Technology projects face many challenges prior to initiation, one of them being capital budgeting decision making i.e. being able to showcase the benefit delivery against the cost to the firm. This becomes challenging to gauge during the execution of the project and even more challenging in times of shrinking budgets, as the resources decrease and yet the benefit expectation remains consistent. In this paper we discuss how can a program sustain challenging scenarios and adapt the benefit reflection models to showcase the true benefit assessment. We will walk thru the various methods of capital budgeting used for project assessment during the business case and share the recommendation on how to continue to assess the project during its execution to be able to derive the benefit assessment in no time.
Capital Budgeting Decision Making Techniques
Net Present Value – The net present value approach is the most intuitive and accurate valuation approach to capital budgeting problems. Discounting the after-tax cash flows by the weighted average cost of capital allows managers to determine whether a project will be profitable or not. And unlike the IRR method, NPVs reveal exactly how profitable a project will be in comparison to alternatives. The NPV rule states that all projects which have a positive net present value should be accepted while those that are negative should be rejected. If funds are limited and all positive NPV projects cannot be initiated, those with the high discounted value should be accepted.
Payback Period – The payback rule, also called the payback period, is the length of time required to recover the cost of an investment. The payback period is calculated as follows: Cost of Project Annual Cash Inflows All other things being equal, the better investment is the one with the shorter payback period. Return on Investment – ROI measures the amount of return on an investment relative to the investment’s cost. To calculate ROI, the benefit (or return) of an investment is divided by the cost of the investment, and the result is expressed as a percentage or a ratio.
Rate of Return – The IRR is the interest rate (also known as the discount rate) that will bring a series of cash flows (positive and negative) to a net present value (NPV) of zero (or to the current value of cash invested). Using IRR to obtain net present value is known as the discounted cash flow method of financial analysis.
Life time value assessment – The present value of the future cash flows attributed to the FTE during his/her entire relationship with the company. Present value is the discounted sum of future cash flows.
As can be seen from the techniques shared above, the core components defining the benefits assessment are costs and savings. How the costs and savings are estimated make up the benefit realization. From 100K view the estimations can be used to gauge the directional sense of the project i.e. to go ahead with the decision or not. However, to sustain the challenging times and yet being able to reflect upon the benefit delivery model, one need to build a MECE unit model for both cost side and save side. How this helps is given the uncertainty looming around the scope of the project if it decided to change scope, it becomes easier to weed out/add the costs for that particular scope without impacting the overall model. The unit model used to gauge both costs and saves thus is the key component of consistent monitoring of a project. Not only, does this aid in the benefit assessment it also brings transparency across board on both costs and saves as the project moves forward towards delivery. Instituting such model stimulates a more informed, data-driven discussion on a range of possible outcomes; a more structured approach to making decisions and a better dialogue about the trade-offs.
To develop such a unit model one needs to look at two aspects of the costs and saves i.e. resources and scope components. Resources are simply a split between labor, software and hardware. Scope Components on other hand will required a framework to derive granularity of a unit. Visually this can be viewed as below.
Scope Components will require granularity such that they are mutually exclusive and collectively exhaustive to build the entire scope of the effort. E.g. A scope that is for two regions (A and B) and deals with three technology components (A,B and C), software and hardware.
The components in blue in this case would make up the Y axis i.e. Scope Components.
The unit model with granularity, as discussed earlier, helps have better dialogues about the trade-offs within a project.
Having the unit model one can maneuver around the costs and associated savings to build an option pool to move forward with the project. This helps senior leadership team take decision on the fronts they want to address and the direction they wanted to move ahead with the project. Moreover, the Unit Model increases the transparency across financial and benefit realization front, ease of costs and saves maneuverability and ease of scope add removal impact analysis.
The Unit Model consumes some time for build out, however, the benefits it results in heavily outweigh the initial effort on build out.