1+1=5

Nov 01, 2002 10:30 PM  By

Anyone for a $6,000 shower curtain? Remember the $4,500 hammers the military used to buy? Even in the real world, extravagance and irresponsible spending sometimes supplant fiscal sobriety, but most managers have no wish to be so reckless. Instead, faced with a need to invest, they calculate and quantify, searching for a solution that adds up to the best possible return — ideally, a figure far higher than the sum of all its parts. But whatever type of improvement you imagine for your operation, miniscule, major, long-lasting or short-term, if you don’t have a proven method for measuring its value at the proposal stage, it’s liable to add up to more than you bargained for.

That cutting-edge software package with all the bells and whistles that your systems people have been talking up will make life easier for everyone in your operations. But will it plump up the bottom line? Yes, that voice-recognition-based RF warehouse picking system you’ve been reading about will streamline your workflow. But will it increase profits?

To invest or not to invest; that’s the question. There are countless products out there that can make your day-to-day operations faster, more accurate, and more efficient.

Yet in a time when the economy is uncertain and cash is tight, will a particular product have a positive impact on your financial situation? How long will it take to recoup your monetary outlay? How can you quantify its benefits based on something more than your gut feeling?

Calculating return on investment (ROI) is hardly new. Large corporations have always made stringent analyses of the potential return on capital investments. Some even take into account the future value of the cash to be spent on a project and whether it would perform better if you invested it.

However, you don’t have to be a large corporation — or wait until you’re burned on a major investment — to pay attention to ROI. Savvy operations professionals whip out their calculators every time a new capital expense is proposed. All you need is a good understanding of your current costs and how the proposed investment will affect them.

Simple formula

Your accounting team will doubtless come up with hundreds of permutations of this calculation, but the basic formula for figuring ROI is this:

  1. Spell out your need to upgrade an item or process. Describe the item or process and tell why you want to change it. Perhaps you want to increase sales, or improve throughput in the warehouse, or answer more calls with less labor. Ultimately, you want to reduce costs and increase profits.
  2. Analyze the current cost structure of the item or process you are planning to upgrade with this investment. Make sure that you understand all of the components of the cost and back up your narrative with facts and figures.
  3. Calculate all the costs of the upgrade. Be sure to include capital, equipment, hardware, and software expenses, as well as the costs of training, travel, and implementation.
  4. Identify specific returns that you hope to realize from this investment. Figure out by year how much the process will achieve for you (how much you can increase sales or reduce costs) once you have made the investment — and crunch the numbers per year for the first three years after the investment. Consider both savings and cash flow.
  5. Divide the total cost of the investment by the average annual improvement. The result of this calculation will be the number of years it will take to recoup investment. In that time, the gains you will have accrued will equal your initial investment. Any gains thereafter can be considered a true return on investment. For a more precise application, you will need to work out the savings by month until you have zeroed out the investment, especially if you have a seasonal business.

Here’s an example: One of our clients has been looking into automating his facility’s shipping and manifest area with an in-line scale and bar code reader. The current order process involves having the order routed and labeled by the time that it gets to the manifest area. The company employs one or two people at manifest stations to take packages, place them on the scale, and scan their bar codes to capture weight and shipping method. By using an in-line scale and bar code reader, the company strategists theorized, they could eliminate these positions, improve throughput, and ultimately, lower costs.

This proved to be the case when we ran the numbers. The scanner/scale interface, multiplexer, in-motion scale, installation, and miscellaneous costs would total $40,000 for the initial investment. Eliminating two manifest positions would save $37,050 per year. The investment would be paid back in 12.96 months, after which the annual savings of at least $37,050 — the true return — would kick in. But that was only the beginning.

Higher math

Our client’s initial calculations did not include some potentially significant savings. Eliminating the two positions that called for employees to lift product would reduce the chances of costly back-related injuries and improve daily throughput in the area. When these factors were considered, the true ROI was even higher than the initial $37,050.

We can’t stress enough the importance of not reducing your ROI calculations to the point where you miss significant returns. Keep in mind that there are typically two kinds of positive return:

  • tangible returns, such as additional sales, reduced costs, and improved throughput, and
  • intangible returns, such as improved safety, a better working environment, improved customer service, greater productivity, or other benefits that can’t be clearly quantified now but might yield significant returns in the future.

So make sure that you look at the big picture. How do you do that? By walking through every aspect of the process that you want to improve, both on paper and on site, and leaving no potential gain unobserved.

As an example, let’s consider a proposed investment in a call center staffing package. Participants in recent benchmarking sharegroups report that call centers that use staffing software packages typically have a significantly lower cost per order and cost per call than those that do not — in some cases, between 18% and 24% lower. These are the tangible returns of the staffing systems, and they would be among the primary items in pre-purchase ROI calculations.

But if you stopped there, you’d be ignoring other, less obvious, intangible benefits, among them improved service levels, lower abandonment rates, increased productivity for supervisors (who no longer have to spend time making up schedules manually), and increased job satisfaction for employees (who can lock in vacations and time off more easily), which translates into lower employee turnover. All will eventually contribute to the bottom line, and it’s important to factor these intangibles into your ROI calculations.

When you do your calculations, remember to look for benefits that may be outside your particular “box” — that is, beyond your company’s four walls. For example, some states offer retraining tax credits. Some municipalities provide tax incentives for construction and expansion. These items, too, should be applied to your calculations of overall ROI.

Goal-tending

We’re often asked what is considered a good rate of return for a project. That will more than likely have to be determined within your company. What are your goals? Where are your weaknesses? Are you at a competitive disadvantage?

The other question we are asked is how soon a purchase should pay for itself. Many companies require total payback within three years or sooner for technology purchases. You may want to see a quicker payback — or you (and your accountants) may be open to a slower one, if the durability of the asset enables you to amortize it for a longer period of time. Remember in your ROI calculations that true assets must be purchased and amortized, while other items, such as training, implementation services, or maintenance, are generally classified as expenses. These differences will affect how you calculate your ROI.

Also keep in mind that technology changes quickly; you don’t want to get into a position where you have to keep paying for an item that has become obsolete or no longer provides a competitive advantage.

Once you have calculated your ROI, completed the project, and spent the funds, don’t think your work is done. The final step of the ROI measurement process is auditing the results. You must audit the project after implementation to make sure that you are achieving your goals. If you are not, then you must find out why — and make the necessary changes (for example, additional programming, retraining, or process adjustments).

In times of economic distress, ROI calculations are excellent tools to help justify needed expenditures to leery executives. But that’s just as true in boom times. The companies that do best in good times and bad are the ones that justify every dollar spent — and don’t spend a dollar unless they see ROI.

Bill Kirkland is a vice president and partner with F. Curtis Barry & Company, a consultancy specializing in e-commerce and direct marketing operations strategies and systems. He can be reached at 1897 Billingsgate Circle, Suite 102, Richmond, Virginia 23233; phone: (804) 740-8743; e-mail: bkirkland@fcbco.com; Web site: www.fcbco.com.

Making Sense of ROI

  • Never base a return-on-investment calculation on industry averages or vendor-canned equations.
  • When measuring the potential for return, consider future forecasts and generally accepted internal rates of growth.
  • Remember to incorporate into your ROI calculation any changes in procedures that may take place because of a project. Examples would be new forms, new procedures, or paperwork reduction.
  • Ask your vendors for real-life examples and contacts who can substantiate your assumptions about return.
  • Be careful with ROI calculations that involve reducing permanent current headcount. Usually the workers affected can become more productive or be reassigned to other areas.
  • Do not plan to realize a gain on a software or technology investment until after a “burn-in period.” It can take employees as much as six to 12 months to become fully efficient with a new tool.
  • Consider the cost of capital or interest expense if there are leasing or purchase options available on the project.
  • Look at the long-term viability of the technology or purchase. In other words, make sure that it will be fully paid for before it is obsolete.
  • Make sure that you consider any current systems, assets, or infrastructure that your project may render out-of-date. These can increase the payback hurdle if you have to write them off.
    BK