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Operations Finance Calculating ROI to Realize Project Value

Calculating ROI to Realize Project Value

Businesses are in business to make money. But calculating the true value of any project (Lean Six Sigma or otherwise) with respect to its impact on margin has always been challenging, mainly due to the ambiguity of turning notions into dollar values.

For instance, it is clear that training employees will improve expertise and productivity, but how does that translate to bottom-line savings or revenue growth? Spending thousands of dollars on automated systems and software is likely to improve work efficiency, but what’s the dollar-value improvement of that efficiency?

Return on investment (ROI) is a key calculation in answering these questions, as well as showing the project value and its impact on the margin.

Depending on the industry, there are multiple interpretations of ROI. For the purposes of this article, ROI is an indicator used to measure the financial gain/loss (or “value”) of a project in relation to its cost. Typically, it is used in determining whether a project will yield a positive payback and have value for the business.

Why is ROI Important?

  1. It quantifies project value – Perhaps the most important aspect of ROI is its ability to show business leaders dollar figures of a project’s worth. ROI turns the subjective into the objective, which can often turn uncertainty into support.
  2. It can build stakeholder support – Tying a dollar value to a project may help with a “go/no-go” decision. Many times, stakeholders want to see what the dollar value is to them if they are to support a particular project. Without an ROI, that is very difficult to do.
  3. It can uncover additional benefits – The process of calculating ROI forces practitioners to investigate benefits that might not have seemed obvious at project inception.
  4. It can lead to project prioritization – Once the decision has been made to launch a project, ROI helps determine the project’s ranking among other priorities; usually, projects with greater ROI are ranked higher and gain resource support more quickly.

How to Calculate ROI

The formula for determining ROI is:

ROI = [(Financial value – Project cost) / Project cost] x 100

In looking at the formula, there are two components we need to determine: Financial value and project cost.

Financial Value

Financial value is simply the project’s payback. Calculating value can sometimes be complicated based on the uncertainty of assigning actual dollars to a proposed outcome. The trick is breaking down the value into presently known components and then defining those components.

When trying to quantify the value piece of the ROI formula, remember the acronym TVD. If a practitioner can define the present Time, Volume and Dollars needed to complete the process, the project’s value can be derived. This acronym corresponds with a formula calculating project’s potential value from a different perspective. It forces practitioners to define what the success factors look like at the end of the project and then break down those success factors into specific numbers. Here’s the formula:

TVDPresent – TVDProject

Where:
• T = Time required for the process
• V = Volume or quantity of units, transactions, people, etc. required
• D = Dollars or cost required
• Present = Current value
• Project = Values a successful project will yield

To better understand this formula, consider a few examples. The first is a project that will reduce process cycle-time of a particular product by 10 percent.

In this example, the project team calculated a single unit cost to be $2,455, based on the current values for the time it requires (13 hours), the volume or amount per time (1 unit), and dollars (wage rate of $85 per hour and $1,350 in total cost of materials). They also calculated that, based on producing 480 units per year, this will equal $1.178 million per year in cost for this product line.

They then calculated the project values by reducing the cycle time by 10 percent, from 13 hours to 11.7 hours; all other variables remained the same. The new costs are $2,344.50 per unit and $1.125 million per year for the product line.

Therefore, the project value is: $1,178,400 – $1,125,360 = $53,040 savings per year.

Consider another example, in this case focused on revenue growth support. The company in the first case now has customers lined up, and needs to increase capacity. They had been selling 480 units per year, at a price of $3,200 each, for a total revenue of $1.536 million. However, because the project team reduced process cycle time by 10 percent, the company can increase output by the same amount. Therefore, their annual production can go from 480 units to 528 units, for a yearly revenue of $1.689 million.

Calculating the value of this improvement project requires a change in the value formula from above. In this case, TVDPresent is subtracted from TVDProject, to find the potential for revenue growth, or $153,600.

The final cost reduction example is slightly more complex. Assuming that quality has slipped a bit since the company increased its output to 528 units per year, they are now considering an improvement project to reduce returned products by 25 percent.

Based on the different costs of a returned product, they calculated the TVDPresent per returned unit to be $2,844.50. At 40 returns per year, this equates to an annual cost of $113,780. The improvement team proposed a project to reduce the amount of returned products by 25 percent to 30 per year, which would lead to a cost of $85,335 per year.

The project value is now: $113,780 – $85,335 = $28,445 savings per year.

Project Cost

The second unknown component of the ROI formula is project cost. Project cost is calculated by determining two variables: Work decomposition over time and cost of the work. ?

Work Decomposition Over Time
The trick to calculating an accurate project cost is to break down the tasks as finely as possible over time. Listing the work tasks in chronological order is not necessary, but has proven to be a helpful technique in ensuring no work is missed. There’s no “right” tool or methods to use when doing this because it really depends on the project; however, a simple illustration of task breakdown over time is shown below:

Figure 1: Project Work
Work Breakdown Date
Task 1 ?
Subtask 1
Sub-subtask 1-1 Jan. 10
Sub-subtask 1-2 Jan. 12
Sub-subtask 1-3 Jan. 15
Subtask 2
Sub-subtask 2-1 Jan. 16
Task 2…

The method above is simple and effective, but other tools to consider in defining and breaking down work are:

  • Gantt chart – Graphically displays the work breakdown over time, as well as total duration needed to complete tasks, and the percentage of the project completed.
  • Work breakdown structure (WBS) – A WBS is used to define and group work elements within a project. Each work element can be broken down into smaller tasks.
  • Process map or process flow diagrams – These could be used to illustrate the project work as a sequence or flow of steps, which can help ensure that all required work is accounted for.

Cost of Required Work
For each piece of required work listed in the approaches above, practitioners must consider certain variables when assigning costs. These can vary tremendously from project to project, but some common factors to consider include:

  • Resources, including the type and quantity of workers needed
  • Hours required to perform the work
  • Wage rate per resource
  • Capital costs (i.e. equipment/hardware costs and software costs)
  • Leases/rentals

Once the work is defined to a manageable level, it should be fairly easy to determine the costs and add them to the work model, as in Figure 2.

Figure 2: Project Work and Costs
Work Breakdown Date No. Workers Rate Hours Hardware/Software Costs Total Cost
Task 1 ?
Subtask 1
Sub-subtask 1-1 Jan. 10 2 $80 10 $1,600
Sub-subtask 1-2 Jan. 12 $350 $350
Sub-subtask 1-3 Jan. 15 1 $60 10 $600
Subtask 2
Sub-subtask 2-1 Jan. 16 1 $100 20 $2,000
Task 2…

Practitioners also should consider one-time costs versus costs over time. For instance, is there a one-time price for a piece of equipment, or is it leased over five years? Are some of the resources providing one-time or ongoing support? Make sure to include the total cost over a given period of time.

For more complex costing, some might want to consider including opportunity cost as well. Even though this is not a true project cost, it defines the value of the next-best choice available to a decision made between more than one option. For instance, assume the above project will cost $190,000 total. The company that invests the $190,000 in this project denies itself interest that could have accrued by leaving the $190,000 in the bank or other long-term investment. The opportunity cost of the decision to invest in the project is the value of the interest.

Finally, some advice – if there is any ambiguity as to what the cost might be, it is advisable to always estimate higher. This will help prevent cost overruns, which will only delay the project.

Putting it All Together

Once the financial value and project costs are calculated, filling in the blanks of the ROI formula is easy. It may be helpful to include this information in an ROI chart that shows cost versus value over time, and where the project hits a break-even point.

Using the examples already discussed, assume this project’s value is $81,485 per year ($53,040 per year in cycle-time reduction cost plus $28,445 per year in error reduction) for the next six years, which equates to $488,910 in total savings. Assuming there is a one-time project cost of $190,000 in year 1, the chart in Figure 3 highlights the break-even point.

Figure 3: ROI Chart

  Cost Savings ROI
Year 1 $190,000 $81,485 ($108,515)
Year 2 0 $162,970 ($27,030)
Year 3 0 $244,455 $54,455*
Year 4  0 $325,940 $135,940
Year 5  0 $407,425 $217,425
Year 6  0 $488,910 $298,910

* Break even in Year 3

As seen from the above examples, ROI is a simple yet powerful indicator of the true value of a project, which also can be used to help gain on-going support within an organization.

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Comments

Heiti Ide 10-11-2010, 08:13

Dear Mr. Schweighardt,

The chart in figure 3 shows a ROI calculated differently from the formula presented in the article.
Could you help me understand why?

Thank you very much for your attention.

Reply

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