Sell Your Project; How cost benefit analysis and a little psychology can help get your project funded. |
You are a highly trained skilled professional. You can face the toughest integrals with impunity, install software without blinking an eye, balance a free-body diagram while standing on your head. But you break out in a cold sweat when you are asked to develop a (gasp!) Cost Benefit Analysis. Why is this? It's because most of us engineers are not properly nurtured in the fine art of economic analyses, and that is unfortunate. Good ideas are a dime a dozen, but being able to show that your good idea will make money for your organization is a skill worth its weight in gold. In this article, we'll look at some practical tips for showing why your project will more than pay for itself, and therefore pass the corporate hurdles on its way to approval. Actually, there is no need for anyone with a basic understanding of engineering principles to have any trouble performing a proper Cost Benefit Analysis, or CBA. The skills and math involved are no more complex than the simplest engineering formulas, and the basic equations are derived using freshman calculus (but we won't derive them here). It's all a question of identifying and balancing the proper factors in the equation. WHAT ARE THE FACTS? The first step is identifying the factors that go into our CBA. Some will be hard, tangible numbers, others will be fuzzier. Let's start with the tangible ones. The most basic issue is the time horizon of your project. If it is a short term project, say twelve months or maybe a few years, this is our horizon. On the other hand, if it has no preconceived ending time, we might want to consider it infinite. However, infinite CBAs tend to raise eyebrows, and you're usually better off selecting some reasonable time horizon like ten or fifteen years; you don't want to be in the position of pleading that a project needs forever to pay for itself. Along these same lines, even if you expect a project to last for quite awhile, you may want to deliberately select a shorter horizon (five years or so) to show that it pays for itself relatively quickly, with everything after that pure profit. There are no wrong answers here, it all depends on what you want to prove. As far as costs go, first you will need to identify your startup costs. These are the costs that you incur at the beginning of the project, long before it pays you back a dime. These costs are your up front investment in the project. They will include cost of equipment, construction costs, training costs, hiring costs, licensing costs, etc. Anything that you do once and up front goes into this category. These usually aren't too hard to estimate; you will probably receive bids from vendors and contractors that will be good enough for your analysis. Even if you are doing your CBA in advance of receiving formal bids, most vendors will give you unofficial numbers that you can use in your justification analysis. These can be revised later when formal bids are received. Next, we need ending or salvage costs. If your project is not anticipated to end (say, installing a new plant for long term production), you can skip this step. But if it is a closed-ended project with a specific termination date, you need to think about the cash flows at closing time. Costs might include clean-up costs, outplacement of personnel, dismantling of equipment, etc. On the other hand, the ending cash flow may actually be positive; if you sell your equipment, cash out your deposits, etc., you may be looking forward to a one-shot income at close-out time. These kinds of numbers can be difficult to predict with any accuracy, and you might have to settle for a conservative estimate. Recurring costs are the next category, and potentially the largest source. What are your annual or monthly labor expenses, rent, material costs, utility expenses, loan servicing costs, etc.? You might have some sort of use rate or depreciation that your project must pay to your parent organization which also must be considered. If all these factors last the entire life of the project, you can sum their annual (or monthly) amounts to an overall recurring total. If they span different lengths of time (for instance, a monthly loan payment for the first five years, but labor and material costs for all 20 years of a project) you will have recurring costs that change periodically. Recurring costs are usually the easiest to estimate, based on current labor and burden rates, rents for equivalent equipment, etc. You will also probably have recurring benefits. Annual or monthly revenues or savings go in this category. If these are expected to be constant during the life of the project, they can be summed against the recurring costs. Frequently, however, these are not expected to kick in until sometime in the middle of the project, or perhaps are expected to grow gradually during the project. Any other incomes or expenses that you anticipate must be considered as well. Large single costs or revenues that occur during the project, but not necessarily at the beginning or end, must be estimated, as well as their most likely dates of occurrence. These might include second-phase construction costs, bond maturities, additional training, equipment conversion costs, etc. SOME DEFINITIONS Now let's see how these income and expense items fit into our cost benefit model. We've heard all our lives that we can't compare apples and oranges. In performing a CBA, the first step is to convert all oranges (and pears, bananas, etc.) into apples, however we choose to define those apples. There are several types of factors that we need to consider. Present Values (PV): these are cash flows that occur now (or reasonably close to now). They include our startup expenses, as well as any other expenses and incomes (negative and positive cash flows) that occur at the beginning of the project, or close enough to the beginning that we consider any small delay to be trivial. All we need to describe these cash flows is the dollar amount involved. Future Values (FV): these are the cash flows that occur some time in the future, naturally. Again, they can describe incomes or expenses, including our salvage costs and salvage incomes, as well as our non-recurring middle-of-project costs. To properly describe them we need three items: the dollar amount involved, the number of time units into the future, and the interest rate per time unit. These time units can be anything we choose: days, months, years, etc, but let's try to be consistent throughout our analysis. The interest rate will be selected based on a variety of soft factors (see below) and the time units we are using. Annual Values (AV): these are our recurring cash flows that occur in equal amounts at equally spaced intervals. Calling them "annual" is just a convention; they might be monthly, daily, or any other interval. The AV concept is not strictly necessary, because we could define an AV just as a bunch of repeated FVs. However, since we tend to see a lot of them, it is worth using the AV definition as a short cut. To describe these, we need the repeating dollar amount, the spacing between payments, the total number of payments, and the interest rate. That's it! Those are the various kinds of "fruit" that we need to reconcile into apples. To do our CBA, we need to convert all our PVs, FVs, and AVs into any one kind of cash flow. If we convert them all to present values, we call it a "present value analysis", which tells us what our project is worth in equivalent dollars right now. If we convert them all to future values, it is a "future value analysis", which tells us what our project is worth at some fixed point in the future. Likewise for the annual values. Which do we use? That is up to us, as long as we pick one that tells our story and makes our argument for us. For this article, we'll stick with present values for our "apple" definition. Alternately, we can do a rate of return analysis, which we'll discuss soon. CONVERSION FORMULAS AND FACTORS How do we do this conversion? A couple of formulas will take care of it. For our present value analysis, we want to convert everything to a PV. In that case, we need a formula to convert FVs to PVs and another formula to convert AVs to PVs: PV = FV(1+ i)-n PV = AV[((1 + i)n - 1) / (i(1 + i)n)] where n is the number of time units and i is the interest rate per time unit. Using these formulas, you can convert all of your expected future payments and incomes into their equivalent present values, thus "time compressing" all cash flows to the present day. Sum up the positives, subtract the negatives, and see if you are making money or losing it. Of course, there's still the issue of whether you are making enough money or not, but we'll get to that later. An alternate method for converting cash flows is to use "compound interest tables" which are compiled and published. Banks use them all the time to calculate your loan payments. I use the tables at the back of "Engineering Economic Analysis" by Donald G. Newnan (1988, Engineering Press, Inc.), but many other equivalent publications exist. These tables give conversion factors for changing between PVs, FVs, and AVs by a simple multiplication. You'll get the same answer as if you had calculated from the formula, but the tables save time and are popular with non-techie types. As a simple conversion example, let's say you expect to win the lottery and receive one million dollars per year for 20 years, and you want to know the present value of this windfall. This is clearly an AV, and we want to convert it to a PV. If we assume an interest rate of 10%, we would plug n = 20 and i = 0.10 into our AV to PV formula. Crunching through this will give you a present value of $8,514,000 for your winnings. Not as good as it sounded, is it? As long as we can describe all of the cash flows identified for our project into our three formal constructs (PV, FV, and AV), we can convert them all into one total project present value. If the total value is positive, the project makes money. If it is negative, it loses money. |
by John Cesarone, Ph.D., P.E. © 1999, Institute of Industrial Engineers |
