UCSD LAMP 2013: Financial Success

1. UCSD LAMP 2013:Financial Success Dan Goldzband, CMA University of California, San Diego, Extension Division General Dynamics Global Imaging Systems, San Diego CA * All opinions expressed are the soley the presenter’s and do not represent the positions or policies of General Dynamics or the University of California.

2. Financial Success Overview: Purpose General: • Provide a useful understanding of the basis of accounting and finance and how R&D fits into that schema; • Enable you to communicate more effectively with your company’s financial managers and staff, for your mutual benefit. Specific: Provide tools to track and analyze your own LAMP project’s performance.

3. Financial Success Overview: Presentation Outline • Underlying concepts: finance vs. accounting • Nature and analysis of costs • Projecting project development cost / Using the Budget & Costing Template Exercise: Set up Budget & Costing Template • Evaluating future project or product financial performance Exercises: • Project your team project’s financial performance • Southwest Airlines landing system

4. Financial Success Overview: Presentation Outline (part 2) • Evaluating company financial performance Review Cohu, Inc. financial statements Select companies for more rigorous financial statement analysis at 2nd meeting • R&D case studies: Assignment: R&D case studies to report at 2nd meeting Case Exercise: Gold Peak Electronics (if time permits)

5. Company Performance Simulation Exercise

6. Underlying Concepts: Finance vs. Accounting

7. Finance vs. Accounting(dueling definitions) • Finance: Science of market valuation • Financial management: Area of management where decisions are based primarily on considerations of value. • Accounting: Information system used to collect and organize data and provide information regarding an entity’s financial performance and condition.

8. Finance vs. Accounting(basic work products) • Accounting: financial statementsand various performance analyses derived from them (historical): Income statement Balance sheet Cash flow statement • Finance: performance projections and valuations (future-oriented): Cash flow projections NPV / Economic value added analysis

9. Nature and Analysis of Costs

10. Cost Definitions -- Part 1 • Cost: The amount ofresources surrendered to acquire or create a new resource. • Expense: Amount ofresourcesused or consumed to deliver goods/services to customers, or carry out the company’s major or central operations (use of either existing assets or new resource) Note: Costs are recognized as expenses only when they can be matched, either directly or indirectly (i.e., within the same period) against revenues. Only then is the cost resource considered to have been consumed.

11. Cost Analysis concepts • Cost Object: Anything about which cost data is collected; the point of reference of cost measurement. • Cost Driver: Any independent factor (variable) that causes costs to be generated.

12. Cost Classifications(non-exclusive) ClassificationBasis Product costs vs. period costs Relationship to revenue generation Direct vs. indirect Relationship to occurrence of specified activity Cost behavior: Variable vs. fixed Relationship to volume of activity

13. Product Costs: accounting treatments according to product character Tangible product: Product in form of finished goods inventory until actually sold (i.e., reclassified from a cost to an expense) Examples: Delta Design (Cohu) test handlers, kits and spare parts GD GIT motors, resolvers and other devices HP printers Services: Product in form of service, series of services or other intangible. Cost of providing these services or intangible benefits is expensed as incurred, regardless of how much (or little) revenue results in same period. Examples: AT&T communication services Google web-based advertising Southwest Airlines transport services

14. Product Costs: analysis Definition: Costs pertaining strictlyto the creation, acquisition or generation of the company’s product or services. Traditional manufacturing model of product costs: Raw materials + Direct labor + Overhead (includes depreciation) = Product cost

15. Period Costs Definition: Costs not related to production activities. These usually occur as a function of the passage of time, or at least independently of fundamental production or operational activities. Typical period costs: • Selling costs (advertising, commissions, delivery, support) • General and administrative costs • R&D Note: What is the fundamental activity of any company?

16. Product vs. Period Costs (standard P&L format)

17. Direct vs. Indirect Costs Traditionally applies specifically to product costs Definitions: • Direct costs: Product costs which can be related or traced to specific, discrete units of production or services. • Indirect costs: Product costs which cannot be related or traced to specific, discrete units of production or services, or for which it is impractical to do so.

18. Direct vs. Indirect Costs(with production as cost driver)

19. Cost Behavior Patterns • Variable costs: Vary in relation (usually directly) to the volume of a specific activity/cost driver (usually production or sales) • Fixed costs: Do not vary directly as a function of same activity. (“Fixed” actually a misnomer—they vary, but not ).

20. Fixed vs. Variable Costs(contribution margin format P&L)

21. Specific Cost Classifications

22. Specific Cost Classifications

23. Product Costing Tools • Bill of Materials (BOM) • Routing

24. Costed Bill of Material

25. Costed Labor Routing

26. Key Cost Accounting/Mgt Terms • Standard cost: Pre-determined, per-unit cost for a component of production or service (material, labor or OH). Used in internal control process as benchmark standard. • Cost variance: Amount of difference between actual and standard cost. • Target costing: The process of setting product cost goals at or near start of product development process and designing products to meet those cost goals.

27. III. Projecting Project Development Cost

28. Evaluating Financial Performance Project cost evaluation: • Development cost vs budget • Achieving product target cost Financial contribution evaluation: • NPV • ROI • Payback

29. Project Development Costs Materials and Services: • Materials • Purchased services (consulting) Labor (at burdened rates): • R&D • Overhead

30. LAMP Project Financial Management Tool: Budget and Costing Template • Collect and report project development costs by period • Project 12 months net income and calculate projected Return on Investment

31. IV. Evaluating Future Project or Product Financial Performance

32. Evaluating Product Financial Performance • Payback • Return on Investment (ROI) • Net Present Value (NPV, aka Economic Value Added, or EVA)

33. Project 1: Sample Assumptions Investment 750,000 P&L / Cash Flow: $ / unit Qty Ext Revenue 250 10,000 2,500,000 Variable cost 100 10,000 (1,000,000) Contribution Margin 1,500,000 Fixed Costs (excl Depreciation) (1,000,000) Depreciation (150,000) Op Profit 350,000 Tax @ 35% (122,500) Net Income 227,500 Plus: Depreciation (non-cash expense) 150,000 Annual Cash Flow 377,500 5-year economic life, discount rate: 12%

34. Timing of Product Financial Evaluations • At project inception vs • Upon project completion

35. Payback • Criteria: Time required to recover investment • Calculation: Investment / annual cash flow • Scenario 1 Payback: 750,000 / 377,500 = 2 years

36. Return on Investment (ROI) • Criteria: Financial return • Calculation: Annual cash flow / Investment • Project 1 ROI: 377,500 / 750,000 = 51%

37. Net Present Value (NPV) • Criteria: Value added from final product. • Calculation: Sum of present values of cash flows (negative and positive) • Project 1 Incremental Value: Investment (750,000) PV of Op C/F’s 1,360,803 NPV 610,803

38. Relative Merits • Payback: Critical to capital management • ROI: Ease of understanding and applicable to post-investment performance evaluation • NPV: Directly addresses fundamental issue of shareholder value

39. Relative Disadvantages Payback: Disregards time value of money and actual value created ROI: Disregards time value of money and actual value created NPV: Best used as investment decision rule, not well-suited for post-hoc analysis

40. Project 2: Sample Assumptions Investment 1,500,000 P&L / Cash Flow: $ / unit Qty Ext Revenue 275 10,000 2,750,000 Variable cost 100 10,000 (1,000,000) Contribution Margin 1,750,000 Fixed Costs (excl Depreciation) (1,000,000) Depreciation (150,000) Op Profit 600,000 Tax @ 35% (210,000) Net Income 390,000 Plus: Depreciation (non-cash expense) 150,000 Annual Cash Flow 540,000 7-year economic life, discount rate: 12%

41. Payback (Project 2) • Criteria: Time required to recover investment • Calculation: Investment / Annual cash flow • Scenario 1 Payback: 1,500,000 / 540,000 = 2.78 years

42. Return on Investment (ROI)(Project 2) • Criteria: Financial return • Calculation: Annual cash flow / Investment • Scenario 1 ROI: 540,000 / 1,500,000 = 36%

43. Net Present Value (NPV)(Project 2) • Criteria: Value added • Calculation: Sum of present values of cash flows • Scenario 1 Incremental Value: Investment (1,500,000) PV of Op C/F’s 2,464,429 NPV 964,429

44. Comparison of Methods and Results Project 1 Project 2 Payback 1.99 yrs 2.78 yrs ROI 50% 36% NPV 610,803 964,429

45. Assignment (right now!) Project your project’s • ROI • Payback (Suggest you add to final report, refining the estimates as necessary)

46. Group Exercise • Read WSJ article: “A Radical Cockpit Upgrade Southwest Fliers Will Feel” • List every conceivable (and plausible) investment, expenditure or operational change that Southwest will have to make to implement and maintain this system (the negative cash flows in an NPV analysis). Also list any non-obvious possible positive cash flows or benefits.

47. V. Evaluating Company Financial Performance

48. Basic Financial Statements • Profit and Loss Statement / Income Statement (presents economic performance, always 3 years) • Cash Flow Statement (presents all cash flows, always 3 years) • Balance Sheet (presents all resources, obligations and aims to arrive at accounting of enterprise value, always 2 years)

49. The Four Questions • What is the trend and quality of recent earnings performance? • What are the trend and drivers of recent operating cash flow performance? • How has the company been providing for its future, and how is it financing this investment? • Assess the company’s financial condition and its financial strategy.

50. Financial Performance Profitability: Ascertain profitability (net income and other interim income measurements) and trend Cash Flow: Is the company generating a positive and increasing operating cash flow?