How Cost of Delay helps evaluate savings projects
[Cost of Delay series — Part VI: “Cost savings”]
“Save a boyfriend for a rainy day. And another, in case it doesn’t rain.”
(Mae West)
With ‘Maintenance’ and ‘Growth’ we have the cash income part of value covered, and we’re ready to sink our teeth in cash outflows, starting with ‘Cost savings’. From a Cost of Delay perspective, the cash outflow category isn’t fundamentally different than cash income. We’re still interested in the question of how much we stand to lose if execution is delayed (or to gain if it is accelerated). But in this article, we will examine questions relevant to the quantification of projects involving cash outflows. The first is how we translate a one off benefit, i.e. expressed as a single absolute money number, into a Cost of Delay (CoD) which we have chosen to express as a rate (money per unit of time). The second question is how we quantify efficiency benefits, and more specifically projects to save staff time.
Our first question is how we can convert a one off to a recurring financial amount. Some payoff functions consist of a single payout at one specific moment in time. The clearest example is a financial option, which has a fixed expiry date on which the option pays out or expires worthless. Some savings projects behave the same way, yielding a onetime cash benefit. Such non-recurring benefits don’t immediately compare with the Cost of Delay estimates we made for other types of projects, which we expressed as a “x EUR per month” rate. Fortunately there is a simple way to convert a one off benefit to a recurring equivalent.
To realize this magic, we needn’t look any further than the Discounted Cash Flow (DCF) concept, one of the basic methods in the financial toolbox. DCF uses a “time value of money” interest rate to translate the value of future cash flows to today’s money. Using a discount rate of 10% per year, the total value of a future cash flow stream of an initial 1,000 today and then ten times 1,000 every year would look like this.
The total cash inflow is 11,000. But because money in the future is worth less than money today, the total value expressed in terms of today’s money is 6,862 (which is called “Net Present Value” or NPV). It’s also interesting to see what the NPV would become if the regular cash flow kept going on forever. (A so called “perpetuity”, or in this case also “annuity” since it’s recurring once per year.)
Future years don’t contribute all that much anymore expressed in today’s money. Even after just 30 years the contribution is already quite small — let alone after eternity. And the other thing to note in the table is the total NPV: 10,000 equals the perpetual amount divided by the discount rate. That is an inherent property of a perpetuity, and working this perpetuity calculation in reverse gives us our easy method to translate one off payouts to run rates. In our example, we would say that the one off benefit of 10,000 is the equivalent of a Cost of Delay of 1,000 per year. Many companies have a specific discount rate, reflecting their cost of capital, for any investment-related analysis. Absent such specific discount rate, we can keep it simple and use 10% as a reasonable proxy. If you have a project with a one off payout, divide it by 10 to have its Cost of Delay per year. And this also works on other timeframes: a 10% annual discount rate is the equivalent of a 0.7974% monthly discount rate, and a 10,000 one off payout is the equivalent of 79.74 per month in perpetuity.
For our second question, we don’t need fancy footwork to reinterpret a financial formula. But it’s worth spending a bit of time on the question of how we should properly account for efficiency gains. Many efficiency projects are justified on the basis of “saving people x hours”. Saving time is definitely a good thing, but its true value in financial terms is not well understood. Expressing the saved time in terms of salary costs will seem obvious, but for Cost of Delay folks it is clearly unsatisfactory. For us, measuring in terms of output value, as opposed to input costs (which salaries are) is the whole point! So the question simply becomes: what is the saved time worth, in terms of output value?
The answer may be: nothing. If the saved time has no impact on throughput, there is financial benefit. We can study two mechanisms to invest saved time towards a positive impact on throughput. The first mechanism is shortening cycle time: the saved time results in shorter overall execution time — we deliver faster. The second mechanism is using the saved time to stary work on valuable items waiting in queue (making sure we don’t overdo it on capacity utilization, remember the article on limiting Work In Progress). If neither of these mechanisms work, the only benefit of saving time is people going home earlier. That’s a very good thing, but it doesn’t impact the bottom line[1]. On the other hand if we can deliver faster or pull work forward from the queue, then that’s the source of financial benefit and it is typically a multiple of salary costs.
Ironically, if Finance staff expresses efficiency gains in terms of salaries, they simultaneously risk underselling and overselling the true value of saved time. Underselling, because the output value unlocked by the saved time may be many multiples the salary cost. And overselling; because the saved time may be worth nothing if it can’t be productively reinvested in acceleration or capacity increase. For Cost of Delay practitioners on the other hand, the evaluation as such is business as usual but will require communication effort. Strictly speaking, our estimated value of the time saving project will not be fixed, but contextual. The estimated value will depend on other projects than the time savings project itself, and it may change over time depending on what’s waiting in queue. That may seem weird (if not wrong) to stakeholders. But we don’t necessarily need to follow every twist and turn in the queue value du jour: working with a long term average value of queue items produces a stabler estimate. And at the end of the day, all we’re telling our stakeholders here is that the value of a time savings project is best understood in terms of opportunity cost.
In the next article, we’ll have a look at the value of projects yielding a cost avoidance benefit. The value of risk management, in other words.
[1] This conclusion is consistent with Goldratt’s Theory of Constraints: unless we relieve a bottleneck in some way, there is no financial benefit.
