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CHAPTER 3

Economics

The most powerful argument in favor of pursuing a project is that it will save real money (unless of course it will also save lives).

In taking on such a challenge, make sure you have a good understanding of the requirements of how your company calculates savings, and at what rate they will green-light a project. Learn the ROI and payback requirements, and how they will be calculated.

Return on Investment (ROI) is the most commonly-used measure for investments. ROI is expressed as the percentage of return earned per year. If the yearly income varies, each year can be evaluated separately, or the years can be averaged together (see ARR below).

ROI of common investments:	Savings account	3%
	Money Market	5%
	Mutual Fund	12%
	Small corporate investment	50%
	Capital improvements	30%

Formula: ROI (Return on Investment) = Yearly Income / Total Investment

Example: Replacing 2000 old-style fluorescent fixtures in a school with new technology and electronic ballasts requires an investment of $150 per fixture, or $300,000. The reduction in energy, and costs of ballast replacement and lamp replacement, will yield a savings of $75,000 per year. The ROI calculation is:

ROI = 25% = 75,000 / 300,000

25% is below the school’s standard ROI of 33%

Based on these numbers, the school could not justify the investment until it contacted the utility company, which offered a rebate of $45 per fixture or

Rebate 2000 x $45 = $90,000

Recalculation taking the rebate into account results in a new ROI calculation of:

$210,000 (new investment) = $300,000 (old investment) – $90,000 (rebate)

33% = $75,000 / $210,000 The school was able to make this investment because, with the rebate, the ROI met the guideline.

Average Rate of Return (ARR): This calculation is the same as for the Return on Investment (ROI), but extended over the entire life of the investment. The ROI will vary from year to year, but all the returns and all the investments are added together to determine the ARR.

ARR Formula: ARR = Average Yearly Income after Tax / Investment over life

Example:

Springfield Controls purchased a small alternative-energy source (say a hydro-electric generator on a nearby river), for a total investment of $1.4 million. This investment was paid for entirely with internal funds. The average net income (after all expenses and taxes) over the years of the analysis was $210,000:

ARR = $210,000 (average income) / $1,400,000 (total investment)

ARR = 15%

It’s interesting to note that, by borrowing, you can sometimes significantly improve the ARR (or ROI). Why is this true? Consider the impact of borrowing funds, where the rate you pay is below your ARR or ROI requirement. The organization will earn a return on the borrowed money equal to the spread between the ARR and the loan interest rate. The US government supports this type of decision by allowing the interest to be deducted from the organization’s income tax bill! As companies found out in the late 1980’s and early 1990’s, and again in the late 200Xs, there is significant risk in excessive debt because payments must continue to be made, even if sales go down and profits evaporate.

The ROI can also be improved if the government or utilities have rebates or tax credits for certain types of investments (such as alternative energy). In addition, in most states, a small turbine can be hooked up to a utility network so that, if your plant is closed in the evenings, and the power output exceeds the closed plant’s requirements, you can sell the excess power back to the utility (effectively running the meter backwards). That income also can improve the ROI.

Payback method: The second most common method of evaluating investments is to determine the number of years (or months) it will take to pay off your investment based on the investment’s return. The payback method is frequently used along with ROI, and is the reciprocal thereof.

Formula: Payback in years = Total investment / Yearly Income from the investment

Organizations are vitally interested in how soon their money will come back. In the re-lamping example above, the rebate will improve the payback time from four years to three years.

Interesting savings calculation (phantom unless you can monetize it)

Quick calculation of ROI from time savings:

Consider a project to move the parts room. It is clear that repositioning the parts room would save time, but would it save enough time to make the change worth while? We could estimate the savings in minutes per day for the crew. Let’s say we could reasonably see 20 minutes savings per day, per mechanic. If we have 17 mechanics they will save 340 minutes or 5.67 hours per day.

There is a universal formula to calculate Return on Investment in any currency with any labor rate, from labor savings in minutes! There are two simple assumptions:

1.Any savings should generate a 50% ROI or provide a 2-year payback.

2.The total cost of a worker is 2.5 times their hourly wage. This cost includes wages, benefits, overtime, all leave and vacations, lost time, and all the overhead of that worker.

Answer:

Savings in Local currency = Labor rate per hour in local currency x savings in minutes x 20

So in our example US$20 / hour * 340 minutes a day savings in minutes x 20 = $136,000

Here is the arithmetic behind that quick calculation:

Assuming that 2 years is about 440 days of work

((Labor Rate x 2.5) x 440) / 60 = 18.33 (Cost per minute for 2 years. Round up to 20) x Labor rate

If you do the algebra, pull out the Labor rate and since all that’s left is multiplication

(2.5 x 440) / 60 = 18.33. Put the labor rate back in and that’s the savings per minute. Pretty easy.

Economic Modeling: How do you know an alternative is Lean?

Economic modeling will help you determine the Leanest alternative (economically speaking). Economic modeling simulates the costs and income from a particular maintenance alternative, given the economic ‘facts’ of the case. Models can be as simple as projecting the costs and income, to sophisticated models that include interest rates, tax policies, and other variables. If the consequences warrant it, alternatives can be analyzed using economic modeling.

Many different strategies can be used in maintaining particular assets. Of course, the first choice is to employ an asset that needs no maintenance! If no maintenance is possible, look at that alternative before ‘settling’ on a PM or another maintenance alternative.

Each choice has both economic and non-economic consequences. Economics is important, but other issues might suggest a particular strategy. For example, PM might be the best strategy for a particular asset but your company has no PM system and a bad track record of allowing downtime for PM, so PM will not work. There are 6 or 7 major strategies, and many more combinations and sub-strategies. A few of them could be:

•Run the unit in breakdown mode–where it gets no attention unless broken. This example is always used for comparisons. In modeling, doing nothing should always be a choice (and sometimes it’s the best choice).

•Redesign the asset to be quick-connected in place, so that you can do a quick switch upon failure and rebuild it off-line for use when the next one fails. Although the failure rate will be the same, each failure would be handled more quickly.

•Design a basic PM program with inspections, basic maintenance, and occasional as-required corrective jobs.

•Just bite the bullet and install a whole Back-up (say a pump) that can be switched over quickly before any chargeable downtime is incurred.

•Planning for component replacement with quick connections is like the second choice above, except that the asset is swapped on a scheduled basis before failure.

Example: Repeated failure of a chemical transfer pump has been occurring for the last several years. Downtime from lost production is valued by the cost accounting department at $500 per hour after the first hour (no cost for the first hour). There is a reservoir that will run for 1 hour before the downstream process shuts down. Labor hours are valued at $40.

Engineering analysis shows that the application is severe and that this performance is the best that can be expected (eliminating the no-maintenance alternative). The skilled mechanics working with engineering have designed a PM task list that will drop the number of failures dramatically.

Economic model for breakdown mode

Currently, in breakdown mode, the pump is failing 4 times a year. Each incident requires 10 labor hours and $2000 of parts to get the pump back on line. Downtime from calling maintenance to full operation is 14 hours (2 hours to respond to the call and 2 hours to get the system filled up and back in operation. A mechanic is required for only 10 of those 14 hours. It is a 1-person job).

In this model, the only thing required from management is to keep the spare parts in stock. A simple min-max system would suffice, with inventory levels depending on the lead time.

Economics of breakdown maintenance

The economics of this choice are clear, but what are the other consequences? There are several kinds of consequences. For one, the customer (operations) is disturbed 4 times a year for over one shift each time, amounting to 52 hours of chargeable downtime a year. This problem is not too bad if you have only one such pump, but imagine if you had 100 pumps, each failing for over one shift, 4 times a year. Of course the pumps would break at the least convenient times, and probably the failures would bunch up (lengthening the time to respond and the downtime).

Running in breakdown mode requires 40 hours of maintenance worker time. Another consequence would be the cost of $35,600 per year (in both above- and below-the-waterline costs). On the plus side, this situation requires little management and no capital expenditures. Although safety and environmental considerations are beyond the scope of this model, it is intuitively obvious that unscheduled and random events such as breakdowns are the least safe choice.

Economic model for hot swapping

Another breakdown alternative is to replace the pump after failure with a rebuilt pump and rebuild the faulty unit off-line. In the computer field, this approach might be called hot-swapping. Components (such as circuit boards) are swapped with the computer running. We can’t actually swap the pump while it is running but we still call the method hot-swapping (maybe we could call it warm swapping). To set up the method we would have to purchase a second full-pump unit and adapt it for quick changes.

The second pump will cost $15,000. After engineering the quick change, swapping to the second pump will take 2 hours. Downtime is down to 6 hours (2 hours to respond, 2 hours to swap and 2 hours to fill the system). The rebuild will cost the same amount as the breakdown model above, $2000 for parts and 10 hours off-line. Only 1 pump core is needed to rotate with the installed pump so we have to be sure to charge for only 1 pump core. The purchased pump is a capital expenditure.

Management needs to ensure that when the damaged pump is removed from service it is rebuilt reliably within 2–4 weeks. That element of management is in addition to a simple stocking strategy like the one described above. If the pump is not rebuilt in time, you run the risk of spending money for the spare and still having the downtime of the breakdown option. Having a breakdown on top of not having the pump rebuilt is the worst of both worlds (and is fat maintenance not Lean Maintenance).

Economics of hot swapping

What are the consequences of this choice? Once again there are several kinds of consequences. The Operations or production process is disturbed 4 times a year but this time it is for less than one shift. Chargeable downtime drops by 24 hours per year, or better than a 50% reduction, which is an improvement. There is no difference in the cost of maintenance labor or parts for this scenario. Annual costs have improved to $19,600 because of the reduction in downtime. The costs above the water line are the same. Each incident will still need 40 hours of maintenance labor and $2000 of parts. There is a capital cost, but it gets paid off within the year. More management is needed than with the previous example, to insure that the pump is rebuilt in a timely way. Safety is not affected because the failure mode is still random and unscheduled.

PM

PM is a common strategy. In fact, it might be tough to run a breakdown-only scenario because most firms do some PM (even if it is only a shot of grease). Frequently we notice that the greatest returns come from the most basic PM activity. There is a diminishing return to increased PM expenditure. Of course, if the subject is a fuel pump on a jet engine, the added benefit is worth while. The effectiveness of the PM is always at issue and is discussed in another section. An ineffective PM will consume resources without providing an adequate Return on Investment. It is important to look deeply at different strategies because the best way to take care of an asset might depend on the downtime cost, not just the breakdown cost.

The PM routine was designed by the mechanics, will take 1 hour a week, and requires downtime to accomplish (but that hour of downtime is free). We will assume that the PM routine as designed is effective. Additional corrective repairs (resulting from the PM inspector finding deterioration and fixing it before failure) take 5 hours per incident (3 incidents per year on average) and $1700 worth of materials per incident. With the new PM program, the system becomes significantly more reliable, and breakdowns will drop to 1 every other year (each breakdown costing the same as the original breakdown mode. that is: 10 labor hours + $2000 worth of parts and 14 hours of downtime).

Economics of PM

What are the consequences of a PM strategy? The customer is disturbed 3½ times a year. The significant difference is that 3 of the interruptions are scheduled. Operations can choose when to go down for the corrective work. Overall, the chargeable downtime is about the same as with the hot-swap example, and provides more than a 50% improvement over the breakdown mode.

One of the biggest changes is that the model calls for 72 hours of labor, or a 55% increase. The above-the-waterline costs are higher, and the total annual costs are slightly higher than hot swap but still well below Breakdown. Again, with one pump the impact is not noticeable. A hundred pumps would require 3200 extra hours, or about 2 people full-time. There is no capital cost.

Much more management (perhaps a CMMS PM module) is needed than with either of the two last examples to ensure that the PM is done weekly and the corrective maintenance is done in a timely way. The stocking system has to ensure that spares are on the shelf when needed. Safety is improved because of reduced non-scheduled events.

PCR

Another PM alternative is Planned Component Replacement, which has two versions: Planned rebuild (as in the previous example), and planned discard (used for low-cost components). PCR is closely related to the quick-change alternative except that the pump is changed out on a planned basis before failure.

PCR was one of the primary strategies of the aircraft field as well as in Air Forces around the world. Advantages include the ability to schedule technology upgrades to the equipment. Good scheduling practices are encouraged by allowing accurate workloads to be determined for an entire year, and longer for major overhauls. PCR is expensive, and is usually only justified where the consequences of the breakdown are expensive, dangerous, or both. Newer approaches toward higher levels of intrinsic reliability and advanced Predictive Maintenance inspections have forced PCR into a back-seat role in its traditional industries.

In our ongoing example, a PCR interval of 2 months would be required. The pump would be changed every two months, whether it needs it or not. The PCR operation (as with the hot-swapping operation) would take 2 hours of mechanics’ time. Bringing the pump back to operational specifications would take 5 hours on the bench each time, plus $500 worth of materials. One other advantage is that PCR can result in extremely high levels of reliability. The new failure rate would be once in 10 years (with costs similar to those of the breakdown example).

What are the consequences of this choice? Once again, there are several kinds of consequences. Production is disturbed 6.1 times a year for less than half a shift. The interruptions are almost all scheduled. Chargeable downtime drops by 19.3 hours per year, or better than a 20% improvement over hot swapping, which is a large reduction. There is also a 3-hour increase in maintenance labor with this mode. Annual costs are improved to $14,570 because of the reduction in both above-the-waterline costs and downtime. There is a $15,000 capital cost, but it is paid off in less than a year.

As mentioned previously, more management is needed to ensure that the PCR is done on schedule before failure, and that the pump is rebuilt in a timely way. Safety is improved because there are few unscheduled events.

Back-up

Many organizations choose to operate critical processes with one or more back-ups. Back-ups are all around us in critical systems. Few people would be inclined to fly globally if jets still had one engine and no way to fly when it broke. Most hospitals of any size have back-up power generation to replace electricity in a utility outage. The downside to building plants with back-up pumps and compressors come in operational and economic areas.

In the operational area it is thought that having back-ups makes the maintenance department sloppy and removes the urgency from the equation. If we have one compressor we are extremely focused in keeping it going. Having two or more compressors take away the excitement from a breakdown. One of the upcoming key performance indicators of manufacturers is Return on Assets. Return on assets goes down as the asset base goes up (for the same profit level). Of course the reason for the back-up is to enhance and stabilize the production and the profit levels too.

An alternative strategy is to mount a back-up pump in the system with an automatic alarm. We assume there is enough room to fit a back-up in place. The operators can then switch the pumping load to the back up when needed. The cost of the back up and associated piping and controls is $25,000, including labor, and will take 20 hours of work time (one time fee). A back up can be switched on without downtime. Failure rates may be assumed to be the same as in a breakdown, but without downtime. The cost of the back-up pump is charged only once, and it should be capitalized, depreciated, and held in an asset account.

What are the consequences of a back-up strategy? Customers are happy because they are never disturbed (which is why this set up is so popular). After installation, chargeable downtime is zero. Labor and parts (above the waterline), are the same as for the breakdown model, and annual costs are the lowest, though there is high capital cost. Not much management is needed beyond being sure the unit is repaired after failure and put back in service, to be ready for the next breakdown. Safety considerations are the same as for the breakdown model, (not great).

Here is what you should take away from modeling: Modeling is a Lean activity. It is one of the few ways you can sit in an office with a spreadsheet and have an impact on maintenance and operating costs for the next twenty years.

Every maintenance alternative that can be imagined costs money, and every alternative has consequences. Pick the alternative that gives the least costs and the consequences you want!