Calculating ROI for automation projects

Management approval for your next automation project depends not just on its technical merits, it also has to pay for itself. There is a range of financial criteria to consider once you have put the finishing touches on the engineering part of your proposal.

"Not again," thought Bob. "The new system that we proposed is not on the approved projects list. This is the second year in a row it hasn't made the cut. I thought everyone here supported the purchase. It would make the plant run better and sure make our life a lot easier. I just don't understand how those in the head office make decisions. I bet they've never worked in an actual plant."

Perhaps the comments above are familiar. Those of us in the automation field are very interested in new technologies and the opportunities they provide for improved performance. However, plant and corporate management must be concerned with business issues and overall plant profitability. Every company has limited funds available for investment with many more claimants than can possibly be funded. This difference in view often leads to misunderstanding and confusion.

New technology is of value only if it provides a suitable financial return. Many articles have been published on the potential economic benefits and return on investment (ROI) of installation of new automation and advanced automation technology in the process industries. Unfortunately, the benefits claimed are often unrealistic and unsubstantiated. This leads to significant credibility issues when the forecast benefits are not achieved and to a lack of confidence on the part of management on proposals in this area. In this article a short review of the proper way to perform financial analysis for these technologies is presented. Hopefully this can help Bob, and you, obtain support for the next automation investment of interest.

Review of plant economics

The first step is to examine the plant as a financial asset. We may think of plants as a collection of equipment and personnel that convert raw materials into products. From a financial point of view, a plant is an asset that consumes money and produces money, hopefully producing more than is consumed. The major monetary components are shown in Figure 1.

By convention, financial inputs are classified as either capital or expense. Expenses include all the ongoing costs of producing the products such as raw materials, net utilities (used less produced), operating costs, maintenance expenses and other miscellaneous costs. Capital has two components - working and investment.

Investment capital refers to the cost of major equipment or system additions that will last for several years and can be depreciated for tax purposes. Working capital is the value of inventory and required net short term financial funding.

Return on invested capital

Ultimately, the management of a company has an obligation to increase the long-term financial value of the corporation to its owners, who are normally the shareholders. The primary measure used here will be return on invested capital (ROIC). This is not only a good internal measure but also correlates with long-term stock market performance.

Automation and ROIC

From a financial point of view, the plant objective is maximise the long-term ROIC. How can automation and advanced automation affect manufacturing cost and revenue components? The key effects are summarised in Figure 2.

To increase ROIC, capital must be reduced or profit increased or preferably both at the same time. The primary areas where automation and advanced automation savings are normally found are illustrated in the boxes at the bottom of the figure. When a project is considered, all possible savings areas should be evaluated. Potential capital savings include both fixed and working capital components.

Working capital can be reduced by reducing raw material, intermediates and product inventories and also by reducing owned spares for equipment stocked in the warehouse. Capital deferred also results in savings due to the time value of money.

Deferred capital can result from longer equipment life due to better control or from more production from the same equipment which results in a postponed plant expansion. Expenses can be reduced by lowering energy usage and decreasing raw material costs through increasing yields of desirable products. In special cases it may be possible to substitute a lower valued raw material.

There are several types of maintenance costs including scheduled maintenance, unscheduled call-out and major shutdown. Reductions can occur in all types of maintenance costs due to improved automation performance and enhanced monitoring of process equipment. Specific savings can include reductions in unscheduled maintenance, number of routine checks, time to perform required maintenance tasks, maintenance materials purchase and number and costs of required tasks during scheduled shutdowns.

Abnormal event prevention deserves some special comments. Reducing occupational health and safety (OH&S) issues is at the top of every plant manager's agenda. Improved automation is often a key to reducing these types of events. If your proposed investment will result in safer operation or reduced emissions it should definitely be included in the justification description, even if no quantitative economic value can be attached to these improvements.

Next is the area of increased average selling price for products. Automation can contribute to this goal by increasing the yield of more valuable products. Reduced amounts of lower valued by-products will increase average revenue per unit feed. Off-specification material, which can be reduced through improved control, usually brings a discounted selling price. Occasionally an increase in product quality due to improved control will actually permit selling the existing product(s) at a higher price.

With regard to increased production, the key question is whether or not the additional product(s) can be sold. Increases are only financially valuable for production limited plants, ie, those manufacturing products where the market can absorb the increases. If not, no benefits can be claimed for the improvements. Increased production can result from the capability, with better control, to operate closer to production limits at constant product quality. Increased production can also come from reduced unscheduled down time for equipment due to better reliability, shorter batch cycle times, lower grade-transition time, less product re-blending, and decreases in scheduled shutdown duration and frequency. The shutdown frequency can be reduced, for example, by increasing a furnace run time between required decoking or not cleaning a heat exchanger prematurely.

To estimate the potential magnitude of the savings, examine the normal expenditures and look for specific quantifiable areas where savings are possible. Often historical data will provide a basis for this analysis. External consultants with experience in this area can also help ensure that potential savings are not overlooked and that there is proper documentation for the estimated savings used for the justification.

Investment costs and analysis

Next, investment costs must be estimated. When performing investment analysis, it is important to consider the full life cycle costs, not simply the initial purchase price, of new equipment and new software systems. Many studies have shown that more than two-thirds of their life cycle costs occur after installation.

Make sure that you budget for ongoing training. The best long-term job security today is maintaining your and your staff's skill levels and expertise. It is easy to fall into the trap of being so busy with day-to-day problems that you lose sight of the longer term requirements.

We now have benefits and costs. How are these converted into a proper overall project financial analysis? How can we demonstrate that the proposed investment will increase the long-term corporate ROIC more than other potential investments?

Although the specific investment evaluation protocols vary from company to company and you need to follow your company's guidelines, they all have at their heart the calculation of the net present value of the incremental after tax benefits generated by the plant due to the equipment or technology and comparing it with the net present value of the required investment. In financial terms, all assets, be they stocks, bonds or chemical plants, are valued the same, ie, as the net present value of the future sequence of after tax cash flows. If the value is greater than the investment the project is considered for funding. Net present value implies discounting a sequence of net cash flows (receipts less expenditures) back to the current time. But there are many subtleties.

Initially, it might be thought that the proper discount rate is one simply a little higher than the average corporate ROIC calculated above. If the investment value was positive then the ROIC would be increased and the investment justified. However, the correct selection of the discount rate is more complicated. Three interrelated factors must be considered. The first is that the cost of capital that the corporation has to pay for additional funds used for investments is significant and is different for each corporation.

The cost is affected by the relative usage of debt and equity for the corporation and called, therefore, the weighted average cost of capital. Investments made by the corporation must obviously produce a return that exceeds this cost so the discount factor needs to be at least this amount. The second is that the corporation has alternative options for investment both within and outside the company. Since standard financial investments are available, the discount rate must be greater than the return from these investments or else the company will invest its money there. Alternatively, the firm could pay a dividend to shareholders with the cash and the shareholders themselves could invest in these standard investments. The third factor, closely related to the second, is that not all investments are equal in the predictability of the cash flows produced. The cash flow from a new pump is likely to be much more predictable than that from a new software system that has never been installed in the plant before. In accordance with financial analysis theory and practice, when the actual value of the cash flow is not fixed, but can only be estimated, a risk premium should be added to the discount factor that recognises the uncertainty or riskiness of the estimated cash flow.

The financial analysts will then compare the profitability of various investment proposals from all parts of the corporation and rank them. One key ranking used is the profitability index defined below.

Let:

NPV(ATCF) = net present value of after tax cash flow generated by the investment

NPV(IC) = net present value of required investment [image]

It is common to graph the sequence of investments and resulting cash flows as shown in Figure 3. The elapsed time to positive cash flow, ie, the time at which the discounted cumulative cash flow crosses into the positive region, is also important. This is sometimes called the discounted payback period.

For your investment to be favoured it should have a higher risk adjusted profitability index than others and a shorter discounted payback period.

Post audits

A key discipline for long-term successful project financial management is to regularly, rigorously and objectively post audit all major investments to see if they did or did not achieve their predicted return on investment. The first step in this process is to capture a set of base operating data prior to the installation of the system. This is compared with operating results after installation of the new system or technology and the improvement calculated. Correction to standard operating conditions or adjustments due to changes in raw materials or operating conditions are often required. Understanding problem areas and areas of unanticipated benefits leads to better evaluation of future investments.

Conclusion

We all want our preferred investments to be funded. However, to successfully obtain the money for these investments requires that we understand the criteria by which the financial management of the company allocates available funds. In this review the key points to consider have been summarised. By following these guidelines, Bob will hopefully be more successful next year and receive funding for the new system.