Something that engineers often need to decide is whether to pursue a particular project or not. Let’s say an engineering company is trying to decide whether or not to pursue a long term maintenance contract, or to invest in a particular R&D project. In order to do this properly, understanding the project’s finances and whether or not they help or hinder the company are absolutely essential.
Projects that have a positive impact on the company may be accepted and funded. Projects that don’t have a positive impact are almost automatically doomed and will very likely never get off the ground.
The problem is that many engineers don’t know where to start when it comes to finances. This is a major issue for anyone trying to evaluate a project’s merits and anyone who’s trying to launch a new project. The project’s finances are the basis of its business case.
In today’s post, I’m going to explain how to conduct a proper financial analysis for a project, and how to use the results from that analysis to decide if you should move forward with or not.
The goal of financial analysis for engineering projects
In short, the goal of financial analysis for engineering projects is to determine whether or not a given project, if implemented, would help the company financially or not. Simple, right?
In truth, it is pretty simple. The calculations are all quite easy – especially for someone with an engineering background.
Financial analysis really comes down to answering three questions:
- What does it mean to have a positive financial impact on the company?
- How do you calculate financial impact?
- What numbers do we include in the calculations?
Once you can answer all three, you’re ready to roll.
What does it mean to have a positive financial impact on the company?
This is a bit of a mouth-full, but here it is:
A project has a positive financial impact on the company when the net present value of all incremental cash flows resulting from the project is greater than zero.
Whew. Ok. Let me unpack that a little bit.
Net present value is greater than zero
Net present value is a financial measure that looks all of the cash inflows and outflows for a given project or investment over time. When you solve the net present value for a series of cash flows, you first convert all future cash flows into today’s dollars. This is important because of something called the time value of money. I explained this in my last post, but the fundamental thing to know is that a dollar today does not have the same value as a dollar tomorrow, so you can’t compare them directly. To deal with this, we typically convert future dollars into today’s dollars. Once we do that, we’re working with a common baseline.
Once we convert all future inflows and outflows of a project, we can add up the inflows, subtract the outflows, and tadah! if the result is above zero, we have a financially viable project.
It’s a bit too much to go into here, but suffice it to say that net present value is a more reliable measure of the profitability of a project than return on investment (ROI), payback period, or any of the other common measures. This will be the subject of a future post, but for now, just trust me ;-)
Incremental cash flows
There are two important things to latch onto here. One is that we are talking about cash flows. This means that all we care about are real dollars an cents changing hands. For example, equipment depreciation doesn’t count in this kind of analysis because it’s a non-cash expense. The company’s accountant would claim equipment depreciation as a legitimate business expense, but no actual money changed hands as a result of that depreciation, so we don’t care about it here. We care about things like improved sales and paying vendors.
But, we don’t care about just any cash. We care about incremental cash flows. That is, we care about how cash flows will change as a result of implementing a project compared to how cash would flow in the business if the project weren’t implemented. This is how we isolate the effects of the project.
How do you crunch the numbers when doing financial analysis?
For the most part, the calculations used in financial analysis are pretty straightforward. Things get a little more sophisticated when you look at the tax implications that come from buying, selling, or depreciating equipment, but that’s a bit over the top for most analyses that an engineer would conduct or evaluate. We won’t worry about that stuff for now.
Crunching the numbers really comes down to repeating two steps over and over again: plotting out a series of cash flows, and determining the net present value of those cash flows.
To help contextualize this, let’s pretend that we’re analyzing a simple R&D project to improve our company’s best-selling product, the WidgetMaster 3000. In this example, all we’re going to look at are the upfront expenses to run the R&D project and the expected future income that the company will get because the product will be even better than before.
In this hypothetical project, let’s say it costs us $100,000 to actually implement the project and we can complete the project in a year. We’ll call this year 0. Let’s also assume that after we improve the product, the income the company generates is expected to go from $10,000 per year to $20,000 per year. We also assume that in 12 years, we’ll have to discontinue the product.
I always use Excel for this kind of work. See below where I’ve plotted the cash flows over the next 12 years.
Note that in the incremental income, I’ve only put $10,000 per year. That’s because this is the incremental income that would result from the project. In other words, the benefit I expect to get from investing $100,000 in year 0 is $10,000 per year for 12 years.
Next, I use Excel’s handy net present value function to determine the present value of each series of cash flows.
The NPV function has two variables that need to be filled. First, it needs an interest rate, expressed as a decimal. Next, it wants the values of the future cash flows. The values for future cash flows can be entered individually, but I typically select a range of cells as it’s much faster to do that.
For the cash outflows in this example, I’m using an interest rate of 10%, (see your company’s accounting or finance department to see what you should use in your case) and I’m selecting all the cash outflow values (i.e. the E4:P4). You’ll also notice that I’m adding the value in cell D4. That’s because this is the expense that is incurred in the current year – year 0. The value of that expense is already in today’s dollars – $100,000.
I do all the same things for the cash inflows as well.
Analyzing the numbers
Referring to the screenshot above, you see that the NPV for outflows is $100,000 while the NPV for the inflows is $68,136.92.
What does this tell us?
That’s right – the outflows are higher than the inflows. This means that the investment that is being proposed to improve the WidgetMaster 3000 is too high given the projected increased income. That means that this project isn’t financially worthwhile as it is being proposed.
In order for this project to be worthwhile, either the initial costs would need to be lower (less than $68,136.92), or the incremental income would need to be higher (at least $100,000) in order for this to be a smart project financially. If you can’t do either of these, then you should just abandon the project.
Which cash flows to include in your financial analysis?
There are several cash flows that you need to include in your analysis beyond what I used in the example above. Please note that all of these should be considered incremental, even if I don’t say that explicitly.
- Incremental project costs – Every current and future cost associated with the project needs to be included.
- Incremental income – All additional income associated with the project.
- Opportunity costs – These are the revenues that you aren’t earning since you’re pursuing this project instead of some other project. These are important because the company could potentially be putting their money towards something else if they weren’t investing in the project being analysed. This means they’re losing money on that lost opportunity.
- Taxes – Any changes to the tax you pay as a result of changing the company’s income needs to be accounted for. To keep it simple, you can use the company’s average tax rate to calculate changes to tax. Again, you can ask your accounting folks about this. In my experience, most engineering management teams don’t expect to see taxes accounted for and can generally be left out.
- Equipment purchases or sales – Any time you need to buy or sell equipment as part of the project, it should be included in your analysis. If you sell equipment for something other than it’s “book value”, then there will be tax implications as well, but again, you should consult your friendly neighbourhood accountant for that.
- Carrying costs – Carrying cost is a bit like a loan from the company to the project. Generally, a project “borrows” a certain amount of money from the company as a float and then returns that money to the project at the end. This is just the cash that the project has on hand in order to keep things going; paying for materials, consultants, travel, and the like. The company incurs a cost when it lends float money to the project because it could have been using that money for some other purpose, even if just having it sit in a bank account somewhere earning interest. So to use the loan analogy again, the actual cost is like interest on that loan. Like taxes, this cost is generally not such a big deal for most projects, and most engineers wouldn’t worry about including this.
When evaluating larger projects (large being a function of what an average project looks like in your company), it gets more and more important to include things like taxes and carrying costs. Be sure to work with your company’s accountant or finance person to get this sorted out.
Which cash flows not to include in your analysis?
There are two important rules you need to be sure to follow with respect to exclusions: never include sunk costs or cash flows that aren’t incremental.
- Sunk costs – Sunk costs are costs that happened in the past. People are often very tempted to include these costs in analyses, but you should never do this. A sunk cost is, well, gone. Whether you decide to invest (or invest more) in a project today can’t change anything about money that was spent in the past. When you conduct an investment analysis, you’re trying to figure out where to spend your money tomorrow so as to secure the highest return. Never include sunk costs.
- Non-incremental cash flows – You shouldn’t include any cash flow that would have been there anyway if the project hadn’t been launched. To properly evaluate the effects of a proposed project, you have to look at how that project would change the baseline cash flows of a company.
Now you know how to evaluate the finances of a project. Woohoo! Great work. I know this stuff can seem complicated, but it’s not so bad once someone shows you.
If you have any questions about what I’ve written here, just use the comments section below. I promise to read and respond to every comment.
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