A SYSTEM DYNAMICS BASED MODEL FOR EVALUATING
THE PERFORMANCE OF AN ENGINEERING FIRM
Saroj Koul and Prem Vrat
Dept. of Mechanical Engineering
IIT Delhi, Hauz Khas
New Delhi-110 016, India.
MS # 73
Abstract: This paper examines four. policy options for evaluating the
overall performance of a Public sector engineering firm in India. The major
areas viz. finance, production, human resources and research & development are
taken up for the study. The System Dynamics methodology was chosen as the tool
for conducting the analysis because it provides means for understanding the
dynamic inter-relationships between key functional parameters thereby allowing
to explore the impact of different policies.
Public sector firms in India holds a key position for accelerating the
pace of industrial development and socio-economic growth. Poor performance of
some of them has caused, great concern as they were conceived to provide
support to the economic structure. As such, the performance of each industry
needs to be monitored at the highest level to increase productivity and
profitability.
System Dynamics| Ty 4| models are constructed, based on a theory of
causes of dynamic behavior. It identifies options which can be tested and then
used to predict the outcome of such alternatives. For the firm under study an
integrated model has been presented after developing the finance, human
resources, production and the research & development sub-models individually.
Fig.1 gives the overall influence diagram of the integrated model. A brief
discussion of each of the sub-models is as follows.
Finance Resource Sub-model: For evaluating the financial performance
the major function have been studied| 2| and the resultant influence diagram
of the developed Finance Sub-model is given in Fig.2. Subloop Fl starts from
proposed profit level and shows that it is in turn dependent on the input
resource, the sales volume and the orderbook position. The level of pre-tax
profit(PBT) determines the quantum of income-tax(ITAX) and dividend payments.
Subloop F2 achieves the organisation's proposed profit level through financial
planning for budgeted resource allocations. Subloop F3 aims at increasing the
organization's supply of funds through loans(LADV) in the context of monetary
resources needed by it. The other cycle of this subloop consists of the loan
repayments(REPAY). Intended role of this cycle is to meet the organisation's
requirements of monetary resources needed through its supply of funds after
taking into consideration its commitments towards loan repayments. Subloop F4
helps to maintain a sound financial position of organization by keeping its
unpaid debt and other payment liabilities restricted in relation to its
assets. Subloop F5 maintains the consistency of firm strategy with assets and
assessments of the internal resource capabilities based on an estimation of
the assets position and trained personnel available.
Page 272
System Dynamics '91 Page 273
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Page 274 System Dynamics '91
Human Resource Sub-model: Here the primary sections are acquisition,
development, motivation, maintenance and evaluation | Bis Fig.3 gives the
influence diagram of the main variables included in each of these sections.
Subloop HR1 keeps track of the number of trained manpower available after
taking into account the personnel who have left the firm during a given
period. Subloop HR2 maintains the number of trained manpower available in
accordance with manpower requirement. In case, the manpower existing is higher
than required, the value of recruitment may be null or even negative. Subloop
HR3, keeps the grievance level and its impact on work and performance to a
very low level. This goal is sought to be accomplished through promotion
policy and its implementation as a part of reward offered by organisation to
its ~ employees. Subloop HR4 limits the level of recruitment and trained
manpower available to budgeted resource allocations available. Subloop HRS
keeps the grievances at a minimum through an appropriate set of managerial
measures to meet employees demands. This is concerned with relatively long
term policy measure for reducing grievances on a steady base. In case, when
measures adopted are directly linked to work performance, prompt and immediate
measures for improving the performance can be aimed at. The distinction
between these two cycles is in respect of their orientation and cycle time.
Production Sub-model: The influence diagram of the Production Sub-model
is given in Fig.4. In Subloop Pl the organization strategy determines the
proposed production level. It leads to production plans thereby generating the
production rate which in turn determines the volume of production and
inventory position. This then indicates the level of fulfillment of the
proposed production level and which attains the proposed production goal
through production planning and the resultant production rate. A comparison of
the proposed production level with the volume of production and inventory
determine discrepancy between the actual and planned production. It tries
to rectify the discrepancy between actual and planned production by modifying
the proposed production. level. Subloop P2 aims maintaining a smooth
operation of the plant through a maintenance, repair and replacement
schedule. As a result, better operational status of machines and equipment
may accelerate the full utilization of the organisations production capacity.
In Subloop P3 production rate generates some amount of rejections. These
depending on its unacceptable level lead to improved production methods
and workers training. This determines the extent improvements in quality
assurance which in turn affects production rate. Improved production methods
and workers training leading to quality assumes improvement is a result of the
pressure for quality assurance coming from outside(sales system). Quality
control improvement then serves to mitigate this pressure. Subloop P4 shows
that the available inventory of production inputs determine production
plans, which in turn governs production rate. The latter leads to
consumption of production inputs which then goes to affect available inventory
of production inputs. Thus a balance is obtained between production schedule
with the available production inputs. Another feedback loop(P42) aims to
fulfil production input requirement level through acquisition of production
inputs. Also to meet the requirements of manpower as part of the production
input requirement loop, loop(P43) links production input requirement
level deployment of skilled labour and available inventory of production
inputs. Subloop P5 aims to meet the production capacity requirements of
production plan. ‘These requirements are met through planned changes in the
organization's production capacity.
System Dynamics '91
Page 275
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Page 276 System Dynamics '91
Research & Development Sub-model: The R&D Sub-model influence diagram of
Fig.5 on the next page consists of five main subloops. Subloop RD1 formulates
the product improvement and innovation possibilities. The inputs to this task
are estimates of time, money and effort involved. Subloop RDI tries to
accomplish the R&D goals through a proper selection of projects, acquisition
and development of required facilities and execution of efforts for
successful completion within time and budget schedules. Subloop RD2 aims to
finalise new product possibilities through a selection of relevant projects
and an estimation of their cost and duration. Subloop RD3 facilitates
continuing progress of work by developing solutions to any technical
difficulties encountered during the development of the projects. Subloop RD4
reduces any discrepancy between scheduled and actual, pace of work by adjusting
the firm's commitment of resources, their utilization, the acquisition and
development of R&D facilities. Subloop RD5 establishes consistency between
the appraisal of work progress on selected projects, and the perceived value
of the improved /new products and technology sought to be realised through
these projects.
Model Validation: The model developed was validated by comparing the
actual and the modeled values of pertinent variables for the past five years.
Some of the variables on which the model has been validated are total
manpower, current assets, sales, retained profits, wastages, capacity and
progress of R&D work. Table 1 shows comparisons for only two of the key
variables.
Table 1: ACTUAL VS SIMULATED VALUES OF CERTAIN MAJOR VARIABLES*
(in Rs. Millions)
YEAR MTOTAL SALES
ACT MDL % VAR ACT MDL % VAR
1980-81 68333 68333 ie}
1981-82 69788 70140 0.
1982-83 71800 71190 -0.
1983-84 74793 73350 -1.
1984-85 74464 74580 0.
0 7870 8132 3.33
5 9431 9550 1.26
8 11790 11950 1.35
9 13250 12510 -5.58
1 14820 14530 -1.95
Ovvar 2534 2231 2514 2254
* (Actual as per the 5 yrs published data)
As seen from Table 1 the percentage variation(VAR) between the actual and
modeled values is within reasonable limits. Previous research and experience
with models of this type and magnitude have established that if the simulated
model can reproduce the historical values of key variables within +10% then
structure of the model developed is probably sound| 5 Chap.3|. The data
provided in the table lends support to the validity of the model. The model
thus realistically represent actual operating conditions and as such it can be
used as a flexible tool for policy analysis and evaluation.
Policy Experimentations: The utility of the model developed is that
various corporate policies can be analysed and evaluated without actually
System Dynamics '91 Page 277
tampering with the actual day to day operations of the firm. In this paper
the following policy experiments are discussed.
1. Suggesting a policy for setting of profit goals for next planning
period: This experiment studies the effect of a few profitability ratios on
the variable profit after tax(PAT):
a) Effect of budgeted/actual orders on profit after tax: The organisation
depends for its profits on the orders executed in a working cycle. Table 2
gives the value of profit after.tax(PAT) as a result of variations in the
ratio of budgeted sales to actual sales over a range of 1.25 to 0.7.
Table 2: PROFIT AFTER TAX FOR VARIOUS RATIOS
OF BUDGET SALES ‘TO ACTUAL SALES
Ratio of Bud.sales/ Act.Sales
PAT (4%). 6th yr 8th yr 10th yr
above 1 . .
An inference of this experiment is that the profit after tax(PAT) would
always be adequate(4-5%) if measures are adopted to keep the ratio of Budgeted
sales to Actual sales around 0.85 to 1.0%.
b) Effect of the Profit margin on sales(PMOS) ratio: Profit margin on
sales is the ratio of profit after tax(PAT) to sales(SALES) and is a measure
of profitability. Table 3 depicts effect of different values of this ratio and
indicates that if the PMOS ratio is held at 4.5% it would yield adequate
profit after tax.
Table 3: EFFECT OF DIFFERENT VALUES OF THE PMOS RATIO
PAT/SALES
Ratio 6th yr 8th yr 10th yr
5.0% 4.67 4.73 4.71
4.5% 4.54 4.56 4.55
4.0% 4.21 4.35 4.57
c) Effect of the Return of total assets(ROTA) ratio: Return on total
assets is the ratio of profit after tax(PAT) to total assets(TA) and a
measure of profitability. Table 4. indicates the effect of different values of
Page 278 System Dynamics '91
Return of tolal assets(ROLA) on the ratio of Profit after tax(PAl) and total
assets(TA). It indicates that adequate profit may be obtained when this ratio
ROTA is fixed around 2.0%.
Table 4: EFFECT OF DIFFERENT VALUES OF ROTA ON PAT/TA
ROTA PAT/TA (%)
6th yr 8th yr
2.0 4.12 4,93
2.5 5.18 6.20
3.0 6.17 7.38
3.5 7.19 8.61
All the above three experimentations conducted for setting up of the
profit goal for the next planning period indicate that adequate profit(4.5%)
will be realised if the ratio of Budgeted/Actual Sales is kept within a range
of 0.85 to 1.0.
2. Analysing. the effect of training gaps and delays on various skill
levels: For this experimentation, various skill levels in the organisation
have been categorised. Considering the category of un-skilled/semi-skilled
workers. It is further divided into twelve trades which have been fixed a
priority with respect to the production output and the productivity of a work
centre. Fig.6a plots productivity( the VA Ratio)based on regular training
cycle. for trades|Ti(.11) > T2(.08)|. In case, the training period is delayed
by a period of two quarters of a year for the same two trades Tl and T2 the
plot for productivity(the VA Ratio) varies as indicated in Fig.6b. Also, Table
5 analyses the effect of training delay period on the productivity ratio(VA).
Value addedIVASIN01%,022)intradeT? Trade t 12
Vs Value added(VAS2)(012,0.2)in a 4 Trade Ty >Ty2 a
tradeT2. Ty 7h (07,14) measured in terms of
| Value added (0.6e-3,1.4e~-3-)
‘A “7
aye Ww.)
van as —
oe
eed” rz in
Lb
0 time in years 8 0 Time in years 8
Fig 6& For TWO TRADES I THE CATEGORY OF UN- Fig 6b VARIATION DUE TO TRAINING DELAYS FOR
SKILLED /SEMISKILLED WORKERS THE MANPOWER gj TWO TRADES IN THE. UNSKILLEC/SEMI
Vs THE CORRESPONDING VALUE ADDED SKILLED CATEGORY
System Dynamics '91 Page 279
TABLE 5: EFFECT OF TRAINING DELAY ON PRODUCTIVITY
TRAINING VALUE ADDED
UNSKILLED/SEMISKILLED
4th yr 6th yr 8th yr
a) No delay 69.25 92.30 113.0
b)Delay by 1 qtr. 65.78 87.70 107.3
c)Delay by 2 qtr. 55.40 73.85 90.5
d)Delay by 3 qtr. 48.47 69.60 79.0
An inference here is that to keep the productivity within the actual
limits the delay in training for this type of category should never exceed one
quarter of a year.
3. Suggesting a desirable policy for funds commitment so as to reduce the
working capital employment: Main variables affecting working capital are
inventory(RVI), sundry debtors(SDEBT), loan advances(LADV), cash(CASH),
liabilities(LIAB) and the provisions(PROV). In the present policy experiments,
only the effect of inventory and sundry debtors has been’ studied. Fig.7
shows(in days) the effect of these variables for a ten-year period. Table 6
relates the effect of working capital by changing the inventory and sundry
debtors.
Table 6 : EFFECT OF INVENTORY AND SUNDRY
DEBTORS ON WORKING CAPITAL
Inventory Working Capital Sundry ‘Working Capital
——-———--————~ Debtors ———_--------
8th yr 10th yr
a) Reduction 0.7 0.17 a) Realization 1.8 0.42
by 40% increased
by 30%
b) Reduction 0.8 0.2 b) Realization 1.6 0.39
by 30% increased
by 20%
c) Reduction 1.0 0.25 c) Realization 1.5 0.35
by 15% increased
by 10%
An optimal mix of working capital, as can be inferred from Table 6 is
generated if the inventory is reduced by 15% and measures adopted to realise
bad debts by 10%.
Some of the policy experimentation that can be conducted in future are:-
Page 280 System Dynamics '91
1. Analysing the profits and internal resources generated and hence
suggesting a desirable range of rate of return that improves the
liquidity.
2. Suggesting a suitable policy for investment only to be made from
internal resources.
3. Analysing the interests and dividends and suggesting a suitable
policy for supplementary source of income.
4. Suggesting a policy for financial packages.
‘Conclusions: An integrated model consisting of four areas, namely
finance, human resources, production and R&D for effective policy analysis of
a firm has been developed. The model also provides a means by which the
maturity, effectiveness and feasibility of realisation of corporate goals can
be evaluated. The 'ideal' policy so identified can then be implemented with a
greater degree of confidence. The potential improvement after successful
implementation will eliminate the limitations of present practices.
REFERENCES
1. George P. Richardson and Allexander L. Pugh III, Introduction to System
Dynamics Modelling with DYNAMO, MIT Press/Wright-Allen Series in System
Dynamics, 1983.
2. S.Koul, Prem Vrat, 'A System Dynamic Model to evaluate the financial
performance of a firm', paper presented at APORS'88, Aug. 24-27, Seoul,
Korea.
3. S.Koul, Prem Vrat, ‘Modelling of Corporate Manpower using System
Dynamics: A case study', III National Conference of SD, Dhanbad, India,
1988.
4. James M. Lyneis, Corporate Planning and Policy Design: A System Dynamics
Approach, MIT Press/Wright-Allen Series in System Dynamics, 1981.
5. Edward B. Roberts, (ed.), managerial Applications of System Dynamics, MIT
Press/Wright-Allen Series in System Dynamics, 1980.
