Estimating and Business Case
Estimating and Business Case
Our last post explored the abuses of estimates. I thought it best to recognize the abuses, thinking acknowledging these thoughts from the no estimate crowd, may make them amenable to a discussion of how other see the problem and perhaps, eventually, a movement toward a solution that all find acceptable.
Individuals cannot do all the things they want to do, and so to it is for businesses. Whether the business is for profit or a nonprofit, there are limited funds and available talent, that put constraints upon what can be undertaken. These constraining factors lead the organization to optimize the projects that are undertaken to both fit within the capabilities and constraints, but also to maximize the benefit, the benefit being profitability for the for profit, and biggest benefit to the most constituents for the non-profit concern.
In addition to these afore mentioned constraints and benefits, we have risk. There is risk associated with any project undertaken by the organization, in that the project takes resources, but does not provide the believed benefit when concluded. There is even the possibility that the project will never deliver the expected benefit. This requires we recognize the possibility that the expenditure for the work, may not bring any income into the organization or otherwise provide any benefit to the customer.
There are some fundamental ways we evaluate the benefit of the project. These are:
- Return On Investment (ROI)
- Payback period
- Internal Rate of Return (IRR)
Return On Investment
Investment in this regard, refers to the expenditure for the project. Expenditure is how much is going to be spent, and since we must do the project before we truly know how much will be spent, we must find a surrogate for this information. We need some way of getting a reasonable, as rational as we can, and because there are components of this information that are rooted in professional experiences, analysis and judgement, we call this an estimate.
Return on investment is the benefit of the investment (money brought in or saved) divided by the amount of money spent. It is funny that often both are estimates or guesses. It should be obvious that the larger the benefit with respect to the cost the better off we are. The larger this number, the more consideration is given to this project, once we also account for the risks.
ROI = (Gain from the Investment – Cost of Investment) / Cost of Investment
In this less mathematical approach we consider the cost (again derived from the estimates) and compare this to the money brought into the organization annually due to the result of this project (that is the product or service that we make). We look at the amount of profit per year we make and see how long it takes to pay back the investment. This is a very simple calculation and does not consider the time value of money for the return or the consequences of applying this expenditure to some other project. Even with this low level of sophistication, we still require something on the cost side of the sheet, that is what are we spending before we spend it – or estimates. We estimate the project to cost $500,000 dollars, the annual positive cash flow is $250,000, tells us the payback period is 2 years.
Payback Period = total investment / annual positive cash flow
Internal Rate of Return
Internal rate of return, or IRR, is the annualized compound return rate for the investment. If a project’s rate of return is better than the alternative uses of the funds, the project is deemed to be a good investment and acceptable. We will make more money investing in this project than another or even another type of investment (bank or stocks).[i]
The internal rate of return equation looks like this (reference https://www.investopedia.com/terms/i/irr.asp)
What I would like to know, is how do we know which project to undertake? With no estimates, none of these equations can help us understand or model the potential situation. Without some modicum of consideration for the cost and the potential up side for the project, we are not able to ascertain a reasonable decision (albeit with limited information but armed with perhaps at least a review).
You may not like estimates, and you may not think you get anything out of these, but ultimately you do. The money secured for doing the work, that pays for the work, that is based upon more than an ego somewhere or a general idea that it could be good to spend this money on this project and hope it will all work out. Perhaps that is possible to go without estimates for lower end projects that do not require great expenditures, but significant project spending, puts more at risk. It is prudent to consider the expenditure and what that means for the viability of the organization over time.
[i] Pries, K. H., & Quigley, J. M. (2009). Chapter 2 Technical Tools. In Project Management of Complex and Embedded Systems (pp. 60-62). Boca Raton, FL: CRC Press.