Organizations are realizing the importance of measuring which business process models are the most beneficial. One of the best ways to determine how well these models suit the business is a cost-benefit analysis to estimate the return on investment.
As today’s companies search for ways to improve their efficiency, senior managers are increasingly realizing the importance of using tools to measure which business process models are the most beneficial to an organization. One of the best ways to determine how well these models suit the business environment is to conduct a cost-benefit analysis to estimate a return on investment (ROI). ROI is an influential factor in triggering process improvement efforts.
Conducting a cost-benefit analysis is a challenging task, but an overview of the analysis process can facilitate understanding of the challenges and how they can be addressed.
ROI Fundamentals
ROI is the ratio of the amount of resources invested in a project to the net benefits reaped from it, often expressed as percentage. It can be used in cases where management needs to know how the business is going to benefit from a project that carries significant costs. The percentage can be calculated with the following formula:
ROI = ((Total benefits – Total cost)/Total cost) x 100%
For example, if an initiative that cost $10 million provides total benefits of $17.5 million, then, according to the formula, the ROI is 75 percent.
It is obvious from the above equation that:
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ROI less than 0 percent is not economical
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ROI equal to 0 percent is considered a “no loss, no gain” situation
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The greater the ROI, the larger the benefit
Essentially there are two factors to take into account when calculating ROI: cost and benefit.
Estimating Costs
Estimating the costs associated with the project is the first step to begin the analysis. Often, process improvement efforts can span over a long period — typically one to five years. To more accurately estimate costs for an entire effort, it is wise to establish major phases and tasks within each phase. This breakdown provides more insight into the activities involved and can help management better understand individual components of the effort and the resources required to conduct it. These resources often include people, tools, infrastructure and training required to accomplish tasks.
Following are the factors to consider while estimating costs:
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Labor = Number of business days required for the effort x business hours per week x average labor rate per hour
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Special services, such as assessment and consulting = As quoted by vendor
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Administrative expenses = Total administration work hours x labor rate per hour
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Training material and resources = Number of trainings x average hours per training x number of people to be trained x average labor rate
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Resources (additional hardware, software, tools, etc.) = sum of all resource costs (as quoted by vendor) and related miscellaneous costs like installation and setup and training to users
Thus, the total cost of the effort is the sum of all the above costs:
Some components of the cost equation may vary depending upon the situation. This variation is quite natural but can be controlled. For example, the labor hours may vary on account of challenges faced during implementation, whereas cost of assessment may not vary unless the scope of the assessment is changed. It would be better to consider minimal and maximum variations of cost to give a better estimate to sponsors.
Assumptions for Cost Estimation
Certain assumptions are required to facilitate the cost arithmetic and provide a foundation for the majority of cost factors, Any changes to these assumptions may affect the entire analysis, including ROI.
Some of the possible assumptions are:
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Team size required for the effort
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Labor rate per hour
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Number of business hours per week
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Consulting fee
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Cost of providing training
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Cost of other resources, such as hardware, software tools, etc.
Challenges in Estimating Cost
he most challenging part of cost estimation is determining the number of people required to complete the project and the total number of hours they need to execute the effort. This calls for detailed knowledge about the organization, such as the various business processes, the current maturity state of those processes, major pain areas and — last but not least — the efforts undertaken in the recent past to address the improvement issues and their returns.
Knowledge of the improvement model proposed also is essential. While it may be difficult to have enough resources to satisfy both of the above criteria, the formation of a team to bring in the required expertise for this task is highly recommended.
The team works in following way: Once a process improvement model is chosen, the people who know the model the best ( subject matter experts, or SME) provide step-by-step instructions about implementing the model to the organization’s executives. Based on their perception, the executives decide to what extent the current processes comply with the business improvement model. Having this done for all the processes helps provide a clearer picture about the next steps that need to be taken. The SME may provide further inputs on other aspects, such as complexity of certain recommendations, the kind of training required to execute the plan, and the degree of support and involvement from management.
This step provides input to estimate the number of labor hours required for the effort and create a schedule for its completion. The volume of work involved may vary by the size of the organization and the scope of the process improvement model selected.
The accuracy of the estimation depends on the level at which the model is compared with current processes. Comparative analyses that are calculated down to the minute would be the most accurate, but also the most time-consuming method. A trade off is often required, based on the expected accuracy of the estimates. An explicit caveat is necessary to convey this fact and acknowledge that the estimation could vary to a certain extent.
Estimating Benefits
Now that costs are estimated, the next important task is to calculate benefits. A benefit is defined as a gain to the organization in terms of money, due to new or improved processes. Benefits can be made tangible and traceable to the process improvement method. There also can be non-traceable and intangible benefits, which may not be confidently attributed to process improvements alone.
The traceable benefits of the improvement could be realized in the following ways:
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Reduced waste = ((Total size of waste before improvement) – (total size of waste after improvement) x rate) / Size of waste
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Reduced rework = (Total rework hours before improvement – total rework hours after improvement) x Labor rate per hour
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Productivity gain = (Productivity after improvement – Productivity before improvement) / Productivity before improvement
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Reduced cost of operations = (Cost of operation before improvement – cost of operation after improvement) / Cost of operation after improvement
Non-traceable benefits can include:
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Increase in customer satisfaction
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Increase in revenue
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Increase in market share
Though aspects such as growth in revenue or an increase in customers are measurable, it’s rather difficult to clearly associate them directly to improved processes. Although the improved processes would definitely contribute to such benefits, it can be rather difficult to calculate the degree to which they were the driving factor.
Challenges in Estimating Benefits
Estimating benefits can be very difficult, especially when the data on the performance of current processes is not available. Most of the improvement models benefit organizations by reducing waste, rework and the cost of operations by increasing overall productivity. Unless the data is based on the amount of hours spent doing rework (defect fixing, rewriting code, etc.), or on wasted hours spent on modules and abandoned projects, it’s often difficult to determine how much the process can be improved. No matter how mature the process is, there is always room for improvement, but without adequate data the benefits can be left in doubt — especially by those who are skeptical of the process improvement model to begin with.
Depending upon the situation, two approaches are possible: The first is based on data, and the second is based on industry results.
First, if the data is available, quantify the expenses in the recent past on waste and rework. This sum of dollars represents the opportunity to improve. Saving dollars by reducing these costs chunk by chunk, year by year, is a good foundation for estimating benefits. Look for other similar opportunities and use them for the estimation of benefits. If the data exists for part of, but not the whole, organization, it has to be used carefully. To estimate the organization-level benefits, extrapolation could help, provided that proper assumptions can be made. To provide a fair estimate, patiently gather the required data for at least a full fiscal quarter.
On the other hand, industry data may be used to estimate the possible benefits of a particular model. Sponsors of the model, along with some research organizations, can provide a wealth of accomplished benefits of the model. The benefits vary from industry to industry, so the amount of benefit one could reap would depend upon both the available room (process maturity) before the improvement and the rigor by which the process was implemented.
Note that there will be gestation period for these projects, so benefits may not be realized from day one of an effort; most likely there will only be increased costs initially. However, as the effort progresses, the benefits start showing up. When all the improvements are successfully deployed, the peak of these benefits should arrive after the effort, not during it. Hence, it would be appropriate to see benefits for some period even after the effort is completed.
Time Value of Money
It also is important to consider the change in value of money, due to inflation, as time passes during the improvement program, especially when programs last longer than a year. Be sure to avoid comparing tomorrow’s benefits with today’s costs. The present value of money is referred to as net present value (NPV) and expressed as:
NPV = Sum of benefits / (1 + r)n , where
r = rate of discount
n = period in years
The NPV provides an opportunity to compare the ROI if the money was invested elsewhere.
About the Author: Anand Paropkari is a quality management professional with experience in various models and methodologies, including ISO 9001, CMMI, ITIL, Six Sigma, ITSM, Cobit and TQM. He holds a BE in electronics and telecommunications and a master’s degree in software engineering from Birla Institute of Technology and Science. He can be reached at [email protected].
