There are many factors involved in evaluating manufacturing competitiveness, but financial health is certainly top of mind both for manufacturing executives and for key stakeholders outside of a company, like investors. If you take, for example, two plants both building a firewall product—one might be using manual labor for assembly and inspections, while the other is using smart automation—how can we evaluate their respective financial health to compare which approach is financially “healthier”, both in the near and long term? From an investor point of view, there are seven financial ratios that Wall Street types will commonly use in order to evaluate manufacturing operations and assess their financial health – below we’ll describe what they are, and how each is impacted by the adoption of smart automation.
Revenue per Employee Ratio: The first of the ratios used to measure financial health is the “revenue per employee ratio,” and it’s calculated just like that: the revenue divided by the number of employees. So, for example, if a manufacturer has $10 million per year in revenue and one hundred employees, the revenue is of course $100,000 per employee. Now, if that company has $10 million in revenue and ninety-five employees, the revenue $105,000 per employee – a bit better. This ratio is very simply measuring how much money each employee is generating for the company, and the higher the number, the more favorable from an investor point of view, because that ratio is indicating efficiency which is correlated with the adoption of technology.
Unit Contribution Margin Ratio: Another ratio used in evaluating financial health is the “unit contribution margin” ratio, and it’s calculated by taking the revenue minus the variable cost, divided by the revenue. This measures the percentage of revenue that is attributed to covering fixed costs (the cost of the building the plant is in, the machinery that’s owned, etc.). A high contribution margin ratio means a manufacturer will have an easier time covering fixed costs and is less risky, as an investment. Investors also will look at the unit contribution margin of each of the products that the plant is producing – if a plant is producing 15 products, each of those products has a unique contribution margin – looking at the contribution margin of all the products can help them to understand how dependent the company is on its “star product”, the one that carries the company, so to speak. When variable costs in this equation go down, the unit contribution margin improves.
Return On Net Assets Ratio: A “return on net assets” ratio is yet another option to measure financial health, calculated by taking the net income and dividing it by the resources the company is applying: the fixed assets and the working capital. Fixed assets would again be machinery, while working capital translates to current assets, including cash, accounts receivable and inventory, minus the current liabilities such as accounts payable. This measures how effectively a manufacturing company uses its assets, machinery and equipment to produce revenue. The higher this ratio is, the better, because it means the company is using its fixed assets and working capital more effectively to make money. While implementing smart automation might increase the fixed assets portion of this equation, it also reduces working capital due to lower wages liability. The payback period for equipment impacts this metric, but generally speaking if the payback period is less than one year, the return on net assets increases.
Inventory Turnover Ratio: This measure is used to assess the efficiency of a business by taking the cost of goods sold, divided by the average inventory balance. The inventory turnover ratio is really measuring the overall efficiency of the business, and the higher the turnover ratio, the better. By implementing smart automation, the average inventory balance is reduced – thanks to better forecasting and more stable production output both of which reduce the need for safety stock– and the net effect is an increase in the inventory turnover ratio.
Repairs and Maintenance Expense to Fixed Assets Ratio: This ratio is based on the total cost of the repairs and maintenance, divided by the fixed assets. So if you have total fixed assets of, say, $1M in equipment, and last year you spent $100,000 for repairs and maintenance on that equipment, then this ratio would be 10 percent. Generally speaking, anything lower than 10 percent is considered good. This ratio starts to increase as machinery ages and needs more maintenance, and further still upon eventual replacement. Buying new equipment, in particular bringing in more automation, improves the repairs and maintenance expense to fixed assets ratio because of the lower cost of repairs and maintenance.
Total Manufacturing Cost Per Unit Minus Materials: Why do we look at the total manufacturing costs minus the materials? Well, direct materials are easily traceable – we can identify those costs very simply and straightforwardly. However, the other costs involved in manufacturing are less traceable. If we take the total manufacturing costs, remove direct materials and then divide that by the number of units produced, we’ll have a good indicator of how much overhead is required to produce a good, and how efficient a company’s processes are compared to other entities. Lower ratios here indicate better efficiency. With smart automation in a factory, the number of units produced increases due to higher throughput, while the total manufacturing costs decreases because fewer operators are needed, so this ratio is reduced – which is what investors want.
Manufacturing Costs to Total Expenses Ratio: This final ratio measures expenses incurred while producing a product, as well as indirect costs needed to operate the business. A higher ratio here indicates that more expenses are attributable to costs directly needed to manufacture the product. Smart automation has little impact on this particular ratio, as manufacturing costs decrease due to more efficient manufacturing operations, but at the same time total expenses also decrease causing the ratio to remain roughly the same.
So in a summary of these ratios, six out of seven are positively impacted by smart automation, while the last results in a neutral push effect. But what about profit – the bottom line? In a situation where manufacturers are reliant on manual labor, as in our initial firewall product example, sales are increasing over time but so are costs. And costs are increasing at an increasing rate. As we add more shifts to increase more product, the cost per shift increases, because of a typical premium on a second shift. For the third shift, there’s an even higher premium. So, the cost per worker increases as a manufacturer scales up production to add more lines to satisfy sales. Ultimately, they will start to see other inefficiencies related to labor, including training, turnover, and recruitment. With smart automation, as sales increase costs increase but at a decreasing rate. This is because the same automation equipment can be used on multiple shifts, producing more units but without incurring additional costs. By this metric, and the seven ratios above, smart automation is an all-around sound investment.