Introduction: -
Companies employ financial modelling as one of their most significant tools to assess the financial viability of their businesses. The application is particularly relevant within the manufacturing sector. Wherein there is a complex pricing model for any product produced by a manufacturer, there will be many different elements (many of which are frequently changing), which must be accounted for when conducting such modelling.
Manufacturing companies invest heavily to produce products; however, they will not receive revenue until the product is sold. Therefore, to understand future financial performance, manufacturing companies use a financial model to project revenues, costs, profits and cashflow over a period of time. Financial modelling assists management evaluate i) whether to make an investment; ii) whether to expand; and/or iii) how effectively the business operates.
The financial modelling used in manufacturing companies has three major components: forecasted sales volume; forecasted production costs; and forecasted operating expenses which include working capital and fixed and capital expenditures. Additionally, the financial model is used to evaluate various scenarios including: increasing production capacity; varying raw material prices; and/or entering into new geographical markets.
Financial modelling is an integral aspect of establishing a competitive edge in the manufacturing sector. The continued importance of financial modelling will remain as manufacturing companies compete more aggressively for market share by using critical data such as; simple financial ratios; new technologies; and forecasting production schedules.
What is Financial Modelling for Manufacturing Companies?
Financial modelling for manufacturing companies is the process of creating a structured financial representation of a manufacturing business using spreadsheets or financial software.
The model typically includes:
Ø Revenue forecasts
Ø Cost of goods sold (COGS)
Ø Production costs
Ø Capital expenditure
Ø Profit and loss statement
Ø Cash flow projections
Ø Balance sheet forecasts
The objective of such models is to analyze financial performance and predict future outcomes based on assumptions.
Key Components of a Manufacturing Financial Model
1. Revenue Projection
Creating a Financial Model requires identifying all revenue sources. Revenue from manufacturing products depends on:
Ø Production Volume
Ø Selling Price per Unit
Ø Demand for Product
Revenue= Units Sold* Price per Unit
Example: - If a company produces 100,000 Widget A at ₹500 each, the Revenue will be:
Revenue = 100,000 * 500 = ₹5,00,00,000
2. COGS (Cost of Goods Sold)
COGS includes direct costs incurred in creating and selling a product. COGS consists of:
Ø Raw Material Cost
Ø Direct Labor Cost, and
Ø Factory Overhead costs.
Example:
Raw Material- 2,00,00,000
Direct Labor- 1,00,00,000
Factory Overhead- 50,00,000
Total COGS= 3,00,00,000
3. Operating Expenses
Operating Expenses are the indirect costs associated with running a business.
Operating Expenses include:
Ø Administrative
Ø Marketing
Ø Rent and Utilities
Ø Research and Development.
Example:
Administrative- 20,00,000
Marketing- 15,00,000
Total Operating Expenses= 35,00,000
4. Capital Expenditure (CAPEX)
Capital Expenditures (CAPEX) are the costs that a manufacturer incurs when purchasing fixed assets like:
Ø Machinery
Ø Equipment
Ø Manufacturing Facilities.
CAPEX is often included in the Financial Model when doing the forecast for future expansion projects.
Example:
Machinery Purchase=1,50,00,000
5. Working Capital
Working Capital is the amount of money needed to operate a company on a daily basis.
Working Capital= Current Assets- Current Liabilities
Working Capital for Manufacturing Companies consists of:
Ø Inventory
Ø Accounts Receivable
Ø Accounts Payable
Example of Manufacturing Cost Structure
Typical cost breakdown:
Ø Raw Materials – 40%
Ø Labor – 20%
Ø Overheads – 15%
Ø Logistics – 15%
Ø Marketing – 10%
This shows that raw materials are usually the largest expense in manufacturing.
Production Growth Forecast
The graph above illustrates how production levels may increase over time when a company expands its operations.
Example production trend:
|
Year |
Units Produced |
|
2020 |
50,000 |
|
2021 |
62,000 |
|
2022 |
76,000 |
|
2023 |
88,000 |
|
2024 |
105,000 |
This growth may occur due to:
Ø Increased demand
Ø Expansion of production capacity
Ø Improved technology
Ø Efficient supply chain
Step-by-Step Process to Build a Manufacturing Financial Model
1. Business Estimations Are Elements for Estimating Finances
To Develop a Financial Model for a Manufacturing Business, You Must First Create Business Estimations
The basis of the financial model you will develop is the estimations you have created.
Some examples of business estimations are:
Ø Expected sales growth
Ø Total amount of manufactured goods your factory can produce
Ø Unit price of each item you plan to sell
Ø Cost of raw materials used to manufacture goods
Ø Labor costs to manufacture goods
Ø What is the current inflation rate?
Sales Estimation Example:
We expect a 8% annual increase in sales. The average selling price of an item will be ₹500. All estimations made are important to the development of your Financial Model!
You also must make an estimation of how many items you will sell over a period of time
2. Sales Estimating Considerations:
We keep track of how much our products are selling currently
How fast or how slow our industry is growing (annual sales for our company & industry)
Your position or market share
How Many Items We Have Sold Historically (sales trends)
Ø Year 1 = 100,000 items sold
Ø Year 2 = 110,000 items sold
Ø Year 3 = 121,000 items sold
Your company's future production levels will be based on maximum production and how many resources you have available
3. Estimate Your Cost of Production
All manufacturers need to take into consideration the total costs related to production.
A breakdown of production costs is:
1) Raw materials: the physical components needed to
manufacture your items
2) Direct labour: wages paid to employees who directly work on producing your items
3) Manufacturing overhead: electricity, repairs to machinery, rent on your building
Cost Distribution Per Unit
Ø Raw Material = ₹200
Ø Labor = ₹100
Ø Overhead = ₹50
Total Cost of Manufacturing per item = ₹350
4. Project Operating Expenses
Operating Expenses are the indirect costs of running your company that are not included in your production costs.
Examples include:
Ø Salaries for Admin and Management
Ø Marketing
Ø Rent for Office Space
Ø Insurance
Ø R&D
|
Expense Type |
Amount |
|
Marketing |
₹20,00,000 |
|
Administration |
₹15,00,000 |
|
Utilities |
₹10,00,000 |
5. Forecast for Capital Expenditure (CAPEX)
Manufacturing companies frequently have to invest large amounts of money into new machines, equipment and Factory Infrastructure.
Future capital expenditures (CAPEX) need to be estimated within your financial model.
CAPEX Examples:
Ø Purchasing New Machinery
Ø Building a Factory Addition
Ø Upgrading Technology
Example:
Investment of New Machinery= ₹ 1,50,00,000
This provides a Long-Term Roadmap for Growth!
6. Building Financial Statements
When creating a complete Financial Model, a company should create the 3 Primary Financial Statements:
a. Income Statement
The income statement shows a Company’s Profitability.
Revenue - COGS = Gross Profit
Gross Profit - Operating Expenses = Operating Income.
b. Balance Sheet
The Balance Sheet shows the Company’s Financial Position.
Includes:
Ø Assets: Machinery, Inventory & Cash
Ø Liabilities: Loans & Payables
Ø Equity: Owner’s Equity
c. Cash Flow Statement
The Cash Flow Statement shows the Company’s Cash inflows and outflows.
Manufacturers rely heavily on their Cash Flow to manage:
Ø Purchasing Inventory,
Ø Paying Suppliers,
Ø Paying Back Loans.
7. Perform Scenario and Sensitivity Analysis
Scenario and Sensitivity Analysis is done to test how a change(s) in Assumptions affects the Company’s Financial Results.
Some Scenarios to Consider are:
Ø Increase in Raw Material Prices
Ø Decrease in Product Demand
Ø Increase in Labor Costs
Example: If Raw Material Prices Increase 15%, Profits Could Decrease Significantly – Scenario Analysis Helps Management Prepare for These Types of Risks!
Real World Example
A real-world example of financial modeling in manufacturing can be seen by looking at organizations such as the Toyota Motor Corporation. Financial modeling for Toyota helps them to project:
Ø World-wide demand for vehicles
Ø Production capacity
Ø Supply chain costs
Ø Investing in new manufacturing plants
For example, if they are going to build a new manufacturing plant, they create financial models to estimate:
Ø Cost of building the plant
Ø Investment in machinery
Ø Expected production volume
Ø Making a profit over 10 to 20 years
Using these types of models will tell the company whether to proceed with a project because it is viable.
Likewise, the automobile manufacturer Tata Motors in India also uses financial models for analyzing demand for vehicles, planning production and managing costs.
Importance of Financial Modelling in Manufacturing
1. Improved Financial Planning
The use of financial modeling enables manufacturing businesses to establish a roadmap for their financial planning. By utilizing historical data and anticipated market conditions, companies can create projections related to future revenues, costs and profits.
The financial models created by companies also allow management and owners to answer a variety of questions including:
Ø How much revenue can we expect to receive in the coming year?
Ø What will the costs associated with production be?
Ø How much profit will we make?
Utilizing appropriate financial planning will minimize potential financial shortfalls and assist companies in utilizing their resources more effectively.
2. Control Costs & Improve Efficiency
Manufacturing companies need to manage a variety of different types of costs including raw materials, employee wages, machinery maintenance costs and shipping costs.
Financial modeling provides management with the ability to analyze these types of costs and identify ways to lower costs.
Some examples of this could include:
Ø Reducing the amount of wasted raw material
Ø Improving production efficiency
Ø Lowering the cost of transportation
By controlling their costs, manufacturing companies are able to enhance their profits.
3. Investment Decision Making
Manufacturing companies frequently need significant capital expenditures to invest in the following types of assets:
Ø Production Facilities
Ø Machinery
Ø Technology
Ø Production Lines
Financial modeling assists companies in determining whether these types of capital expenditures are sound investments.
For example, before deciding to build a new production facility, Toyota Motor Corporation uses financial modeling techniques to evaluate the estimated:
Ø Project costs
Ø Projected production capacity
Ø Projected revenues
Ø Projected return on investment (ROI)
This information allows Toyota to determine whether it will be financially feasible to pursue the project.
4. Risk Management
Manufacturing companies face many financial risks, such as:
Ø Increase in raw material prices
Ø Supply chain disruptions
Ø Changes in market demand
Ø Currency fluctuations
Financial models allow companies to perform scenario analysis and see how these risks might affect profits.
For instance, automobile manufacturers such as Tata Motors analyze how changes in steel prices or fuel costs could impact their manufacturing expenses.
This helps companies prepare strategies to reduce risks.
Advantages of Financial Modelling in a Manufacturing Business
1) Improved Financial Planning
They will allow companies to forecast their future revenue, costs & profits much more accurately.
2) Strategic Planning
They will allow managers to create & implement their long-term strategic plan(s) such as expanding into new markets.
3) Performance Evaluation
They will allow managers to compare actual performance against forecasts.
4) Better Resource Allocation
They will allow companies to allocate resources effectively to maximise profits.
5) Enhanced Investor Confidence
Well-structured financial models will encourage investments from both private and 3rd party lenders.
Disadvantages of Financial Modelling in a Manufacturing Business
1) Dependence on Assumption
Financial Models are based on certain assumptions, & if these assumptions prove to be inaccurate, then the results produced will also be inaccurate.
2) Time-Intensive
It takes a significant amount of time & expertise to develop a detailed & accurate financial model.
3) Complexity
The development of financial models used by manufacturing will generally have many different variables and therefore will be much more complex than those used by other industries.
4) Data-Dependent
To provide good quality financial models, it is necessary for companies to have a large amount of accurate & relevant data.
5) Risk of Calculation Errors
The potential for calculation errors in a spreadsheet can therefore lead to poor financial decisions on behalf of the company.
Conclusion
Financial Modelling has proven itself to be an exceptional tool for assessing the Manufacturing Industry’s Financial Performance and Planning for Future Growth.
Financial Modelling allows Manufacturers to forecast Revenues, estimate the costs to produce Products, evaluate Investment Decisions and solve their Business Risks.
Manufacturers are benefiting from Financial Modelling because it improves operational efficiencies, controls costs and creates Business Strategies for Manufacturers to grow over a long period of time. Real World Examples of Companies that use Financial Modelling as part of their Manufacturing Process are Toyota and Tata Motors and both of these Organizations utilize Financial Modelling for Production Planning, Investment Decision Making and the Development of their global Expansion Strategies.
The benefits of Financial Modelling far outweigh the drawbacks therefore Financial Modelling should continue to be one of the key tools for Manufacturers to gain competitive advantages in today’s challenging economic environment. Accurate financial data and realistic financial assumptions can be used to formulate financial models that will provide Manufacturers with valuable Financial Planning tools for success.
Learn Financial Modeling 🚀
Enroll Now🔗 Related: Explore More Finance Guides