How To Use A Cost-Benefit Analysis

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Copyright 1999 Mack Hanan. All rights reserved.

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This is the fourth and final seminar in Mack Hanan's How To Close High-Margin Sales Workshop. This seminar, How To Interpret A Cost-Benefit Analysis, walks you through an interpretation of the Cost-Benefit analysis prepared in Seminar 3. To complete this seminar , you will need to prepare the example analysis outlined in Seminar 3 using Mack Hanan's ProfitMaster software. A free evaluation copy of that software can be downloaded from www.salestoolz.com/pmedform.html. For more information, see Mack Hanan's books, Consultative Selling and Competing On Value (Hanan & Karp).

Do you have questions about Consultative Selling? Send them to Mack Hanan via VARBusiness University. Got a question about using ProfitMaster? Contact Rich Press, (602) 998-1862.

In the first two seminars of our four-part workshop, you learned the principles of Consultative Selling. To quickly review: Instead of bidding your next sale on price and performance in response to an RFP, be proactive. Seek out:

1. A customer's line of business with revenues you can increase, or

2. A customer support or service operation, other than IT, whose costs you can decrease.

In Seminar 3, you saw how these entered into preparation of a Cost-Benefit Analysis you can deliver to customers. As you the inputs that allow the ProfitMaster Cost-Benefit Analysis to calculate the customer's payout, payback and return on investment. Aim for a return of 100 percent to 150 percent. If you come up with less, the customer's costs can exceed his benefits. (See the instructions on TroubleShooting). When your ability to deliver benefits significantly exceeds the customer's costs, you can increase the cost of his expenditures. Calculate the advantage of realizing margin based on commensurate benefit values over your current margins from selling on price-performance.

To create a Cost-Benefit Analysis, use the evaluation copy of Mack Hanan's ProfitMaster (see How To Close High-Margin Sales: Seminar #3) . To interpret the results, Follow the line-by-line guidance below. Each line is correlated with the same-numbered line on the example analysis.

Line 1: Total Expenses

Total expenses are also called the Total Investment or Net Cash Out. They are the costs of the Cost-Benefit Analysis and include the acquisition of all capital equipment and materials that you specify as hardware, software, training and support expenses (other than annually recurring maintenance), and any other variable costs. Values enclosed in parentheses and in red indicate a negative value (or, what the customer is spending) Move the mouse just under the years in the Total Expenses line. A box will appear around the numbers. Double click to review the details behind the amounts shown in this line.

Now you will see all the up front expenses you entered under Year 0 and the subtotals for each category of expense including Hardware, Software, Expenses and Depreciation. Note that Support and Depreciation and Amortization are the only costs carried over the five years of the project.

Depreciation is the reduction in an investment's value over time as the result of its use or loss of future usefulness from obsolescence. Software Support Training is expensed. Double-click within the box to collapse the detail.

Line 2: Total Benefits

Total Benefits are the sum of the increased revenue and reduced costs generated by applying your solution. Numbers on this line represent their totals in each year they accrue. Again, move the mouse to the line of numbers under the years next to Total Benefits and double-click when a box appears around the numbers to see a detailed breakdown. Here you see the amount of new business generated in each year as a result of your proposal, as well as the amount saved on overtime during the same period. Double-click within the box to collapse the detail.

Line 3: Gross Profit Improvement

Gross Profit Improvement is the result of subtracting Line 1: Total Expenses from Line 2: Total Benefits. If Total Expenses exceed Total Benefits for any year, the excess would be enclosed in parentheses to indicate a negative value. That is not so in our example. Here, we see a Gross Profit Improvement of $70,000 in the first year, gradually increasing to $588,000 by the end of the project in Year 5.

Lines 4 &5: Less Taxes & Net Profit Improvement

In this line, taxes are subtracted from the Gross Profit Improvement to determine the Net Profit Improvement. The customer's corporate rate is assumed to be from 35 percent to 44 percent. Net Profit Improvement is the net profit after taxes (NPAT). It is almost always 0, as it is in our example, or a negative amount in Year 0.

Line 6: Cash Flow

Cash Flow is the gross benefit in Cost-Benefit Analysis. It represents the sum of Line 1--Total Expenses plus Depreciation plus Line 5--Net Profit Improvement. It will almost be negative in Year 0 because, in that year, it represents the impact of the up-front expenses in the project. In our example, it is negative $98,000.

Line 7: Cumulative Cash Flow

Cumulative Cash Flow is the compounded sum of each year's Cash Flow added to the previous year's Cumulative Cash Flow. It is almost always negative in Year 0 as it is in our example, negative $98,000. The customer's payback begins to occur when the Cumulative Cash Flow equals Total Expenses. In our example, that happened somewhere between year 1 where Cumulative Cash Flow is negative $36,000 and Year 2 where Cumulative Cash Flow moves into the black with $61,000. If you look down three lines to Payback (months), you will see that Payback occurred in the 17th month of the proposal. After the first dollar following Payback, Cash Flow turns positive and profits are realized.

Line 8: Net Present Value

Net Present Value (NPV) is today's value of the sum of all future cash flows after they are discounted for the time value of money that is lost by their current unavailability for investment. It is almost always negative in Year 0 as it is in our example ($98,000). One of the two most critical factors to success in any cost-benefit analysis is seeing hot the NPV can be increased or be made to flow faster

Line 9: Internal Rate Of Return

Internal Rate of Return (IRR) is the average annual percent return on a dollar invested over the proposal's life cycle, calculated in discounted dollars. The second most critical success factor to your analysis is seeing how Payback can be achieved faster.

Putting The Analysis To Work

Cost-Benefit Analysis is an iterative process. It requires entering different inputs in a What If scenario before the "a-ha moment" of the single best solution can be realized. Use the What If feature in ProfitMaster to try out different iterations.

As we noted above, the two critical questions behind the success of your Profit Improvement Proposal are:

1. How can Net Present VAlue (NPV) be increased or be made to flow faster?

2. How can Payback be achieved faster?

NPV and Payback affect the dollar value and time value of money. They also affect a customer's risk: reward ratio--the higher the NPV the lower the risk; the longer Payback is deferred the higher the risk.

In order to try to increase NPV or make it flow faster and to try to advance Payback, the two most productive parts of a Cost-Benefit Analysis to troubleshoot in a What If scenario are (1) Line 1: Total Expenses and (2) the components of your solution that went into that total.

As you examine options to advance the payback and increase NPV, ask yourself four questions about the expenses.

1. Are Total Expenses unnecessarily excessive?

2. Is the Year 0 expense unnecessarily front-end loaded?

3. Can the Total Expenses be segmented into a series of smaller sums whose progressive payback can self-capitalize some or all of the successive investments?

4. Is lease instead of buy a better option? Leasing will not impact Total Expenses. As a result, Cach Flow benefits can begin immediately in Year 0. Net Present Value is calculated the same way whether you lease or buy. There is no Payback under Lease because there is no entry for Total Expenses, unless there is an option to buy. The Lease rate replaces IRR.

Trying On Other Solutions

You can ask three questions about the solutions you propose to identify other ways to advance payback and increase NPV?

1. Is the number of components unnecessarily excessive? Look for ways to economize on the systems you will install.

2. Is the cost of any component unnecessarily excessive? If so, seek out competitive prices and negotiate with your suppliers.

3. Are there alternative components that can be more cost-effective? Often there are. Do your research. New technologies are pouring into the market. Your choice of components, vendor partners and competitive services will significantly impact your Profit Improvement Proposals to your clients.