Management of an Industrial Company Atlas Copco Industrial - - PDF document

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Management of an Industrial Company – Atlas Copco Industrial Technique

Slides to the textbook by Håkan Kullvén English version June 19, 2019

Table of Contents:

• 0. Introduction ................................... 2
• 1. The Business .................................. 4
• 2. Planning the Business .................. 12
• 3. Acting in the Market .................... 20
• 4. Organizing the Business ............... 25
• 5. Costing Products and Orders ....... 34
• 6. Decisions about Investments

....... 52

• 7. Following Up the Business ........... 63
• 8. Analyzing Change

......................... 81

• 9. Financing the Business

................. 86

• 10. Annual Report 2018 ................. 101

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• 0. Introduction

[Slide 0.1] Hi. Welcome to the course

“Management of an Industrial Company” and this introduction in which I will present the course and myself.

[Slide 0.2, not included] The course builds on the

book “Management of an Industrial Company - Atlas Copco Industrial Technique" by me, Håkan Kullvén. The book is published by Studentlitteratur, Lund, in 2018. If you have any suggestions for changes you can send these to me at kullven@outlook.com. If you want to practice on the concepts of this chapter, you can do this at www.socrative.com, student login, room STUD0.

[Slide 0.3] In this slide you find some information

about my previous and current workplaces (SAAB, Fridh's auditing firm, Bofors, the University of Karlstad, Södertörn university, IFL, KTH and Uppsala University, where I work now), my research (about activity-based costing for Telia; measures for the Swedish Rescue Services Agency; quality, job satisfaction and finances in municipal care for some municipalities, and measures for the Swedish Defence), my published books (on service quality, management control, budget and budgeting, and about management of an industrial company based on a deep study of Atlas Copco Industrial Technique), and my contact information (Uppsala: Ångström room 4209A, mail kullven@outlook.com, and telephone +46 73 500 4580). Currently, I am working on a deep study of the construction consulting company Ramboll, which is planned to be published as a book in 2020.

[Slide 0.4] Now, let’s summarize some of the key

words of the course. The course is built on the book ”Management of an industrial company - Atlas Copco Industrial Technique” by Håkan Kullvén, published by Studentlitteratur, Lund,

• 2018. The course and the book are also available

in Swedish. In the course and in the book, all parts are covered by examples from the company Atlas Copco Industrial Technique. The book and this course are divided into the following chapters: 1. The business, 2. Planning

3 the business, 3. Acting on the market, 4. Organizing the business, 5. Costing products and orders, 6. Decisions on investments, 7. Following up the business, 8. Volume change, and 9. Financing the

• business. Also, in the course, there is this introduction as chapter 0, and a chapter 10 which contains

data from the latest published annual report after this book was published. Management is about making decisions, such as what products to sell, what prices to set on products, what to invest in, what processes should be used, and how should the company perform. For this, they need information of different kinds, one of an economic kind: About the process and its input and output. To measure input, process and output, there are three different areas that are

• important. Note that there is no clear-cut difference between these three areas, the division is made

by pedagogical reasons, to make it easier to capture the content. In the course, you will learn all these subjects in more details. One can look at the cash flow, cash in and cash out, with the use of models such as cash-flow analysis, finance, and investment appraisal. One can look at revenues and costs with the use of accounting (the annual report and valuation are important aspects here) and measures for profitability, stability and finance. And one can look at the profit or loss for a period, where the costs are expensed to that periods products and similar, with the use of full costing (with models such as absorption costing that analyzes direct and indirect costs; ABC or activity-based costing, process costing, equivalent units costing, joint product costing, or by-product costing. One can also look at relevant revenues and costs in contribution margin costing. And one can analyze volume change with variable and fixed costs.

[Slide 0.5, not included] Well, that was an introduction to the course “Management of an Industrial

Company”. I hope that the overview gave you a good idea of the content of the course. Bye!

4

• 1. The Business

[Slide 1.1] Hi. Welcome to the course

“Management of an Industrial Company" and Chapter 1 of 9: The Business. In this chapter, we will look more closely at what a business is and discuss such things as business entities, development processes, innovation, entrepreneurship and business logics.

[Slide 1.2, not included] The content gives a

summary and an overview of Chapter 1 in the book “Management of an Industrial Company - Atlas Copco Industrial Technique" by me, Håkan Kullvén. The book is published by Studentlitteratur, Lund, in 2018. If you have any suggestions for changes you can send these to me at kullven@outlook.com. If you want to practice on the concepts of this chapter, you can do this at www.socrative.com, student login, room STUD1.

[Slide 1.3] In this course we follow the company

Atlas Copco Industrial Technique, a company that manufactures tools such as nut-runners, screwdrivers, drills, grinders and similar for the

• industry. The tools can be both hand-held and

fixedly mounted in different ways.

[Slide 1.4] Founded in 1873, Atlas Copco currently

has 36,000 employees and BSEK 87 in turnover. The group is part of the Wallenberg sphere and consists of four business areas: Industrial Technique, Compressor Technique, Vacuum Technique and Power Technique. In this book we follow the business area Industrial

• Technique. This part of the business started up

around 1995, has 7,000 employees and has a turnover of BSEK 17. The business area is divided into the divisions Motor Vehicle, General Industry, Service, Chicago Pneumatic

5 Tools and Industrial Assembly Solutions. Production takes place mainly in Sweden, Germany, Hungary, USA, UK, France and Japan. Atlas Copco is a group, that is, a group of companies. What forms are there for companies? We shall look more closely at this next.

[Slide 1.5] There are some different types of

business entities that are regulated differently and that we’ll discuss in more detail. A sole proprietorship (second column) is when one starts an activity on one’s own. Such an activity is taxed in one's personal declaration, and the profit or loss affects the tax for that person. The

• wner gain from profits and will be responsible

for the losses privately. A general partnership and a limited partnership (next two columns) are when two or more persons are doing business together. For that purpose, a general partnership is formed so that all persons are jointly and severally responsible for the business personally; If the business loses money, creditors can go to any of the owners and request the entire payment. A limited partnership differs from the general partnership in that at least

• ne person is still personally responsible, but one or more other persons are only responsible for the

capital that they put in the company. If you are a member of a general partnership or a limited partnership; Make sure to set up a partnership agreement with the assistance of a legal representative so that you don’t get into severe trouble! A cooperative (next last column) is when several people join in a common interest (buy food cheaper, distribute their goods, etc.) without the objective to gain a profit in the business entity. If you want to have a profit, it’s the limited company (last column) that applies as the next type of business entity. In a limited company, each owner only risks the shares that they have bought, and therefore doesn’t have to pay privately should the business go bankrupt or so. A company such as Atlas Copco generally arises through entrepreneurship and is developed through innovation and development. Let's look further at what this means.

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[Slide 1.6] Atlas Copco was once started up

through entrepreneurship. Entrepreneurship is a process in which individuals identify

• pportunities and, based on these, act. The

process in which this happens involves a search process; Often the entrepreneur goes into unknown areas. It may be to develop and sell a brand-new product, to start a restaurant in a place where nobody tested business before, or something else. Therefore, the entrepreneur must seek for and be open to new thoughts, new ideas, adapt to changing conditions and so

• n. We can all be entrepreneurs, and an important characteristic to succeed with this is the flexibility

and the ability to adapt. A prerequisite for being able to conduct entrepreneurial activities is access to capital. One possibility that sometimes exists is to start a limited company and by that receive capital from people who are willing to buy shares of it in a market. But often this isn’t possible. Many entrepreneurs start their business with their own personal savings; with loans and contributions from relatives and friends; through crowd funding (for example, FundedByMe, Crowdcube, Tessin, Innovestor, Oiko Kredit and Pepins (where the contributors becomes co-owners); or Kickstarter, Toborrow, Sparlån, Lendify and Indiegogo (where the contributors don’t become co-owners); business angels who are people with capital that they are prepared to invest in venture capital; venture capital markets where several actors merge with capital; industrial partners; financial institutions; and with bootstrapping - to be innovative in for example that friends work for free for the entrepreneur, to bring machines and material one already owns in to the company, and so on.

[Slide 1.7] To innovate is to develop new and

improve earlier products. This is done in product development processes, often carried out in

• projects. Product development refers to all

activities that contribute to the development and improvement of the company’s offers to

• customers. There are three traditional ways to

deal with development processes:

• 1. Sequential product development, in which the

different steps are carried out one at a time in a project model. This leads to a structured, but sometimes bureaucratic and lengthy, development process. A common model for this type of development is the stage-gate model, in which each stage starts and ends with a formal decision (a gate) whether it should continue and how. The product development project often consists of six steps: planning, concept development, overall construction, detailed construction, and, finally, start of production and running-in.

• 2. Parallel product development, in which the next step starts when the first parts of the earlier step

have been carried out; when there are preliminary decisions in this step to build upon. This leads to a shortened development process.

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• 3. Iterative product development, in which the whole concept is developed directly as a functional
• product. For the rest of the process, this is improved in different ways so that there is always a

complete concept that is developed further and further. This leads to a continuous development. Agile or interactive methods for product development are becoming more and more common. In relation to these methods, different techniques for visual planning have been developed, e g sticky notes on a board. A common tool for this is Scrum, which means planning the different steps on a daily or weekly basis with the work to be done divided into very small parts. Another common tool for this is Pulse, which focuses on making people meet. Other common methods include prototyping, to present a product in, for instance, virtual reality so that it can be tested before it is developed; computer-aided design (CAD), to construct a digital model of the product being developed to be able to present it and discuss changes in relation to it; set-based design, that keep many different solutions to the same problem open at all times during the development process; quality function deployment (QFD), to specify the customer demand in detail and see what in the product is capable or incapable to meet those needs; design for manufacturing and assembly (DFMA), to involve production and assembly at early stages in the development; and failure mode and effect analysis (FMEA), to identify possible problems in the development of the product.

[Slide 1.8] The figure shows how the development

process is constructed at Atlas Copco. The development process is essentially sequential and consists of three steps: The Business Definition Phase, the Design Phase and the Commercialization Phase. For each phase there are decision points, where the project either is terminated or can proceed to the next phase. Atlas Copco also has major elements of other and more agile development processes, such as Scrum and Pulse.

[Slide 1.9] What drives the development of

products at Atlas Copco Industrial Technique is primarily the customers' needs and demand. The company is both technology-driven, where the employees' competence regarding different forms of tools determines the development to a certain extent, and customer-focused, so that the development is nevertheless directed towards what customers need. Today's development is much influenced by new technology such as the Internet of Things and Big Data. Another thing that drives

8 development is the quest for sustainable development today, including adaptation to laws and policies and investments in climate improvement measures. Now let's finish this chapter with a look at the different types of business logics that exist.

[Slide 1.10] So, we are going to look at the

different business logics there are and how they are working based on a model that professor Eric Giertz at the department of Industrial management at KTH has constructed and described in his book “Measuring Success – Identifying Performance Indicators” published by Celemi, Malmö, year 2000. He divides the business logics into six main categories: Producing and extracting raw materials, Manufacturing (with the sub categories Contract manufacturing, Labor-intensive processing plants, Capital-intensive processing plants, and Assembly plants), Distribution of goods (with the sub categories Freight forwarding, Transshipping, and Retailing), Basic common services (with the sub categories Organizations that exercise authority, Institutional services, and Subscriber- related services), The service sector (with the sub categories Local manual services, Knowledge- intensive services, Local consumer establishments, Rental services, Teaching, Distance support, and Artistry), and Spidering (with the sub categories Contracting, Replicating, and Brokering). Let’s now look at each and every one of them in that order. Just remember, that close to all larger companies are conglomerates of different business logics; often, they have a dominant logic but also have elements of several other logics.

[Slide 1.11] First, let’s look at some statistics about

the different business logic’s and the change in employment in them. We can see that producing and extracting raw materials is a decreasing and very small part of the whole

• employment. Manufacturing is also decreasing

but is still a large part of the employment. Distribution of goods is a rather large and constant part, basic common services a little bit smaller but constant part. What is increasing heavily during the years is the service sector, which now is over 60% of the employment. Spidering is a rather small but a little bit increasing part of the employment. Now let's take a closer look at the different types of business logics. The review focuses on the main groups, and within these the various types of business logics are briefly described with examples. For each main group, some characteristics and some common performance indicators are then

• discussed. Note, however, that the different types of business logics within each main group can

have partly different and more specific characteristics and common performance indicators; For a more complete description, please refer to the book or other sources.

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[Slide 1.12] Producing and extracting raw

materials covers such as forestry and sand pits. Distinguishing characteristics are often that they have a decreasing number of employees, and that it’s highly mechanized and capital-intensive. Prices are to a large extent world market prices

• r regulated prices. The material is sorted at-

source based on quality. The information systems and the transportation systems are

• important. Important performance indicators

for the operations are such as volume per time unit, volume per worker time unit, yield, capital turnover, machine utilization, profit margin, and the cost per kg, liter or similar.

[Slide 1.13] In manufacturing, there are four types

• f business logics: Contract manufacturing

refers to operations such as general contract printers and machine shops, Labor-intensive processing plants, e.g. foundries and glass factories, Capital-intensive processing plants, for example steel mills and pulp mills, and assembly plants, e.g. vehicle assembly and consumer electronics assembly. Manufacturing is characterized by the fact that labor costs and capital costs are often high, that productivity is important, and that setup and throughput times are important. Performance indicators are such as capacity utilization, productivity, resetting times, throughput times, material utilization, energy consumption and delivery reliability.

[Slide 1.14] Within Distribution of Goods there are

three types of business logics: Freight forwarding refers to activities such as trucking firms and shipping lines, Transshipping such as airports and wholesalers, and Retailing such as grocery stores and pharmacies. Distribution of goods is characterized by the fact that the services contain more and more logistics and systems for this, that it is important to maintain high capacity utilization for lower costs, and that it is important to attract many loyal customers. Performance indicators are often such as revenue and cost per capacity unit, number of customers or deliveries per day, gross margin and customer satisfaction.

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[Slide 1.15] There are three types of business

logics within Basic Common Services: Organizations that exercise authority relate to activities such as courts and public administration, Institutional services such as the police system and hospital impatient care, and Subscriber-related services, e.g. telecom

• perators and sewage and sanitation plants.

Characteristics are that the businesses are often regulated by laws or other rules, that the budget is important and that they often require large investments in infrastructure and therefore also large volumes. Performance indicators are often cost-to-budget, number of customers, and number

• f complaints.

[Slide 1.16] Within the Service sector, there are

seven types of business logics: Local manual services with activities such as hair salons and car repairs, knowledge-intensive services such as computer services and consultants, Local consumer establishments such as restaurants and day care centers, Rental services, e.g. apartment rentals and car rentals, Teaching e.g. universities and compulsory schools, Distance support, e.g. help desks and taxi switchboards, and Artistry such as actors and professional sports figures. Characteristics are that competence and specialization are important, that it is often labor-intensive businesses, that a high uniform workload is key factor and that customer service is an important competitive factor. Performance Indicators are often such as billing ratio, capacity utilization, customer satisfaction and complaints per customer

[Slide 1.17] Spidering is about linking sellers and

buyers, and within this there are three types of business logics: Contracting with activities such as package tour operators and event organizers, Replicating such as franchisers and central purchases, and Brokering such as network portals and real estate brokerage. Characteristics are often that long-term business relationships are built up, that they are based on a standardized business concept, that the gross margins are important, and that the IT-based business is growing increasingly. Important performance indicators are, for example, market share, number of repeat customers and contribution margin per product.

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[Slide 1.18, not included] Well, that was chapter 1 of 9 in the course “Management of an Industrial

Company”, and it dealt with the business. I hope that the overview gave you some new insights that you will have use of. Bye!

12

• 2. Planning the Business

[Slide 2.1] Hi. Welcome to the course

“Management of an Industrial Company" and Chapter 2 of 9: Planning the Business. In this chapter, we will look more closely at how the company is planning; we will look at such things as the company's strategic goals, models used for this, and the management control to achieve the plans

[Slide 2.2, not included] The content gives a

summary and an overview of Chapter 2 in the book “Management of an Industrial Company - Atlas Copco Industrial Technique" by me, Håkan Kullvén. The book is published by Studentlitteratur, Lund, in 2018. If you have any suggestions for changes you can send these to me at kullven@outlook.com. If you want to practice on the concepts

• f this chapter, you can do this at www.socrative.com, student login, room STUD2.

[Slide 2.3] The basis for the goals of the business is

the company’s mission. The mission is what the company wants to accomplish, why it exists. It’s about the overall purpose of the company. This mission can then be translated into a vision; An idea of a possible future state. It shows where the company is heading and what it wants to achieve. From the vision, a business concept, an idea of how the company should earn money from the business based on the company's vision and mission, is formulated. What should the company do (what offer should they provide), for whom (what customers, what needs, and the like should be covered), and how (what resources in terms of skills, machines and the like are needed) in

• rder to earn money? The business concept is fulfilled by strategies, different action plans for

achieving the objectives. These strategies exist at different levels and in different parts of the

• company. A common breakdown of overall, generic, corporate strategies is in differentiation

strategies (to create products that are so unique and superior that customers prefer them in front of the competitor’s), cost leadership strategies (to create low costs through lean processes and thereby to be able to offer products at low prices), and focus strategies (to focus on a specific customer group for the product and make sure the product is the best choice for this particular group).

13

[Slide 2.4] This slide shows Atlas Copco's mission,

vision and strategies (which they call resource plans). The mission is to deliver sustainable and profitable growth and at the same time perform well in relation to financial, environmental and social perspective in the long term. They will do this by building on five pillars; Presence, innovation, service, operational excellence and people, and by prioritizing excellence, safety and well-being, competence, innovation and

• resources. The vision is expressed as "First in

mind - first in choice". This is then translated into a number of strategies, which are termed resource plans at Atlas Copco and which are primarily based on a differentiation strategy. For the planning, several different analysis models are generally used. Now let's look at some of the most common models for this work.

[Slide 2.5] The SWOT model is an analytical tool

for understanding the company's Strengths (S), Weaknesses (W), Opportunities (O) and Threats (T).

[Slide 2.6] The so-called BCG (Boston Consulting

Group) matrix divides products when it comes to two variables: Market growth and market

• share. A product with a low market growth and

a low market share is a dog, in this case a puppy

• r a pet, which may be a valuable product for

the future. If the product has a high market growth on a small market, it will constitute a question mark, that might be a valuable product for the future. If the product earns a high market share in the next stage, the product is a star which earns high profits for the company. However, in this position constant investments in increased production are often required, due to the increasing demand, so often companies with products in this phase have problems with

14 financing, due to the cash outflow. If the market eventually slows down in growth, the product may become a cash cow that, besides profits, now also gives a high cash inflow since not much expansion

• f production capacity is needed anymore. In the final stage, both the market growth and the market

share are low, and the product now again becomes a dog, now maybe more a mutt kind of dog.

[Slide 2.7] The product life cycle curve shows

where in their respective life cycle products are in terms of both sales and profit. In the beginning, during the product development phase, the sale is 0 and the company loses money since it then (in most cases) only have

• costs. In the following introduction phase, sales

raises, and may contribute to a profit. During the growth phase and later during the maturity phase, when sales stagnate, the product often contribute to profits. The final phase is the decline phase, when the product is being phased

• ut because sales and profits decrease.

[Slide 2.8] The stakeholder model points out that

the company isn’t there only for its owners, but also for it’s customers, employee, the society and environment, it’s business partners s and so

• n. It’s therefore important to balance the

remuneration to these stakeholders, otherwise the other stakeholders will not cooperate with the company. So; an adequate profit to the

• wners, good products to the customers, fair

payments to the business partners, adequate salaries to the employees, and so on, is needed. Now we have discussed various models for planning the business. Let's move on to management control, which is a way to make sure the plans are fulfilled.

15

[Slide 2.9] With management control, we want to

ensure that our employees work to achieve the goals that we have with the business. It’s a tool to help economize; to make sure that the right resources are in the right place, and that resources are used in the right way for the right

• products. Through a high degree of efficiency

(well utilized resources, doing things right), perhaps the ultimate objective, a high degree of effectiveness (achieving the objectives, such as making money, doing the right things) is reached, but there are also other factors involved in the effectiveness such as what customers want, how prices are set, and so on. One important part of management control is to set objectives from the mission, vision, business concept and strategies that the company has set for its business. Objectives could be set for, as examples, market share, number of employees, share of new products per year, and so on. Management control is then a tool that we use to get employees to work towards our objectives. We can do this in two ways; we can force them to achieve those objectives through responsibility (you should sell for at least MSEK 10, you should be at work 8 hours every weekday, and so on), or we can show up the objectives for the employees and assume that they will work towards them when they understand how important they are; visibility.

[Slide 2.10] There are four types of management

control: People control means hiring the right people, to train them properly and so on. Action control involves controlling the way in which the employees work, by e.g. creating routines for the various operations that need to be

• performed. Result control involves controlling

what the employees should accomplish, by specifying what is to be accomplished and then verify such compliance. Cultural control, finally, means to create an environment so that the right work is done; to ensure that the employees work in the company's interest. Several of the models for costing, reporting, performance measures and the like that we will discuss in the following chapters are parts of management control. But we should now look at some models especially for management control; the balanced scorecard, forecasts and budgeting.

16

[Slide 2.11] Balanced scorecard are common tools

in companies to bring together measures for the areas that are important to the company. They take their departure in the company’s vision and strategies and derive measures from these. Often this means that measures should be developed for five different perspectives: The financial perspective includes measures of economic performance. Examples of measures here can be total costs, total revenues, total sales, return on investment and the like. The internal process perspective contains measures that show if the business processes work

• smoothly. Examples of measures can be process time, quality costs, number of failures, and so on.

The employee perspective contains measures for employee skills and job satisfaction. Some examples

• f measures in this perspective are the educational level of the workforce, the average number of

years of employment, job satisfaction according to a survey, and so on. The learning and growth perspective show how the company and its employees learn and innovate. Measures in this area can be the total budget for research and development, the number of training days per employee, the number of patents per year, and the number of new products per year. The customer perspective, finally, contains measures on how customers perceive us. Measures used here may be, for example, customer satisfaction according to a survey, the number of repeat customers, the number of customer complaints, and so on. In the public sector, this perspective is

• ften changed to a citizens' perspective or similar.

Some companies are also developing their own perspectives to this, such as an ethical perspective, a sustainability perspective or similar in cases where these are deemed to be important in the company's vision and strategies. Other companies are excluding one or two of the perspectives if they don’t appear in their visions and strategies. In some companies, and in the original model (which is from the US), there is no employee perspective; instead, then, measures for employees are

• ften part of the internal process perspective.

[Slide 2.12] Forecasting, attempting to investigate

what might happen in the future, is done by companies in many ways. In different ways, the company set up plans for their coming activities, sets targets for these activities, and set up some expectancy levels for the activities. All this is done at different levels; at the local level for the different units, summed at different higher levels, and in total for the whole of the company for the coming year or so. Again, it is constructed in different ways in different companies, so these are just some common parts.

17 Many companies look especially at trends for the critical success factors, the key performance indicators and the key drivers.

[Slide 2.13] Budgeting is a common model for

• forecasting. A budget is typically set up to create

coordination (make the different departments' plans to be synced), to be able to control the business (by being a starting-point for commitments on revenues and costs), to improve communication (by the process in which various departments budgets are discussed jointly) and to follow up and check what was accomplished compared to plan. Budgeting is performed either through bottom up or top down, or a combination of these. In a bottom-up budget, the budget process begins at the lowest level in the company, and the budgets on these levels are then built up into a global budget. In a top-down budget, the budget process begins at the highest level in the company, and the total budget is then broken down into budgets for the lower levels. A bottom-up budget creates more motivation than top-down do, but to gain time in the budget process, we can use elements of top-down budgeting. Basically, the budget process can be broken into five phases: First the budget instructions, which explains the conditions for the budgeting process and provide information on how the budget process should be carried out, are handed out. Then budgets are constructed, and after discussions regarding changes in them, the budgets are decided upon in a meeting within the company's board

• f directors. During the budgeted year, then, the budget is carried out (with changes due to

circumstances of different types), and throughout the year, the company also follow up the outcome against the budget. Budgeting has great advantages, and that is why many companies use budgets. The budget dialogue means that all employees can influence the business through their own ideas and views on what should be done the following year. The budget is also often a prerequisite for being able to delegate

• responsibility. Furthermore, the budgeting process often creates cost awareness amongst the

employees and informs the employees about the plans for their business and for the company at large. However, budgeting has also received a lot of criticism. In some companies, this criticism leads to changes in the company’s budgetary processes, but in some companies the criticism has made them chose to stop budgeting. Some key disadvantages of budgeting is that it takes a lot of time, that budgets are never fulfilled, but sometimes turns out to be completely or partially wrong, and that budgets may limit the possibilities for what employees can do; they feel locked-in by budget figures. All this is, as mentioned, problems that can be addressed by improvements in the budget processes, but is also often something that makes some employees feel bad about budgeting

18

[Slide 2.14] How is management control used at

Atlas Copco? They focus mainly on dialogue on important factors. The business board meetings and business review meetings that management has with various parts of the business several times a year discuss how the operations work now, and what plans the local managers have for the future. In this way, they control that measures are taken that are in line with the desired development, while at the same time creating continuous learning within and between the parts of the organization. To achieve enough productivity, there is also an annual requirement to reduce costs by 3% over all activities each year, a requirement that is common (but with different percentages). Atlas Copco uses forecasts a lot; they identify critical success factors, key performing indicators, key recurring activities and key drivers for these, and set expected values and goals on them. All this is followed up and forecasted. Furthermore, they work a lot with benchmarking; comparisons between units and with competitors to ensure that the work is sufficiently efficient and effective.

[Slide 2.15] This and the next slide shows an

example of a report for the business board meetings that the management and parts of the company conduct about three times a year.

[Slide 2.16] … continuation on last slide, with

continuation of the report for the business board meetings.

19

[Slide 2.17] Much of Atlas Copco’s management

control is about managing culture; to ensure that all employees understand the core values

• n which the business is based. An important

key here is "The Atlas Copco book" that deals with these core values and which all employees should understand the content of.

[Slide 2.18, not included] Well, that was chapter 2 of 9 in the course “Management of an Industrial

Company”, and it dealt with planning the business. I hope that the overview gave you some new insights that you will have use of. Bye!

20

• 3. Acting in the Market

[Slide 3.1] Hi. Welcome to the course

“Management of an Industrial Company" and Chapter 3 of 9: Acting in the Market. In this chapter, we will look more closely at how the company's market looks; we will look at such things as marketing, the network approach, marketing mix and quality.

[Slide 3.2, not included] The content gives a

summary and an overview of Chapter 3 in the book “Management of an Industrial Company - Atlas Copco Industrial Technique" by me, Håkan Kullvén. The book is published by Studentlitteratur, Lund, in 2018. If you have any suggestions for changes you can send these to me at kullven@outlook.com. If you want to practice on the concepts of this chapter, you can do this at www.socrative.com, student login, room STUD3.

[Slide 3.3] There are different types of markets.

Perfect competition is the ideal in a market

• economy. We have perfect competition when

we have a very large number of small sellers and buyers in a market where the products are exactly alike. In such a market, customers will prefer the cheapest product, that is, only those companies that have the lowest costs and thus the lowest prices can sell. In this situation, the invisible hand is said to control the market: Stakeholders seek profit which means that the capital is constantly seeking out the areas where a higher efficiency, and thereby lower costs and prices, can generate good profits. In such a market, the price will constantly be pushed down, and the value of the product will be pushed upwards. The question is, however, what is the exact same product? Often there is instead a monopolistic competition, where the products are in some sense similar, but where certain features make customers prefer one or the other product; some prefer locally produced potatoes, some prefer the iPad over other handhelds, and so on. This allows the companies to, to some extent, determine the prices themselves. Oligopoly is characterized by a few companies dominating the market. The construction industry in Sweden is one example, where four to five major construction companies dominate while there are many small competitors. The dominant companies determine the prices in that market to a large

• extent. Sometimes those companies set the market mechanisms out of control, by forming cartels

and dividing up the market among themselves which means that they can then determine the prices in their local markets. Such cartels are prohibited by anti-trust laws but are sometimes discovered to have been operating. For instance, the asphalt market in Sweden received a lot of attention some

21 years ago when it was discovered that major players had formed a cartel, and they were convicted in court for this. Monopoly, finally, means that a company has total control of a market. Often, such a monopoly is, to a certain extent, an illusion. Take for example the spirits market in Sweden. Here, Systembolaget is said to have a monopoly, and it has to a certain extent. But there is also competition; from bars, pubs and restaurants; from importers through, for example, grocery stores, from illicit distilling, by buy abroad (for example, from travels on ferry to Åland and to Germany), and so on. A company with a monopoly has control over the price and can maximize profits by maximizing volume x price. In addition to market economies, as we have discussed now, there are also some planned economies in which not the invisible hand, but governmental organizations control resources, supply and prices. Often there is that kind of planned economy in parts of a market economy as well. So, for example, in Sweden defense and immigration are controlled by government organizations. When a society has large elements of both a market economy and a planned economy, this is called a mixed economy.

[Slide 3.4] Atlas Copco Industrial Technique works

primarily in a monopolistic competition, where they and their competitors (mainly Apex Tool Group, Ingersoll-Rand, Stanley Black & Decker, Uryu and Bosch, but also a large number of local and regional competitors in, among others, Asia) are trying to compete against the others with the advantages of their products. Sometimes, however, they have an oligopoly or a monopoly, for example, when a customer prefers a few brands or may just want Atlas Copco's tools. Atlas Copco, as previously mentioned, works in a product-driven as well as a customer-focused way, and therefore segments its market in various industries (motor vehicle, general industry and so on) and per customer (distributors, protect customers, stability customers and uptime customers) to be able to turn to respective segment in as adapted a manner as possible.

[Slide 3.5] The products, goods and services that

are produced by a company are supposed to be sold to customers in markets. There are basically two perspectives for this: the network perspective, and the marketing mix perspective. Usually, a company uses a combination of the two. The network perspective means that the company tries to win its customers by creating trust and customer loyalty, so that the customers tend to prefer us not just because of such aspects as e g pricing, but because the customers have confidence in us; knows that we’ll offer them what is best for them as customers in the long run. This can be achieved e g by focusing on services, and by having attractive activities on

22 the aftersales market. Often, the network perspective is referred to as strategic partnership or relationship marketing; to build good relationships with customers, suppliers and others. Competition through the marketing mix perspective is built on the 4Ps. The 4Ps are Product, Price, Place and Promotion. The company ensures that the mix of these four P will form an as attractive

• ffer as possible for customers, and in this way enables the company to earn a good profit on the
• ffer. The word “place” may be a bit misleading expression. It refers to the distribution of products,

such as how the products are sold to customers. Often, the chain is such that the raw materials (or extraction) industry sell to the manufacturing industry, which sells to wholesalers, who sells to retailers, who in turn sells to individual consumers. The company builds up its strategies for the markets and describe those in its marketing plan

[Slide 3.6] How does the company set the prices

• n their products? Strategic pricing is how the

company wants to price their products in the long term. The price then depends on which of three approaches for pricing the company uses; value-based, competitor based or cost-based

• pricing. Most companies combine the three

approaches, with more or less of each of them. For example, maybe the company starts from a cost base, and then sets the price based on the prices of the competitors’ products with regard to what customers are willing to pay for the products. A value-based (or customer-based) pricing means that the company sets the price based on what the customer is willing to pay. The price must then, of course, together with the prices of the other products that the company sells, cover the company's costs. However, the focus is on the customers' willingness to pay. Elements of such a pricing strategy is common for such companies as those that sell travels, concerts, spare parts and so on. In such cases, for example, a concert experience is put together based on the sellers view on the customers' willingness to pay. Some customers are willing to pay very high fares to sit close to the stage, to have a bite to eat during the concert, and so on. Other customers just want to hear the concert and can prefer a seat with limited view at a lower

• price. Spare parts for a car often cost very little to produce but has a high price because the customer

needs them to make the (often very expensive) car to work. Market-based (or competitor-based) pricing means that prices are set relative to competitors’ prices. When the competitors reduce their prices, the company also reduces their own prices, and all the companies in the business monitor each other and set their prices relative to those of the

• competitors. We see this clearly in industries such as consumer electronics in Sweden, where

Elgiganten and other companies since many years have been involved in a constant price war. We also see it in Internet commerce, such as on eBay, in clothing stores and sports shops, in the market for broadband and mobile telephony, and so on. Cost-based pricing is very common and is the traditional approach to pricing. The costs that the company has had for the product lacks impact on the customer experience and hence the customers willingness to pay, but in some sense, of course, the company needs to find ways to get paid for their

23

• costs. The cost-base is evident in public procurement, where cost-based prices are often required.

We also see it clearly in the gasoline market, where changing world prices for gasoline has a direct impact on the prices. As the base the price, the company often use a cost estimate, including a demand for a certain profit.

[Slide 3.7] Atlas Copco works almost exclusively on

a B2B or Business to Business market; they basically sell only to other companies. Therefore, relationship marketing, or the network perspective, is the most important perspective for them. Atlas Copco refers to this as a strategic partnership. The sales process usually involves a contact between the customer and a sales team from Atlas Copco. Often, Atlas Copco also has employees in the customer company, who continuously review the tools and can provide information about the need for repairs and changes of tools. Such information also comes through the Internet of Things; the tools are usually connected in real time and provide such information. For the large customers, there are also customer-responsible salespeople, Key Account Managers, who have a direct contact with the customer.

[Slide 3.8] Concerning the marketing mix, 4P, the

following can be mentioned, among other things, about Atlas Copco Industrial Techniques’ activities in marketing: Atlas Copco uses products from the five brands that appear in the

• figure. The price of the tools is around SEK

100,000 for daily sales, but it can also extend up to several million for a project, for example for a new production line. The price is determined in a negotiation, which is mainly based on the value for the customer, but for daily sales, price lists, negotiated with the respective customer, are used. Atlas Copco is a price leader in most markets. In terms of place, Atlas Copco is a global company that sells 80% of everything directly to its end customers; so, they have built up a global

• presence. Finally, for promotion, they do not use so much advertising. But one example is films on

YouTube about their concept Smart Connected Assembly within Industry 4.0 Finally, let us see what shapes the customer's experience of the company's products.

24

[Slide 3.9] Much of the market trends today is

towards a service orientation or servification. One can see everything as services, sometimes masked as goods. We sometimes buy a car, a house, a CD; absolutely, but we don’t do it for its own sake but to be provided with services; to be able to travel, to have somewhere to live, to listen to music. The medium that makes something a product isn’t that interesting, but what value something can give a human being. Also, there is a tendency towards more and more services when it comes to goods as well. For instance, the car in our example is a physical product, but it’s sold with more and more service content in it; customization, the delivery, guarantees, offers, the service-mindedness in the process, membership in a club for the brand, and so on. Grönroos (2000) has summarized service orientation in the figure in the slide. At the top left, expected service can be found. Then we have an experience: The experienced service. This may differ from expectation, so we get a gap between experienced and expected service which forms the experienced quality. But it's more complex than that: In fact, it isn’t the experience that forms this, but what we think we are experiencing, colored through the image in the form of rumors, tradition and so on, which gives us an idea of the service. What are we expecting and what do we get? This can be divided into two parts; The technical quality is in some sense what we get as “hardware” so to speak. It’s about the supplier's know how, the computerized systems used, the machines we can see in production, the technical solutions and so

• n. These are tangible indicators of the quality. The second part is the functional quality: how we get
• it. It’s about the attitude of the supplier and its personnel and partners, internal relationships,

behavior, service mindedness, internal climate, environment, appearance, accessibility, customer contacts and so on. Both the technical and functional quality are important to us as customers, and they also color each other and are colored by the company's profile to, first, an expected and, then, an experienced service and a difference between them that forms the experienced quality.

[Slide 3.10, not included] Well, that was chapter 3 of 9 in the course “Management of an Industrial

Company”, and it dealt with acting in the market. I hope that the overview gave you some new insights that you will have use of. Bye!

25

• 4. Organizing the Business

[Slide 4.1] Hi. Welcome to the course

“Management of an Industrial Company" and Chapter 4 of 9: Organizing the Business. In this chapter, we will look more closely at how the company is organized and managed; we shall look at such things as types of organizations, project management, production design, inventory optimization, leadership, responsibility, HRM and learning organization.

[Slide 4.2, not included] The content gives a

summary and an overview of Chapter 4 in the book “Management of an Industrial Company - Atlas Copco Industrial Technique" by me, Håkan Kullvén. The book is published by Studentlitteratur, Lund, in 2018. If you have any suggestions for changes you can send these to me at kullven@outlook.com. If you want to practice on the concepts of this chapter, you can do this at www.socrative.com, student login, room STUD4.

[Slide 4.3] How is a business organized? The

starting point for a traditional organization is a line organization, where the company is divided into departments responsible for different functions; a human resources department, a finance department, and so on. In larger companies, each manager is responsible for some subdivisions, which in turn are responsible for other subdivisions at lower levels. In even larger companies, the top level is divided into SBUs, Strategic Business Units, units that are responsible for operations that are unique in the company; that are strategic different. It could be e g one unit for cars, one unit for bicycles, and one unit for sports equipment. Often, the line organization is combined with staffs, which are not part of the decision tree but more there to support other departments, and this type of organization is referred to as a line and staff organization. In a line organization, each employee has only one senior manager over them. In some cases, the

• rganization is instead a functional one, where employees can have multiple bosses and where who

manages depends on what is to be done; e g a production manager manages all productions decisions, an investment manager all investment decisions, and so on.

26

[Slide 4.4] A model called value chain, that has

inspired many companies to organize their activities as a process, a flow; instead of a hierarchy of functions, companies are organized based on the primary activities carried out; the flow of these activities. The units that are not part of this flow (these primary activities) are

• rganized as support activities. In this way, a

leaner and flow-oriented organization is created. In a matrix organization, the traditional line

• rganization is combined with another division

that follows the flow, for example, the flow of the products, projects, or the like. This means that there are two managers at each intersection; for example, to produce product A, there is both a manager of production and a manager of product A that are involved. There are also many other ways to divide the organization; as a network, in different groups or teams, as a flexible division depending on the current goals, and so on.

[Slide 4.5] The top left shows how the governing

bodies in Atlas Copco are organized, below this the organization in business areas and divisions, at the top right you can see the legal unit Atlas Copco Industrial Technique AB Tool Sweden, and below, as an example, the business controller function's organization. As you can see, they all have the form of line organizations.

[Slide 4.6] The operating units in Atlas Copco are

• rganized in other ways. The top left shows that

product companies, distribution centers and customer centers are organized according to the principle of value chains, below this you find the principle for the divisions in different countries, and to the right the matrix organization with the divisions on one axis and the units in the different countries on the other axis.

27

[Slide 4.7] The project organization is used for

tasks of different kinds; for developing a new product, for investigating the possibilities of moving production to another country, for buying a new system for enterprise resource planning (ERP), and so on. This means that there are three different dimensions in the project: the output that should be accomplished, the deadline for the project and the resources (e.g., costs and man-hours) that can be used. These three parts need to be balanced. It could, for instance, be the case that a project has met the deadline but not the output strived for, or that the output has been accomplished but at costs that are too high, and so on. For each project, there should be a project manager who is responsible for the project vis-à-vis the project owner, the one who has decided on the project. To her help, there is a project group consisting of the project manager and some other employees, consultants and so on who are needed for the project to succeed. Often, a project is multi-disciplinary, involving engineers from different technological fields, marketing people, and so on, in order to have all these perspectives in the

• project. There could also be an advisory board that could be consulted for advice of different kinds

for the project, a steering committee that follows the project and what it accomplishes. For specific tasks, there could be sub-groups within the project that work with these tasks. Since a project deals with something that needs to be accomplished in a certain time, the project is

• ften divided into different packages: different steps that should be accomplished. What should be

accomplished is often defined in terms of gates. These gates define what should be accomplished before the next step is taken. Common techniques for this are PERT (Program Evaluation and Review Technique) and CPM (Critical Path Method), which define which steps should be taken, in what order and how they are linked to one another. But there are also companies that use more agile project methods, as described earlier.

[Slide 4.8] Earned value management is a tool that

combines cost, time (deadline) and result accomplished with each other and analyzes the variances from this and what this means for the

• project. The purpose is to focus on the three

parts of the project (resources, deadline and

• utput) and how they succeed.

The model divides the variance between planned cost or planned use of resources, called planned value, for a period of time and the actual use of this, actual cost, by the two reasons for the variance: a variance in cost, which is called cost variance and a variance in time, which is called schedule variance. This is done by

28 introducing the concept of earned value, which are the planned costs for the activities performed for that same period. Total variance, again, is planned value less actual cost. Cost variance is earned value less actual cost, and schedule variance is planned value less earned value. Through this, we may, for instance, see whether a negative variance in total (we have used more resources than planned) is because we have a negative cost variance (we have used more resources than planned for the activities we have actually carried out)

• r because of a negative schedule variance (we have performed more activities than planned, which

is positive in some respect but which causes more costs than planned, since each activity demands specific resources). Or, it could be a combination, where one could be positive and the other negative, and so on. From this, we may also estimate where the project will land should it continue like this. We can calculate the estimate at completion, how much the total cost for finalizing the project will be by first dividing actual cost by earned value and then multiply it by the budgeted total cost for the project. And we can also calculate the estimated time to complete by first dividing the planned value by the earned value, and then multiply this by the budgeted total time.

[Slide 4.9] How is the production of a company

designed? A company adjusts its level of technology and its level of automation based on e g volume decisions. A manual production involves relatively little machinery and relatively little automation. It’s a kind of craft production. In the second extreme, we find a completely automated production, where the element of manual work is very low. Such a production process is based on strict flows where production takes place in a certain order and always in the same way, however given the variations that the machinery in question allows. For example, there are many machines such as lathes, mills and the like that allow automatic conversion based on which operations are to be performed on individual products. Between manual and automated production, we can find semi- automated production, where some activities are automated and others not, or where some manual

• perations are needed in an otherwise automated operation.

A second aspect of the design concerns volume and variation. Some companies tailor their products to their customers, resulting in a one-piece process. Others do not allow variations but produce high volumes of a single variant in a continuous process. As an intermediary we can define the intermittent process with some adaptation (batch production).

29

[Slide 4.10] What layout does a company have in

its production facilities? We distinguish between a fixed position (think of e g building a bridge, which must be done at a certain fixed location), a functional layout based on the activities performed in production (for example, turning machines in one place, drilling machines in another), flow groups with work cells (a flow where different groups or teams perform a certain part of the activities in the process), and a line-based layout with a product-oriented placement (think of an assembly line in a car factory). Now let's look at how inventory levels and purchasing quantities are determined for production.

[Slide 4.11] Inventory optimization is the method

• f balancing healthy stock levels with securing

set service level goals and keeping costs under

• control. The average inventory is the minimum

inventory (the safety stock; the inventory just before a deliverance) plus the maximum inventory (the safety stock plus the order quantity) divided by two. For economic purchasing or manufacturing many companies uses the Wilson formula to find the economic order quantity. Using the formula, the economic order quantity (EOQ) is calculated considering the ordering cost, the holding cost and the annual demand. The ordering cost (per order) is the average cost for purchasing or starting up production, including (for purchasing) costs from the purchasing department, freight, goods reception, invoice handling, etc., and (for manufacturing) production planning, set-up time in production machines and at assembly lines, internal transports, scrap derived from start-up of orders, etc. The holding cost (per unit) is the cost per unit for warehouse handling and managing, warehouse space, the estimated interest for capital tied-up as inventory and work in progress, stock-taking differences, scrap from stock, etc. The annual demand is the number of units per year, derived from the forecasted sales of the product and spare part in which it is included. Higher ordering costs therefore result in larger order quantities, which on the other hand will increase the capital tied up in inventory as well as the holding costs. The economic order quantity may therefore be found where the total cost is at its lowest, which is where the ordering cost is as high as the holding cost. The economic order quantity can be found with taking 2 x Demand per year x Ordering costs per

• rder, and then divide this with the holding cost per unit and, finally taking the square root of this.

And the total relevant cost is total ordering cost, which is the ordering cost per order x (demand per year/order quantity) plus total holding cost, which is the holding cost per unit x (order quantity/2).

30

[Slide 4.12] An example on inventory optimization:

WrapUp AB will start to buy an entoli-module to their production of Cazartor. The suppliers price for each entoli-module is SEK 85, and they need 125,000 units of it next year. The holding cost for each entoli-module is estimated to SEK 3, and each order of it is estimated to cost SEK 2,000. From this, we should now calculate the

• ptimal ordering quantity and the total relevant

cost.

• a. How many entoli-modules should they order

each time? The optimal ordering quantity can be found by the Wilson-formula, which gives 2 multiplied with the annual demand of 125,000 units, then this multiplied with the ordering cost per order SEK 2,000, and this divided with the holding cost per unit SEK 3. Finally, we take the square root from this, which gives us the answer: We should order 12,910 units each time. With this ordering quantity, the total ordering cost will be the same as the total holding cost, and when this happens, we have the lowest total relevant cost.

• b. What is the total relevant cost for entoli-modules for next year with this order quantity? There are

two parts in the total relevant cost: The total ordering cost, and the total holding cost. We can start with the total ordering cost, which can be calculated as the ordering cost per order SEK 2,000 multiplied with what we get from dividing the demand per year 125,000 units with the order quantity 12,910 units. This equals SEK 19,365 in total ordering cost. Then, we calculate the total holding cost as the holding cost per unit SEK 3 multiplied with what we get from dividing the order quantity 12,910 units with 2. This equals SEK 19,365 in total holding cost. Now, we can calculate the total relevant cost as the sum of the total ordering cost SEK 19,365 plus the total holding cost SEK 19,365, which equals SEK 38,730. This is the total annual relevant cost for dealing with this component in procurement and inventory carrying. This cost doesn’t include the cost for the modules as such (the material cost).

[Slide 4.13] Let us now change perspective and

discuss the management of an organization. There are many different views on and opinions about what a manager should do. Perhaps Mintzberg's division into the interpersonal role (figurehead, leader of subordinates, and liaison builder), the informational role (monitor, disseminator, and spokesperson), and the decisional role (entrepreneur, disturbance and conflict handler, resource allocator, and negotiator) is easiest to grasp. The managers lead the business and the people in it (including themselves) for today's situation and for adaptation to tomorrow based on the three roles.

31 Hamel gives a more complex view of what the managers do, and lists eight functions that the managers stands for: Formulate goals and plan goal realization, motivate and coordinate efforts, coordinate and control activities, develop and recruit talents, accumulate and apply knowledge, acquire and allocate resources, create and nurture relationships, and balance and meet the demands from investors. In whatever way the role of the manager is defined, it becomes a bit complex. Some researchers, such as Preston, say that leadership is more like a flow than several roles. Preston has followed managers during their working week, minute by minute. He finds that things happen more in a flow; the manager, so to say, flares around from one arena to the next. The manager participate in meetings, presents new products, travels for a customer visit, and so on. Decisions are not taken in a formal way but arise as employees' interpretations of what the manager says and are decided more formally after action taken. The managers' role then becomes more a source of inspiration and a cohesive link for the company.

[Slide 4.14] A business can be described according

to how it’s managed. This is often referred to as Corporate Governance. The highest level of governance in a company is its Annual General Meeting, with the shareholders deciding how the company should handle their capital. The Board, then, has the responsibility for the

• rganization and the management, and

appoints a CEO (Chief Executive Officer) who

• versees the daily management. Auditors, who

are not managers and who are not employed by the company, supervise the work. Where can the managers, those whose task is to ensure that the company's objectives are achieved, be found? A common division of leadership is in senior management, middle management and

• perational management. The senior management is the board and the business top management,

which sets the direction of the company and ensures that this is achieved. The operational managers are those that work in the business itself, such as supervisors in the plants. Between the two levels there are the middle managers who become the bridge between the two. For senior management, financial measures are important, for example, that the company achieves a certain profit and a certain profitability broken down into different revenues and expenses. For the operational managers, on the other hand, operational measures such as the number of customers, the number

• f products sold, and the like are more important. At the middle level, both are important; the

middle managers can thus be translators of the measures. The company's managers are given different responsibilities, depending on what they can influence. Let's look at this responsibility next.

32

[Slide 4.15] When we form responsibility, we

basically make someone responsible for what s/he can influence. If someone is responsible for something that s/he can’t influence, management control becomes more difficult. The ideal is to have an investment center, which includes responsibility for profit divided by total capital used (i.e. investments made) - thus the same as the responsibility of the company. This responsibility can only be given to decision- makers at a very high level, for example, managers of strategic business units; only they are able to influence all revenues, all costs and all the use of capital for different investments. The next level of responsibility is a profit center, that is a responsibility for revenues less costs. Also, this responsibility is, in most cases, given only on a high level. A revenue center means that the manager has responsibility for both revenues and costs, but not in relation to each other. It is common in sales departments, as a responsibility to reach, let’s say, at least MSEK 100 in revenues and to use no more than MSEK 5 in costs. A cost center entails responsibility for costs and is common on lower levels in a company; for supervisors, managers of different departments, and so on. Sometimes departments are buying and selling products and services between each other, and by this, artificial profit centers are created. Finally, there are often departments responsible for hours or the like; a manager of a cleaning department may be responsible for how many hours cleaning that are performed, a consultant may be responsible for the number of hours charged to customers, and so on.

[Slide 4.16] In connection with the leadership, one

• ften mentions HRM, which stands for Human

Resource Management; I e how employees are recruited to and treated in the company. An important part of an organization's function is to know how to get and retain staff that fits into the company, and to be able to terminate contracts with personal that doesn’t fit in. Corporate organizations have for about hundred years to a large extent been governed by what is called the principles of "Scientific Management”, that Frederick Taylor developed in the late 1800s, and that have had a great effect on productivity in business. Scientific Management builds on two fundamental ideas: That there is one best way to carry out all the different activities, and that the right person should be placed in the right place - different employees have different strengths and you must handle this in a good way. Specifically, this means that the work is divided so that different people are responsible for different parts, and thus become specialists in their part of the

• flow. The flow is also controlled by work studies, which aim to find the optimal way to perform

different tasks, and supervision and monitoring. Recently, this approach has been further developed

33 in to lean; thoughts on how to create organizations that are fast, lean in resources, and that has a high efficiency. There are also other approaches that highlight the human needs and visibility for the employee; Human Relations emphasizing the importance of being seen, and Socio technique that aim to "build the good work.” Managing human resources also includes creating a learning experience. How does it happen? Let's finish with a review of this.

[Slide 4.17] The purpose of a learning organization

is to create development, innovation and flexibility in the company; To avoid stiff structures that are difficult to change. But how can one achieve this, how is learning created in an organization? Knowledge management is a structured approach to manage learning in

• rganizations.

Basically, it's not organizations, but individuals, who learn. To some extent, learning takes place through courses and the like, but mostly through experience and how experiences are

• stored. Knowledge is formed in the community of practice in which the individual works. There is

some explicit knowledge, such as how to weld, how to learn something, and so on. But there is also tacit knowledge; Embodied knowledge, which can’t be learned directly but taught in a community. This includes knowledge about what it means being a welder, being a teacher, and so on. This knowledge is embodied in individuals and spread in the community through socialization; By the people hanging out with each other, working together. According to many, this knowledge, which is embodied in individuals, can then be transformed into visible and learned knowledge in a process called externalization. Learning is about competence, i.e. knowledge and abilities in direct connection with the tasks that are performed. With this view, organizations can learn through the gathering and dissemination of knowledge available in each employee. There is a structural capital, the accumulated knowledge, in contrast to the human capital, which, so to say, goes home at five o'clock. These two together gives the intellectual capital. Learning can take place either on the surface, single-loop learning, or in depth through reflection, double-loop learning. In single-loop learning, new knowledge is learned. In double-loop learning, we also question our previous knowledge, and internalize this new knowledge.

[Slide 4.18, not included] Well, that was chapter 4 of 9 in the course “Management of an Industrial

Company”, and it dealt with organizing the business. I hope that the overview gave you some new insights that you will have use of. Bye!

34

• 5. Costing Products and Orders

[Slide 5.1] Hi. Welcome to the course

“Management of an Industrial Company" and Chapter 5 of 9: Costing products and orders. In this chapter, we will look more closely at how the company analyze costs for decisions and for follow-up. We deal with the concepts in costing, accruing costs, costing methods (absorption costing, contribution margin costing and stepwise costing) and various variants of these, and solve some examples for the different calculation methods.

[Slide 5.2, not included] The content gives a

summary and an overview of Chapter 5 in the book “Management of an Industrial Company - Atlas Copco Industrial Technique" by me, Håkan Kullvén. The book is published by Studentlitteratur, Lund, in 2018. If you have any suggestions for changes you can send these to me at kullven@outlook.com. If you want to practice on the concepts of this chapter, you can do this at www.socrative.com, student login, room STUD5.

[Slide 5.3] When looking at a company's

• perations, one can consider it as a collection of
• processes. These processes use different types
• f input. Examples of inputs used could be labor,

materials, electricity, machinery, facilities, and so on. These resources are then transformed to

• utput in the processes. Outputs are what the

business delivers; various goods and services. The use of input in the processes to create

• utput constitute the physical flow of the
• perations.

If we want to measure the economic result of the operations, the best would of course be to compare its output with the input used. Then we know if the business is adding value or not. But, how do we measure this, how can we compare? Well, by introducing a common denominator; money, for example Swedish Krona, Euro, Dollar or

• similar. If we do that, we get the reverse flow; how much we pay for the input used and how much

we get paid for the output sold. This reverse flow can be measured in three different ways. If we measure the cash flow as such, how much we are paying or getting paid, we use the concept of cash out for what we pay for the input and cash in for what we get paid for the output. We can compare with our own private wallets. Cash in measures that we get money for our output/to the wallet, cash out measure that we pay for our input/from the wallet. We’ll use these concepts when discussing investment analysis and financing. If we instead measure the commitment, how much we promise to pay and how much our customers promise to pay us, we talk about the costs for input and the revenues for output. When we for

35 example are ordering materials for SEK 5,000, we commit to later pay SEK 5,000 for the material. And when customers order goods for SEK 20,000 from us, they promise to later pay us SEK 20,000. These commitments are accounted for in the company; they are noted, so that we’ll know which costs and revenues we have had and will have. Therefore, we use these concepts in the context of bookkeeping and accounting. In costing, we are usually interested in the profit (or loss). We want to know whether we make money or not, we want to know how much we earn or lose on various products, orders, customers, and so on. For this, we first need to match our costs and revenues; we need to register them in the same period; they are recognized and are being accrued. When costs meet the revenues they are used for, they are said to be expensed. The difference between the revenues and the expensed costs is the profit, or the loss. These concepts are used for costing and such. Please note, however, that the English language is not as clear-cut in this as many other languages are; most often, we use the word cost for the expensed costs as well. It’s, therefore, important to understand, in each situation, if the cost is expensed or not; if it’s matched with the revenues that it has been used to create or not. The same holds true for the revenues, even if they seldom cause the same problem as the costs (most

• ften, they appear in the correct period and for the correct e g product.

What does it mean to accrue costs to revenues? This is what we’ll discuss next.

[Slide 5.4] With the basic concepts discussed in

this section, we measure the profit (or loss) of a business, a product, an order, a customer or the

• like. As an example, to measure a product's

profit or loss we need to compare the output with the input used. Is the value of the output higher than the value of the input, that is, did we economize with our resources? Did we get

• ut more than we used up?

Expensed costs are costs that have been matched to the revenues that they were used

• for. They are matched therefore means that

they are comparable. For example, the revenues we have for the product can be compared with the expensed costs we have for the same product, and the revenues we have in a year can be compared with the expensed costs we have for the same year. Thus, the revenues for a collection of products can be compared with the expensed costs for the same collection of products. Therefore, we can measure the performance by letting revenues for a year or for a product meet the expensed costs for the same year or the same product; costs have then been expensed and now meet the revenues for the same year, the same product or the like. Note that the result is absolute; in monetary terms. There is another concept, profitability, which we’ll discuss later in the course. It’s not the same, but a relative concept, where the profit (or loss) is related to something else, such as capital used. Then you get a percentage, stating for example that the profitability is 10% on capital used.

36

[Slide 5.5] Costs and revenues are divided in

various ways depending on the type of assessment we want to perform. If we look at how revenues and costs are registered or recognized, we talk about direct and indirect costs. If we summarize the direct costs and the indirect costs, we get the full cost. If we are to decide, we need to compare the relevant revenues with the relevant costs. The difference between the relevant revenues and the relevant costs is called the contribution

• margin. What is not relevant is irrelevant: irrelevant revenues and irrelevant costs. The irrelevant

revenues and irrelevant costs should not be a part of the calculations for the decision as such. When deciding on volume, we can still use the concept of relevant and irrelevant, but the calculations becomes easier if we use the concepts of variable and fixed instead. We then define what revenues and costs that varies when the volume varies, and how they vary, which is useful for volume analysis. Note that it says "is approximately equal to" between direct, relevant and variable, and between indirect, irrelevant and fixed. So, for example, in a certain situation, a relevant cost often is the same as a direct cost; a product's relevant cost is normally recorded directly on a product and is therefore also a direct cost. A product's variable costs normally changes when the decision is to reduce the production volume and are therefore also relevant costs. And so on. However, in many other situations, the concepts are not the same. If a decision is made, for example, to stop manufacturing a product, all the costs, not only the direct ones, are relevant costs. And in that situation, not only the variable costs are changing, but also the fixed costs. So: there are similarities, but also differences that make it important to define the costs and revenues properly.

[Slide 5.6] Costing can be used both before and

after the decision. One can divide the models for costing into three different groups: full costing, contribution margin costing and stepwise costing. In full costing, all the costs of the product (or the

• rder, the customer, and so on) are included.

The main model here is absorption costing, following the basic model of full costing. Activity-based costing, abbreviated ABC, is a more advanced model that has emerged in recent times. Process costing is used when the

• bject to be calculated is not a single product or the like, but rather a continuous process. Equivalent

unit costing is used when products consume resources relatively similar, but when there is something that differs between them and where we can use equivalents, that is comparative measures, to catch this difference. Joint product costing is used when two or more products share the same production

37

• process. By-product costing, finally, is used when two (or more) products are produced in a joint

process and one (or more) of them is a main product and one (or more) is a by-product. In contribution margin costing, a products relevant costs are subtracted from its relevant revenues into a contribution margin. Stepwise costing is a combination of contribution margin costing and full costing, where first the contribution margin and then the result (including the full cost) is calculated in several steps.

[Slide 5.7] The concepts of direct and indirect are

used for the registration of revenues and costs; we register them, and want to follow them up, for different orders, customers, products and so

• n. Since it’s primarily the costs that are causing

problems here, we'll focus on them. The same problem also occurs in some cases for revenues. We exemplify with products, but the same line

• f reasoning applies to all types of objects

(orders, customers, and so on) that we want to follow up. What we want, is to register all our costs on the various products. Some costs are easy to register; for example, if we use a material for a product, we

• nly must record the cost of that material on that product. This is referred to as a direct cost.

Materials used for a product, work performed for a product, licensing costs for manufacturing a product and so on are examples of direct costs. Other costs are not as easy to register. Take for example the cost of a lathe machine used for several different products, or the cost of an advertising campaign for several different types of services. On which products should this be registered, and how should the cost be divided between them? We solve this problem in two steps. First, we record the cost on the department that used the resource that caused the cost (the lathe department when it comes to the cost for the lathe machine and the sales department when it comes to the cost for the advertising campaign). It therefore is an indirect cost in that department. Then the department's costs (in total) are allocated to the products that utilizes its services, often as an addition to the direct costs. In this way, all costs are allocated to the different products; some directly, others indirectly. The total cost of each product represents the products full cost. The same applies if we calculate something else, such as different customers, different orders, or similar.

38

[Slide 5.8] Absorption costing is a model used by

many companies in industry. For each product, the direct material, dM, needed can easily be recorded on each product. We also need something called material overhead which are input used that depend on direct materials. This may be such as, for example, rental for the storage area, indirect materials, such as screws and nails, purchasing costs and the like. As this is related to direct materials, it’s allocated to products as a percentage of direct material. Another direct cost is direct wages. This can also easily be recorded on each product. We also need such resources as for example foremen, machinery, energy and so on. As this is often related to machines used, this if often allocated to products as a machine cost per hour. There may also be special direct production costs, such as patent costs and licensing costs, and these can easily be recorded on each product. If we summarize all costs so far, we have the total production cost, PC. There are also other costs than those related to the production itself. First, we have sales overhead, such as costs for advertising, for general sale and so on, and then we have general and administrative

• verheads, such as the costs for accounting, for personnel recruitment and so on. The two are often

summarized to sales, general and administrative, abbreviated to SG&A, and are often allocated in relation to the total production cost. There is no reasonable cause explanation for this, but the argument for the allocation is that the higher the cost of production a product has, the more allocations it can be burdened with. Often there are also direct sales costs, such as commissions paid to salesmen. These can (most often) easily be recorded on each product. If we now sum up all costs, we get the full cost, FC. The allocation of overhead costs, especially when it comes to sales, general and administrative overhead and, to some extent, material overhead, are quite arbitrary and, therefore, the full cost is in no way “the true cost”. But most companies consider the so-calculated full cost as a good approximation for the true cost, and therefore use it for many different purposes. Now let's practice on absorption costing.

[Slide 5.9] Savox AB paints on commission for

• ther companies. For the year 2018, the

company has forecasted a direct material cost of SEK1,400,000, materials overhead of SEK 280,000, direct wages in production of SEK 400,000, indirect production costs of SEK 880,000 for the planned machine time of 8,800 hours, other direct production costs of SEK 40,000, direct sales costs of SEK 100,000, and sales, general and administrative costs of SEK 1,200,000. Now the company has received an

• rder for painting a plastic component. For this,

39 paint for SEK 5,000, 5 direct working hours, that each cost 1,200 SEK, 10 machine hours as well as a direct sales cost of SEK 1,000 will be needed.

• a. What is the full cost for the company according to plan?

This is a typical situation for an absorption costing system. What we first do, is to look at the cost system for the year. First, we set up the different parts of the costing system, as well as the values according to the information given: Direct material SEK 1,400,000, material overhead SEK 280,000, direct wages SEK 400,000, machine cost SEK 880,000, other direct production cost SEK 40,000. This sums up to the production cost, SEK 3,000,000. To this we add sales, general and administrative SEK 1,200,000 and direct sales costs SEK 100,000, and get the full cost for the year of SEK 4,300,000. This is the answer for a, concerning the full cost

• b. What mark-ups should the company use during the year?

Next, we calculate the mark-ups for the year. For material overhead, the mark-up is 20 % of direct material, calculated as the material overhead SEK 280,000 divided with the direct material SEK 1,400,000. For machine cost, the cost per hour is SEK 100, calculated as the machine cost SEK 880,000 divided with the number of hours according to the information given, 8,800 hours. And, finally, for sales, general and administrative, the mark-up is 40 % of production cost, calculated as the overhead for this SEK 1,200,000 divided with the production cost SEK 3,000,000. These are the answers for b, concerning the mark-ups and cost per hour.

• c. What is the cost for the order now received?

Finally, we cost the order now received. Direct material is, according to the information, SEK 5,000. This we multiply with 20 % for material overhead, which gives SEK 1,000. Direct wages is 5 hours, we take this times the cost per hour SEK 1,200, which gives SEK 6,000. The machines are used 10 hours, we multiply this with the cost per hour SEK 100, which gives SEK 1,000. There are no other direct production costs, so we get a production cost from this of SEK 13,000 as the sum of the parts. This is multiplied with 40 % to get the cost for sales, general and administrative, which is SEK 5,200, and since we also have a direct sales cost of SEK 1,000, the total full cost is SEK 19,200. And that is the answer to c. This is a typical calculation for a full cost system using absorption costing. So, the steps are first to find the mark-ups and the costs per hour for the next year, month or so; and then to use these in costing that periods orders.

40

[Slide 5.10] Atlas Copco uses absorption costing

for the product cost, see a discussion later in this chapter for costs above this. As can be seen, the basic model for absorption costing is followed but with some additions. They start with direct material, and to this adds a mark-up for material on-costs (other costs than direct salaries in the logistics centers) as a percentage

• f the cost of direct material. They add direct

costs in production in the form of cost for subcontractors, direct salaries (from logistics centers and direct production centers), and

• ther direct manufacturing costs, and the indirect costs in production are entered in two different

ways; if they occur in the assembly, they are added as a cost per assembly hour, otherwise they are added as a cost per machine hour. The sum of all costs so far gives the workshop cost, and on this is a mark-up for product line costs is added, which finally leads to the standard product cost.

[Slide 5.11] In this slide, the content in each of the

different cost components in Atlas Copco's product costing systems are specified. Direct material includes raw material, assembly parts and components valued as standard quantity (with normal scrap) times standard price (normal at landed cost). Material on-cost includes indirect costs allocated in percent of direct material from logistics cost centers for purchasing, goods reception, storing and material handling. Subcontracting costs includes direct costs for work performed by external companies. Other direct manufacturing costs includes such as external work hired and travel expenses. Direct wages include the number of hours worked times cost per hour are registered per product. Machining on-cost, per hour includes other costs except direct wages from machining activities allocated as a cost per machine hour times number of hours used by the machine per product. Assembly on-cost, per hour includes other costs except direct wages from assembly activities allocated as a cost per assembly hour times number of hours used by the assembling resources per product. The posts above sum up to a workshop cost Product line on-cost is allocated as a percent of the workshop cost with different rates for each product line. The posts above sum up to the standard product cost

41

[Slide 5.12] The arbitrariness of full costing has

been criticized, and given rise to activity-based costing, ABC. Absorption costing is, as earlier mentioned, based on the concept of full costing, where direct costs are directly recorded on products, while costs that are indirect are recognized at the department that used them and then are allocated on the products. Activity- based costing instead start in the resources that cause the costs and records those that are relevant directly to the products. Those that are common (irrelevant; shared between two or more products) are first recognized on the activities (such as turning, painting, billing, sales) that consume them. And then the costs of that activity are distributed to the products using a driver. A driver is what causes the costs of an activity. It could be the number of lathe hours, the number of painted details, the number of sales orders, and the number of sales meetings respectively for the

• activities. By dividing the cost of an activity with the number of the driver, a cost per driver is
• btained. This cost per driver is then allocated to each product based on the number of drivers used

by that product. In theory, activity-based costing gives a perfect assessment of the cost per product, if handled

• properly. In practice, it provides a much better assessment than what absorption costing gives, but

not a perfect assessment. For example, often more than one driver affects an activity (for example, it isn’t just the number of painted details that affect the activity painting, but also how difficult it is to paint each item). Furthermore, there are no suitable drivers for some activities; for instance, what in a product drives such activities as accounting? Activity-based costing is used by many companies, but even more common is that some important costs in an absorption costing system are dealt with using activities and drivers when the costing system otherwise would be too arbitrary for those. Let’s practice with an example in activity-based costing.

[Slide 5.13] Savox AB has decided to use some ABC

in their costing system. Compare this exercise to the last one, with an absorption costing system for Savox AB. For the year 2018, the company has budgeted a direct material cost of SEK 1,400,000, materials handling of SEK 280,000 that is driven by liter paint, which is estimated to 56,000 liter for the year, production that costs SEK 400,000, machining that costs SEK 880,000 for the planned machine time of 8,800 hours, other direct production costs of SEK 40,000, direct sales costs of SEK 100,000, sales activities of SEK 400,000 that are driven by number of orders, which are estimated to 400 for the year, and general and administrative costs that they can’t find a driver for and that they don’t believe are caused by orders as such of SEK 800,000. Now the company has received an order for painting a

42 plastic component. For this, 140 liter paint for SEK 5,000, 5 direct working hours, that each cost 1,200 SEK, 10 machine hours as well as a direct sales cost of SEK 1,000 will be needed.

• a. What is the full cost for the company according to plan? What we first do, is to look at the cost

system for the year. First, we set up the different parts of the costing system, as well as the values according to the information given: Direct material SEK 1,400,000, material handling SEK 280,000, production SEK 400,000, machining SEK 880,000, direct production costs SEK 40,000. This sums up to the production cost, SEK 3,000,000. To this we add direct sales costs SEK 100,000, and sales activities SEK 400,000. This gives us the full cost for the year of SEK 3,500,000. This is the answer for a, concerning the full cost. But compared to the earlier exercise, this is SEK 800,000 less. The reason is that we don’t include the general and administrative costs, since they were not deemed relevant. Maybe they could find activities and drivers for some of these (such as they did for the activities material handling with # of liters, production with # of production hours, machining with #of machining hours, and sales with # of orders), but in close to all cases, there are always some costs that can’t be placed on orders and such in an ABC system.

• b. What costs per driver should the company use during the year? For material handling, the driver is

number of liters, and the cost per driver is SEK 5, calculated as the activity cost SEK 280,000 divided with the planned usage of the driver 56,000 liters. The same idea is used for the activities machining (SEK 880,000 divided with 8,800 hours) and sales activities (SEK 400,000 divided with 400 orders). The other activities and relevant costs don’t need a calculated driver: for production, we used the known number of hours and known cost per hour for that personnel, and direct production costs and direct sales costs can be traced directly to respective order,

• c. What is the cost for the order now received? Direct material is, according to the information, SEK

5,000. Material handling is calculated with the driver 140 liter times the cost per driver SEK 5 to SEK

• 700. Production is calculated with the known cost per hour SEK 1,200 times the known number of

hours 5 to SEK 6,000. Machining is calculated with the driver 10 hours times the cost per driver SEK

• 100. There is no other direct production costs for this order, so the production cost is SEK 12,700 as

the sum of these parts. Then, we add the known direct sales cost SEK 1,000 and the sales activities calculated with the driver 1 order times the cost per driver SEK 1,000. The sum of all this is the full cost SEK 14,700. And that is the answer to c. Note that it is lower than when they used absorption costing in the last exercise; because this specific order has received less costs due to the change to drivers (other orders will receive more), but mainly because we only calculate with relevant costs in

• ABC. If the price is based on the cost, the company needs to use a higher margin.

Let's go ahead and see how Atlas Copco uses activity-based costing

43

[Slide 5.14] Atlas Copco uses activity-based costing

in cases where they want to calculate the full

• cost. This is done relatively rarely. For

administration and sales, they then try to find as relevant ways to allocate the cost as possible. What can be distributed directly is distributed directly, what they find good causal links for according to ABC is distributed by means of activities and drivers, and what is left is distributed as a percentage of the product cost. The resulting costing model will thus be an intermediate between absorption costing and activity-based costing.

[Slide 5.15] What does a company have its

absorption costing system for? This varies, of course, but Atlas Copco, like many other companies, uses its calculations as a basis for determining the correct batch size (economic

• rder quantity), for selecting production

methods, for choosing between producing themselves or outsourcing, for comparisons against the sales price, as a basis for pricing transfers between the company's own units, for assessments when developing new products, for investments in expanded production capacity and in divestments of operations. But they use it just as a starting point; as we shall see later, the calculations must first be modified so that they become relevant to the decision. Note that Atlas Copco does not use the cost for pricing (see chapter 4 on acting in the market for a discussion on this; instead, they set value-based prices), as many other companies do. What does it mean to establish decision-relevant costs? Let's look at this next

[Slide 5.16] The concepts of relevant and

irrelevant are used for decisions. Instead of the word “relevant”, one can say "depends on"; if the revenue or cost is dependent on the decision, it’s relevant; if it isn’t, it’s irrelevant. There are several different types of decisions where these concepts are used, e g for analyzing different products, that we’ll look at later. First, let’s focus on how the concepts are used when costing products. Let’s say that we produce five different

• products. On each product, we record the

revenues and costs that are relevant for that product. The relevant costs are the costs that we have if

44 we produce that product. That is, the material, the work and so on that depends on that product. If we were to stop production of that product, we would no longer have those costs. For each product, we calculate the relevant revenues and costs. The difference between the relevant revenues and the relevant costs represent the contribution margin of that product. If we multiply the contribution margin with the volume, the number of products sold, we get the total contribution margin. If we then sum up the total contribution margin for all products, we still don’t know if we have a profit or a loss. We must first subtract our irrelevant or common costs; the costs that do not depend

• n a product (such as the machinery used by several products, the costs of the accounting

department, the cost of common rooms, and so on). Thus, we can’t see, from the contribution margin, if the product has a profit or not; we can only see if it makes a positive contribution margin to cover common costs or not. If we divide the contribution margin to the price of the product, we get the contribution margin ratio. This is often referred to as the gross margin. If, for example, the contribution margin is SEK 20 and the price is SEK 100, the contribution margin ratio is 20%. This measure says a lot about how the product will help to cover our common costs.

[Slide 5.17] So, contribution margin costing only

uses relevant revenues and costs; those that are relevant to the decision. Let's look at a few such common decision situations and see in more detail what we should consider when the contribution margin is established for them. When we want to decide whether to accept an

• rder or not, we should only consider decision

relevant, order specific effects in the short term. So, we should only include relevant revenues and costs for the order. This might mean that an

• rder should be accepted even if full costing

gives a loss: If the relevant revenues are larger than the relevant costs, we get a positive contribution margin that helps to cover our irrelevant, or common, costs. If we have spare capacity in the company, all products, orders and so on should be produced that provides a positive contribution margin. But if we don’t have spare capacity, if we have a constraint, also called a bottleneck (for example, a limited number of lathe hours, a limited supply of materials

• r the like) that restricts and forces us to choose, how do we choose? Since we want to have as high

a total contribution margin as possible, we should choose the product, order or similar that gives the highest total contribution margin. This is the same as to choose the product that gives the highest contribution margin per constraint (such as the contribution margin per lathe hour, or the contribution margin per kg of material). If we have two or more constraints, we go about in the same way but will have to weigh up the various constraints. This can be done by linear programming, which is not discussed here. Then the analysis focuses on what combination of products, orders or similar that gives the highest total contribution margin, considering all the different constraints.

45 Generally, for decisions on changes, the basic rule is that we need to take into consideration revenues and costs that are relevant for the decision in the short term. Next, let's practice some decision-making situations.

[Slide 5.18] ChoicesAB present calculated data for

9 requests from customers, see the table. The company has enough capacity to accept all these 9 production orders. Which of the requests should the company accept? When making decisions, we should only look at the relevant revenues and the relevant costs; those parts that are relevant for the decision. So, we shouldn’t care about the full cost, since that include some irrelevant costs - costs that have been allocated one way or another. This means, that those orders for which the price, which is the relevant revenue, is higher than the relevant cost, should be accepted - they give more revenues than costs to the company. This is true for orders B, C, D, E, G, H and I. It doesn’t matter if they accept F or not - it doesn’t give anything as a net, and it doesn’t cost anything as a net either. Concerning A, it has higher relevant costs than relevant revenues, so they will lose from it as a net value, and therefore they shouldn’t accept it. This might be difficult to grasp. Take e g order E, where the price is lower than the full cost. Don’t they lose money on that order? No. The rest of the costs aren’t interesting for the decision. If you e g are thinking about buying a ticket to a concert, and thinking about if it is worth the price or not, an allocation of costs for e g your apartment shouldn’t affect the decision to go to the concert or not -

• nly the relevant revenue (the pleasure) compared to the relevant cost (the price of the ticket, the

traveling cost to go there, and so on) are interesting for the decision.

[Slide 5.19] Bodyworks AB produces two parts to

producers of exclusive dolls; Arms and Legs. For these products, the following information (per unit) is provided: For Arms, selling price SEK 200, variable relevant cost SEK 120, allocated cost SEK 40, machine time per unit 10 minutes, and material used per unit 2 kilogram. And for Legs, selling price SEK 140, variable relevant cost SEK 100, allocated cost SEK 40, machine time per unit 40 minutes, and material used per unit 0.5 kilogram.

• a. Which of the two products should they

produce, if there is only 30,000 machine minutes available but enough of all other resources? There are two alternative ways to solve this, both gives the same answer in all situations:

46

• 1. Choose the product that gives the highest contribution margin per scarce resource. The

contribution margin is SEK 80 (SEK 200 - SEK 120) for Arms, and SEK 40 (SEK 140 - SEK 100) for Legs. Please note, that allocated cost isn’t a relevant cost. Next, we divide the contribution margin with the usage of the scarce resource, for Arms SEK 80/10 minutes each, and for Legs 40/40 minutes each. So, they should produce Arms, since this product has the highest contribution margin per machine minute (SEK 8 compared to SEK 1 per minute).

• 2. Choose the product that gives the highest possible total contribution margin. First, we

calculate the contribution margin, as above it is SEK 80 (SEK 200 - SEK 120) for Arms and SEK 40 (SEK 140 - SEK 100) for Legs. Then, we calculate how many units we can produce

• respectively. We have 30,000 machine minutes available, each Arm takes 10 minutes to

produce, so we can produce 3,000 Arms (30,000 minutes/10 minutes). Or, we have 30,000 machine minutes available, each Leg takes 40 minutes to produce, so we can produce 750 Legs (30,000 minutes/40 minutes). Now, we can calculate the total contribution for each product: For Arms, 3,000 units x SEK 80, and for Legs, 750 units x SEK 40. So, they should produce Arms, since this product has the highest total contribution margin (SEK 240,000 compared to SEK 30,000)

• b. Now, which of the two products should they produce, if there is only 1,000 kg of material available

but enough of all other resources? So, now there is no shortage of machine minutes, but instead a shortage in material. We can solve this in the same two ways as we solved the earlier question.

• 1. Choose the product that gives the highest contribution margin per scarce resource. We

divide the contribution margin with the usage of the scarce resource, for Arms SEK 80/2 kg each, and for Legs SEK 40/0,5 kg each. So, they should produce Legs, since this product has the highest contribution margin per kg material (SEK 80 compared to SEK 40 per kg).

• 2. Choose the product that gives the highest possible total contribution margin. First, we

calculate how many units we can produce respectively. We have 1,000 kg material available, each Arm takes 2 kg to produce, so we can produce 500 Arms (1,000 kg/2 kg). Or, we have 1,000 kg material available, each Leg takes 0.5 kg to produce, so we can produce 2,000 Legs (1,000 kg/0.5 kg). Now, we can calculate the total contribution for each product: For Arms, 500 units x SEK 80, and for Legs, 2,000 units x SEK 40. So, they should produce Legs, since this product has the highest total contribution margin (SEK 80,000 compared to SEK 40,000)

• c. Finally, if they can only sell a maximum of 1,000 Arms and a maximum of 1,000 Legs, how many of

the two products should they produce, if there is only 1,000 kg of material available but enough of all

• ther resources? We know from b. above that Legs are most profitable as material is scarce, but we

shouldn’t produce the 2,000 Legs that can be produced with the limited material since we can only sell 1,000 of it! So, we should produce the 1,000 Legs that can be sold in the first place. We use up 500 kg of material for 1,000 Legs (1,000 Legs x 0.5 kg per Leg), so we have 500 kg left (1,000 kg available - 500 kg used). For this, we can produce 250 Arms (500 kg/2 kg per unit). So, the answer is that they should produce 1,000 Legs and 250 Arms. This gives the highest total contribution given these two bottlenecks (a constraint in the possible to sell and a constraint in the amount of material available). One more thing should be said here. This only shows the mathematical effects from this. There are many other effects. One; can they really sell only arms like in a, or only legs like in b? Don’t the customers want two arms and two legs for each doll? This makes it obvious that the calculations are

• nly one part of the decision.

47

[Slide 5.20] Absorption costing has the advantage

• f weighing in all the costs, contribution margin

costing doesn’t which makes contribution margin costing in some way an incomplete costing method. Contribution margin costing has the advantage that it is decision relevant, absorption costing is not as it also contains costs that are irrelevant for decision-making. It’s possible to combine the two, and that is done in stepwise costing, where the revenues and costs relevant for different levels of decision are summarized. So, for example, stepwise costing can begin with the contribution margin per product as relevant revenues less relevant costs, sum the products contribution margin and add the relevant costs for the product group (which is common costs, irrelevant costs, for the products) and get the contribution margin for the product group; then sum all the strategic business units, SBU, product groups contribution margin and add the relevant costs for the strategic business unit (which is common costs, irrelevant costs, for the product groups) and get the contribution margin for the strategic business unit: then sum all strategic business units contribution margin and add the common costs for the company (which is irrelevant costs for the strategic business units), and reach the profit (or loss) of the company. The same type of stepwise calculation can be made for such objects as orders and similar.

[Slide 5.21] In some situations other costing

models fits better. Process costing is well suited when we do not produce products that should be calculated one by one, but more a constant flow of like products where it isn’t meaningful to measure each unit separately. If we produce nails, we do not calculate the cost per nail but for the whole process; if we are a hairdresser, we do not calculate every trim for themselves but the whole day's or month's activities summarized. Then we divide the total cost by volume. If the units produced are somewhat different, process costing can’t reflect this difference between the units. Then an equivalent units’ cost is better. An equivalent unit is a comparative measure. Let's say that some nails are using twice as much material as the others. Then small nails get the equivalent 1, the larger nails the equivalent 2, and then the material cost is distributed to the different nails using these equivalent measures. Each large nail then gets double the material cost as the other nails. Similarly, perhaps customers with a lot of hair takes, say, 50% longer to trim than

• thers. Then customers with a lot of hair receives the equivalent number 1.5, unlike the other

customers that receive the equivalent number 1 in the distribution of trimming cost.

48 If two or more products are manufactured under a partly joint process, and then refined each one individually, the cost that is common is distributed in some way among the products (for example with process costing), and the part that is specific for the different products is registered directly on each product. If for example, we extract and distribute oil and gas, probably the first part, the actual extraction, is a joint process and therefore allocated between the products based on the volume in cubic meters. Then, once the oil and gas are extracted, they are conveyed in different ways. The oil gets its distribution costs, the gas gets its distribution costs. However, sometimes one (or more) of the products is the main product and one (or more) a by-

• product. Say for example that we grind wheat, and as products get both wheat flour, which has a

high value, and bran, which has a low value. Wheat flour is the main product, bran is a by-product that we can sell or discard. The by-product is not a standalone product, we cannot think of discarding the wheat flour and retain the bran, but the other way around is possible. Then, contribution margin costing is used for the by-product, to see if it makes sense to further refine it. All other revenues and expenses, whether they are relevant or irrelevant, are allocated to the main product, as well as the contribution margin of the by-product (positive or negative). This is a by-product costing system. Let's finish this chapter with exercises on these other methods for full costing.

[Slide 5.22] In this exercise, we will look at the

company Spiken. This company produces nails

• f one single dimension and without hardening.

This year they estimate to produce 85,000 boxes

• f such nails. According to the budget, the

company will have the following costs for their production: Variable costs of SEK 1,105,000, and Fixed costs of SEK 765,000. The year before this, they produced 115,000 boxes of nails. Normally, over a 10-year-period, they produce 100,000 boxes of nails per year. So, the question is: What is the cost of a box of nails? First, in this case, a process costing system is the best, since they produce the same product in a continuous flow. Please note that the information about what costs that are variable and fixed, and the information about how many boxes of nails they produced the period before and in a normal year are not interesting for the calculation. But it might be; E g, in some companies they divide the fixed cost with the normal volume and the variable cost with the actual or budgeted volume, in order not to let the variations between years just because of changes in volume affect the cost. This is

• utside the scope of this course.

So, we first must calculate the total cost, SEK 1,105,000 + SEK 765,000, and then divide this with the 85,000 boxes which gives us SEK 22 per box. Overall, process costing is this simple. But in real companies, it might be much more complicated, first, because of the mentioned use of normal costing. Then also, because what is volume tend to change between process steps. E g when producing paper, in the beginning the volume is tons of wood, then later tons of wooden chips, then later tons of floating pulp, and later tons of paper in rolls, and so on.

49

[Slide 5.23] As you might remember, Spiken AB

produces nails of one single dimension and without hardening. This year they estimate to produce 85,000 boxes of such nails. According to the budget, the company will have SEK 1,105,000 in variable costs and SEK 765,000 in fixed costs for the year. This means, that the cost per box of nails is SEK 22, which we calculated as (SEK 1,105,000 + SEK 765,000)/85,000 boxes in the earlier exercise. Now, they plan to harden 25,000 of these boxes

• f nails (and to keep the remaining 60,000 boxes

without hardening). Hardening should be done by a subcontractor, and costs SEK 5 per box. What is the total cost for each type of nails, and what is the cost per box of nails for the respective type of nails? Now, the best is to use a modified form of process costing, named joint product costing. In this, the costs in the common parts of the production process, up to the split point, are divided in some way between the different products, often due to number of products, kg material, value of the product,

• r similar. In this case, since the products are the same up to the point where the subcontractor

takes over production with hardening, the split point, it’s quite natural to use number of boxes for

• this. The costs after this spilt point are allocated to the product that uses that part of the process, in

this case the hardened nails while the non-hardened nails don’t have any other costs. We can start with the cost per box in the joint process, which is SEK 22 as we have seen earlier. This means that this also is the cost for the regular (non-hardened) nails per box. The total cost of the regular nails is calculated as 60,000 boxes times SEK 22 per box, which gives the total cost for regular nails of SEK 1,320,000. Now we calculate the cost for the hardened nails. The cost per box is SEK 22 for the common process plus SEK 5 for the hardening, and this gives the cost SEK 27 for each box of hardened nails. The total cost of the hardened nails is calculated as 25,000 boxes times SEK 25 per box, which gives the total cost for hardened nails of SEK 675,000. This type of costing is common where there are large series of the same products but where there are some differences between them. There can be, as in this example, differences in the production process, but there could also be differences in sizes, differences in weight, and so on.

50

[Slide 5.24] As you might remember, Spiken AB

produces nails of one single dimension and without hardening. This year they estimate to produce 85,000 boxes of such nails. According to the budget, the company will have SEK 1,105,000 in variable costs and SEK 765,000 in fixed costs for the year. This means, that the cost per box of nails is SEK 22, which we calculated as (SEK 1,105,000 + SEK 765,000)/85,000 boxes in an earlier exercise. Now, they plan to use some of the waste material that the production gives. Today, they are recycling it at a cost of SEK 0.50 per kg. For this year, they plan to recycle 10.000 kg material at a cost of SEK 5.000, included in the planned variable cost. If they instead sell it as hobby material, they can get SEK 20.000 for it. To do this, they need to pack it, distribute it, and so on, at a cost this year of SEK 15.000. How should they calculate in this situation? The best is to use a modified form of joint product costing, namely by-product costing. This is suitable in those situations where there is one or more main products (in this case nails) and one or more by-products (in this case the hobby material). They wouldn’t think of stopping selling nails and

• nly sell hobby material, that doesn’t seem to be profitable, but they might stop producing the by-

product (or as earlier in this case, never start to produce it). In this situation, we want to see the relevant revenues and costs of the by-product to be able to make decisions about it, so the costs in the common parts of the production process are allocated to the main product, while the by-product gets its relevant revenues and costs. The result of this, this contribution margin, is then allocated to the main product and if it is positive (if they gain from the by-product) they produce it, if it is negative (if they loose from the by-product) they seize to produce it. The costs for the nails are, as earlier, the common variable costs of SEK 1,105,000 plus the common fixed costs of SEK 765,000, in total -1,870,000, a minus because these are costs. Then we calculate the hobby material, and we take the relevant revenue in the form of the selling price +20,000, to this add the relevant revenue in the form of spared costs (for recycling) +5,000, and then subtract the relevant cost for selling it -15,000. The sum is positive with SEK 10,000, and this is allocated to the main product, nails, which result in that that products cost is lowered with SEK 10,000 and is now SEK 1,860,000 instead. So, the company gain from selling hobby material, and the suggestion is therefore that they should continue with that. There is a specific section about contribution margin in this chapter, if you want further explanations

• n why we only look at relevant revenues and costs for decisions.

51

[Slide 5.25] Kvadraten AB produces a beautiful

square of something, used for decoration

• purposes. It has three different types of these

squares: Aztec, Baztec, and Caztec. Each unit of these has a direct cost in sales of SEK 20, the same for all three products. The total manufacturing cost, which is to produce all three products, is estimated to SEK 2,320,000 for this year. During the year, the production is estimated to 20,000 units in total, with 10,000 units of Aztec, 2,000 units of Baztec, and 8,000 units of Caztec. The cost is estimated to depend

• n the number of units, but also on the number of square meters for each product. Each Aztec is 2

square meters large, each Baztec is 3 square meters large, and each Caztec is 4 square meters large. What is the cost for each unit of Aztec, each unit of Baztec, and each unit of Caztec? In this example, there are one difference between the different products; that they are different in size, something that affects the cost. Therefore, an equivalent unit costing system is useful for this. What we do then, is to take the equivalent, in this case the square meter used per product for each

• f the three products, times the quantity for each of them. This multiplication gives the number of

equivalents for each of them, for Aztec 20,000 (2 x 10,000), Baztec 6,000 (3 x 2,000), and for Caztec 32,000 (4 x 8,000). If we sum these three, we get the total sum of equivalents 58,000. The next step is to see what part of the total cost each type of product should take. We then look at the relative size of the sum of equivalents for each of the three products and multiply this with the total cost. Aztec, then had a total sum of equivalents of 20,000, and if we divide this with the total sum of equivalents for all products, 58,000, and takes this multiplied with the total cost of SEK 2,320,000 given in the information, we get a cost of SEK 800,000. The same used for the other products gives SEK 240,000 (6,000/58,000 x SEK 2,320,000) for Baztec and SEK 1,280,000 (32,000/58,000 x SEK 2,320,000) for Caztec. The sum of all these costs is the same as we started with as a total, SEK 2,320,000. Then, we find the allocated cost per product from this: For Aztec, SEK 800,000 divided with the quantity 10,000 products, which gives SEK 80 each; for Baztec SEK 240,000/2,000 products, 120 SEK each, and for Caztec SEK 1,280,000/8,000 products, SEK 160 each. Finally, to this we add the direct cost of SEK 20 each, which gives, for Aztec, SEK 80 + SEK 20 = SEK 100, Baztec SEK 120 + SEK 20 = SEK 140, and Caztec SEK 160 + SEK 20 = SEK 180. So, the equivalent unit’s cost is when the common costs are allocated to the products based on the difference between them measured as equivalents and the relative number of each product. To this, the relevant costs for each product is added.

[Slide 5.26, not included] Well, that was chapter 5 of 9 in the course “Management of an Industrial

Company”, and it dealt with costing of products and orders. I hope that the overview gave you some new insights that you will have use of. Bye!

52

• 6. Decisions about Investments

[Slide 6.1] Hi. Welcome to the course

“Management of an Industrial Company" and Chapter 6 of 9: Decisions about investments. In this chapter, we will look more closely at how the company makes decisions for investments. We begin by explaining why interest needs to be included in the calculations, then discuss different types of investments, then explore the different concepts for the calculations and the different methods used. Finally, this sums up to a presentation on how the basis of decision is designed and how the decisions are made.

[Slide 6.2, not included] The content gives a summary and an overview of Chapter 6 in the book

“Management of an Industrial Company - Atlas Copco Industrial Technique" by me, Håkan Kullvén. The book is published by Studentlitteratur, Lund, in 2018. If you have any suggestions for changes you can send these to me at kullven@outlook.com. If you want to practice on the concepts of this chapter, you can do this at www.socrative.com, student login, room STUD6.

[Slide 6.3] An investment is meant to give a value

in the future, often defined as more than one year from now. As we must manage longer time perspectives than we do in costing, the interest has an effect. A SEK today is worth more than a SEK a year from now, since a SEK today can earn interest if it, for example, is placed in a bank account, and the interest rate makes it worth more than one SEK after one year. The interest is calculated starting from when the payment is

• made. Therefore, we’ll, in this section, use the

concept of cash in and cash out rather than revenues and costs. Suppose that we deposit SEK 1,000 in a bank account on January 1, 2019, and that we’ll receive 10% interest on this account. 10% interest is unrealistically high nowadays, but by choosing 10%, it becomes easier to see the effects of the interest rate. If we think of time as a line and increase the amount by 10% each year by multiplying the amount with 1.1 each year, the amount, including interest, grow from year to year until it after five years, in late 2023, amount for SEK 1,610. So, SEK 1,000 today is worth as much as, for example, SEK 1,610 in five years, if the interest is 10%. It’s also worth as much as SEK 1,100 at the end of 2019, SEK 1,210 at the end of 2020, SEK 1,331 at the end of 2021, and SEK 1,464 at the end of 2022. This effect, where the interest is calculated not only on the

• riginal deposit, but also on the interest obtained previously, is called compound interest, and the

result obtained is called the future value. By multiplying the original capital with (1 + interest) to the power of the number of years, we obtain the amount it has grown to during that number of years.

53 The future value is a good start, but it is easier to turn it all over and instead calculate the present

• value. Now let's see how this can be done.

[Slide 6.4] As said earlier, it's easier to understand

values if they are specified as values now, present value. We can obtain the present value by inverting the formula for the future value, that is, by dividing 1 with the formula for the future value that we have just discussed. What is SEK 1,610, obtained at the end of year 2023, worth today, 1 January 2019, if the interest is 10%? That is, what is the present value of this amount? Note that SEK 1,610 is the value we got in the previous calculations after five years from SEK 1,000 that were deposited in the bank at the beginning of year 2019 to 10% interest. By dividing the amount with 1.1 (where 0.1 represents the interest of 10%), we obtain the value in the previous year, and by then continue to divide the remaining amount with 1.1 for each year, we finally obtain the present value SEK 1,000 on January 1, 2019. This means that SEK 1,610 at the end of 2023 is worth as much as SEK 1,000 in the beginning of 2019; the present value of SEK 1,610 at the end of year 2023 is SEK 1,000. The present value is obtained with the formula used earlier, for future value calculations, inverted by dividing 1 with it. In order to simplify (if we use manual calculations), a calculation of a series of similar payments can be merged. We shall now look more closely at this.

[Slide 6.5] Sum of present value is the sum of

present value for a series of payments; for the same payments for several consecutive years. If, for example, we pay SEK 1,000 at the end of 2019, 2020, 2021, 2022 and 2023; what is the total present value of all these payments if the interest is 10%? Of course, we can get the answer if we make a present value calculation as before for each of the five years, and then sum those up, but we can also simplify this by making a single calculation for all five years. There is a formula for the sum of present value that manages this summation for us. If we use the formula, we obtain the sum of present value of SEK 3,791. This means that the present value of SEK 1,000 for five years amounts to SEK 3,791 if the interest is 10%. The formula we have now developed can also be inverted, and with this we get an opportunity to calculate the annuity of an investment. Let's take a closer look at what this means.

54

[Slide 6.6] Present value calculations are very

common in investment appraisal. A variant of this that is used quite often is the calculation of

• annuity. An annuity is a value converted to an

annual amount. In earlier calculations, we found that the present value of SEK 1,000 for five consecutive years amounted to SEK 3,791. Now let's turn this

• around. We pay SEK 3,791 today, January 1 in
• 2019. What is the annual value of this payment
• ver five years, if the interest is 10%? If we take

the formula we used to calculate the total present value, and let the numerator change places with the denominator and vice versa, we obtain the formula for the annuity. If we then multiply the formula with SEK 3,791, we obtain SEK 1,000, the value we had for a single year in the previous calculations. Thus, the annuity of SEK 3,791 is SEK 1,000 for five years, if the interest is 10%. That is, the SEK 3,791 in present value has the same value as the annuity SEK 1,000 per year for five years, just as we have noted previously, given that the interest is 10%. Now we have developed all the formulas that are needed and can look more closely at what investments are and how an investment appraisal can be made.

[Slide 6.7] Companies often classify their

investments in different types, based on the investment's purpose. Replacement investments, for example when an existing lathe is replaced with a new one, are relatively simple to make an investment appraisal for and often causes a low risk. They are dealt with in a separate category. Expansion investments, when we for example buy another lathe machine to increase the volume, contains a higher risk and more uncertainty in the estimate, since we can’t be certain to find a market for the higher

• volume. Rationalization investments often means that we replace manual labor with machines, or

that we replace an old technology with a new one, and also in those cases we often have large uncertainties, and must also take into account how the new technology affects the rest of the machinery and the like. Finally, about investments in the internal and external environment, they

• ften have no cash inflows, but are often forced upon the company by law or regulations or are

invested in as a part of company policy. They cannot "compete for the same money" as economically profitable investments but are often given their own budget. The balance sheet includes investments specified as property, plant and equipment, intangible and financial investments. There are also investments that are not visible in the statement of financial position, such as investments in marketing campaigns and in education. Another aspect, which often affects the classification, is the economic life of the investment. Investments with short economic lives do not tie up the company’s capital on long-term and we can

55 therefore make a less detailed assessment for those. Long-term investments tie up capital for a longer time period and tend to affect the company's future operations, and therefore need a more careful investment appraisal since they give an increased uncertainty.

[Slide 6.8] Atlas Copco classifies its investments in

different ways; partly they are divided according to the balance sheet into tangible fixed assets, goodwill and intangible assets, and finally larger expense projects; they are divided into replacement investments, expansion investments, rationalization investments and investments in the internal and external

• environment. Atlas Copco also uses investment

calculations when acquiring companies; vertical integration in the value chain and horizontal integration of competitors.

[Slide 6.9] We can think of an investment as

something which takes place on a timeline. Above the line, we have positive entries, below negative entries. At time 0, thus directly at the point of departure of the investment, we often have a negative outlay called the Initial outlay, I. This is often the payment for the machine, property or whatever it’s that we are investing in. Next, we often have an annual positive amount, cash inflow, CI, which usually can be calculated as the volume of products sold times the price per product. These are payments for what we can produce with e g the machine. Sometimes we have no such cash inflows, and therefore no positive payments in the calculation. Usually, we also have cash outflows, CO, the same years, which may be payments for such resources as salaries to the employees working at the machine, payments for electricity, material and so on. It’s obviously possible to calculate cash in and cash out separately. However, since the interest is the same for both, we can also summarize them. If we do that, calculate the cash inflows minus the cash outflows for each year, we get the annual net cash inflow, a. The economic life, y, is the time we believe that it’s economically viable to maintain the investment. It can be much shorter than the technical life. After the economic life, we often have a disposal value, D, which can be positive because we get paid for the machine that we phase out, or negative, for example because it involves payments to remove and dispose the machine.

56

[Slide 6.10] As for the economic life, Atlas Copco

has set a limit at five years. This is because the risk and uncertainty in the input values are that great at longer periods of time. But often, investments are made in the longer term than five years, for example when buying another company or investing in real estate. In such cases, Atlas Copco add a positive residual value that corresponds to what the investment is worth after five years to the calculations.

[Slide 6.11] The calculation also includes an

interest, i, expressed in percent. What interest should we use? This largely depends on the risk associated with the investment. Basically, we have a real interest, which is an expression of the general increase in wealth of the community

• ver time. If we add inflation, how much prices
• n average rise in the society, we get a nominal

risk-free interest. This is the demand for interest we have on risk-free investments. We can assume that an investment in government bonds, to loan to the state, is a completely risk- free investment. The state doesn’t go bankrupt, and if it should do so, the government's money doesn’t have any value anymore. By looking at stock exchange sites on the web, we find the interest

• n government bonds for different time periods, such as five years or ten years. This is the nominal

risk-free interest for investments that have an economic life of five and ten years, respectively. On this nominal risk-free interest, we can then add some more percentages to cover the risk of the

• project. High-risk projects receive a high-risk premium, low-risk projects may receive small additional
• charges. The sum represents the interest, i.

Many companies use WACC, weighted average cost of capital, as the basis for the interest. The weighted average cost of capital is the average interest they must pay to their investors. So, they weigh the cost they have for borrowed capital (interest paid) with the interest demanded by the

• wners for their capital. Not all liabilities are included in the calculations; only equity and those

liabilities that they pay interest for, the capital employed.

57

[Slide 6.12] Here's how Atlas Copco calculates its

cost of capital for investment assessment: They expect a long-term real interest rate of 2% and long-term inflation of 2%, giving 4% nominal risk-free interest on the debt, which represents 20% of the capital, i.e. 0.8% weighted. For shareholders' equity, 5% is added to the risk premium for the owners, which gives 9% cost of capital for equity (80% of the capital), i.e. 7.2%

• weighted. In total, 8%, which before tax (which

is assumed to be 24% in the long term weighted in the countries Atlas Copco operates) gives 10.5%. This is the risk-free cost of money, and on this the risk is added (which we will discuss more about later).

[Slide 6.13] There are several different methods

for investment appraisal to choose from. The net present value (NPV) method is a method that calculates an investment's present value (the word “net” is a clarification that it includes all cash flow for the investment). A positive net present value means that it’s a profitable investment; if it’s an investment that doesn’t provide any cash inflows the lower the negative value, the better. When choosing between alternative investments, the investment that gives the highest positive net present value (if there are cash inflows as well) or the lowest negative value (if the investment doesn’t bring any cash inflows) is best. If we must choose between two or more investments that have different economic lives, this method isn’t valid, see the annuity method below for those cases. The annuity method calculates the annuity of an investment, that is, its annual net cash inflow or its annual cash outflow. The alternative that has the highest positive annuity (if there are cash inflows as well) or the lowest negative annuity (if the investment doesn’t bring any cash inflows) is most profitable when choosing between alternatives. Since annual cash flows are calculated with the method, it can be used even if the alternatives have different economic lives. The internal rate of return, IRR, method can be used if the investment also has cash inflows. First, the net present value of an investment is calculated with a specific interest. If the net present value is positive, we try with a higher interest, and if it’s negative, we try with a lower interest, until we get a net present value that is as close to zero as possible. The interest when this happens is the internal rate of return. If the interest is, say, 15%, this means that the investment has a return of 15%. The higher the interest, the better, and companies tend to specify certain values on the internal rate of return that need to be exceeded, such as "the internal rate of return must be at least 12% on this type of investment." Theoretically, there is an important difference between these three methods, a difference that is not that interesting in practical life. When ranking alternatives, the internal rate of return is a more

58 correct method if there is a shortage of capital in the community since it takes the relative use of capital into account, while annuity (and, if the economic life of the alternative investments is the same, the net present value method) is correct if there is no shortage of capital since it doesn’t relate the profitability to the use of capital. The methods can sometimes give different answers in terms of ranking, and in these situations, it may be interesting to know the reason why it’s so.

[Slide 6.14] There are also some methods that

aren’t valid, but that are commonly used in

• practice. Payback period is a simple and very

common method that can be used only when we also have cash inflows from the investment. With the method, we sum the annual net cash inflow until that sum is equal to the initial

• utlay. If, for example, we have an initial outlay
• f SEK 1,000, and annual payments of SEK 250

per year, the payback period is four years. In cases like in this example, when all the years have the same annual net cash inflow, we can also divide the initial outlay with the annual net cash inflow, in this case SEK 1,000/SEK 250 = 4 years. The method is not correct, both because it’s myopic (it doesn’t include the years after the payback period in the calculation), and because it doesn’t take interest into account (this can be remedied, but then the simplicity of the model is lost). Then, this method is not valid at all, but because it’s so simple, it has a strong foothold in practice. Abroad, for example in the US and in England, it’s common to make a calculation of the accounting rate of return, ARR, when appraising investments. This can be compared with the calculation of the payback period and contains the same types of problems. Since many companies in Sweden are parts

• f groups that are controlled by foreign companies, it may be interesting to know about this type of

investment appraisal too. First, the average of the annual net cash inflow is calculated as (sum of cash inflow – sum of cash outflow)/economic life. Then, the average investment is calculated as (initial outlay + disposal value)/2. And then the average of the annual net cash inflow is divided with the average investment.

[Slide 6.15] Atlas Copco uses the net present value

method as the main method for their investment appraisals, but supplements with the payback period for choices between alternatives that are equivalent in profitability according to this. Now let's practice some of the different investment appraisal methods.

59

[Slide 6.16] IntrovertAB is planning to set up a

production of expandable Introvertörer. If they go into this production, it will result in initial investments of SEK 1,000,000. The production will then run for eight years and give annual cash inflows of SEK 500,000, and annual cash

• utflows of SEK 250,000. After eight years, the

site must be restored. This results in an additional cash outflow of SEK 1,000,000. The discount rate for this type of project, with this level of risk, is 8% In a, we should calculate the investment's net present value and decide if the investment is profitable. So, we take the initial outlay of -SEK 1,000,000, and to this we add the difference between the annual cash inflows of SEK 500,000 and the annual cash outflow of SEK 250,000, which gives +SEK 250,000, times the formula for sum of present value (Capital x ((1-(1 + interest)-economic life)/interest) which, with 8 years and the interest 8 percent, gives ((1-(1 + 0.08)-8)/0.08) minus the disposal value of -SEK 1,000,000 times the formula for present value (Capital x (1/(1 + interest)economic life)) which, with 8 years and the interest 8 percent, gives (1/(1 + 0.08)8). This is -SEK 1,000.000 + SEK 1,436,660 -SEK 540,269 which, in sum, gives -SEK 103,609. The investment gives a negative net present value and is therefore not profitable In b, we should calculate the investment's annuity and decide if the investment is profitable. So, we take the net present value -SEK 103,609 times the formula for annuity (Capital x (interest/(1-(1 + interest)-economic life)) which, with 8 years and the interest 8 percent, gives (-103,609 x (0.08/(1-(1 + 0.08)-8)). This gives -SEK 18,029. The investment gives a negative annuity (we knew that already, since the net present value was negative the annuity also must be so) and is therefore not profitable. In c, we should calculate the investment's payback time. The payback time can be calculated as the initial outlay, SEK 1,000,000, divided with the annual net cash flow, SEK 250,000, which gives 4 years (SEK 1,000,000/SEK 250,000). We don’t know if this is profitable or not, it depends on the demand for payback time the company has settled. If it is e g no more than 3 years; the investment is not profitable, if it is e g no more than 5 years, the investment is profitable. Note that if the annual net cash flow would be different each year, we should sum the different years net cash flow until the sum equals the initial outlay. When that happens, we have the payback time. In d, we should calculate the investment's IRR, internal rate of return. A tip for calculating this was to summarize all cash inflows and cash outflows first. So, let’s do that: Total cash inflows = yearly cash inflows of SEK 500,000 times 8 years, which gives SEK 4,000,000. Total cash outflows = yearly cash

• utflows of SEK 250,000 times 8 years + the initial outlay of SEK 1,000,000 + the disposal value of SEK

1,000,000, which gives 4,000,000 SEK. Thus; at 0 % interest rate, the net present value is 0, because then the cash flow is 4,000,000-4,000,000 = 0. So, in this very special case, the internal rate of return is 0 %. This means that the investment doesn’t give any return at all, so it is probably not profitable (we don’t know the company rule of how high the return must be, but it’s most probably more than 0 %).

60

[Slide 6.17] The company Nyinvest AB plans to

invest in a new machine. This machine requires an initial investment of SEK 500,000. The machine is estimated to have an economic life

• f 10 years. The company plans to sell products,

produced in the machine, for SEK 200,000 per year, and estimates that this will result in yearly cash outflows of SEK 100,000. The machine is depreciated with SEK 100,000 per year during the first five years. After ten years, the machine has a negative disposal value (due to costs to dismantle and scrap the machine) of SEK 200,000. The company uses 8 % as interest on this type of investments. The demand for internal rate

• f return is 8 %. The demand for payback time is 3 years.

In a, we should calculate the investment's net present value and decide if the investment is

• profitable. So, we take the initial outlay of -SEK 500,000, and to this we add the difference between

the annual cash inflows of SEK 200,000 and the annual cash outflow of SEK 100,000, which gives +SEK 100,000, times the formula for sum of present value (Capital x ((1-(1 + interest)-economic life)/interest)) which, with 10 years and the interest 8 percent, gives +SEK 100,000 x ((1-(1 + 0.08)-10)/0.08) minus the disposal value of -SEK 200,000 times the formula for present value (Capital x (1/(1 + interest)economic life)) which, with 10 years and the interest 8 percent, gives -SEK 200,000 x (1/(1 + 0.08)10). This is -SEK 500.000 + SEK 671,008 -SEK 92,639 which, in sum, gives SEK 78,369. The investment gives a positive net present value and they should therefore invest In b, we should calculate the investment's payback time and answer if they should invest. The payback time can be calculated as the initial outlay, SEK 500,000, divided with the annual net cash flow, SEK 100,000, which gives 5 years (SEK 500,000/SEK 100,000). Since the demand is 3 years (or shorter), they should not invest; it takes too long time to get the money back. Note, however, that this isn’t a valid method and they should therefore not thrust it. In c, we should calculate the investment's IRR, internal rate of return. Calculate the net present value and try with different interests (higher if the present value of one calculation is positive; lower if it is negative) until the result is as close to zero as possible. When we do so, we find that 12 % is as close as we get. With 12 %, the net present value is calculated as: -SEK 500,000 +SEK 100,000 x ((1-(1 + 0.12)-10)/0.12) -SEK 200,000 x (1/(1 + 0.12)10). This is -SEK 500.000 + SEK 565,022 -SEK 964,395 which, in sum, gives SEK 627, which is as close as you get (without using decimals of course). So, the internal rate of return is slightly more than 12 percent, which is more than the demand of 8 %, and they should therefore invest

61

[Slide 6.18] Let's conclude by looking at how

investment decisions are made in Atlas Copco. Many other companies have processes like theirs. Decisions on investments for smaller amounts are taken by the general manager in the

• department. If it is a matter of a major

investment, the decision is raised higher in the

• rganization; by the division president, the

president of the business area, Atlas Copco’s group president and CEO or, for the largest investments, by the board. For each executive level, the level closest below gives its approval, so, for example, decisions made by Atlas Copco’s group president and CEO have been approved by the president of the business area. So, what is the content of the investment proposal used for making decisions about investments? We'll look at this next.

[Slide 6.19] This is the beginning of the form used

by Atlas Copco for investment proposals. We see that it is a comparison between making the decision or continuing as now. Here also several facts are given for the investment calculation.

[Slide 6.20] In the second half of the form, the

calculations are then reported, and which components have been added to the cost of capital to cover the risks. The risks are in Atlas Copco divided into the country's risk, the technology risk, the risk of the investment type and the product risk. Also, the environmental impact and similar are discussed in this part of the form. Together with this form, a report about such aspects as the market situation, technology, competition and so on (depending on type of

62 investment) is handed in. And, also, a sheet with the calculations for the investment is included. Let’s look at this sheet next.

[Slide 6.21] This slide gives an example of how an

investment appraisal can be made. The example is based on the spreadsheet in Excel that can be downloaded on the book's website.

[Slide 6.22, not included] Well, that was chapter 6 of 9 in the course “Management of an Industrial

Company”, and it dealt with decisions about investments. I hope that the overview gave you some new insights that you will have use of. Bye!

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• 7. Following Up the Business

[Slide 7.1] Hi. Welcome to the course

“Management of an Industrial Company" and Chapter 7 of 9: Following up the Business. In this chapter, we will look more closely at how the company follows up on their business. We start by looking more closely at bookkeeping and accounting, and how reports for the business can be designed, and then we look more closely at what information the annual report can provide.

[Slide 7.2, not included] The content gives a

summary and an overview of Chapter 7 in the book “Management of an Industrial Company - Atlas Copco Industrial Technique" by me, Håkan Kullvén. The book is published by Studentlitteratur, Lund, in 2018. If you have any suggestions for changes you can send these to me at kullven@outlook.com. If you want to practice on the concepts

• f this chapter, you can do this at www.socrative.com, student login, room STUD7.

[Slide 7.3] As a basis for accounting, the events

that affect the financial result and the financial position are registered in a system called

• bookkeeping. It’s done according to a method

known as double-entry bookkeeping, which means that every event should be reported with (at least) two accounting entries. The method is also called T-accounting because, in the days when computers were not used, it was set up like a T giving two different sides to account on. We treat accounting as if it was performed by paper and pen, without a computer, since the technique will be more apparent then. The same principle is used with the computer. If we draw up the balance sheet as a T-account, we have our assets on the left side. The left side is called debit. Since the assets are on the left side, increases in assets - such as the purchase of a machine – are recorded on the left side; they are debited. The right side is called credit. Decreases in assets are credited, that is, noted on the right side of the account. Equity and liabilities are on the right side of the T-account. Therefore, increases in equity and liabilities – for example, if we obtain a loan – are registered on the right side, they are credited. Decreases in equity and liabilities are debited, registered on the left side of the T-account. If we draw up the income statement as a T-account, we have our costs on the left side. Since the costs are on the left side, they are registered on the left side, they are debited. In practice, costs can also be "reduced", for example if we complain about a purchased product and get the money back. Revenues are on the right side, and they are therefore credited, that is, reported on the right side. In

64 the same way as for costs, we sometimes must pay back to customers that are dissatisfied with our products, and then the account is debited instead. In this way, all events, all the transactions, are recorded. As a basis for the registration, there need to be a verification; an invoice, a receipt, or the like that shows that the event has occurred. The verifications are recorded in chronological order, and a list with all verifications in chronological

• rder is called a general journal. We can also prepare a summary for each account individually,

where we see, for example, all events that affected the cash account, all events affecting the purchasing account, and so on. This list is a systematic list per account called general ledger. Now let's practice some accounting transactions.

[Slide 7.4] Now, we should account the following

by using T-accounts, and summarize the accounts for the period:

• a. Share capital of SEK 100,000 is paid to the

bank account. So, we need an account for share capital, which is a liability and which we credit (liabilities increase in credit) with SEK 100,000, and an account for bank, which is an asset and which we debit (assets increase in debit) with SEK 100,000.

• b. SEK 50,000 is taken from the bank account

and placed in the cash box. So, we credit the bank account (assets decrease in credit) from which we take the money with SEK 50,000, and we need an account for the cash box, which is an asset, that we debit with SEK 50,000 since the asset increase.

• c. Material is bought for 10, paid from the bank account, and put into inventory. So we credit the

bank account with SEK 10,000 since the asset decrease, and we need an account for the inventory, which is an asset, that we debit with SEK 10,000 since the asset increase.

• d. Salary is paid from the bank account with SEK 5,000. So, we credit the bank account with SEK 5,000

since the asset decrease, and we need an account for salaries, which is a cost and which we debit (costs are registered in debit) with SEK 5,000.

• e. Energy is paid by cash with SEK 2,000. So, we credit the cash box with SEK 2,000 since the asset

decrease, and we need an account for energy, which is a cost and which we debit with SEK 2,000.

• f. Material for SEK 30,000 is bought on credit and put into inventory. So, we debit the inventory with

SEK 30,000 since the asset increase, and we need an account for accounts payable, which is a liability, which we credit with SEK 30,000 since liabilities increase in credit.

• g. Products are sold for SEK 40,000, and the money goes to the bank account. So, we debit the bank

account with SEK 40,000 since the asset increase, and we need an account for sales, which is a revenue, which we credit since revenues are booked in credit.

• h. Products are sold for SEK 20,000 on credit. So, we credit the account for sales with SEK 20,000

since revenues are booked in credit, and we need an account for accounts receivable, which is an asset, which we debit with SEK 20,000 since the asset increase.

65

• i. The material in f above is paid for by cash. So, we credit the cash box with SEK 30,000, since the

asset decrease, and we debit the accounts payable with SEK 30,000, since the liability decrease.

• j. The customers pay the products in h above with cash. So, we debit the cash box with SEK 20,000

since the asset increase, and we credit the accounts receivable with SEK 20,000 since the asset decrease.

• k. The inventory is valued to SEK 5,000 at the end of the period. The rest of the material has been

used; should be costed. The inventory is now valued at SEK 40,000 (SEK 10,000 + SEK 30,000) according to the books, and therefore we have to credit inventory with SEK 35,000 so the sum of the account is SEK 5,000, and we need an account for material which is a cost, which we debit with SEK 35,000 since costs are debited. Now, it’s time to close the books. We start with the balance sheet: On the inventory account the difference is debit SEK 5,000, on the bank account debit SEK 75,000, on the cash box account debit SEK 38,000, on the accounts receivable account there is no difference, on the share capital account credit SEK 100,000, and on the accounts payable account there is no difference. We move the difference on each asset and liability account to the balance sheet. Then, it’s time for the income statement: On the salaries account the difference is debit SEK 5,000,

• n the energy account debit SEK 2,000, on the material account debit SEK 35,000, and on the sales

account credit SEK 60,000. We move the difference on each revenue and cost account to the income statement. If we summarize the income statement, we see that the revenues in credit are SEK 18,000 higher than the costs in debit. The difference is the profit of the period, which we put on the debit side, and credit the same amount on the balance sheet (this profit is part of the liabilities since it belongs to the owners of the company). If we now summarize the balance sheet, we see that debit and credit is the same, which it always should be.

[Slide 7.5] Atlas Copco uses SAP as its business

system (ERP, Enterprise Resource System), which includes bookkeeping and accounting, but there are also systems for costing, financing and the like.

66

[Slide 7.6] BAS is by far the most common

Standard Chart of Accounts (SCOA) in Sweden, and as a basis for its accounting, Atlas Copco uses a variant of this which they call SCOA2. In SCOA2, besides the BAS account (digits 1-4) there is also information about whether the transaction is entered manually or by a system (digit 5) and a suffix (digits 6-7) with additional information, if needed. Besides account, Atlas Copco also records which unit of responsibility, which cost element, which organizational area and so on that is involved in the transaction. Let us now look more closely at the reports used in the business. This of course varies a lot between different companies and different units within these, but a look at common report types in Atlas Copco can still give a certain insight.

[Slide 7.7] For their divisions and for the units in

the flow (product companies, distribution centers and customer enters), reports containing, amongst other, action plans, a matrix as in the slide (in this example for a customer center, different for different businesses) with orders received, revenues,

• rders on hand and operating profit for the

current month, the same month previous year, accumulated for the year and the last twelve months; information about the market, competition, operations, projects and red flags; as well as relevant measures such as for quality, prices, profit (or loss), costs and capital used.

[Slide 7.8] Atlas Copco also uses a system named

Kiosk which sorts revenue and costs in a way that fits different types of decisions in the

• business. The slide shows an overall report in
• Kiosk. This can then be broken down in more

detail, which will be shown shortly. The report shows the input, the resources used (costs for materials, personnel, consumables, fixed assets and so on), processes and activities (production, assembly, planning, purchasing, engineering, quality, administration and so on) and the

• utput (revenue from products and spare parts

as well as service and other charges).

67

[Slide 7.9] In Kiosk, the various parts can then be

divided up, so that they can be specified as actual previous year, this year, and target level to date; and in more detail when it comes to the

• utput, process and input. This first part of

three shows the output in the form of revenue…

[Slide 7.10] In this second part of three of a more

detailed Kiosk report, the input (the costs) are specified…

[Slide 7.11] And this third and last part of a more

detailed Kiosk report specifies the cost of capital, the total cost and the result

68

[Slide 7.12] Atlas Copco also uses a system called

FAST in which groups of costs are analyzed for different periods as actual and forecasted. This is to make it easier to see changes in different items over time.

[Slide 7.13] Let us now look more closely at the

annual report, which is an annual presentation

• f the business. This is presented to the

shareholders at an annual general meeting. The annual general meeting of the annual report for 2017 was held for Atlas Copco's part on April 24, 2018 in Solna, Sweden. For voting by decision, the Nimbus voting system was used - it is needed to keep track of all shares (total in Atlas Copco over 1 billion shares divided into 70% A shares that have one vote and the remaining B shares that have 0.1 votes).

[Slide 7.14] When should the annual meeting be

held? Suppose that the annual report covers the financial year 2017. The Annual General Meeting, AGM, the meeting at which the shareholders decide on, amongst other matters, the annual report, is to be held within six months after the financial year, that is no later than June 30, 2018, in this example. The meeting invitation must be delivered to the shareholders at least one month prior to the meeting and the documents (the annual report) must be submitted to the authorities within one month after the meeting. At the meeting, the shareholders decide on a variety of questions about the company, including the annual report. Different shares can have different weight in number of votes, at the most the strongest share can have ten times as many votes as the weakest share. So, for example, a strong share, called a class A-share, can have 10 votes, and a weak share, called a class B-share, can have

69

• ne vote. Or, a class A-share can have one vote and each class B-share can then have 1/10 vote. In

addition to the issues concerning the annual report, the annual general meeting also decides on strategic issues, on various investments, and more. The meeting also choses a board of directors who should manage the company, and an auditor who's task it is to audit the management of the

• company. The board in turn appoints a Chief Executive Officer, CEO, who leads the company's

business operations, and performs corporate governance to ensure and verify that the company is managed in the right way.

[Slide 7.15] The slide shows the ten largest

shareholders in Atlas Copco. As can be seen, Investor has most of both the votes (over 22%) and of the capital (almost 17%), the subsequent having less than five percent each. This means that a small number of shareholders control this type of company. The largest shareholders are also represented in the company's Board of Directors, in Atlas Copco as well as in most other companies, which provides additional

• pportunities to influence the company in the

desired direction for these.

[Slide 7.16] A company that has more than 50

percent of another company's votes (more on this later), is considered to control it. Suppose that we have a company that has more than 50 percent of the votes in several other companies. Then it's now a parent company, the other companies are subsidiaries, and together the companies form a group. All companies of a certain size, also those we have discussed now, should prepare an annual report. The parent company should prepare an annual report for its

• wn activities as well as for the group. The

annual report is for the shareholders to get a good picture of how their capital have been managed, for others to judge whether they want to buy shares in the company or not, and so on. An annual report should cover the preceding fiscal year and include the following components: A director’s report, in which the directors of the company discuss significant events that occurred during the year or that are expected to occur soon. An income statement, which reports the financial results for the period in the form of revenues and expenses. A balance sheet, often called a statement of financial position, that shows the financial position at the end of the period, that is, assets, equity and liabilities.

70 A cash-flow statement, which shows the reasons for changes in cash and cash equivalents, that is, the inflows and outflows that occurred during the year. Smaller companies (in Sweden e.g.; no more than 50 employees and 80 MSEK in revenues, and not listed) doesn’t have to include this. Notes, that are more detailed specifications to the posts in the income statement, balance sheet and cash flow statement. The board's proposal for how the profit or loss should be distributed, and the board members' signatures. The auditor’s report, in which the auditors gives their views on the financial statements and on how the board has managed the company. In the auditor’s report, the auditors state whether they believe that the annual general meeting should give the board discharge from liability for their management

• f the company, adopt the income statement and the balance sheet, and accept the distribution of

the profit or loss that the board has proposed. In e g Sweden, very small companies (no more than 3 employees and MSEK 3 in revenues) can but must not have an auditor and an auditor’s report.

[Slide 7.17] A company's income statement is a

specification of the profit (or loss) of the company, that is, of its revenues and costs. From the operating income, the operating expenses are deduced, and the result is the operating

• profit. This thus shows the result of the business
• itself. Then follows the financial items, financial

income such as interest and dividends, and financial expenditures such as interest and bank charges, which gives the profit before tax. Finally, the appropriations which we’ll discuss later, and the taxes follows. This gives the profit (or loss) for the year. In the balance sheet, or the statement on financial position, assets and equity & liabilities are positioned so, that the most stable ones are at the top and the most volatile ones are at the bottom. The assets fall into two groups: Non-current assets that are meant to be held for more than a year, and current assets, that are intended to be held for less than one year. There are intangible non- current assets such as patents and goodwill, property, plant and equipment, and financial non- current assets such as shares and bonds. Among current assets, we find inventories, where also work in progress is included, current receivables such as accounts receivable, investments in securities, such as shares, and cash and cash equivalents. The same asset can be included in different groups depending on how it’s supposed to be hold. One example is that shares that are supposed to be held for a long time, such as shares in subsidiaries, are included in financial non-current assets, while shares that are supposed to be held for a short time for speculation are included in current assets as investments in securities. A machine used in the operations is included under non-current assets as property, plant and equipment, while machines that are bought and sold by a trading company are included as current assets in inventories. Next, equity and liabilities are presented. Both are debts, the former to the business owners, the latter to external lenders. The shareholders' equity is divided into restricted equity, such as share capital, which is to stay in the company "forever," non-restricted (distributable) equity, for example

71 retained profits, that are available for distribution to the shareholders, untaxed reserves, which we’ll discuss later, and provisions for, for example, future pensions. The liabilities are classified into non- current liabilities, to be paid later than one year after the closing date, and current liabilities, due within one year after the closing date. For example, if we have a bank loan of MSEK 10 and MSEK 1 of this has to be repaid (amortized) per year, MSEK 1 is a current liability and MSEK 9 is a non-current liability this year. The difference between revenues and costs in the income statement is, at the closing date, of the exact same size as the difference between assets and equity & liabilities in the balance sheet and represents the company's profit (or loss) for the period. This profit becomes part of the (non- restricted) equity. Also, in conjunction with the balance sheet, pledged assets and contingent liabilities are specified. These are memorandum items, warning that there might be that the company must take over liabilities for someone else. For example, the company may have gone surety for another company’s, such as a supplier’s, loan. If the supplier can’t pay back the loan to the bank, the company must do it instead because of this bail. These memorandum items are there to provide shareholders and others this information so that they are aware of these risks.

[Slide 7.18] The slide shows the income statement

• f Atlas Copco for the year 2017.

[Slide 7.19] The slide shows the first part of the

balance sheet of Atlas Copco for December 31, 2017: the part that accounts for the assets.

72

[Slide 7.20] The slide shows the second part of the

balance sheet of Atlas Copco for December 31, 2017: the part that accounts for the equity and liabilities.

[Slide 7.21] There is no absolute truth when it

comes to the valuation of revenues, expenses, assets, equity and liabilities. Take for example a

• computer. What is it worth? The historical

purchase price, the use value, what it costs to buy a new computer of the same kind today, or for a newer version of it, the value we get out of it, the value for you or the value for me? When we prepare the annual report, we must adapt to a variety of laws and regulations, accounting conventions and generally accepted accounting

• principles. The objective of this accounting

governance is that the annual reports should be as similar as possible when it comes to valuation and such between businesses, and as fair as possible when it comes to describing the company. Important laws and regulations in this area are bookkeeping laws, which govern how accounting should be done, laws for different types of associations, such as for limited liability companies (there are other laws for other types of companies) which govern how accounting should be performed for those, annual report laws, which govern how the annual report should be prepared, tax laws, which governs how the annual report should be prepared for proper taxation, and so on. An important regulatory law is the (US) Sarbanes-Oxley Act, SOX, which describes how the company should be managed so that the owners' money are secured. Different countries have their own laws of that type, for example the Swedish code for corporate governance. There are also several accounting conventions that should govern accounting. One of the most important is the principle of true and fair view, which stipulate that the company should always strive to provide as accurate a description as possible. Other important principles are the matching principle, that revenues and costs are to be matched to each other; the going concern principle, that the valuation should always be made based on the assumption that the company will conduct its

• perations in the foreseeable future; the consistency principle, that the same principles should be

used from year to year, the prudence principle, not to value revenues too high and not to value expenses too low; and the realization principle, not to account for revenues before we can be absolutely sure that they have occurred. There are also many other conventions in the field. As may be seen, the principle of a true and fair view is in some conflict with the other principles, and the kind

• f considerations that must be done because of this is typical of accounting. Should, as an example, a

73 machine be valued at the value it has for us (true and fair view) or to the historic cost less depreciation (the prudence principle)? Several standard setters’ control what is referred to as Generally Accepted Accounting Principles, GAAP, by issuing recommendations for how this and that should be accounted for. These recommendations should be followed by companies in their accounting. In Sweden it’s mainly the Accounting Standards Board, the Financial Reporting Council, and FAR SRS that publicize such

• recommendations. The latter, FAR SRS, is an association of auditors and accounting firms in Sweden

that also give out recommendations on auditing. The Swedish organizations prepare, to a large extent, their recommendations based on international recommendations. Here two important standard setters can be mentioned: The International Accounting Standards Board, IASB, is the EU standard setters in the field. They publish IFRS, International Financial Reporting Standards. They also coordinate, to a large extent, their recommendations with the U.S. counterpart, the Financial Accounting Standards Board, FASB. The recommendations are becoming more and more like each

• ther in all the countries in the world, but there are some differences in different countries.

[Slide 7.22] Let’s now look more closely at how

assets are valued, and then also take the

• pportunity to explain the concept of

appropriations, or untaxed reserves. Current assets should, according to laws and recommendations, as a result of the prudence principle be valued according to their lowest expected value. This means, for example, that inventories should be valued at the lower of the historical acquisition cost, the actual (replacement) cost, and the sales value. If for example we have several pants in our inventories, and these were purchased for SEK 21 each, now costs SEK 18 to purchase, and can be sold for SEK 25 each, they should be valued at the lowest of these three values, SEK 18 each. There are rules about the valuation of non-current assets in the accounting laws that sets the upper value for the valuation (because these laws are there to ensure that no assets have been valued too high so that profits that do not exist are recognized). Machines may, for example, at the highest be valued to their historical cost less depreciation according to plan. Tax law sets the lower level for the valuation (because the tax law is there to ensure that the correct tax is imposed and, therefore, that the company doesn’t undervalue their assets to hide profits). Under the Swedish (and many other countries) tax law, the company can each year choose between two alternative ways of calculating this minimum value for the machines and can then select the alternative that is most beneficial to the company, which gives the lowest value, that year. The two methods are the reducing balance method and the straight-line method. The same method must be used for all machinery and furnishings that year, but the company can change between them over the years. What do the two rules mean?

74

[Slide 7.23] The reducing-balance method means

that at least 70% of the booked value (machines and furnishings purchase value less depreciation) must be capitalized. This means that 30% of the booked value can be depreciated for the year. The reducing-balance method gives a large (30%) depreciation at the beginning, but then a declining depreciation. If, for example, we buy a machine for SEK 100,000, we can depreciate it with SEK 30,000 the first

• year. Next year, we can depreciate 30% of the

remaining SEK 70,000 (SEK 100,000 - SEK 30,000), which gives SEK 21,000. The year after that, we can depreciate 30% of the remaining SEK 49,000 (SEK 70,000 – SEK 21,000), which gives SEK 14,700, and so on. With the straight-line method, the company is allowed to depreciate up to 20% of the initial value per year, which means that at least 80% of the value will be left after the first year. So, the first year the machine can be depreciated with SEK 20,000 and the value is SEK 80,000 after that, the next year SEK 20,000 can be depreciated and the value is SEK 60,000 after that, the year after that SEK 20,000 can be depreciated and the value is SEK 40,000 after that, and so on; each year 20 % of the purchasing value is

• depreciated. For the same machine, then, the reducing-balance method is best the first two years,

then the straight-line method is best, but in a company with a mix of machines and equipment purchased in different years, the calculations has to be done each year using both methods to determine which method is the best that year. The difference between the depreciation that is accomplished with those methods mentioned, and the depreciation according to plan, and that therefore means that costs may be deducted from the taxable profit, is an untaxed reserve. Sooner or later this reserve will be taxed, the sum of depreciation is always the same as the purchase price of the machine for all the years regardless of the individual years' depreciation. So, it's not a question of "avoiding tax", but more about deferring payment of taxes to a later year. Another way to create untaxed reserves, is to exploit the rules of tax allocation reserve (in Sweden,

• ther countries allow similar possibilities). This rule currently (income year 2018) means that the

company each year may deduct 30% of its net profits to a fund, as an expense, which reduces profits and therefore taxes. Sooner or later, within six years, the fund must be returned and taxed.

[Slide 7.24] Based on the balance sheet, we can

construct several measures for the company's financial gearing and liquidity. Concerning financial gearing, the equity ratio is a measure for the ability to survive, that is, the measure gives an indication of whether the company will survive in the long term. It’s calculated as the shareholders' equity divided by total capital. For example, if the equity is MSEK 20, and the total capital is MSEK 100, the equity ratio is 20%. The higher the equity ratio, the greater the ability to

• survive. This is because shareholders capital can

75 be used for taking risks, while other’s (liabilities) are not, but must be paid back. If we can’t pay our debts, we must, under certain circumstances, file for bankruptcy, and can therefore not continue our

• business. The company which has the highest equity ratio in a industry survives, while the other

companies are going bankrupt if there is a price war, all other things being equal (equally good products, just as capable management, and so on). Therefore, we should compare our equity ratio with that of our competitors. Liquidity is the ability to pay in the short term. Can we pay our debts on time? There are two common measures of liquidity. The current ratio is calculated by dividing current assets with current

• liabilities. In the former, accounts receivable is included, in the latter trade payables are included.

The idea is that the customers must pay their debts to us (accounts receivable) in due time so that we can pay our accounts payable in due time. The rule of thumb is that this ratio should be at least two, which means that the current assets should be at least twice as large as the current liabilities, for us to pay our debts on time. See, however, the discussion about the next measure below. The second measure of liquidity, the quick ratio (sometimes named acid test ratio), is slightly

• different. In addition to accounts receivable, inventories are also an important part of current assets.

When we have payment problems, and need to get more money quickly, it’s difficult to sell the inventory at reasonable prices in most companies. For these companies, the current ratio is therefore misleading. Better, then, is to exclude inventory from the calculation. The quick ratio is calculated as current assets less inventory, divided with current liabilities. The rule of thumb is that this measure should be at least one: Then, customers will pay the accounts receivable at the same rate as we pay our accounts payable. However, this only applies if customers and suppliers have the same payment terms. For example, in a supermarket, customers receive no credit at all, while the store gets maybe 30 days of credit from its suppliers. A supermarket, therefore, could manage with a significantly lower quick ratio. Conversely, a construction company often have very long-term customer credit terms, but maybe only 30 days of credit from their suppliers, and therefore need to have a considerably higher quick ratio. We therefore must analyze the payment periods before we can assess the appropriate level of the quick ratio. Note that, in practice, the calculations may well be more detailed than what is discussed above. For example, untaxed reserves can be divided into two parts; a tax component, which add to the liabilities and that will be paid when the untaxed reserve is presented for taxation, and an equity component, which adds to equity, in the analysis of the equity ratio.

[Slide 7.25] Based on the income statement and

• n the balance sheet, we can also develop

measures of the company’s return, which are measures for the profitability of the company. In this measure, the profit (or loss) of the year is set in relation to the capital. Return on equity, ROE, indicates the return the owners have had

• n their capital and is calculated as profit (or

loss) of the year divided by equity on average. Return on capital, ROC, shows the return on the total capital and is calculated as profit (or loss) before tax plus financial expenses divided by total assets on average. Note that the financial costs are subtracted in the calculation of return on

76 equity, but not in the calculation of return on total capital, as financial costs are a cost for the owners but not for total capital (financial costs are the "profits" that lenders receive). Also, note that assets, equity and liabilities are included with their average value, which can be calculated as (the value at the beginning of the year + the value at year end)/2. This is because the profit (or the loss) is an effect of the operations during the year.

[Slide 7.26] The company DuPont has created a

formula that is used by many companies and is called the DuPont formula. In this, we add sales to the formula for return on capital. This means that the return on capital, profit before tax plus financial expenses divided with average capital, consists of two components; first, profit before tax plus financial expenses divided with sales, named the profit margin, and, second, sales divided with the average total capital, known as asset turnover. Multiplying the two measures together, we get back to return on capital. Thus, the company can, in order to obtain a high return on capital, create a high profit margin. Examples of companies that work with a high profit margin are Rolex, Versace, and Porsche. These companies do not have that high volumes compared to other companies in their industries, but they have high profit margins on what they sell and can thus create profitability. Alternatively, the company can work with a high asset turnover rate in order to create a high return on investments. Examples of companies that work with this strategy are Fiat, HM and IKEA. These companies do not have such high profit margins compared to other companies in their industries but have a high turnover rate on their capital and can thus create profitability through high volumes. (There is also a variant of the DuPont formula that is based on return on equity and then breaks out a measure for financial gearing, something we’ll not discuss further here). Now let's practice on the different measures that we have dealt with.

[Slide 7.27] The following data refers to the two

competing companies DEFAB/FEBAB: Sales SEK 5,000,000/SEK 8,000,000, Profit before tax SEK 850,000/SEK 600,000, Financial income SEK 500,000/SEK 250,000, Financial expenses SEK 150,000/SEK 200,000, Average Equity SEK 500,000/SEK 600,000, Average total capital SEK 2,000,000/SEK 1,600,000. For each of the two companies, we should now calculate: a. Profit margin is profit before tax plus financial expenses, and this divided with sales. This gives, for DEFAB, SEK 850,000 in profit before tax plus SEK 150,000 in financial expenses), and this divided with SEK 5,000,000 in sales = 20%. And for FEBAB SEK 600,000 in profit before tax plus SEK 200,000 in financial

77 expenses), and this divided with SEK 8,000,000 in sales = 10%. So, DEFAB has a profit margin that is the double of FEBABs: DEFAB earns double as much per sold SEK compared to FEBAB.

• b. Asset turnover is sales divided with the average total capital. This gives, for DEFAB, SEK

5,000,000 in sales divided with SEK 2,000,000 in average total capital = 2.5 times. And for FEBAB SEK 8,000,000 in sales divided with SEK 1,600,000 in average total capital = 5 times. So, FEBAB has an asset turnover that is the double of DEFAB: FEBAB uses its capital double as much as DEFAB for selling.

• c. Return on capital is profit before tax plus financial expenses, and this divided with average

total capital. This gives, for DEFAB, SEK 850,000 in profit before tax plus SEK 150,000 in financial expenses, and this divided with SEK 2,000,000 in average total capital = 50 %. And for FEBAB SEK 600,000 in profit before tax plus SEK 200,000 in financial expenses, and this divided with SEK 1,600,000 in average total capital = 50 %. So; both companies earn as much in return on capital. One, DEFAB, mainly because its high profit margin; the other, FEBAB, mainly because of its high asset turnover. From this we can remember that both profit margin and asset turnover are important for the profitability of an organization. The company can get a good return on capital by having high prices

• n their products in relation to the cost. But it can also earn as good a return on capital by using its

capital effectively. The model used here is the DuPont formula, which divides the return on capital in profit margin and asset turnover.

[Slide 7.28] Terrata AB present the following

information for year 2017 (year 2016 in brackets): Sales SEK 52,934,000, financial income SEK 26,000, financial expenses SEK 138,000, profit before tax SEK 1,236,000, profit

• f the year SEK 1,116,000, inventories SEK

4,757,000 (SEK 5,121,000), total current assets SEK 19,161,000 (SEK 20,518,000), total equity SEK 5,566,000 (SEK 4,982,000), total non-current liabilities SEK 5,443,000 (SEK 6,429,000), total current liabilities SEK 14,306,000 (SEK 14,951,000), total equity and liabilities SEK 25,315,000 (SEK 26,363,000). For year 2017 we now calculate:

• a. the current ratio as current assets SEK 19,161,000 divided with current liabilities SEK

14,306,000 which gives 1.34. This measures the ability to pay, and many textbooks suggest that it should be above 2 to be good. But that is a very arbitrary target, and we will instead discuss further in g about the quick ratio.

• b. the asset turnover as sales SEK 52,934,000 divided with average total capital ((SEK

25,315,000 year 2017 + SEK 26,363,000 year 2016)/2) which gives 2.04 times. So, the assets are used for sales more than twice per year. This will be discussed further in relation to d about the profit margin and e about the return on capital.

• c. the equity ratio as equity SEK 5,566,000 divided with total capital SEK 25,315,000 which gives

0.22. This is a measure on the ability to survive, the higher the better. Is it good enough? It

78 depends on what the competitors have on this measure. If all companies are equal good at what they do, the company with the highest equity ratio survive a price war.

• d. the profit margin as (profit before tax SEK 1,236,000 plus financial expenses SEK 138,000)

divided with sales SEK 52,934,000 which gives 2.60%. In many businesses, this is very low, but they might be in a market with low profit margins or they might be a low-price operator, and we will look at this further next

• e. the return on capital as profit before tax SEK 1,236,000 plus financial expenses SEK 138,000

and this divided with the average total capital (SEK 25,315,000 year 2017 plus SEK 26,363,000 year 2016) divided with 2) which gives 5.32%. How good this is, depends on what business Terrata is in, it must be compared to its competitors and to earlier years. We can also get the return on capital by taking the asset turnover in b, 2.04 times, times the profit margin in d, 2.60% = 5.30% (small difference due to rounding). Now, we don’t know how good these measures are, but we can guess that the relatively low profit margin is compensated with a relatively high asset turnover; this might be a low-cost operator with a very effective and efficient operation.

• f. the return on equity as profit of the year SEK 1,116,000 divided with average equity ((SEK

5,566,000 year 2017 + SEK 4,982,000 year 2016) divided with 2 which gives 21.16%. This seems like a very good return for the owners and is probably reached from relatively large loans with low interest.

• g. the quick ratio as (current assets SEK 19,161,000 minus inventories SEK 4,757,000) and this

divided with current liabilities SEK 14,306,000 which gives 1.01. This is a much better measure of the ability to pay than the current ratio in a, since the inventories often are difficult to sell fast and with enough high prices in a crisis. The rule of thumb here is that it should be at least 1 if they have the same rules for payment for their customers as they get themselves from their suppliers. In that case, maybe they should strive for a little bit higher quick ratio to be at a more secure side. If they give their customers longer terms of payment than they get from their suppliers, they need an even higher quick ratio, and vice versa if the

• pposite is the case.

[Slide 7.29] The slide shows various key figures for

Atlas Copco: Equity ratio (48.3%), current ratio (2.06), quick ratio (1.55), return on equity (29.2%), and return on capital (20.3%). The various parts of DuPont are also shown here; return on capital 20.3% consists of a profit margin of 21.1% multiplied by the asset turnover rate of 0.96. Other measures used in Atlas Copco are, for example, orders received, which amounted to BSEK 81, EBITA of BSEK 20 and an EBITDA margin of 23.6%. All values are based on the annual report for the year 2017. On the book's course homepage there is a spreadsheet that reports this calculation as well as later years' calculated measurements.

79

[Slide 7.30] The annual report also includes an

account of how the business affects a sustainable development; a sustainability

• report. The content for 2017 is presented on this

and three more slides. Common to all is that the year's results (in 2017 in this case) are compared with four previous years (year 2013-2016). In this first slide of four about the sustainability result for 2017, the economic value that the business contributed with is reported.

[Slide 7.31] In this the second of four slides about

the sustainability report for the year 2017, the usage of energy and water as well as the management of CO2-emissions are reported.

[Slide 7.32] In this the third of four slides about

the sustainability report for the year 2017, the situation of the employees are reported in measures like proportion of women and men, employee turnover, nationalities, number of accidents, sick leave in days and number of diseases.

80

[Slide 7.33] In this the fourth and last slide about

the sustainability report for the year 2017, the ethical norms and how they are followed up in the business are reported.

[Slide 7.34, not included] Well, that was chapter 7 of 9 in the course “Management of an Industrial

Company”, and it dealt with following up the business. I hope that the overview gave you some new insights that you will have use of. Bye!

81

• 8. Analyzing Change

[Slide 8.1] Hi. Welcome to the course

“Management of an Industrial Company" and Chapter 8 of 9: Analyzing Change. In this chapter, we will look more closely at how the company analyzes the effects of volume

• changes. We define fixed and variable costs and

see how these are affected by volume changes in a volume analysis.

[Slide 8.2, not included] The content gives a

summary and an overview of Chapter 8 in the book “Management of an Industrial Company - Atlas Copco Industrial Technique" by me, Håkan Kullvén. The book is published by Studentlitteratur, Lund, in 2018. If you have any suggestions for changes you can send these to me at kullven@outlook.com. If you want to practice on the concepts

• f this chapter, you can do this at www.socrative.com, student login, room STUD8.

[Slide 8.3] For volume decisions, when we consider

increasing or decreasing the volume of a product, it may be better to look at variable and fixed costs, instead of relevant and irrelevant

• costs. When we do this, we do a volume

analysis. A variable cost is a cost that changes in total when the volume changes (a fixed cost is a cost that doesn’t change in total when the volume is changing, more about that later). An example of a variable cost may be the cost of materials. Say that this cost is SEK 2 per unit. When we produce 0 units, the cost of material is SEK 0, when we produce one unit, the cost of material is SEK 2, when we produce two units, the cost of material is SEK 4, when we produce 1,000 units, the cost

• f material is SEK 2,000, and so on. The variable cost we are now discussing is a proportional variable
• cost. There are also examples of decreasing (fading) variable costs, where the cost increase with the

volume but at a decreasing rate (for example, if we get discounts for larger purchases of materials) and increasing (progressive) variable costs, where the cost increases with the volume but at an increasing rate (for example overtime, for which the hourly rate will be higher at higher volumes). In the three charts now discussed, you see the total variable cost. If, instead, we should look at the cost per unit (in the chart in the lower right corner), the proportional variable cost would be the same regardless of volume (always SEK 2 per unit in the example above). The increasing variable cost is increasing per unit, and the decreasing variable cost is decreasing per unit as can also be seen in that chart.

82

[Slide 8.4] A fixed cost is a cost that doesn’t

change in total when the volume is changing. An example of a fixed cost is the cost of machinery. Say that the machine costs SEK 50,000. If we produce 0 units, the cost of the machine is SEK 50,000, if we produce 1,000 units, the cost of the machine is still SEK 50,000. This is an (absolutely) fixed cost. There are also production-dependent fixed costs (not in the charts), such as costs for lighting; we do not need lighting if we do not produce anything at all, but as soon as we start manufacturing, we must have lighting. A stepped or stepwise fixed cost change in intervals. Take for example the cost of the machine. Sooner or later, when the production volume is higher than the capacity of the machine, we must buy another machine. The cost rises to SEK 100,000 (should the cost for the new machine be the same as for the old one), and we're fine with the two machines until we reach the next capacity level and must buy another machine. Finally, there is irreversible stepwise or stepped costs (not in the charts); if the volume decreases, we have a period when we have overcapacity before we have sold the machine. This is because it takes some time to sell machines. In the charts to the left, you see the total fixed cost. If, instead, we should look at the cost per unit as to the right, the fixed cost would decrease with volume (SEK 50,000/1 = SEK 50,000 at 1 produced, SEK 50,000/1,000 = SEK 50 at 1,000 produced). And the stepwise fixed cost would decrease in the same manner until a new e g machine is bought, then it goes up per unit but isn’t as high as in the start, then it goes down, then it goes up when a new machine is bought but not as high as last time, and so on; we get a chainsaw type of cost curve.

[Slide 8.5] We can sketch the fixed and the

variable costs in a graph, with revenues and costs vertical and volume horizontal. The fixed cost is independent of the volume. To this we add the variable cost, which increases with increasing volume. The sum of the two represents the total cost. Thus, we see the variable cost as the difference between total cost and fixed cost. The total revenue, price multiplied by volume, may also be entered in the graph. Then we get a point where revenues are equal to the costs. This point is called the break-even point. At this point, where we have a critical volume and a critical revenue, the result is 0. If the actual volume is higher than that, we have a margin of

• safety. This margin shows how much the volume can be reduced without a loss.

The diagram is useful for understanding how the result depend on the volume. However, it has its

• limitations. For example, it only applies in a relevant range of activity, at larger changes in volume for

example the stepwise fixed costs can change. And we can only do the analysis for one product, not for several products simultaneously in combination.

83 Now, let’s practice on this!

[Slide 8.6] The company Fasta Rör AB is selling a

product for SEK 20 each. In January, the total cost was SEK 1,630,000, and in February, the total cost was SEK 1,930,000. No other differences were found between the two periods except that the volume was 82,000 units in January and 102,000 units in February. Now we should answer the following questions:

• a. What’s the variable cost per unit? When

volume increase/decrease, the total variable cost increase/decrease, but not the fixed costs (since there were no other differences between the two periods, e g no new machines or so). So, a change in volume must have resulted in a change in total variable cost. If we compare the two periods, the cost increase with (SEK 1,930,000 – SEK 1,630,000 =) SEK 300,000 when the volume increase with (102,000 units – 82,000 units =) 20,000

• units. This means that the variable cost is (change in cost SEK 300,000/change in units 20,000 units =)

SEK 15 per unit

• b. What’s the total fixed cost? The total fixed cost must be what is left of the total cost, when we

have subtracted the total variable cost. We can pick one of the periods, lets pick January (we get the same result if we pick February instead): Total cost is total fixed cost + total variable cost, which in its turn is variable cost per unit times volume. In February, this means that the total cost SEK 1,630,000 is Fixed cost + (SEK 15 in variable cost per unit times 82,000 units); which means that the total cost SEK 1,630,000 minus the total variable cost SEK 1,230,000 is SEK 400,000 in total fixed costs.

• c. What’s the break-even point? The break-even point can be found where the revenues and the

costs have the same amount, that is, when price times volume is the same as the variable cost per unit times volume plus the total fixed cost. In this case, SEK 20 in price times volume should be equal to SEK 15 in variable cost per unit times volume plus SEK 400,000 in fixed cost. This means that SEK 5 (price minus variable cost) times volume should be equal to SEK 400,000 in fixed cost. This means that volume can be found at SEK 400,000 in fixed cost divided with SEK 5 which is 80,000 units. So, the break-even point, where the revenue is as high as the cost, is at 80,000 units.

• d. What’s the margin of safety, in number of units as well as in percent in February? The margin of

safety in units is the difference between the actual volume, which is 102,000 units in February, minus the break-even point, which is 80,000 units, and this gives 22,000 units. The margin of safety in percent is this margin of safety, 22,000 units, divided with the actual volume, 102,000 units, and this gives 22 %. So, volume can decrease with 22% without reaching a loss.

84

[Slide 8.7] What happens with costs and profit

(loss) when a company is automated (or industrialized) compared to when it is not? Discuss this in text as well as with two diagrams;

• ne for an automated company, one for a

handicraft company. The answer could be that when a company is automatized, the fixed costs will increase, and the slope of the variable cost will (relatively) decrease (and therefore also the slope of the curve for the total costs will decrease). Therefore, the profit (or loss) is higher in an automatized company. This can be illustrated by the two diagrams; the one to the left shows a handicraft production, and the one to the right an automated production. You can see the difference in sloop, and you can see the difference when it comes to the distance between the revenue and the total cost lines in the two charts.

[Slide 8.8] The examples we have discussed so far

are arbitrary and simplified descriptions of

• reality. One reason for this is that it is not just

the volume of a product that affects the costs. For example, the company often has more than

• ne product, and these products have different

variable and fixed costs. When the mix of products changes, this also affects the cost. In a company, things such as exchange rates, measures that lead to savings and changes in productivity, changes in prices, and one-time effects (one person gets sick and we are forced to hire a substitute, we dispose of extra material a period and so on). All of this complicates the analysis and must be dealt with in some way. Atlas Copco's analysis in the so-called PK bridge (Product cost bridge, with the K for the Swedish word “Kostnad” that means Cost) goes to the point that they divide their costs into different groups: direct material, subcontracting and other direct manufacturing costs; personnel costs; various other expenses; capital costs; and the product line costs. Then six types of deviations, so-called bridge parts (bridge between planned cost and actual cost), are analyzed; the volume effect of fixed and variable costs as discussed in this chapter, the mix effect with changes in volumes of different products, the currency transaction effect which are deviations due to changes in exchange rates, the price change effect, which is the change in the prices of used resources, one-time effects which is the influence of different non-recurring activities and the like, as well as efficiency/savings which is the rest; what cannot be explained by the other bridge parts.

85

[Slide 8.9] The slide shows an example of analysis

• f the various bridge parts in the PK bridge. In

the left column there are the various cost components, and in the following columns there are the different bridge parts and summaries of the bridge from planned cost (input position) to actual (final position).

[Slide 8.10] Atlas Copco also uses so-called

variance accounting. In this, it is calculated what effect, among other things, volume changes will have on costs for input resources. In this context, the term absorption is used. Say we have a fixed cost of SEK 1,000,000 for a

• machine. Suppose we calculate a volume of

2,000 units. Then we calculate a cost of SEK 500 per unit (SEK 1,000,000/2,000 units). Now suppose we get a higher volume, say 4,000

• units. If everything else is the same, the cost will

instead be SEK 250 per unit (SEK 1,000,000/4,000 units). We therefore have an over-absorbed fixed cost. Conversely, if we only achieve a volume of 1,000 units the cost will instead be SEK 1,000 per unit (SEK 1,000,000/1,000 units) and we have an under-absorbed fixed cost. Absorption therefore means that we get a lower (over-absorption) or higher (under-absorption) fixed cost per unit due to changes in volume that affects the fixed cost per unit. Atlas Copco’s variance accounting system divides under- and over-absorbed fixed costs into two groups; workshop costs and product line costs. Furthermore, by analyzing the difference between planned cost and actual cost per unit of different input resources, it calculates price deviations on purchased materials, on labor, for machines and the like and, by analyzing the difference between planned use and actual use for different resources such as machine hours, assembly hours, units of different input materials and the like, the variances that occur in work in progress.

[Slide 8.11, not included] Well, that was chapter 8 of 9 in the course “Management of an Industrial

Company”, and it dealt with analyzing change. I hope that the overview gave you some new insights that you will have use of. Bye!

86

• 9. Financing the Business

[Slide 9.1] Hi. Welcome to the course

“Management of an Industrial Company" and Chapter 9 of 9: Financing the Business. In this chapter, we will look more closely at how the company is financed. We start by looking more closely at what capital is and what operational and financial risks there are. We then discuss why a company needs capital and how this need can be estimated using various methods. We identify different sources for financing, and then look at how the cash flow statement is drawn up and what it shows. Finally, some financial measures are discussed.

[Slide 9.2, not included] The content gives a summary and an overview of Chapter 9 in the book

“Management of an Industrial Company - Atlas Copco Industrial Technique" by me, Håkan Kullvén. The book is published by Studentlitteratur, Lund, in 2018. If you have any suggestions for changes you can send these to me at kullven@outlook.com. If you want to practice on the concepts of this chapter, you can do this at www.socrative.com, student login, room STUD9.

[Slide 9.3] What is finance? Well, if we start by

looking at the balance sheet and at the income statement and try to identify financing there, we find the use of capital on the debit (left) side of the balance sheet; tangible assets such as machinery and buildings, financial assets as shares and bonds, intangible assets such as goodwill and patents, and ... intellectual capital. The latter, intellectual capital, can’t be found

• there. Intellectual capital is investments in

training of the employees and the like. These are very important assets, and certainly a use of capital, but since it’s difficult to evaluate these assets in an objective manner, it’s not allowed to include them in the official balance sheet. On the credit side (right side) of the balance sheet we can see how the company has acquired capital; through equity such as share capital and retained earnings, and through liabilities such as bank loans and the like. Capital is acquired by the company, and the capital is used by the company. The two parts are of equal size, and that means that the total capital can be measured on either the debit (usage) or the credit (acquire) side. In the income statement, we can find the company's cost of capital in the form of its financial costs (as well as depreciation, but that is not discussed here). This is not the only financial cost; the company also has a cost for its equity in the form of the owners' demand for return on equity. Internally, the company may therefore use their own measure of that cost, as we discussed earlier when discussing costing, and include that cost in their calculations.

87 Let’s now do another analysis of the balance sheet; now with accounting concepts. On the left side we have, first, non-current assets. When the company is investing in a non-current asset, like a machine or a building, most natural is to finance this with non-current liabilities, as non-current assets are supposed to be used for a long time and thus be financed for a long time. The difference between non-current assets on the left (debit) side and non-current liabilities on the right (credit) side is called fixed capital. When the company, instead, tie up capital in current assets, such as inventories and accounts receivable, it’s more natural to finance these with current liabilities, since it concerns short-term investments. The difference between current assets on the left (debit) side and current liabilities on the right (credit) side is called working capital. If we to this add the safety capital, to cover variations in sales and the like, we obtain the company's need for total capital. From where do the company acquire this capital? From the owners, in the form of equity. The total capital can be measured as the sum of non-current and current assets, or as the sum of equity and non- current and current liabilities.

[Slide 9.4] If we look at the need for capital of

Atlas Copco, this amounts to MSEK 60,723 on December 31, 2017. Fixed assets amount to MSEK 51,222 and long-term liabilities to MSEK 28,844, so the fixed capital amounts to MSEK 22,378 (MSEK 51,222 – MSEK 28,844). Current assets amount to MSEK 74,516 and the current liabilities to MSEK 36,171, so the working capital amounts to MSEK 38,345 (MSEK 74,516 - MSEK 36,171). In total, the capital, and thus equity, amounts to MSEK 60,723 (MSEK 22,378 + MSEK 38,345). This also includes a safety capital.

[Slide 9.5] Finance is a buffer for risks that the

company takes, but finance also adds risks to the company. We can divide between two different types of risks, operational risks and financial risks. Operational risks are risks due to the operations

• f the company as such. It can be risks that the

market changes, that something happens in production, that the supply chain gets some problems e g delayed deliverances, and so on. Financial risks are risks due to the way the company’s investments are financed, the risks induced by finance. It could be the risk of changes in exchange rates, the risk for changes in financial expenses, like interest paid for loans, and the risk for new tax rules that are affected by our financial instruments. All this implies, that it is important to balance the risk in a company. If the company has a high

• perational risk, it might take lower financial risks and vice versa. But the company should take some

88 risks; it is because of taking risks that a company can gain profitability. The company should balance the risks at a certain level.

[Slide 9.6] The operational risks that Atlas Copco

specify and discuss are market risks, product development risks, production risks, distribution risks, supply chain risks, legal risks and compliance risk, risks that acquisitions or divestments fail, employee risks, risks to reputation, information Technology risks, safety and health risks, external environmental risks, risks of corruption and fraud, and human rights risks

[Slide 9.7] The financial risks that Atlas Copco

specify and discuss are the risk of changes in exchange rates, the risk for changes in financial revenues and expenses, the risk that customers do not pay, the risk related to communication with the capital market, and the risk for new tax rules and regulations.

[Slide 9.8] Before we go more into detail with the

calculation of the capital requirements, it may be appropriate to discuss ways to reduce the capital and thus reduce the need for capital. Capital rationalization means to slim down the flow from raw material over work in progress to the finished goods inventory, so that as little capital as possible is tied up in the flow. It also means to reduce capital in any other way possible, such as by delaying payments to suppliers (increased capital through accounts payable), faster payments from customers (less capital tied up in accounts receivable), decreased throughput times, implementing Just In Time, which is a method to reduce the inventories down to zero or near zero, to streamline marketing, sales, order processes, supply processes and the like, and to choose bank accounts smarter, for example to reduce the number of buffers needed. All this is called cash management.

89

[Slide 9.9] How do we calculate our need for

capital? For fixed capital, it’s about assessing what investments need to be made in machinery, buildings, and such. For safety capital, it’s about using experience and judgments on how much sales and such will vary with time. We’ll focus on working capital now. We can then distinguish three methods. The percentage method means that we assume that working capital is increasing with sales, which is quite common. For example, if sales increase by ten percent, we can assume that the, often, major components in both current assets (accounts receivable and inventories) and liabilities (accounts payable) also increase by ten percent. In some companies, it turns out that some current assets and current liabilities historically have changed slightly different, and then we can use that experience instead. Perhaps, for example, the company has experienced that when sales increase by ten percent, so does the accounts receivable and accounts payable, while inventories increased by only four percent because it’s more dependent on the number of outlets than on sales, and tax liabilities do not increase at all, because it has no connection at all with the volume. Then we can calculate different increases for different parts of the working capital. The average method means that the elements of the working capital that are parts of the production flow – accounts payable, raw material inventory, work in progress, finished goods inventories, and accounts receivable – are calculated based on formulas. Mathematically, accounts receivable can be estimated by calculating the average accounts receivable = (credit in days/360 days) x sales in SEK per year. (Note that we use 360 days rather than the 365, or 366 for a leap year. The error is marginal, the benefits are that we do not have to use different calculations for different months but get exactly 30 days per month, and that we do not have to correct for leap years.) If the credit period to our customers is 30 days and we sell for SEK 120,000 per year, the average accounts receivable is SEK 10,000, calculated as (30 days/360 days) x SEK 120,000. Similarly, the accounts payable are calculated by the average accounts payable = (credit in days/360 days) x purchases per year. The average raw material inventory can be calculated as = (lowest inventory + largest inventory)/2. The inventory is at its lowest just before we get a new shipment of materials. The inventory is at its largest just after we have received a delivery. Say for example that we have a buffer of inventory (that is, the lowest we allow the inventory to be before we receive another delivery) of 1,000 units, and that each delivery consist of 15,000 units. Then the largest inventory, just after delivery, is 16,000 units (1,000 in buffer just before delivery + 15,000 in delivery) and the average inventory is 8,500 units ((inventory at its lowest 1, 000 + inventory at its largest 16,000)/2). Other inventories, such as work in progress and finished goods inventory, can be calculated as the number of products times all or part of the product cost per unit, depending on the degree to which the products have been finalized. E g for the work in progress, half the product cost can be used (some products are just beginning to be produced, other are close to be finalized, on average half of the cost have been used), and for finished goods inventory, the product cost per unit can be used, and then in both cases multiplied with the number of products.

90 The resource method and the balance sheet method are two more precise methods, that are similar in structure and that gives the same estimate of the total working capital needs. The difference is that they specify this requirement in different ways; the resource method by resource and the balance sheet method per balance sheet item. We’ll, in the following examples, take a closer look at the two methods.

[Slide 9.10] An entrepreneur will start a new

• company. For this, she is calculating her capital

needs for the first year: She will need machines for SEK 100,000. She plans to sell products for SEK 2.000.000, and to give the customers 36 days in credit. She will buy 10,000 units of material for SEK 80 each, a total of SEK 800,000, in batches of 1,000, with a buffer of 100 units, and will get 18 days in credit. She estimates that the work in progress will be SEK 5,000, the finished goods inventory will be SEK 8,000, and the cash, which is the safety capital, will be full, SEK 1,000, at the year end. How much capital does she need for her operations? For fixed capital, the need is in the form of the investment, SEK 100,000 For the working capital, the average method is well suited. We use that in the following. The idea is to use our knowledge as well as calculations to reach to the need of working capital. We do this in the following way:

• 1. We know that the need for safety capital, which will also be the cash, is SEK 1,000
• 2. Accounts receivable can be calculated with the formula for this as 36 days in credit divided with

360 days per year times SEK 2.000,000 in sales, and this gives SEK 200.000

• 3. For inventories, the raw material can be calculated with the formula where we first find the

average inventory in units and then multiply this with the cost per unit. The formula is minimum level 100 units which is the buffer plus the maximum level which is 100 units in buffer plus 1,000 units

• rdered each time, and all this divided with 2, which gives the average of 600 units. We take this

times the cost per unit, SEK 80, and get the average raw material inventory SEK 48,000. We know that the work in progress is estimated to be SEK 5,000, and that finished goods is estimated to be SEK 8,000.

• 4. Now we can sum the current assets: SEK 1,000 in cash plus SEK 200,000 in accounts receivable plus

SEK 48,000 in raw material inventory plus SEK 5,000 in work in progress plus SEK 8,000 in finished goods inventory, and all these summed gives total current assets, SEK 254,000 Accounts payable can be calculated by the formula 18 days in credit divided with 360 days per year times the yearly procurement, which is SEK 800,000, and this gives SEK 40,000, which is also the current liabilities since the company doesn’t plan any more parts of current liabilities. This gives the working capital SEK 254,000 in current assets minus SEK 40,000 in current liabilities, which gives SEK 214,000 in working capital.

91 So, the need for capital is SEK 100,000 in fixed capital plus SEK 214,000 in working capital, which gives SEK 314,000 in total need. Some of this will probably come from loans from the bank, and the rest must come from the entrepreneur or other that are willing to invest money in the new business. The average method is suitable in many cases, both for new businesses and for those that have been in business for a long time. Often, the calculations are added to the percentage method, for those parts of the capital that needs to be scrutinized more.

[Slide 9.11] The entrepreneur that started a

company a few years ago is now planning for the next year, year 2019. One part of the plan deals with the need for capital. The working capital in the planned balance sheet for the end

• f the year 2018 includes, amongst other,

working capital as follows: finished goods inventory SEK 40,000, work in progress SEK 15,000, raw material inventory SEK 20,000, accounts receivable SEK 12,000, cash SEK 4,000, and accounts payable SEK 20,000. Next year, she will buy a new machine for SEK 100,000, for which she will take a loan that covers the whole investment. She estimates that the revenues will increase with 20 %, and she estimates that the working capital will increase proportional to this. And now she wants us to calculate how much more capital she needs for the next year. First, for the fixed capital: She plan to invest in a new machine for SEK 100,000, but she will then take a loan on the same amount, SEK 100,000, to cover for this. This means that she doesn’t need more capital for this. For the working capital, the percentage method is suitable since she estimates that the working capital will increase relative to the increase in revenues; and in this case, they will increase proportional to it. So, we must calculate this year’s current assets and current liabilities, the two parts of the working capital, and see how much these will increase next year. Current assets in 2018 are finished goods inventory of SEK 40,000 plus work in progress of SEK 15,000 plus raw material inventory of SEK 20,000 plus accounts receivable of SEK 12,000 plus cash of SEK 4,000. All this summed gives SEK 91,000 in current assets year 2018. Since these are estimated to increase with 20%, they are estimated to increase with SEK 18,200, which is calculated as SEK 91,000 this year times the change 20% Current liabilities in 2018 are only accounts payable of SEK 20,000, nothing more than that. Current liabilities are also estimated to increase with 20%, which means that they are estimated to increase with SEK 4,000, calculated as SEK 20,000 this year times the change 20%. Current liabilities help us with financing; it is a type of loan from (in this case) our suppliers. So, we will subtract current liabilities when estimating the further need for capital. This means the need for more capital is SEK 0 in fixed capital plus SEK 18,200 in current assets minus SEK 4,000 in current liabilities = SEK 14,200. This is the change in the need for capital estimated for the next year.

92

[Slide 9.12] With the resource method, we can

calculate the average working capital requirements in a precise manner. Suppose that we produce 54,000 units per year, which means that we produce 150 units per day (54,000 units/360 days). The calculation can also be done weekly, monthly, annually or whatever is most appropriate in the specific case. Assume also that we use material for SEK 200 per unit and that we use this material directly in the beginning of the production process, and that we work on this material throughout the production process resulting in a salary of SEK 100 per unit produced. In a real case, there is of course a variety of materials used and of processing work undertaken by several different employees and machines in various stages of the production process – but to illustrate the calculations we can simplify in this way. We should only include those resources that gives cash outflows in our calculations, no expenses such as depreciation, that doesn’t result in cash outflows should be part of it, since they do not result in an increased need for working capital. The material thus involves a payment of SEK 200 per unit produced. We can assume that the company stores the material in raw material inventory on average 40 days, and that they are given a supplier credit, accounts payable time, of 30 days. So that means that 30 days of the raw material inventory time is financed by the suppliers, and that the company only needs financing for 10 days more (40 days less 30 days in credit). After this, the material is used in production (work in progress), and the capital is tied in the, say, 20 days that the production lasts for one unit. Then the finalized product is kept in a finished goods inventory and tied for another, say, 30 days, after which it’s sold and the capital is tied up for another maybe 20 days, the customer credit time that results in accounts receivable. For the work performed, the company pays SEK 100 per unit produced. Work is, of course, not stored in any inventory or so, and doesn’t result in any accounts payable (although it might result in some credit because the employees are paid after the work, but we ignore this here). As said earlier, the work is performed continuously during the production process, which as said earlier lasts for 20 days. This means that at the beginning of the production process no work at all is tied up to the product, then we add a little work every day, and at the end of the production process we have tied up the entire amount. Therefore, we tie up on average half the amount, SEK 50 of the SEK 100, during the production process; nothing at all at the beginning, everything at the end, on average therefore half ((SEK 0 + SEK 100)/2) of the amount. After this, the whole amount of cash outflow for work is tied up for 30 days in the finished goods inventory, and for 20 days of customer credit as accounts receivable before we get paid. The capital requirement can now be calculated as the number of days during which the capital is tied up, multiplied by the number of units that we produce per day, multiplied by the cash outflow per

• unit. We need to sum the number of days that the payments for material and labor are tied up first:

For material, 40 days in raw material inventory - 30 days accounts payable time + 20 days work in progress + 30 days in finished goods inventory + 20 days accounts receivable time = 80 days. And for work: 20 days work in progress when half the amount is tied up, and 30 days in finished goods inventory + 20 days of accounts receivable time = 50 days when the whole amount is tied up. The capital tied up for material thus becomes 80 days x 150 units produced per day x SEK 200 in payment

93 per unit of output = SEK 2,400,000. And the capital tied up for work becomes 20 days x 150 units produced per day x SEK 100/2 in payment per unit of output + 50 days x 150 units produced per day x SEK 100 in payment per unit of output = SEK 900 000 The total working capital requirement therefore amounts to SEK 3,300,000 (SEK 2,400,000 + SEK 900,000). If, for example, we assume that we also need to invest in equipment for SEK 4,000,000, a fixed capital requirement, and that we need a safety capital of SEK 400,000, the total capital requirement would be SEK 7,700,000 (SEK 3,300,000 + SEK 4,000,000 + SEK 400,000).

[Slide 9.13] The presentation of the balance sheet

method is identical to the presentation of the resource method. The difference between this method and the resource method is that we use the formula to calculate the need for working capital (number of days x number of units produced per day x cash outflow per unit of

• utput) on the respective balance sheet items

(raw material inventory, accounts payable, work in progress, finished goods inventories, and accounts receivables) rather than on each resource (material, work, and so on). Inventory: Raw material storage time is 40 days x 150 units produced per day x SEK 200 in cash

• utflow per unit for material = SEK 1,200,000. Accounts payable: The credit from suppliers is -30 days

(minus because it reduces the need for working capital) x 150 units produced per day x SEK 200 in cash outflow per unit for material = - SEK 900,000. Work in progress: Production 20 days x 150 units produced per day x (SEK 200 in cash outflow per unit for material + (SEK 100 in cash outflow per unit for work divided with 2 since this is tied up with its average value in production) = 20 x 150 x (SEK 200 + SEK 100/2) = SEK 750,000. Finished goods inventory: Finished goods inventory storage time 30 days x 150 units produced per day x (SEK 200 in cash outflow per unit for material + SEK 100 in cash

• utflow per unit for work) = SEK 1,350,000. Accounts receivable: The credit time to customers 20

days x 150 units produced per day x (SEK 200 in cash outflow per unit for material + SEK 100 in cash

• utflow per unit for work) = SEK 900,000. The total need for working capital is, then, just as with the

time method, SEK 3,300,000 (SEK 1,200,000 – SEK 900,000 + SEK 750,000 + SEK 1,350,000 + SEK 900,000), and to calculate the total capital requirement we can, just as for the time method, add the need for fixed capital SEK 4,000,000 and the need for safety capital SEK 400,000 to this, and get the total capital requirement, SEK 7,700,000.

94

[Slide 9.14] Where can we acquire capital, if we

have a need for capital? With a common name, this is called the capital market. It consists of two parts. One of them is the market for liabilities, the market of credits. On this we usually need some form of security in the form

• f guarantees; if we cannot pay, the creditor

should be able to use other ways to receive payment (through our private assets, through another person or some other company who agrees to pay instead of us, or by the creditor receiving a percentage of the company or the like if we fail to pay.) One way to use the market of credits is to issue bonds, or loan notes. Bonds are huge loans over a long period, often more than 20 years, but with the guarantees that are needed to issue such a loan, the possibilities of such are open only for large companies with good collateral and for governments, municipalities and the like. Another possibility is to borrow capital at a bank or from another creditor by mortgage loans, which means that we provide security in the form of mortgages on the company

• r other relatively safe assets. Promissory note loans mean loans on bail or with real security.

We can also get a line of credit (which is also quite common to have in private life), which means that we, for an annual fee, always have the option to a credit. Let's say that the company has a line of credit of MSEK 1. This can then be used when necessary, such as during those parts of the year when

• ur liquidity is strained, and for these periods the company pays a relatively high interest rate. For

the other parts of the year, when liquidity is not strained, the credit is not used, and then the charges from the bank are considerably lower. Debt factoring means that we pledge or sell our accounts receivable to a lender; a factoring

• company. Instead of waiting for maybe a month to get paid from the customers, the factoring

company pays the money minus a fee (often around 3 %) directly to us. So, it’s the factoring company and not we who are paid by the customer. Often the factoring company also take care of the whole invoicing procedure. Finance leases is a way to reduce the need for fixed capital. We hire machinery, buildings and the like from a leasing company instead of buying them. There are two main types of leases; financial leasing works as described above, while with operative leasing, the leasing company also takes care of service and maintenance of the rented equipment. Convertible loan notes mean that we borrow money from a lender, but when it's time for us to pay the lender can choose to either get paid in money or to receive a pre-specified number of shares in

• ur company. If the value of the shares has gone up, the latter option may be advantageous for the

lender and we avoid straining the capital with a cash outflow. Many companies use so-called employee stock options, which basically is the same but where it’s instead the employees who can, after a certain period, choose between cash compensation or remuneration in the form of shares. If the value of the shares has gone up, the latter option is more beneficial to the employee, which is why this is considered to create a good motivation for the employees to work hard so that the company's value, and thereby the value of the employees stock options, will increase.

95

[Slide 9.15] Now we have dealt with one part of

the capital market, namely the market of

• credits. The second part, the stock market, is a

market with potential shareholders; a market for equity. One way to increase equity, and in this way

• btain more capital to the company, is that the
• wners agree that profits from earlier years are

saved in the company instead of being handed

• ut as dividends. This leads to retained profits.

Another way is to perform a new share issue. Basically, a new share issue should, according to law, always be directed towards existing shareholders - this is because they should have the chance to keep the same relative influence as before over the company. This is called a preferential rights issue. In such, transferable subscription rights are distributed to the existing shareholders. Say for example that the terms are 1:3. It means that every previous share gives 1 transferable subscription right, and if I have three such transferable subscription rights, I can buy one new share. When I buy shares, the company receives the capital from this. If I want to, I can sell my transferable subscription rights to someone else (owner or not), and s/he can then purchase one new share for every three transferable subscription rights. In some cases, the company can make a so-called directed equity issue, and offer anyone other than the existing shareholders new shares. This is common when buying other companies; then the other company's shareholders are often offered shares in our company as payment. Such directed equity issues must always be approved retrospectively by the existing owners to apply. There are also bonus issues, which works the same way as a new share issue and gives rights to existing shareholders to get new shares. However, in this case no capital is cashed in by the

• company. Instead, the idea behind a bonus issue is to convert some of the unrestricted equity to

restricted equity, and by this make the company more financially stronger. In this context it’s also worth mentioning the split, as it doesn’t give any cash to the company, but means that the number

• f shares and hence the equity per share and the book value per share is changing; a split on 2

implies for example that if I previously held one share worth SEK 100, I now hold two shares worth SEK 50 each. The purpose of such a split is to make it easier and cheaper to buy the shares of the company on the stock market.

[Slide 9.16] Atlas Copco's activities in the credit

market and on the stock market are stated in the balance sheet that was presented in Chapter 7 on following-up the business. In this picture there is a review of the issues that the company has done in recent years and which affected the share capital in different ways.

96

[Slide 9.17] In addition to the income statement

and the balance sheet, all companies of a certain size should present a cash-flow statement in their annual reports (small businesses are exempt from the requirement to produce one). The cash-flow statement shows how the company's cash and cash equivalents, that is, cash, bank accounts and so on, have changed during the year and what causes this

• change. The change, this year's net cash flow,

may be due to three different flows: net cash from operating activities, which basically is the effect on cash and cash equivalents of the profit or loss achieved during the year; net cash from investing activities, which is the effect because the company made new investments and sold earlier investments; and net cash from financing activities, which is the effect because the company has taken loans and other debts and paid loans and other debts. So, opening cash and cash equivalents have been affected by these three sources and this has led to the closing cash and cash equivalents. Now let's look at Atlas Copco's cash flow statement as an example to understand the different parts.

[Slide 9.18] The slide shows an overview of Atlas

Copco's cash flow statement for the year 2017. Cash and cash equivalents were MSEK 11,492 at the beginning of the year. Net cash flow for the year was positive and amounted to MSEK 12,877. This net came from operating activities with MSEK 21,380, investing activities with MSEK -758 and financing activities with MSEK - 7,745. Together with an exchange difference (which is not discussed further here), this meant that closing cash and cash equivalents amounted to MSEK 24,496. Let us now look at each of the three net cash flows separately.

97

[Slide 9.19] The net cash flow from operating

activities is basically the effect that the profit (or loss) will have on the cash flow. The profit is thus converted into payments. Adjustments to the operating profit are made for depreciation and amortization that are costs that do not entail payments, as well as for changes in inventories, operating receivables, operating liabilities and the like, which make a difference between, for example, booked income and income for the period. Operating profit includes, for example, all revenues - but some of these may not have been paid than but constitute an increase in operating receivables. The operating profit also includes, for example, all costs for materials - but there may also be still unused material, which was purchased and caused payments but is in inventories. Such adjustments are made to find the net cash flow from operating activities; from operating profit.

[Slide 9.20] Net cash flow from investing activities

is adversely affected by investments in property, equipment, intangible assets and the like; and positive by divested property, equipment, intangible assets and the like.

[Slide 9.21] The net cash flow from financing

activities is adversely affected by paid dividends, repayments of borrowings and the like; and positive of borrowings, new share issues and the like.

98

[Slide 9.22] In this summary of the cash flow

analysis, the various flows have been summed

• up. In the annual report, this is the cash flow

analysis shown with the four earlier slides as details in it. You can also compare this slide with the one presented four slides back and that showed the different flows and their effect on Atlas Copco's cash and cash equivalents.

[Slide 9.23] When we do a financial analysis, we

look at the company from a shareholder

• perspective. There are several measures that

may be of interest to assess if, for example, we should place our capital in the company or not. Note that a measure seldom says that much about a company; but that several measures analyzed together could provide a good indication. Earnings per share, EPS, is calculated as the result of the year divided by the number of shares, and therefore shows each share’s percentage of the profit or loss. This gives an indication of how much has been added to each share in the form of capital growth and dividends. Equity per share is calculated as the shareholders' equity divided by the number of shares and shows each share’s part of the equity. Note that equity is often underestimated, since non-current assets by law are valued at historical purchasing cost less depreciation, and not at market value. But this does at least give an indication that can be compared with the price of the share at the stock market. The net asset value per share, NAV, often named the real value, however, include a market assessment of the assets. That value, the net asset value, require careful analysis to be obtained. If we use this measure, we get a good indication of what a share in the company might be worth. But, there are still two important sources of error; intangible assets, like the value of the employees, customer loyalty and the like, are not included in the assets; and the measure still reflects the historic, the past, which doesn’t necessarily say anything at all about the future profits of the

• company. In English, in contrast with the use in Sweden, there is a more common definition and use
• f NAV; the one discussed here is sometimes called Asset-based business valuation in English.

P/E, Price/Earnings, is a measure calculated as the market value per share divided by the earnings per share. This measure shows how many years of earnings that are required before the price we have to pay for a share is covered. Note, however, that earnings don’t go back directly to the shareholder; some are paid out as dividends, some are retained in the company and can create value

99 and therefore a higher share price in the future. Note, also, that no interest is included in the

• calculation. The lower the measure is, the faster the money can be said to be paid back

For those who are interested in getting a quick return from their share purchases, the dividend yield, which is calculated by dividing the dividend per share by the market value per share, gives interesting

• implications. If the value of the measure is high, it means that money invested in share purchases

quickly goes back to the owner in the form of dividends. Other shareholders, who are interested in the company's growth in the long term, might prefer that the money is kept within the company to create new business and thus increase in value instead. There are many more dimensions to calculate for those who want to invest in shares. But, before purchasing shares in a company one should make a more careful analysis than this. A thorough review of the company's annual and interim reports gives good insights into company operations. Besides the statements that we have discussed earlier, the annual report often contains such as investment analysis, inflation analysis, employee analysis, public closure, growth analysis, sustainability reports, value added analysis and profitability structure analysis, that adds a lot to our understanding of the company.

[Slide 9.24] The slide shows a financial analysis

with the calculated values for Atlas Copco for earnings per share (SEK 13.58), equity per share (SEK 49.38), price/earnings (25) and dividend yield (2%). We cannot calculate net asset value per share without an extensive analysis of the real values in the company. All values are based

• n the annual report for 2017. On the book's

homepage there is a spreadsheet that has been used for this calculation as well as later years' calculated measurements. Now let's finally practice on these measures.

[Slide 9.25] Semlan AB reports the following for

this year: Additional value in assets (exceeding booked value) is SEK 500,000, dividend per share is SEK 40, total equity is SEK 1,000,000, total liabilities is SEK 1,100,000, market value per share is SEK 220, number of shares is 20,000, total profit of the year is SEK 1,400,000, and total salary is SEK 440,000. From this we should calculate some financial measures. Note that we have no use of the information about total liabilities and total salary, since these aren’t parts of the calculations. So, we calculate:

100

• a. EPS, Earnings per share. This is calculated as the profit of the year SEK 1,400,000 divided with the

number of shares 20,000 and this gives SEK 70. Each share has earned SEK 70. This doesn’t go directly to the shareholder, but some part of it stays in the company. Anyway, it adds value to the shares.

• b. Equity per share. This is calculated as the equity SEK 1,000,000 divided with the number of shares

20,000 and this gives SEK 50. The equity belonging to each share is SEK 50. Should the company be liquidated, and there were no other hidden values in it, this is what the shareholder should get.

• c. P/E, or price/earnings. This is calculated as the market value per share SEK 220 divided with the

earnings per share, which we calculated to SEK 70, and this gives 3.14. This means that the price of the share is slightly more than 3 times as high as the profit this year; in other words, if we expect the price and the profit to stay at these levels, it takes the company 3.14 years to earn as much as the share is worth in the market.

• d. Net Asset Value per share. This is calculated as the equity SEK 1,000,000 plus additional value in

the company SEK 500,000, and this divided with the number of shares 20,000. This gives SEK 75. This means, that when it comes to the value of the company it should be SEK 75. This is if we have valued the company correctly, and this is the difficult part of the measure; what is a specific building, a specific machine and so on worth. But, let say that all these has been done in a good way; now, compare this measure SEK 75 with the market value SEK 220. Shouldn’t they be the same? Sometimes, but a high market value can be because e g there are values in the employee’s competence, or because the market believes that they will earn much more soon because of a new patent, and so on.

• e. Dividend yield. This measure is calculated as the dividend per share SEK 40 divided with the market

value per share SEK 220, which gives 18%. 18% of the market value is paid to the share owners as

• dividends. Someone who wants to have money fast without selling her shares wants a higher

dividend yield; if you want to invest your money for a long time, you might prefer that the money stays in the company and increase there. Now, are the measures good or bad? It depends on the trends, how it looks like at competing companies, and so on.

[Slide 9.26, not included] Well, that was chapter 9 of 9 in the course “Management of an Industrial

Company”, and it dealt with financing the business. I hope that the overview gave you some new insights that you will have use of. Bye!

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• 10. Annual Report 2018

[Slide 10.1] Hi. Welcome to the course

“Management of an Industrial Company" and extra chapter 10: Annual Report 2018. In this chapter we look at what has happened in the company since the book was printed by discussing new values in the annual report.

[Slide 10.2, not included] The content gives an

• verview of what has happened since the book

“Management of an Industrial Company - Atlas Copco Industrial Technique" by me, Håkan Kullvén was published. The book is published by Studentlitteratur, Lund, in 2018. If you have any suggestions for changes you can send these to me at kullven@outlook.com.

[Slide 10.3] Let us therefore look more closely at

the annual report of Atlas Copco for year 2018. It was presented to the shareholders at an annual general meeting. The annual general meeting of the annual report for 2018 was held for Atlas Copco's part on April 25, 2019 in Solna,

• Sweden. For voting by decision, the Nimbus

voting system was used - it is needed to keep track of all shares (total in Atlas Copco over 1 billion shares divided into 70% A shares that have one vote and the remaining B shares that have 0.1 votes).

[Slide 10.4] The slide shows the income statement

• f Atlas Copco for the year 2018.

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[Slide 10.5] The slide shows the first part of the

balance sheet of Atlas Copco for December 31, 2018: the part that accounts for the assets.

[Slide 10.6] The slide shows the second part of the

balance sheet of Atlas Copco for December 31, 2018: the part that accounts for the equity and liabilities.

[Slide 10.7] The slide shows various key figures for

Atlas Copco: Equity ratio (43.9%), current ratio (1.53), quick ratio (1.17), return on equity (206.5%, exceptionally high due to non- recurring effects on the unbundling of Epiroc), and return on capital (19.5%). The various parts

• f DuPont are also shown here; return on capital

19.5% consists of a profit margin of 22.8% multiplied by the asset turnover rate of 0.86. Other measures used in Atlas Copco are, for example, orders received, which amounted to BSEK 90, EBITA of BSEK 22 and an EBITDA margin of 26.1%. All values are based on the annual report for the year 2018. On the book's course homepage there is a spreadsheet that reports this calculation.

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[Slide 10.8] If we look at the need for capital of

Atlas Copco, this amounts to MSEK 42,472 on December 31, 2018. Fixed assets amount to MSEK 42,932 and long-term liabilities to MSEK 19,153, so the fixed capital amounts to MSEK 23,779 (MSEK 42,932 – MSEK 19,153). Current assets amount to MSEK 53,738 and the current liabilities to MSEK 35,045, so the working capital amounts to MSEK 18,693 (MSEK 53,738 - MSEK 35,045). In total, the capital, and thus equity, amounts to MSEK 42,472 (MSEK 23,779 + MSEK 18,693). This also includes a safety capital.

[Slide 10.9] Atlas Copco's activities in the credit

market and on the stock market are stated in the balance sheet that was presented in Chapter 7 on following-up the business. In this picture there is a review of the issues that the company has done in recent years and which affected the share capital in different ways.

[Slide 10.10] The slide shows an overview of Atlas

Copco's cash flow statement for the year 2018. Cash and cash equivalents were MSEK 24,496 at the beginning of the year. Net cash flow for the year was negative and amounted to MSEK - 9,088. This net came from operating activities with MSEK 16,814, investing activities with MSEK -4,301 and financing activities with MSEK - 21,061. Together with an exchange difference (which is not discussed further here), this meant that closing cash and cash equivalents amounted to MSEK 16,414. Let us now look at each of the three net cash flows separately.

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[Slide 10.11] The net cash flow from operating

activities is basically the effect that the profit (or loss) will have on the cash flow. The profit is thus converted into payments. Adjustments to the operating profit are made for depreciation and amortization that are costs that do not entail payments, as well as for changes in inventories, operating receivables, operating liabilities and the like, which make a difference between, for example, booked income and income for the period. Operating profit includes, for example, all revenues - but some of these may not have been paid than but constitute an increase in operating receivables. The operating profit also includes, for example, all costs for materials - but there may also be still unused material, which was purchased and caused payments but is in inventories. Such adjustments are made to find the net cash flow from operating activities; from operating profit.

[Slide 10.12] Net cash flow from investing activities

is adversely affected by investments in property, equipment, intangible assets and the like; and positive by divested property, equipment, intangible assets and the like.

[Slide 10.13] The net cash flow from financing

activities is adversely affected by paid dividends, repayments of borrowings and the like; and positive of borrowings, new share issues and the like.

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[Slide 10.14] In this summary of the cash flow

analysis, the various flows have been summed

• up. In the annual report, this is the cash flow

analysis shown with the four earlier slides as details in it. You can also compare this slide with the one presented four slides back and that showed the different flows and their effect on Atlas Copco's cash and cash equivalents (see four slides earlier).

[Slide 10.15] The slide shows a financial analysis

with the calculated values for Atlas Copco for earnings per share (SEK 86.56, exceptionally high due to non-recurring effects on the unbundling of Epiroc), equity per share (SEK 34.54), price/earnings (4.13) and dividend yield (1.76%). We cannot calculate net asset value per share without an extensive analysis of the real values in the company. All values are based on the annual report for 2018. On the book's homepage there is a spreadsheet that has been used for this calculation.

[Slide 10.16] The annual report also includes an

account of how the business affects a sustainable development; a sustainability

• report. The content for 2018 is presented on this

and three more slides. Common to all is that the year's results (in 2018 in this case) are compared with the previous year (2017). In this the first slide of four about the sustainability result for 2018, the economic value that the business contributed with is reported.

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[Slide 10.17] In this the second of four slides about

the sustainability report for the year 2018, the usage of energy and water as well as the management of CO2-emissions are reported.

[Slide 10.18] In this the third of four slides about

the sustainability report for the year 2018, the situation of the employees are reported in measures like proportion of women and men, employee turnover, nationalities, number of accidents, sick leave in days and number of diseases.

[Slide 10.19] In this the fourth and last slide about

the sustainability report for the year 2018, the ethical norms and how they are followed up in the business are reported.

[Slide 10.20, not included] Well, that was extra chapter 10 in the course “Management of an Industrial

Company”, and it dealt with Atlas Copcos annual report for year 2018. I hope that the overview gave you some new insights that you will have use of. Bye!