Maximizing Portfolio Profit: An EVA Approach

Mark Lundeen & Shane Johnson September 21, 2007

Maximizing Portfolio Profit: An EVA Approach

Mark Lundeen & Shane Johnson September 21, 2007

Mark LundeenMark Lundeen

Undergrad: University of Illinois Urbana-Champaign; B.A.Undergrad: University of Illinois Urbana-Champaign; B.A.—Int’l Trade & Consumer Economics—Int’l Trade & Consumer Economics

MBA: 2007 Ross School of Business, University of MBA: 2007 Ross School of Business, University of Michigan, Finance & Corporate StrategyMichigan, Finance & Corporate Strategy

Prior to Business School: Prior to Business School:

Grain Trader/Exporter, Archer Daniels Midland, Brazil & Grain Trader/Exporter, Archer Daniels Midland, Brazil & ParaguayParaguay

Current position at Kraft:Current position at Kraft:

Senior Financial Analyst, Pizza Category FinanceSenior Financial Analyst, Pizza Category Finance

Summer Internship: Summer Internship:

Johnson & Johnson Depuy OrthopaedicsJohnson & Johnson Depuy Orthopaedics

Shane JohnsonShane Johnson

Undergrad: 1998 Gonzaga University, B.A—HistoryUndergrad: 1998 Gonzaga University, B.A—History

MBA: 2005 Ross School of Business, University of MBA: 2005 Ross School of Business, University of Michigan, Finance Michigan, Finance

Prior to Business School: Prior to Business School:

Manager, Technical Sales, Advanced Data Exchange, Palo Alto, CAManager, Technical Sales, Advanced Data Exchange, Palo Alto, CA

Current position at Kraft:Current position at Kraft:

Finance Manager, Customer Development Organization—Safeway Finance Manager, Customer Development Organization—Safeway Sales Team, Livermore, CASales Team, Livermore, CA

Prior Kraft positions: Prior Kraft positions:

Sr. Financial Analyst, Customer Service & Logistics, ChicagoSr. Financial Analyst, Customer Service & Logistics, Chicago

Summer Internship:Summer Internship:

K-Mart Holding Corp.K-Mart Holding Corp.

AgendaAgenda

Finance OverviewFinance Overview– IntroductionIntroduction

New Product AnalysisNew Product Analysis– Business Proposition ExampleBusiness Proposition Example

– Key Areas Of FocusKey Areas Of Focus

Earning Variance AnalysisEarning Variance Analysis– Definition & ExampleDefinition & Example

– Other Applications: Distribution ExpenseOther Applications: Distribution Expense

– Sales Profitability AnalysisSales Profitability Analysis

Q&AQ&A

FinanceFinance

What is the role of Finance?What is the role of Finance?

How is Finance involved with new product development?How is Finance involved with new product development?

What are key financial measures to remember when developing a What are key financial measures to remember when developing a new product?new product?

MarginMargin

Raw material costsRaw material costs

Unit costUnit cost

Estimated volumeEstimated volume

CannibalizationCannibalization

P&L OverviewP&L Overview

Per Unit %ORGross Revenue 5.00$

Allowances 0.15$ Operating Revenue 4.85$

Total Trade 0.60$ 12%Net Revenue 4.25$ 88%

Variable Costs 1.50$ 31%Distribution and Transportation 0.40$ 8%Total Manufacturing and Distribution 1.90$ 39%

Marginal Contribution 2.35$ 48%

Project Wolverine

What is a Business Proposition?

A BP (Business Proposition) identifies the strategic rationale and financial implications for a project. The BP is often used to present the project to senior management, gain cross-functional alignment and once approved, is the record of what was agreed to.

The objectives of the BP process are to ensure that:

• There is a clear record of the objectives of the project

• Approvals for investments are clear and well documented

• Investments get the benefit of appropriate multi-functional and multi-level input

• Departments throughout the company are aware of the investment and take appropriate actions to support that investment

• Senior management is aware of any risks associated with the investment

• Proposed investments with unsatisfactory projected returns are restructured or canceled

• Resources are allocated to projects with the greatest chances of success/highest return

When is a BP Required?

The BP process must be followed, with the appropriate levels of authorization received for any change in execution resulting in:

• New product launches

• Line extensions

• Product changes (only those that affect the value proposition to the consumer)

FormulationPackaging

• Flavor extensions Small flavor extensions that do not require

capital spending will follow a simplified process

• Volume assumptions

• Impact of cannibalization

• Pricing / Trade spending

• Competitive response

• Product cost

• A&C Spending

• Capital Expenditures

• Sensitivity analysis

• Comparison to like businesses

Financial Justification - Key Areas of Focus

In order to ensure a complete and sound economic analysis of a business proposition, special consideration should be given to the following:

The primary measures used to analyze the financial attractiveness of investments are:

• Net Present Value (NPV)• Internal Rate of Return (Hurdle Rates)• Nominal Payback Period

Both are Discounted Cash Flow techniques using the time value money concept

However, we must keep in mind that making a decision on a business proposition always requires careful weighting of many parameters, including strategic/defensive needs, financial attractiveness, risk profile, . . . and cannot be narrowly based on financial return measures alone

Financial Justification - Key Areas of Focus cont.

The business proposition is the end result of a long iterative process that starts early in the new product development process and requires continuous refinement of assumptions

• Make some assumptions

• Challenge your assumptions

• Continually revisit your assumptions

• Tighten up your assumptions

• Finally, feel good about your assumptions and put them forward in your “final” business proposition

Business Proposition Process

Idea Generation

Product Development

Business Proposition

SummarySummary

Earnings Variance Analysis (EVA) OverviewEarnings Variance Analysis (EVA) Overview

•EVA analysis is a basic methodology for analyzing EVA analysis is a basic methodology for analyzing business results vs. some base case (usually prior business results vs. some base case (usually prior year or plan)year or plan)

•The main components of EVA are:The main components of EVA are:

Definition: Calculation:Rate Variance F/(U) driven by change in unit cost/contribution Δ in Product Rate * CY Product VolumeVolume/Mix Variance Base Product Rate * Δ in Product VolumeVolume Variance F/(U) driven by change in volume sold/produced Base Category Rate * Δ in Product Volume

Mix VarianceF/(U) driven by changes in the composition of products with different profitability within a portfolio Vol/Mix Variance - Volume Variance

EVA ExampleEVA Example

The EVA framework can be used to analyze a variety of business situationsThe EVA framework can be used to analyze a variety of business situations

CY PY Δ vs. PY CY PY Δ vs. PY CY PY Δ vs. PYMac & Cheese 1,500 1,000 500 18,000 13,000 5,000 12.0 13.0 (1.0) Oreo 1,400 1,300 100 20,000 18,000 2,000 14.3 13.8 0.4 Total Category 2,900 2,300 600 38,000 31,000 7,000 13.1 13.5 (0.4)

Rate Var Vol/Mix Total VarianceMac & Cheese (1,500) 6,500 5,000 Oreo 615 1,385 2,000 Total Category (885) 7,885 7,000

Vol Var Mix VarMac & Cheese 6,739 (239) Oreo 1,348 37 Total Category 8,087 (202)

Conclusions:--Mac & Cheese increased contribution driven by 50% increase in volume--Mac & Cheese rate is actually unfavorable (1500): Potential Drivers: New SKU's that cost more to produce; Deep discounting to grow share--Oreo volume is up only slightly, but contribution is up significantly, indicating stronger brand performance--Total mix is unfavorable because Mac and Cheese is less profitable, but now makes up greater % of Total Category

Volume Contribution Contribution Rate

Problem: With Transportation and Distribution expenses increasingly volatile, Kraft must have correct transfer pricing by product group.

Problem: With Transportation and Distribution expenses increasingly volatile, Kraft must have correct transfer pricing by product group.

•Logistics Group must manage internal costs accurately and Logistics Group must manage internal costs accurately and locate areas of inefficient spendlocate areas of inefficient spend

•Required to match expenses with rebill to business unitsRequired to match expenses with rebill to business units

•Business Units need to know T&D impact on their products for Business Units need to know T&D impact on their products for profitability analysisprofitability analysis

•Need a tool which can accurately forecast T&D costs for new Need a tool which can accurately forecast T&D costs for new products products

With over 1,700 product groups, 40 Manufacturing With over 1,700 product groups, 40 Manufacturing locations and 20 distribution centers, some sort of locations and 20 distribution centers, some sort of overall, activity-based system is needed. overall, activity-based system is needed.

Kraft had Two Options to Address this IssueKraft had Two Options to Address this Issue

Invest several hundred thousand dollars in IT Invest several hundred thousand dollars in IT resources to track product movement in and resources to track product movement in and between all facilitiesbetween all facilities

OROR

Hire a Michigan MBA to figure it outHire a Michigan MBA to figure it out

Distribution & TransportationDistribution & Transportation

Cost Changes in distribution can be caused by multiple Cost Changes in distribution can be caused by multiple issues:issues:

•Changes in cost structure of Distribution CentersChanges in cost structure of Distribution Centers

•Changes in network flow path of productsChanges in network flow path of products

•Changes in handling required per sales unit (pallet Changes in handling required per sales unit (pallet density)density)

By replacing Rate, Volume and Mix with these drivers, By replacing Rate, Volume and Mix with these drivers, we were able to identify and correct inefficient product we were able to identify and correct inefficient product

handling in the Kraft network and find areas of handling in the Kraft network and find areas of potential cost savings.potential cost savings.

Distribution & Transportation--ExamplesDistribution & Transportation--Examples

•Deli Shaved Meat—Rapid growth of new product line Deli Shaved Meat—Rapid growth of new product line led to mis-aligned transfer priceled to mis-aligned transfer price

•Which products have achieved enough scale to ship Which products have achieved enough scale to ship direct from plant, bypassing distribution centers?direct from plant, bypassing distribution centers?

•Which distribution sites are more efficient? What best Which distribution sites are more efficient? What best practices can be shared across the network?practices can be shared across the network?

This is an example of how finance can make a This is an example of how finance can make a meaningful impact on the operations of a large meaningful impact on the operations of a large

organizationorganization

Sales Profitability Due-ToSales Profitability Due-To

$216

$200

$15

($4)($1)$5

06 July YTD Revenue Mix Inflation Trade Efficiency 07 July YTD

Profitable categories becoming a larger percentage of total segment revenue

•Cheese (1)

•Grocery (1)

•Beverage(2)

•Cheese 5

•Grocery 4

•Beverage 6

Next StepsNext Steps

2. 2. Visit our website: Visit our website: www.kraft.comwww.kraft.com

3. Contact us with questions3. Contact us with questions

– Shane.Johnson@Kraft.comShane.Johnson@Kraft.com or or MLundeen@kraft.comMLundeen@kraft.com

1. 1. Q&AQ&A