How to Evaluate Supply Chain Management Costs/ROI

One of the ramifications of the recent economic downturn has been a more stringent financial assessment for capital projects such as SCM implementations.¹⁸ While the possibility exists that the higher internal hurdles may inch downward as the economy recovers, the budgeting of significant capital projects such as SCM will continue to face rigorous financial scrutiny.

Six capital budgeting models are used to evaluate capital projects such as SCM implementions:¹⁹

1. The payback method
   
   The payback method is simple: the measure of time required to pay back the initial investment of a project. Typically this is how payback is calculated:
   
   Original investment/Annual net cash flow = Number of years to pay back
   
   This method is popular because of its simplicity and power as an initial screening method. It is particularly useful for high-risk projects in which the useful life of a project is difficult to gauge. If a project pays back in two years, it matters less how long after two years the system lasts. The weakness of payback is that it ignores the time value of money, the amount of cash flow after the payback period, the disposal value, and the profitability of the investment.
   
   
2. The accounting rate of return on investment (ROI)
   
   The accounting rate of ROI determines the rate of return from an investment by adjusting the cash inflows produced by the investment for depreciation. It yields an approximation of the accounting income earned by the project. To find the ROI, one first calculates the average net benefit:\
   
   

   (Total benefits – Total cost – Depreciation)/Useful life = Net benefit
   
   The net benefit is then divided by the total initial investment to arrive at the ROI:
   Net benefit/Total initial investment = ROI

3. The net present value
   
   

   Money you expect to receive in three, four, or five years from now is not worth as much as money received today; therefore, “future money” has to be discounted by an appropriate percentage rate, typically the prevailing interest rate or the cost of capital. Present value is the value in current dollars of a payment or payments to be received in the future:
   
   Payment x 1 – (1 + Interest)/Interest = Present value
   
   Present value is then used to calculate net present value:
   
   Present value of expected cash flows – Initial investment cost = Net present value
   
   This allows the comparison of the investment (made in today’s dollars) with future savings or earnings.

4. The cost-benefit ratio
   
   The cost-benefit ratio, the ratio of benefits to costs, is a simple method of calculating the returns from a capital expenditure:
   
   Total benefits/Total cost = Cost-benefit ratio
   
   The cost-benefit ratio is often used to rank multiple projects for comparison. For example, it could be used to compare the usage of enterprise suite versus specialized best-of-breed SCM implementations.
   
   
5. The profitability index
   

   A limitation of net present value is that it provides no measure of profitability or an effective means of ranking different potential investments. The profitability index provides a simple solution to this shortcoming. It is calculated as follows to compare the profitability of alternative investments:
   Present value of cash inflows/Investment = Profitability index

   
   
6. The internal rate of return (IRR)
   
   

   IRR is defined as the rate of return or profit an investment is expected to earn, accounting for the time value of money. IRR is the discount (e.g., interest) rate that will equate the present value of a project’s future cash flow to the initial cost of the project. Given a collection of pairs (e.g., time, cash flow) involved in a project, the internal rate of return follows from the net present as a function of the rate of return. A rate of return for which this function is zero is an internal rate of return.
   As an investment decision tool, the calculated IRR should not be used to rate mutually exclusive projects, but only to determine whether a single project is worth the investment. In cases where one project has a higher initial investment than a second, mutually exclusive project, the first project may have a lower IRR (expected return) but a higher net present value (increase in shareholders' wealth) and should thus be accepted over the second project, assuming no capital constraints.²⁰

All of these methods have one thing in common: The end result is usually a single number. This number must pass a company’s threshold for the method used for the project to be funded in any particular budget cycle.²¹

An emerging school of thought believes that ROI is better calculated as a probability curve, as there is a range of potential financial outcomes for any given SCM initiative.²² This approach is more complicated than the traditional methods detailed above, but it provides more nuance and allows for the realities of managing extended supply chains that are more often varying shades of gray and not the black-and-white images that classical financial models tend to develop.