How to calculate the profitability of a material investment?

A company needs to invest, this is to commit it over time by financial, human and/or material means in order to subsequently generate profits. Obviously, since resources are limited and cost, we must be able to make choices by estimating these constraints. In order for the latter to be consistent, a business manager or project manager must rely on criteria as specific as possible. Explanations.

  • Calculation of projected profitability
  • Stages of investment valuation
  • Ensuring Efficiency
  • Taking into account the risks
  • The question of posteriori control

How to calculate the projected profitability of an investment ?

The purpose here is to make a calculation to compare the amount of the investment (in clear, disbursements) with the gains generated by it over its expected lifetime (cash receipts) in order to select the projects that appear to be the most profitable for the company. The choice to be made must be as rational as possible, shared and not questioned. It is therefore clear that investing alone is often an inadequate idea; be advised by professionals, a partner, an accountant or a banker but also by specialized consultants.

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What are the stages of investment valuation?

Step 1 : The valuation of the cost of the project must take into account all planned expenditures, whether capital or not. For example, the cost of acquiring capital assets is incorporated into the calculation incidental purchase costs, installation costs, start-up cost, training fees for the new tool if necessary, change in the BFR related to the investment, the residual value of the previous investment.

Second step : It is not simple because here we have to rely on assumptions. Forecast cash flows must be quantified. The costs and gains of the investment over its operating life generate positive projected cash flows? In order to reduce the risk, the shortest period between the life of the investment, its depreciation period or its obsolescence period is used .

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Step 3 : This is a question of comparing cash receipts and disbursements. The latter, available on different dates, are made comparable thanks to the technical of updating. The discount rate most often used by management professionals is the cost of employees by the company. This can then be corrected to take into account, for example, the additional risk detected and related to the project.

Step 4 : Finally, it is a matter of choosing the criteria for profitability. To do this, it is possible to distinguish the advantages and disadvantages in tabular form between payback time (DR), net present value (NPV) and internal rate of profitability (TIR):

DISADVANTAGES
Recovery Time (DR) Prefers Risk Reduction by Choosing the project with the shortest DR. The project with the shortest DR is not always the most profitable.
Net Present Value (NPV) Prefers the amount of wealth created. The amount of wealth created is not reported to the initial investment.
Internal rate of profitability (TIR) Prefers the rate of return of the project. The project with the best TIR is not necessarily the one that creates the most wealth.

Attention, in this presentation, the calculation is seen from an economic point of view and does not include, for example, the method of financing the project.

How to ensure the effectiveness of the investment?

It’s pretty hard as long as it has not really been tried. On the other hand, it is useful advice and methodology to ensure a minimum ROI (Return on Investment).

The figures shown above are based on many economic assumptions such as the life of the investment or the estimation of the flows resulting from the implementation of the project. Future cash flows are analyzed by comparing two situations: The one that is current by asking, for example, the following question: “What happens if we do not make the investment?” and the future situation.

Validation of economic assumptions is, as you understand, essential. This implies asking yourself many questions. The relevance of decisions based on financial criteria depends entirely on the veracity of the assumptions used to construct the simulation. These Assumptions are provided by operational and management controllers:

  • Is the need fully covered by the planned investment?
  • Is everyone, especially the purchasing department of the company involved in the study of costs?
  • Are the deadlines realistic?
  • What costs and gains are induced?
  • What will become of end-of-life investment?
  • Are there organizational changes to anticipate and which ones?

How to properly take risks into account?

The business manager, the accountant and, of course, the management controller must be involved in risk assessment and question the assumptions of calculation. Risks are most often related to the economic environment, particularly market specificities. An often forgotten risk also comes from legislator on the market, or even the legal environment simply. It is most often wise to have previously carried out a real benchmark to analyze all risks and opportunities.

There are two methods of weighting the choice criteria by integrating the impact of risks:

  • The use of a progressive discount rate to take into account the increasing uncertainty of earnings assumptions over the years;
  • Conducting sensitivity analyses, in particular scenarios.

Should we check a posteriori?

It is a question of common sense in terms of governance that must be answered yes! However, the task is more complicated than one can imagine. Indeed, the cost accounting of a given company is not always organized to isolate the real gains obtained from the project. Tracing these gains can then become perfectly tedious and approximate as many internal events over the period interacted with the implementation of the project.

the other hand, real gains cannot be compared to a situation where the investment would not have been realized On . However, it is possible to study the impacts, for example one year after the start of the service, recalculate the projected profitability taking into account this time updated and actual elements. The use of the dashboard is therefore essential and allows for the integration of key indicators (KPIs) such as productivity and raw material gains.

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