In today’s market, for each commercial/CPQ projects we work on, we need to show business benefit of such projects. We all know that such calculation of business benefit needs to be clear and transparent, with minimum uncertain assumptions and measurable. Especially for CPQ projects & other commercial projects, it has been a challenging tasks for sure, when the most of the benefits are qualitative in nature, only some are quantifiable. I have seen benefit claims of 10mm/year for a CPQ project, but they did have to lower it to 1mm/year when challenged on the ability of being measurable and quantifiable for the next 3-5 years.
Now, in most cases, our clients can ‘define’ such benefit, and manage to prove, with reasonable certainty, that we will realize such benefits and we can show such in our pro forma cash flow for next few years, as well as in the balance sheet. However, that alone might not be enough to sway the CFO or the finance leader. Questions will be raised on the timeline of payback, compared value of today or the cost of investment/loan to invest in this project.
Let’s look at the 3 financial terms that we should all use while we evaluate such benefit stories:
- Payback period: tells us how many years we have to wait to recover the investment, assuming the benefits are measurable and can be claimed in pro forma statements (balance sheet, cash flow form)
- Net present value (NPV): tells us the present worth of future benefits, extremely helpful in determining which project to invest in
- Internal rate of return (IRR): tells us the rate of return on investment compared with the rate of borrowing capital (Weighted Average Cost of Capital or WACC)
Payback period: The payback period method simple computes the time required to recoup the initial investment. For example, for a given CPQ/Commercial project, we’d need to invest 1mm over next 3 years, and the project should provide us with 800k/year measurable and verifiable benefit. How many years would it take to get our money back? We get the answer by dividing 1mm by 800k, which is 2 years. In other words, after we go live with this project, benefit $ from the first two years will only contribute to recovering the investment; business will realize incremental benefit after cost is collected, which is after 2 years.
Net present value (NPV): The net present value (NPV) of an investment discounts all the cash inflows over the life of investment to determine whether they equal or exceed the required investment. If the present value of the inflows less the initial capital outflow is positive, value is added to the firm. Let’s use a scenario for this one, assume that we have to choose one of the two CPQ/Commercial Platforms, Platform A and Platform B.
For Platform A, it’ll cost us 500k initially, then it will give us yearly benefit of 400k for the next 3 years. If the current market discount rate is 10%, we can break up the scenario like this: