Larry Kofton, C.P.M.
September/October 2013, eSide Supply Management Vol. 6, No. 5
Know the key characteristics that differentiate a return on investment report from a cost benefit analysis to present the best information on projects to management.
The supply chain team today has much more opportunity to participate in discussions about company financials and strategy than it did in previous years. As with most companies, yours is probably led by a management team that has created a strategy that includes a mission of growth to become number one. Growth strategies will often include supply chain objectives such as streamlining operations, reducing costs, launching a new line of products or investment in new equipment. These objectives will be then be translated into projects that the company will need to analyze before determining which ones will be the best return on investment.
It's crucial for supply management practitioners to have a method to show management which of these projects will create the most value. It's a key component to being successful against the strategy. Because there are usually many competing projects using a limited number of resources, how does one determine which projects are the best ones to undertake? Two of the most preferred methods are a return on investment (ROI) analysis and a cost benefit analysis.
Many companies assume conducting a return on investment analysis is the most logical choice for choosing projects. However an ROI analysis can be easy to manipulate and has little accuracy. A cost benefit analysis, on the other hand, summarizes the project's total expected costs and compares them to the project's total expected benefits. The outcome of a cost benefit analysis enables management to compare and rank how a project will impact profits. A cost benefit analysis will help you provide management with a simple, standard and accurate view of which projects to undertake.
One main advantage of a cost benefit analysis over a return on investment analysis is that it is easy to understand. The clarity it provides means that everyone involved will understand the financial impact of the project and will be able to answer the question of its viability. Alan Steiss is a former professor of urban planning at the University of Michigan, and in his book Strategic Management for Public and Nonprofit Organizations, he says the cost benefit analysis will help management decide on how to allocate resources. Given adequate estimates, the analysis of costs and benefits provides a relatively straightforward approach on which to base decisions regarding the allocation of available resources among economically desirable options. A complete list of a project's costs and benefits helps management more easily confirm which projects are best to undertake. Another advantage of this type of analysis is that it examines the worth of a project by standardizing the costs and benefits into similar units for side-by-side comparison.
Because the most common unit is money, a cost benefit analysis provides management a standardized financial view (see the example below). Both aspects of a project — costs and benefits — are expressed in terms of a common unit in order to reach a conclusion as to the desirability of a project.
In a 2010 article published in Philosophical Issues, titled A Place for Cost-Benefit Analysis, David Schmidtz, a professor of philosophy and economics at the University of Arizona, confirms that because a cost benefit analysis uses the same units to compare costs and benefits, it provides a clearer picture of the bottom line. Unlike a return on investment analysis, a cost benefit analysis uses values that have a common measure and this reduces distortion of the project's net value.
Steiss also confirms this shortcoming of a return on investment analysis, saying that benefits and costs must be translated into a common measure. By providing a standardized view of a project's financial value, a cost benefit analysis also helps management enforce accountability.
A cost benefit analysis promotes fiscal accountability in projects. Too often, department managers using a return on investment analysis cannot be held accountable for projects, because this type of report does not systematically show the necessary figures and data regarding costs or benefits. These figures can be exceedingly valuable for project accountability purposes because they describe, in a quantifiable and understandable manner, the positive or negative benefits of the project.
In his book, Schmidtz explains how cost benefit analyses improve accountability over a ROI analysis. According to Schmidtz, "The most fundamental argument in favor of CBA has to do with CBA's role as a means of introducing accountability into decisions." Most people will only perform the minimum that is expected of them. Schmidtz emphasizes this in his book as well: "Situations where we are not fully accountable — where we have the option of not paying the full cost of our decisions — tend not to bring out the best in us. Cost benefit analysis with full cost accounting is one way of trying to introduce accountability." With the bottom-line numbers upfront, a cost benefit analysis will go a long way to help set the goal for results.
Many managers claim that an ROI analysis is the better choice because it presents results as a percentage, whereas looking at the dollar values from a cost benefit analysis can cause some confusion. Of course, this is not accurate, because an ROI analysis can easily create variation. The danger for management comes in how the costs and the benefits are calculated. Vijay Sikka, founder and chief executive officer of Sikka Software Corporation, says, "If the assumptions are overstretched, the ROI analysis will not be accurate and will not hold up to the scrutiny of different constituencies."
When a manager states that a project will deliver a certain percentage of return, they are often making the error of simply using the purchase price while ignoring all the costs in the middle. Most of the time management will not see these calculations side by side in an ROI analysis as they would in a cost benefit analysis.
Your supply chain organization can increase its value, and you can grow your career, by supporting management throughout the project decision process. In most cases, you are charged with the task of reducing costs after a project has been agreed on. However, your opportunity exists in the beginning stages, where you can provide the full financial impact of future decisions. A cost benefit analysis will help you demonstrate a clear understanding of your company financials and how a possible new project investment will impact its future profits.
Larry Kofton, C.P.M., is manager, supply chain for Ikaria in Port Allen, Louisiana. For more information, send an email to email@example.com.
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