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The methods used to assess wheter a capital investment is good or not are several and each of them has its own advantages and disadvantages.

These features are often looked through under the technical profile and finance managers make their choice from the methods on the basis of their competence and/or the availability of the data needed for applying them.

For instance, we know the Net Present Value together with the IRR (internal Rate of Return) are the most objective criteria to understand if the project is good or not as a whole, considering all the life of it.

The same NPV method encounters some "trouble" when the capital is rationed (this case is largely dealt with from the related literature and in any case it isn't the subject of this dissertation).

Some argue that the IRR don't consider the hypothetic reinvestment of the intermediate cash inflows and resort to the MIRR (Modified Internal Rate of Return).

Both of them, IRR and MIRR, come across important problems when the cash flows are predicted to alternate, changing continuosly (positive and negative) their sign over the period considered, generating as a result multiple values of IRR and MIRR

The Payback model, in its turn, is the most simple since it gives an immediate perception of the breakeven period, but it doesn’t take into account the whole life of the project and can mislead the managers when it comes to choosing the best from alternative proposals.

One can also adopt all the necessary precautions to make the analysis even more reliable and complete, such as explained in the article n. 26 on this webpage, but we are telling of technical issues and not of the strategic sides.

A good manager entrusted with this financial assessment should consider all the cause-and-effects relationships between strategy and methods in use.

In many case I have observed some distortions, that are, strategic decision making in an opposite direction of the goals of the business

Let’s start to examine three different cases.

Of course, I’ll limit the dissertation to the most recurring ones, while in the business life other debatable behaviours can take place.

1) Lack of information.

Whether you are pursuing a long-term objective or a medium-term one, you need some information on which resting your decisions.

An example will clarify this concept.

You are a manufacturer of mobile phones and are thinking to market a new revolutionary software that could spread the use of objects through the use of the same mobile phones.

This step would be a step in the differentiation strategy compared to the competitors

The new technology should require a huge amount of money invested into Development expenses  and in the specific Advertising, but the managers are not sure whether the market is ready to welcome the new technology.

They realize to need more market information and reliable future macroeconomic data about the areas where marketing these revolutionary mobile phones.

The solution is one out of two, the first listed below is the “Strategic Distortion”:

a)  The finance manager wants to make a decision by analysing the investment proposal without taking into account the reliability of the information.

With the help of the marketing dept. he spots three scenarios concerning the demand for new product, attributing  (as the best risk management procedures teach) to the occurring of each of them a percent likelihood.

Then, he proceeds to the analysis of the investment (in the following example, the NPV technique is used).

Input:

Discount rate (WACC) 12 %

Investment period: 3 years

Investment outlay at period 0: $ 2,000,000

Annual after-taxes net cash inflows per scenario (for simplicity, the same amount in each year):

- Pessimistic: $ 100,000

- Normal:  $ 912,000

- Optimistic: $ 1,400,000

Scenario percent likelihood:

- 25% Pessimistic

- 50% Normal

- 25% Optimistic

Table 1

* The after tax cash flows are considered net of the inflation, as well as the Discount Rate. I remember the relation at issue: Nominal Discount Rate = Real Discount Rate x Estimated Inflation Rate

The result of the investment analysis of Table 1 is negative since the Average NPV is - 3,488 and, in view of the unreliable information, considering also   the risk through this sensitivity analysis, it shouldn’t be undertaken.

b) The uncertainty about this percent scenario likelihood is too high because the information about the consumer demand is believed to be vague, then a potential deferral of one year of the investment comes up.

This way you aren’t calculating the risk, but even you are trying to “dominate it”

In this case, the procedure should give value to the lapse of time you decide to wait for in order to have more reliable information on which resting your decision to make the investment or not at a deferred time.

This method is called in many ways; I like to name it “the waiting option value”.

First of all, you must exclude that scenario that at the time of decision (in this case year 1) gives a negative NPV, since you’ll make the investment at Year 1 only if the new information at that time about the demand for the new product is good ad as a result the NPV is more likely to be positive.

Taking the previous example, the cash flows must be always discounted for four years but from Year 4 to Year 1.

The same investment outlay of $ 2,000,000 must be discounted for 1 period, from Year 1 to Year 0. We make it at the risk free rate, for instance  4%, since we assume that the amount of it will be always $ 2,000,000.

Table 2

The projected result is $  285,064, positive and not negative like that related to an immediate investment.

As a result, the manager should wait for another year, when further information about the consumer demand should be more reliable and make the decision of investing or not.

The solution b is the most advisable since it would avoid the distortion of the first one, that is, a decision made without the needed information.

2) Conflict between investment criteria and performance evaluation.

This situation occurs when the managers of a profit center are evaluated on the basis of criteria that could lead them to accept some investment or reject them  when the same project should have rejected in the former case or accepted in the latter one when examined through an impartial technical criterion.

For instance, if on the basis of a Discounted Cash Flow method the purchase of new machinery that enables the increase in the production of a given model was advantageous, and the performance evaluation criterion was the increase of the ROI of that business unit, its managers could reject the investment when the implicit ROI of the capital investment is lower than the ROI target of the whole profit center.

What happens is due to a contradiction of goals, more strong in some cases, for instance:

a) If the investment assessment method is a DCF, the higher the discount rate the greater the strategic distortion.

b) In case of long life of the investment and the most part of the returns are focused in the last part of it.

c) When the Manager is due to go away (on any reasons) from the business unit as the person in charge of it

The most advisable solution consists of adopting a new criterion in assessing the performance of the managers, achieving as a result a congruent behaviour of them with the interest of the BU.

For any details on these solution, get in touch with www.thestrategiccontroller.com

3) The most recurrent strategic distortion is the following and also the most avoidable

The firm puts on the table its strategy to achieve its goals in the long term.

Whichever strategy is, price leadership one or differentiation one, the top managers predict its success in the long term.

In this situation the capital-budjeting proposal assessment techniques that take into account just a part of the life of the investment are to be rejected.

The strategic distortion is, for instance, making use of the Payback period that, looking at breakeven period, neglects what happens after that and could prefer, in a potential choice from alternative proposals, the investment more advantageous in the short term but not with regard to the whole life of it.

The solution is easy to be found, that goes without saying.......

When analysing the way the finance people make their decision processes about the evaluation of the capital investment projects, I observed some important kinds of error or negligence.

That happens regardless of the model used. Either discounted cash flow models or non-dcf ones, the errors happen in the same extent.

When I write about DCF models I mean in particular the IRR (internal rate of return) and the NPV (the net present value).

By Non-DCF models I mean the Payback Period model and the ARR (Accounting Rate of Return).

The points at issue aren’t the suitability or not of each model for a specific capital investment project; that’s why I’ll examine just those recurring errors and not each model listed above.

What are these errors?

1) Negligence of some expenses to incur at the end of project

You know that the steps an investment project is broken into are three: start period, operating and end one.

We’ll deal with the last step.

For instance, you are evaluating the chance of purchasing a machine for your furniture manufacturing facility dedicated to the computer-driven cutting phase.

After taking into account all the cash flows related to the revenues and costs springing from the previous periods (start one and operating one), you put to your attention the collection, net of taxes, from the sale of the same machine.

Have you forgotten something?

In my opinion yes, you have.

In many cases, the shift of the people dedicated to that machine disposed of at end period involves some sort of emerging outlays, such as retraining, relocation expenses and in the worst scenarios the severance ones.

These costs cannot be neglected, in particular when the people involved are in a great number, and as a result, the  related cash flows are to be taken into exam.

2) Opportunity costs

The concept underlying this figure of costs requires the existence of an alternative yielding some receipts to the option you are analysing.

In some cases, the attention of the analyst focuses only on the cash flows coming out of the investments under exam and not on the receipts the exisisting alternative can generate.

I am not talking about the analyses of two or more projects intended to meet the same requirements from the company but about the remaining option that exclude the “direction” of the same projects.

An example will clear any doubt.

You are analysing two investment proposals about the building of a warehouse on a land owned by your companyBoth of them give a positive Net Present Value (let’s take this method as that used from the CFO) at the end of a five-year plan: Project A with a NPV of $ 780,000 and Project B with a NPV of $ 610,000.

They seem to have a good result, but someone suggests the CFO to take into account also the alternative to both of the building projects of selling the land.

The potential revenue (opportunity cost), net of taxes and cash-generating one, of this solution is  $ 700,000, making only the project A positive and the best solution amongst the three alternatives.

3) Inflation neglected

The cash flows for every piece of the period considered are gross of the inflation rate and that is an error when you are analysing a multi-year investment proposal because of the fluctuating value of the currency meant as purchase power of each unit of it.

These corrections must be made regardless of the method applied to the analysis.

It doesn’t matter whether you are using a DCF technique on a Non-DCF one.

4) Overheads not included or erroneously calculated

When deciding which costs one should think of in order to determine the cash flows of the proposal, some general expenses not clearly tied to it are taken out of the capital-budgeting analysis or calculated in a wrong way.

That happens because of two reasons

A) This category of expenses are believed to be fixed for the sake of simplicity or very hard to link proportionally to the variations of output/processes brought about by the new investment.

B) When they are considered variable costs and affected by the new investment the CFOs/Controllers link them to mistaken drivers and as a result the related cash flows put into the analysis are wrong.

At this point you might make use of some statistical techniques to find the right drivers to which linking the trend of the overheads and understand if the new projects determine a differential amount of them to be taken into account into the analysis.

5) Risk neglected

When the uncertainty of the future scenarios is present, the analyst must make use of the appropriate techniques to get the most likely cash flows.

For this purpose I remind you also of the previous dissertation published on www.thestrategiccontroller.com “How to deal with the uncertainty in the estimation process” (page Topics, n° 18), where some tips are made.

After the points highlighted so far, a question arises.

What about the strategy within this context?

The smart controller/CFO shouldn’t limit  the analysis of the investment proposal to the typical financial side of the matter, but include also the adherence of the investment to the strategy.

For instance, if the project involved a new product to be marketed, you should include the after-sales costs in a right and congruent amount, when considered variable.

I mean that if you choose a machine enabling to manufacture a high volume of output and as a result a lower fixed unit cost of the product to the disadvantage of a higher quality, you should take into consideration a fair amount of warranty costs and other kind of after-sales expenses.

This amount is seen as acceptable or not depending on your strategy.

Given an equal volume of cash flows (gross of this category of costs), if price leadership strategy the acceptable threshold is higher than that if differentiation strategy, because in the latter case a loss of sales and market share could result following the brand-name damage.

The solution is to quantify these costs through an accurate estimate work through the appropriate techniques.

The point at issue is even more important when you are comparing two or more projects/proposals and if you aren’t able to quantify these costs, the solution is to apply a qualitative approach that compares the subject proposals with reference both to the financial side and to the strategy aspect and make the best choice.

The ways you can do this are not my favourite because either they don’t consider the weight to attribute to each side of the analyses or the weight is arbitrary.

The full dissertation is available on page SHOP of this website

http://www.thestrategiccontroller.com/2/shop_3813594.html

In many mass production businesses one of the most used analysis tools, the cost variance analysis, is set on the comparison between the static budget data and the actual ones recorded at a point over the fiscal year.

This comparison and the following differences are taken as a basis for the corrective actions to be made and for evaluating the performances of the business managers.

In many cases, and in particular in that of cost centers, it’s appropriate to eliminate the volume effect, that is the cost variance due to the fluctuations in the actual output compared to the estimated one.

That’s why the smart controller prefers to make use of the comparison between the Actual data and the actual data valorized at the standard unit costs, the ones used in the budget

The latter report is called Flexible Budget that replaces the Static Budget (standard unit costs times estimated output).

In the project control, the concepts underlying the Flexible Budget are a peculiarity and the main measure representing this feature is specifically called “Earned Value”.

What sense would any efficiency and effectiveness assessment on the project make without a consideration of the estimated unit costs applied to the work actually performed?

It’s sure that to make this concept understood, we need to take a step back.

We know that a project is broken down into several activities to be performed by each department involved at different stages of its life.

Each activity or set of homogeneous activities made by one department is called Work Package and it needs to be planned, scheduled, evaluated and checked in effectiveness and efficiency during its execution.

The phase we are now interested in is the check at a specific date (TIME NOW).

The reference term at each time now is the Original Budget, that shows how much has been estimated to be completed in quantity and money spent on each Work Package  till that date, achieving a given percentage to the total work done up to the final date (so called state of work).

This “Baseline” is indicated as Budget Cost of Work Scheduled (BCWS) and should be immutable throughout the duration of the Project.

In fact, in case of new works ordered by the customer and following variations in quantity and money value of the final project, the reference changes, producing as a result new evaluations about the work done.

Is it correct to use BCWS in absolute terms or is there something else to take into account?

Which are the “numbers” you have to compare to the BCWS in order to determine whether the company is working well or not?

To have the right answers, It’d better know and look into the technical tools of the argument.

The full dissertation is available on page "Shop" of this website

http://www.thestrategiccontroller.com/2/shop_3813594.html

How many times do you state or hear that you are adopting the concept of Value in addressing your customers?

You couldn’t tell us how many times you did it!

Nonetheless, the revenues are not increasing as you wish and the market share is the same as before or even smaller.

As a matter of fact, if you are really creating value to the customers, at the same time you are creating revenues for your business.

Even if you faced with a value engineering program since the second year, more or less, the profitability has been decreasing in your customer segments because the “reasoned” cost cuts have run out of their effects.

Then, what is happening?

In my opinion, the answers could be two:

1) You are adopting an internal perspective of Value.

2) You are not reinvesting the savings from the “waste” activities into the value-add ones.

What do I mean by internal/external perspective of value?

If, when deciding which product/service features are important to the customers, you keep into account the opinions of the business managers that sort the needs/requirements of the customers on the basis of their experience, knowledge of the market and  give instructions to the engineering/production to develop the processes/products and manufacture the products accordingly, then you are adopting an internal perspective of Value.

This approach is also typical of some recent cost management techniques like Target Costing that try to cut costs and at the same time to keep the functionalities of the product as before...............

..................You’ll have to remember what the customers won’t ever pay for and what is in excess to the normal activity.

That’s why a new kind of waste takes importance: the excess spending of the business on  Value-Add activities tied to  specific value features (customer preferences).

In order to explain better this concept I’ll advance something you will be able to understand better further on.

Let’s imagine that you manufacture the product A, which has just 2 Value features (Price and Delivery Speed) according to the customer perspective.

The costs of the activities attributable to these preferences are $ 12,000 and 10,000.

The revenues traceable to them are respectively $ 24,000 and 8,000...................

..................As you can see in table 2, the customers of these two segments have different requirements about the features the product should have to make their purchase become true,.

In this example the results as a whole could be guessed by taking into account the clear difference in the buying power of the two customer categories, but going into the details you can give a weight to these data.

In the view of the first segment, so-called “Writing pen” customers, the quality of the writing is by far the most important feature (55%), followed by the chance of choosing from more pen models (Model Availability - 15%) to purchase (in our example just two: fountain pens and ball pens) and the cheapness of the product (Price feature - 14%).

About the second segment,  High-end pen customers, a different...................

.............In fact, the standard deviations are respectively 0,84 for the former market an 1,13 for the latter one.

 That means, if the firm would modify something in its activities intended for the first market, the modification should be smaller than those intended for the second kind of customers.

 Taking into consideration the two kinds of strategy adopted, the firm succeeded with its efforts more in the Price leadership strategy used for the Writing pen customers than in the Differentiation strategy suited for the High-end customers.

This conclusion is good for the past period, but for the choices to be made about the future?

How should the company reason?

Let’s look into every value...................

.................That’s good, as we have seen for each value feature, in looking on the most or the least effectiveness of within the Value-Add activities.

We want to go beyond.

For instance, either if you want to or you must choose the most profitable segment for any decision the business is to make or any further benchmarking it wants to do in order to have more details, the following analysis will take an higher value if it includes  the total costs of the company.

When I write about the total costs of the company, I mean also those of the resources consumed in all the operating activity categories we have before examined.

We should do this by.............