Although some projects are done by direct order, most of the projects that we will be involved with will have a justification. The most credible justification is one where the identified benefits of doing the project are greater than the cost of doing the project. It is important to understand that there are many ways of describing the cost-benefit ratio for a project in order to justify it. Using monetary value is just one approach that does not have to be forced over all projects. Many of you have been faced with the problem of making a justification to company top management to carry out corporate training for your department staff or of the importance of introducing a new product line to your company’s production cycle. These are good examples of internal company projects that would be justified with more qualitative results, such as increasing motivation and productivity, the ability to enter newly grown markets, or other results where monetary numbers could be difficult to develop or forecast. In this case one thing that should not be done is falsifying data by developing figures that have no real value. Instead, develop tangible qualitative results with measurable indicators to monitor and link these results to some business opportunity for your company or some problem the project might help to attack.
Doing that, it is important to remember that we are describing a problem or an opportunity and NOT a solution. In other words, we can explain a project justification as a description of what will happen if the project is carried out and what will happen if the project is not carried out.
For example, our company decides to decorate its office space with modern art. This project could cost $100,000. The benefit the company would receive by doing this is pretty intangible, but it is reasonable to say that customers coming through our lobby will be impressed, we hope, by the artwork and might be more favorably disposed toward buying something from us. If we try to justify our project that way, our boss will probably think there are cheaper ways of impressing the customer.
However, there is another aspect: If our lobby is a complete eyesore, we may impress some of our customers unfavorably. There is probably evidence that we have indeed lost some business. This may serve as a good initial justification for a project even without any figures about our potential profits.
Of course, justifications using intangibles are generally more difficult to get approved, especially if project funds are scarce and require more talent on the part of the project manager in developing really persuasive descriptions of the disadvantage the company will suffer if the project is not carried out.
On the other hand, there are many cases when the monetary benefits for the project CAN actually be measured. In that case, it is of course important that such justification be made for the project. In most companies there is no lack of favorable projects; there is usually just not enough money or resources to do them. Monetary justification allows us to rank the possible projects with the most favorable projects at the top and the least favorable ones at the bottom. The company can then go down the list doing as many projects as the company’s funds allow.
Let us digress a bit. A discussion about where companies get their money is in order. Obviously when a customer comes to us and offers to pay us to do a project, the benefits for us are the amount of money the customer pays us to do the project and some intangibles like providing experience so we can get more work like this in the future. Even when the customer is paying, we do not receive all of the money until all of the work is done. The company doing the project must supply the funds necessary to do at least part of the project. Where does the company get this money?
The money to do projects probably does not come out of the company’s cash on hand. The company probably borrows the money from a lending institution or sells some stock to investors. All the money obtained for projects has a cost associated with it. This is the money the company has to pay the lenders and investors for the use of their money.
Another important factor involved here is when the money for the project is spent and received. Since we are paying for the use of the money, the longer we use it, the more it costs us. If the customer can be made to agree to advanced payment or progress payments, we will need to borrow less money for shorter periods of time, and money will be saved on the project. The justification for the project should take these things into consideration.
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There are many different justification techniques that can be used. Some of these require very little effort and produce results that are mere approximations of the justification. These are appropriate early in the project when we want to have a justification that will allow us to move to the next early step. Although the justification will consider all of the benefits and costs that are associated with the project throughout its useful life, early in the project we will be committing funds only to move the project to its next step or phase. At this point in the project, or at points in the future, we can decide to discontinue work on the project. It does not make sense to do a costly collection of estimates into the future when we are talking about committing another $5,000 to move the project to the end of the next phase.
The break-even chart in BREAK-EVEN CHART is one of the simplest justification methods that can be used for projects. Generally this type of justification is used early in the project conceptualization and is very much a rough justification technique. The break-even chart is merely a plot of the total expected cost of two alternatives over time. It can be used to compare two or more alternatives. The break-even point is the point at which one alternative begins to have a total cost less than the other alternative. Although there can be an algebraic solution to the break-even point, the graphic solution is adequate (in the days before computers, that’s all there was).
The break-even chart is made on a set of X and Y axes. The Y axis is total cost, and the X axis is time. The scale should be chosen so that the break-even point occurs somewhere in the middle of the chart.
New alternatives will usually have a fixed cost associated with them. Once this cost or investment is made in the project, it will not have to be made again during the project’s life. This is called the fixed cost of the project. The variable cost of the project is the ongoing cost that continues to occur as we use the project throughout its useful life.
An example of this would be a company’s considering the purchase of a new machine to replace an existing one that is used to manufacture its products. The new machine is faster than the old machine, has fewer maintenance costs associated with it, and produces less scrap and rework. Suppose it would cost $500,000 to purchase the new machine, have it shipped to the site, set up, and started up with its initial tooling. This cost will not occur again so we can say that the fixed cost of the project is $500,000. There is no fixed cost associated with the old machine since it was purchased some time ago and is in place and operating.
The alternatives will also have a variable cost associated with them. The variable cost is the ongoing cost that occurs over time. In our example this is the cost of operating the machine over time, manufacturing parts, and doing the work that it was bought to do. In the example given, we are comparing a new machine to the existing process we now have in operation. When comparing the variable cost of the machines, it is important that the parameters of the comparison be the same for both alternatives. If the old machine is expected to produce 400,000 parts per year, the new machine should be expected to produce the same amount. The variable cost of the machine is the material cost, labor cost, maintenance cost, and all other costs that are significant.
If we were considering buying a new machine, we would expect the variable cost to be less than the variable cost of the machine it will be replacing. The slope of the variable cost line will be lower than that of the variable cost line of the old machine. The new machine’s variable cost line starts at some point on the Y axis equal to the fixed cost of obtaining it. The variable cost line of the existing machine starts at zero on the Y axis.
At some point the total cost lines—the sum of the variable cost plus the fixed cost—must cross. This point is called the break-even point. It is the point at which the money saved in the variable or operating cost of the new machine compared to the old machine is equal to the investment in the new machine. That is, it is the point where the total cost of the two alternatives is equal. The sooner this occurs, the better the justification for the new machine. The difference between the two total cost lines after the break-even point is frequently referred to as profit. This is not correct. It is really the amount of profitability that the new machine contributes to the company in terms of total reduced cost. Profitability depends on the difference between total cash inflows (revenues) and total cash outflows.
As we said in the beginning of this discussion, this is a rough justification method. There are many assumptions made. No effort should be made to improve on the technique by creating more detail and better estimates over time. If a more reliable technique is needed, another justification technique should be used instead.
The assumptions made generally include a static workload over time, constant maintenance cost over time, no additional wear and tear on the alternatives, and no changes in labor rates or material costs.
PAYBACK POINT shows an illustration of the payback point. In this example we have made a $1,000,000 investment and have a cash inflow of $750,000 each year following. When the net cash flows total zero, we have reached the payback point. That is the point where the cash inflows have offset the cash outflows.
The payback period justification method is another rough justification method. Before computers were readily available to project managers, this method was often used as the only justification method and was sufficient to justify many projects. The payback period is similar to the break-even point except that we are comparing the total cash outflows to the total cash inflows. In this method all of the relevant cash flows need to be considered. In most projects there is at first an outflow of money before the revenues, the inflows of money, can occur. The payback period is the amount of time that goes by before the total cash inflows are equal to the total cash outflows. The payback method does not require us to compare two or more alternatives. With this method we need to know only the cash flows associated with this project.
Suppose, as another example, that we are justifying the purchase of a machine that has a total cash outflow of $500,000. Let us say that the purchase of the new machine saves us $125,000 per year over the existing machine that we are using. This would be due to higher maintenance cost, since the older machine is slower and causes more scrap and rework. If the cost savings of the new machine allow us to lower the cost of the product and this, in turn, allows us to have a greater market share, we should include those cash flows as well. Let us say that the cash flows are summarized.
Notice that in Table 2-1 the cumulative cash flows go from negative to positive somewhere between the end of year four and the end of year five. We could even interpolate and say that the payback period occurred 5 percent into the next year with the first positive cash flow. This would be four years and about two weeks.
The payback period method has the advantage of resulting in a quantitative result that allows the ranking of this project with other projects according to their payback point. The other advantage of the payback method is that it allows for the independent estimation of the cash flows in and out for each time period. In the break-even method we assumed that costs would continue as they had before.
The major problem with the payback period and break-even point methods is that neither of them incorporates anything that happens after their respective justification points. If there were a sharp upturn in the cost of the new machine after the break-even point given in the example, or if there were smaller cash inflows in the payback point example, they would have no effect on either the break-even point or the payback point. This is rather short-sighted, and these two methods encourage projects that have high early returns on their investments. In other words they encourage us to invest in cheap equipment or projects. This may be false economy. If we actually continue to use the equipment or the results of the project longer, we may find that spending less in the beginning will have the effect of making us spend much more later in the project’s life. To solve this problem, we must use a more sophisticated justification method.
The internal rate of return on investment method of project justification considers nearly all of the things that are relevant to the project. It also adjusts the values of the money according to the time value of money. The time value of money is explained in Chapter 4, and we will not do it again here. This type of justification was rarely done in business until the advent of computers and then it was seldom done because it was difficult to explain to some managers, particularly managers who had been brought up using simpler methods of project justification. The main advantage of this justification method is that it is a model that is a very close approximation to the actual money flows that the real project will have and very closely represents the real benefits to the company.
INTERNAL RATE OF RETURN CALCULATION shows the calculation that will be performed in determining the internal rate of return on investment (IRR). The equation shown is a summation. That is, the calculation shown is made for each time period relevant to the project. The results of each calculation will be the present value of the cash flow for each time period, positive or negative. The cash flows are then added together to get the total cash flow present value. The value of r is varied until the present value of the total cash flow over all the time periods is equal to zero.
Why would we want to do this? If we think about the present value of money at a given point in time, the present value of the money would be increasingly less than the future value of the money as the interest rates became higher. The higher the interest rate, the lower the present value of the money would be. In the equation, since the value of r is in the denominator, the greater the value of r, the less will be the present value of any money. As the value of n increases, the value of r will have a greater effect on the present value of future cash flows.
Eventually we will reach a point where the value of r decreases the present value of the future cash flows enough that the total of the cash flows comes very close to zero. The value of r when the present value of all the future cash flows reaches zero is called the internal rate of return on investment.
This calculation is quite simple for any computer to calculate and is usually included on financial pocket calculators as well. Computing to find the value of r that makes the total cash flow equal zero is solved by iteration.
The example in a project that has an initial investment of $1,000,000. One year later the cash flow is +$300,000, one year after that the cash flow is +$400,000, and so on as shown over five years. The calculation will have to be made six times for n = 0, 1, 2, 3, 4, 5. The calculation for n = 0 is simple since the value of (1 +r)n will always be 1 regardless of the value of r. In other words, the value of the negative cash flow in year zero adjusted to present value is simply the same value.
What is the IRR of a project that has an investment of $1,000,000, including shipping and installation, and start-up and cash flows at the ends of the years as follows:
The table in the present value of the cash flows for year zero through five for various values of r. Notice that as various values of r are tried, the net cash flow comes closer to zero. Ultimately the last calculation produces a value of r = 25.7%. This is the IRR for this project.