Business Case Analysis
Imagine you are asked to establish a business case analysis to justify the purchase of an equipment/software for the warehouse operations. This can be a physical conveyor system, forklift, workstation or a software which will potentially aid the operations.
From an operations’ perspective, what are the elements that you should look into for the analysis? How can you ensure the benefits and cost are taken into consideration?
There are 4 elements you need to look into to provide a clearer picture.
- Forecast benefits
- Project costs
- Map benefit and cost projections
- Calculate key financial metrics
As an example, your company is deciding to purchase a new software. You, being the project manager understand that there are 2 potential benefits.
This software is able to reduce the number of hours required to build a current product the company is selling. This software provides the additional capability to create a new line of product as well. Additional revenue for the company.
Forecast Benefits
| Year 0 | Year 1 | Year 2 | Year 3 | Year 4 | Year 5 | |
| Current Hours required | 0 | 3,000 | 3,000 | 3,000 | 3,000 | 3,000 |
| Current cost at $10/hr | $0 | $30,000 | $30,000 | $30,000 | $30,000 | $30,000 |
| Future Hours required | 0 | 2,500 | 1,800 | 1,800 | 1,800 | 1,800 |
| Future cost at $10/hr | $0 | $25,000 | $18,000 | $18,000 | $18,000 | $18,000 |
| Benefit 1 (reduced labour cost) | $0 | $5,000 | $12,000 | $12,000 | $12,000 | $12,000 |
Cost reduction if software is in place, due to lesser manhour required
| Year 0 | Year 1 | Year 2 | Year 3 | Year 4 | Year 5 | |
| New product sold (w/o new software) | 0 | 0 | 0 | 0 | 0 | 0 |
| Net revenue | $0 | $0 | $0 | $0 | $0 | $0 |
| New product sold (w new software) | 0 | 1,000 | 1,500 | 2,000 | 2,000 | 2,000 |
| Net revenue ($15/unit) | $0 | $15,000 | $22,500 | $30,000 | $30,000 | $30,000 |
| Benefit 2 (Increased Net Revenue) | $0 | $15,000 | $22,500 | $30,000 | $30,000 | $30,000 |
Additional revenue from the new product launch
Aside from the initial purchase cost, you are being informed that for the subsequent year, there will be a yearly maintenance fee. One of your staffs have to undergo training during the software implementation. For subsequent years, a refresher course is required for your staff to be fully aware of any new additional functions.
Project Costs
| Year 0 | Year 1 | Year 2 | Year 3 | Year 4 | Year 5 | |
| Software Purchase | $80,000 | $0 | $0 | $0 | $0 | $0 |
| Software Maintenance | $0 | $12,000 | $12,000 | $12,000 | $12,000 | $12,000 |
| Total software cost | $80,000 | $12,000 | $12,000 | $12,000 | $12,000 | $12,000 |
| Additional Employee hours required | 800 | 120 | 30 | 30 | 30 | 30 |
| Additional labour cost ($10/hr) | $8,000 | $1,200 | $300 | $300 | $300 | $300 |
Software cost, maintenance cost and additional labour cost
Mapping both the benefits and the cost in a yearly fashion will tell us the net benefits year-on-year.
Map Benefit and Cost Projections
| Benefits | Year 0 | Year 1 | Year 2 | Year 3 | Year 4 | Year 5 |
| Reduced Labour Costs | $0 | $5,000 | $12,000 | $12,000 | $12,000 | $12,000 |
| Increased Gross Profit | $0 | $15,000 | $22,500 | $30,000 | $30,000 | $30,000 |
| Total Benefits | $0 | $20,000 | $34,500 | $42,000 | $42,000 | $42,000 |
Total benefits
| Cost | Year 0 | Year 1 | Year 2 | Year 3 | Year 4 | Year 5 |
| Software + Maintenance | $80,000 | $12,000 | $12,000 | $12,000 | $12,000 | $12,000 |
| Labour | $8,000 | $1,200 | $300 | $300 | $300 | $300 |
| Total Costs | $88,000 | $13,200 | $12,300 | $12,300 | $12,300 | $12,300 |
Total costs
| Annual Net Benefits | Year 0 | Year 1 | Year 2 | Year 3 | Year 4 | Year 5 | Total |
| Net benefits (Benefits – Costs) | ($88,000) | $6,800 | $22,200 | $29,700 | $29,700 | $29,700 | $30,100 |
Annual Net benefits
Return On Investment
ROI = (Total Benefits – Total Costs) / Total Costs
= 30,100 / 150,400
= 20%
Net Present Value (NPV) will convert the benefits into the current value; time value of money (TVM).
Net Present Value
| Year 0 | Year 1 | Year 2 | Year 3 | Year 4 | Year 5 | Total | |
| Net benefits (Benefits – Costs) | ($88,000) | $6,800 | $22,200 | $29,700 | $29,700 | $29,700 | $30,100 |
| Discount Factor with Hurdle Rate (10%) | 1.00 | 1.10 | 1.21 | 1.33 | 1.46 | 1.61 | |
| Discounted Value | ($88,000) | $6,182 | $18,347 | $22,314 | $20,285 | $18,441 | ($2,430) |
Net Present Value
Hurdle rate is also known as cost of capital or discount rate. This varies by company and perceived riskiness of investment.
Payback Period
| Year 0 | Year 1 | Year 2 | Year 3 | Year 4 | Year 5 | |
| Net Benefits (Benefits – Costs) | ($88,000) | $6,800 | $22,200 | $29,700 | $29,700 | $29,700 |
| Running Total | ($115,000) | ($108,200) | ($86,000) | ($56,300) | ($26,600) | $3,100 |
Payback Period
Profitability Index
Profitability Index = Future cash flows (discounted or nominal) / Initial Investment
= 85,570 / 88,000
= 97%
The higher the PI, the more favourable is the projection.
A project is considered to be worth doing if PI >1.
Summary
| Project | Remarks | |
| Net Benefits | $30,100 | Appears to be beneficial. There are annual net benefits subsequently for every year. |
| NPV | ($2,430) | However, converting to current value shows a negative benefit. |
| ROI | 20% | |
| Payback Period (Months) | 4 years + | Payback period is after 4 years. |
| Profitability Index | 97% | |
| Upfront Costs | $80,000 |
Pretty nice post. I just stumbled upon your blog and wished to say that I have really enjoyed browsing your blog posts.
Thanks for the compliment.