 25 and 50 years old (Fig. 1) – the age of the equipment alone is all the justification necessary. This is not the case. We must always justify our need for new equipment (or product outsourcing) in terms that executive management will understand. To accomplish this, we need the assistance of our accounting (finance) department so that we can make a compelling argument based on how long it will take to recoup the capital investment cost of the new equipment.
There are many operational reasons, besides age, for requesting new equipment, each having its own associated cost. Some of the drivers for change include:
- Repair/maintenance costs and downtime of current equipment
- Process development
- Productivity demands
- New market opportunities
- Lower energy costs
- Greater operational efficiency
- Automation/smart technology – reducing the role of human intervention
The cost to run the current equipment can be used as a comparison to the projected cost of operating the new equipment. This, along with the cost of the new equipment, forms a basis by which management will make the decision on whether or not to authorize the purchase. This information must in turn be converted into a financial justification to show the value of the new equipment to the company.
It should be noted that it is imperative that the heat-treat supervisor and others involved with the new equipment proposal work closely with the accounting department to obtain accurate cost information for use in the ROI. Lack of financial facts often drives the heat treater to arguments based on so-called “soft” costs. Unless quantifiable, these are never part of an ROI calculation or a justification for an equipment purchase. Examples of “soft” costs are:
- Environmental impact
- Risk (for example, having only one furnace available to run critical component parts that the company feels cannot be outsourced)
- Assurance of process repeatability
- Rapid identification of problems from internal control of process
- Improved dimensional part stability
- Growth of critical process work
- Interruption to production flow
- Lost productivity due to extended (outsourced) delivery times
- Efficiency improvements/reduced cycle times
- Reduced maintenance costs
What is ROI?
Return on investment measures the gain or loss generated by an investment relative to the amount of money spent. Higher percentages are more desirable, but the ideal range is ultimately dependent on pre-established company policies. The calculation itself is straightforward:
ROI = Gross Profit x 100
Cost of Investment
When considering the ROI calculation, it is important to understand the difference between fixed costs and variable costs. Fixed costs are expenses that occur and are not influenced by production output. These costs are not included when calculating the ROI because they represent the cost of doing business without regard to production or output. Variable costs, on the other hand, are a company’s expenses associated with (based on) the amount of goods or services that it produces and, as such, are included in the ROI calculation.
- Fixed costs include (but are not limited to) insurance, rent/leases, management salaries, property taxes, depreciation and interest expense.
- Variable costs include, but are not limited to, labor to operate the equipment, materials and supplies needed to produce product, sales commission, operating costs (including utility costs), inspections and maintenance.
- Cost of investment includes the cost of equipment, shipping and taxes, installation and training, and debt servicing.
- Gross profit (aka net operating profit) is the profit a company makes after deducting the variable costs of production (cost of goods sold) from its total revenue.
An example, based on the first year’s production, would be as follows:
- Total cost of investment $2,500,000
- Sales (total income produced from operating new equipment) $2,000,000
- Variable costs
Materials & supplies $310,000
Utility costs (electricity, gas, etc.) $195,000
Quality control $ 174,000
Maintenance and repair $65,000
Total variable costs $1,100,000
- Gross Profit ($2,000,000 - $1,100,000) $900,000
ROI = ($900,000 / $2,500,000) x 100 or 36%
In everyday language, for each $1 of initial investment cost, $0.36 was earned from using the new equipment in the first year. If the net profit remains the same over time, the payback period would be 2.78 years ($2,500,000 / $900,000). Typically, management looks for a 2-3 year (maximum) payback period. If the new equipment represents a new technology (Fig. 2), however, it would be reasonable to assume that the gross profit would steadily increase over time, a factor that would justify to management a shorter payback period.
The above calculations are for the purchase of new equipment. However, the same method can be used to determine the ROI of current equipment as a part of the justification for the replacement of the older equipment since the variable costs will likely be higher and, therefore, the gross profit lower.
Example (External vs. Internal Costs)
Another factor in the purchase of new equipment is the savings associated with bringing outsourced work back into the facility (Tables 1-2, online). Outsourcing costs not only include the cost of processing but also shipping, the time lost getting product to and from the commercial heat treater, testing, quality control and many other factors that must be calculated in detail (see online content).
As part of this analysis, the following factors were taken into consideration:
- Orders per day based on historical data (2018) averaged 235 orders/month run in two vacuum furnaces or 10.8 orders/day or 5.4 orders/day/vacuum furnace.
- Orders per day based on furnace performance: 2,831 orders (2018) divided by two vacuum furnaces = 1,415.5 orders/vacuum furnace divided by 50 weeks/year = 28.3 orders/week divided by 5.5 days/week = 5.4 orders/day/vacuum furnace.
- Historical data and calculated performance data are consistent.
- Outside heat-treat cost (2018) actual: $25,000 per quarter x 4 quarters/year + $75,600 ($189,000 (2017 outsource total) x 0.40 (40% brought back in-house) = $175,600.
- Average cost per order = $175,600/year divided by 1415.5 orders/year = $124.05 per order.
- Freight cost estimate: $40/delivery x 3 deliveries/week x 50 weeks/year = $6,000/year
- Internal labor cost estimate: $21.00/hour x 1.6 (fringe benefits) = $33.60/hour
- Internal engineering cost estimate (annual salary $75,000): $36.06/hour x 1.6 (fringe benefits) = $57.69/hour
- Documentation includes items such as: planning, PO generation, paperwork creation, vendor management, vendor visits, etc.
- Documentation cost estimate: 0.5 hours/order x 1,415.5 orders/year x $33.60/year = $23,780/year
- Testing cost estimate (external): 1 hour/order x 1,415.5 orders/year x $33.60/hour = $47,561/year
- Testing cost estimate (internal): 0.5 hour/order x 1,415.5 orders/year x $33.60/hour = $23,780/year
- Cycle optimization estimate (10 cycles): 12 hours/cycle x 10 cycles x $57.69/hour = $6,923
- Rework time is estimated at 7.09 hours/order (average cycle time).
- Rework cost average (10% of total orders): 1,415.5 orders/year x 0.1 = 141.6 orders/year x 7.09 hours/order x $33.60/hour = $33,721/year
- Internal rework cost average: 50% of external rework cost estimate
- Estimated average part cost (if scrapped) = $175.00 per part
- External scrap estimate (1.5% of the loads/year): 1,415.5 orders/year x 0.015 x 20 pieces/load (number of parts requiring rework) x $175/part = $74,314/year
- Internal scrap estimate: 33% of external scrap cost
- Quality control/assurance includes items such as: monitoring quality, compliance to specification, heat-treat audits, etc.
- Quality-control cost estimate (external): 1 hour/order x 1,415.5 orders/year x $33.60/hour = $47,561/year
- Quality-control cost estimate (internal): 0.5 hours/order x 1,415.5 orders/year x $33.60/hour = $23,780/year
- Expedited order cost estimate: 10% of orders at 50% upcharge or 1,415.5 orders/year x 0.1 x ($124.05 x 1.5) = $26,339/year
- Installation costs include off-loading equipment from trucks, moving equipment to location, bringing utilities within 15 linear feet (balance of installation cost in suppliers’ equipment price).
- Maintenance cost estimate (new furnace): 1% of selling price
- Additional machining cost incurred due to increased part distortion on outsourced parts.
- Additional machining cost estimate (10% of parts requiring 0.040-inch stock removal (outsourced parts) versus 0.020-inch stock removal (in-house heat-treated parts): 2 hours x 20 parts/order x (1,415.5 orders x 0.10) x $33.60/hour = $190,176
- Manufacturing (delivery) time penalty cost estimate (20% of parts affected): $175/part divided by 23 days/part (production time) x 3.5 days/part (average added time due to outside heat treat) x 20 parts/order x (1,415.5 orders x 0.20) = $150,782
In Conclusion – An Executive View
Not too terribly long ago, the Doctor sat down with the chairman of the board of a major U.S. manufacturer whose heat-treat department consists of more than 50 furnaces, the average age of which is over 25 years old. The question was a simple one. “Why don’t you authorize more money for modernization of your heat-treat department, especially in comparison to the money spent updating machining operations?”
The answer was simple, yet surprising. “Because my heat treaters are the most innovative people in our plant. They find ways to keep equipment running, are fantastic at work-arounds and band-aid fixes to keep product flowing through the shop. Besides, they have no idea how to justify the purchase of new equipment. Only when they come to me in total frustration, and after I turn them away at least once to see if they will indeed come back, do I authorize money for new equipment.”
A sad yet true commentary on just how well heat treaters do their job! So, let’s justify our requests for new equipment by presenting management with a compelling ROI analysis.
- Mrs. Jeanne Herring, Operations Controller (retired), Ipsen, technical and editorial assistance.