How to Justify Investment?

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.

  1. Forecast benefits
  2. Project costs
  3. Map benefit and cost projections
  4. 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.

  1. 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.

 

  1. 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.

 

  1. 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

 

  1. 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).

 

  1. 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.

 

  1. 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

 

  1. 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

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