Financial analysis comprises a number of considerations and methods. They all begin by assigning costs to all germane capital, fixed, and variable items in the existing state and in the future state, and also considering expected revenues. Some of the accounting is straightforward, but other analyses require time value of money (TVoM) calculations.
I often quip that my family has produced four generations of economists (or at least financial professionals) and that as a mechanical engineer and programmer I’m something of a black sheep. However, that background led me to take a course in engineering economic analysis in the spring semester of my freshman year in college, back in 1981. I also spent the following summer working as a customer service rep for a mutual fund run by my father’s company, Federated Investors.
Time value of money calculations come in many variations, but they all involve series of revenues and payments at an interest rate. One of the most important of these calculations is for present value. This is applied because (under a normal situation where interest rates are positive) money in the future is considered less valuable than money today, which is why interest rates in such calculations are called discount rates. For projects that may involve expenditures and revenues over long periods of time, these must all be converted to present values to determine whether the project makes sense. Interest rates may be different for revenues and expenditures.
Here are some specific elements that come up (many are listed in the BABOK, but not all).
Capital Costs: These are one-time costs for items needed to support the new process. They can include physical plant, machines, tools, IP licenses, software, and one-time services.
Fixed Costs: Ongoing costs that occur at regular intervals, whose magnitudes either don’t change or change at predictable rates. These can include salaries and benefits, rents, utilities, ongoing license fees, regular consumables, insurance premiums, scheduled maintenance, regulatory fees, and so on.
Variable Costs These are costs that occur at irregular intervals or that can be different over time. These can be incurred due to market and regulatory changes, natural disasters (even if covered by insurance), unscheduled maintenance, accidents, and more.
Revenues: These are the projected income amounts over future intervals of time. These can never be known for sure in advance, although estimates may be more accurate to the degree that future conditions are expected to resemble past and current conditions. Projections of future revenues are ultimately up to the entrepreneurial judgment of the owners and managers of the organization. I’ve seen such judgments be very successful and fail completely. Consider the difference between Steve Jobs’ launching of the iPhone, iPad, and Apple Watch, the demand for which could not actually be known (and also the Palm/HP Pre smartphone, which you probably don’t remember for a reason), and the decision to place a new drug store in a growing neighborhood with well-understood demographics.
Value Realization: This is essentially present value of all future forms of income, but it should also include non-financial aspects of value. Examples of the latter are improved employee engagement and morale, reliability, and organizational reputation (although economic values can be assigned to those things).
Cost of the Change: These are the transition costs associated with the installation of or transition to a new process. This is especially germane when transitioning from an existing process to a new (modified or improved) process. It isn’t really germane when a new process is being implemented when it’s not replacing an existing process.
Total Cost of Ownership (TCO): This represents the cost to acquire a solution over its entire life cycle, including capital, installation, ongoing, and retirement costs. Some solutions have a known life expectancy, but in other cases an upper limit will be placed on the duration of the analysis. If the investment doesn’t pay for itself within something like three or five years it will not be undertaken. The actual duration will depend on the nature of the investment.
Cost-Benefit Analysis: This is the present value of the projected benefits minus the present value of the present costs for the proposed endeavor. In theory the benefits will be greater than the costs. The relative cost-benefit (and risk) or pursuing different projects is a major criteria in selecting projects to execute. Efforts should be made to identify and include all relevant costs and benefits in any such analysis.
Return on Investment (ROI): This is expressed as a percentage as the benefit minus the cost over the cost or
ROI = (Total Benefits – Total Cost) / Total Cost
Net Present Value (NPV): As mentioned previously, this is expressed as the present value of the benefits minus the cost of the investment (present value of total cost).
Internal Rate of Return (IRR): This is yet another way to determine the relative worth of pursuing different projects. It is the interest rate (or the discount rate) at which the project would be expected to break event (have a NPV of zero). Projects with a higher IRR are preferred. Companies will sometimes specify a hurdle rate that represents the minimum IRR they expect to realize on an investment.
Note that the nominal interest rate is the published rate that is actually in effect (for the given situation, duration, and so on). The real interest rate is the nominal rate minus the rate of inflation. Real interest rates can be negative, which should be an unusual situation. All of the foregoing calculations should be performed using the real rate of interest, while remaining mindful that both nominal interest rates and the rate of inflation may vary, and sometimes by a lot. I lived through the double-digit interest rates of the 1970s and 80s, and many countries have experienced far higher rates over time. I suspect that we are currently moving into a period of much higher and more volatile interest rates here in the United States.
I’ve written simulations that incorporate costs and revenues for each element, that allow me to determine whether certain scenarios were supportable or were good investments. I did this while working for a customer that gave me average numbers to work with. Customers will often want to keep such information close to the vest for reasons of competitiveness and privacy, so you may need to develop tools that let then enter the correct values and run the analyses on their own.
As a final aside, some interesting work is currently being done on the origins of interest that go beyond the pure time preference of individuals.