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How to Estimate the Cost of a Data Collection System

Start out with your system cost, including purchased hardware and software. Be sure to include spares, cables, batteries, accessories, label supplies, sales tax, service contracts, etc. Do not forget custom programming and interfaces. Most companies want the project cost to include in-house programming and resources. Others treat in-house costs as a sunk cost since they will be incurred regardless of whether or not the project is approved and implemented. Use whatever approach is ac- cepted at your company.

Financial Analysis

Financial analysis is the process of comparing savings to costs. Imagine your project in terms of the stock market. When you buy shares of stock, you pay your money up front with the expectation that you will get your investment back, plus interest or dividends. Companies expect the same from their capital investments. The dividend and return of principal comes in the form of cost savings or income improvements. Two common accounting statements are used to illustrate the savings.

Project Income Statement

We all are familiar with the concept of an income statement. Income statements are prepared on an accrual basis, which means that expenses are recorded when the cost is incurred, not when the bill is paid. Income statements include non-cash expenses such as depreciation. The project income state- ment includes the labor saved or inventory costs avoided on an annual basis. It also should include the depreciation of the data collection system.

Project Income Statement

Year 1 2 3 4 5 Total
System Depreciation (25,000) (25,000) (25,000) (25,000) (25,000) (125,000)
Service Contract (6,020) (8,028) (8,028) (8,028) (8,028) (38,132)
Supplies & Miscellaneous (500) (500) (500) (500) (500) (2,500)
Installation (25,000) 0 0 0 0 (25,000)
Labor Savings 15,900 31,800 31,800 31,800 31,800 143,100
Inventory Holding Cost Savings 8,500 17,000 17,000 17,000 17,000 76,500
Operating Income (32,120) 15,272 15,272 15,272 15,272 28,968
Reduced Interest to Finished Inventory 45,000 90,000 90,000 90,000 90,000 405,000
Pre-Tax Income 12,880 105,272 105,272 105,272 105,272 433,968
Income Tax @ 34% (4,379) (35,792) (35,792) (35,792) (35,792) (147,547)
Net Income 8,501 69,480 69,480 69,480 69,480 286,421

Project Cash Flow Statement

The cash flow statement is similar to the project checkbook. Like the income statement, it includes
the cash savings such as labor and inventory savings. The primary difference is that the cash flow
statement does not include depreciation expense. Instead, the cost of the system is a cash outflow in
the initial period, when the check is written.

Project Cash Flow Statement

Year 0 1 2 3 4 5 Total
System Cost (125,000) 0 0 0 0 0 (125,000)
Service Contract (6,020) (8,028) (8,028) (8,028) (8,028) 0 (38,132)
Supplies Miscellaneous (500) (500) (500) (500) (500) 0 (2,500)
Installation (25,000) 0 0 0 0 0 (25,000)
Labor Savings 0 15,900 31,800 31,800 31,800 31,800 143,100
Inventory Holding Cost Savings 0 8,500 17,000 17,000 17,000 17,000 76,500
Inventory Financing Cost Savings 0 45,000 90,000 90,000 90,000 90,000 405,000
Income 0 (4,379) (35,792) (35,792) (35,792) (35,792) (147,547)
Net Cash Flow (156,520) 56,493 94,480 94,480 94,480 103,008 286,421

Return on Investment

Return on Investment (ROI) measures the average income as a percentage of the cost of the proj-
ect. The formula is average after tax savings divided by the initial system investment. Investment is the
capitalized cost of the project. Use the project income statement to calculate the project ROI. At most
companies, the target ROI or “hurdle rate” is 25%.

Return on Investment

5 Year Avg. Project Earnings (Cost Savings) 57,284
Capital Investment 125,000
Average Return on Investment 46%

Payback Period

The Payback Period tells you how long it takes to recover the cash cost of the project. Payback is
always expressed in time, such as 2.5 years. Use your project cash flow statement to determine the
cash savings of the system. Compare the cash savings from the project cash flow statement to the
initial cash outflow. Then use that to calculate the period of time it will take to recover the cost. Most
companies want to see a payback period of less than 4 years. Automated data collection projects
generally payback in 6 months to 3 years.

Payback Period

Year 0 1 2 3 4 5
Initial Cash Outflow (156,520) 0 0 0 0 0
Net Cash Savings 0 56,493 94,480 94,480 94,480 103,008

Payback Period 2.1 years

Net Present Value

The Net Present Value of Cash Flow (NPV) model takes the cash flow statement and uses an interest
rate (also called discount rate) to convert the annual flows in the future to current dollars. It essen-
tially uses the concept of the time value of money to compare the cost of the project in today’s dollars
to the savings that occur over several years in the future. If you are not familiar with the concept of
discounted cash flow, think of a $1 million dollar lottery that pays off in 20 annual installments of $50
thousand. We all would rather have the $1 million up front than to wait for the annual checks. A dol-
lar today is worth more than a dollar in the future.

One piece of information you must have is the discount rate or interest rate used by your company.
If you do not know it, ask your Chief Financial Officer for the appropriate rate to use. Once you have
the discount rate, apply it to the annual cash flow from the project cash flow statement. Add up the
discounted cash flows and you have the NPV of the project. If you have additional questions about the concept of Net Present Value or how to calculate it, refer to the spreadsheet model or a basic accounting or finance textbook.

Most use the company’s cost of five-year money as a discount rate for bar code projects. You should, of course, use the rate considered appropriate by your company’s financial management. The fol- lowing table is designed to help project managers determine the cash savings needed to justify a capital asset purchase under different discount rate assumptions.

Project Net Present Value

Year 0 1 2 3 4 5 Total
Net Cash Flow (156,520) 56,493 94,480 94,480 94,480 103,008 (286,421
Present Value Factor @ 10% 1.00000 0.90909 0.82645 0.75131 0.68301 0.62092
Net Present Value Cash Flow (156,520) 51,357 78,083 70,984 64,531 63,960 172,395

Example: Assume your company uses a discount rate of 20%. The table below shows that a $100,000 project with a five-year life must save at least $31,793 per year for 5 years. To use this for your project, determine the cost of your investment; let’s say it’s $50,000. Since $50,000 is 50% of $100,000, your cash savings must be $15,897 per year, at a 20% discount rate.

Annual Cash Savings Required

Net Present Value Basis

Assumptions: $100,000 Project Cost — 5 Yr. System Life Savings Received Monthly Over the Life of the System

Discount Rate Required Annual Cost Savings
10% 25,496
15% 28,548
20% 31,793
25% 35,222
30% 38,824
35% 42,588
40% 46,502
45% 50,552
50% 54,726

Written Project Proposal

Good writers always know their audience before they start. The same rule applies here. Who will ap-
prove or reject the project for your company? Who else will influence the decision? Are there second-
ary signatures required? Is the capital budget available or will you be better off waiting until the next
fiscal year?

Once you have a clear understanding of the process and the players, identify what they want to see. Ask them for a sample of a complete and well-formatted capital project proposal. Having a good report template can save many hours and keep the discussion focused on the content of the project rather than the style of the write up.

Gather a Team of Experts

One critical factor in the success of your project is the people on the project team. Recruit a team of
competent, motivated people who are open to change and highly regarded within your company.
This not only adds to your credibility when asking for capital funds, it also greatly increases the prob-
ability that the implementation will go smoothly. At a minimum, the project team should include an
operations expert from the user department and an IT person. Also, it may be beneficial to have an
operations manager and a finance department representative on the team. Keeping the team small
is important, but having motivated impact players from the areas that may influence the outcome is
more important. Every member of the team must feel they will share in the successful implement-
ation of the system.

Describe the Implementation

Start out by relying on the expertise of the user team members and applying good project management skills to produce a good implementation outline. After you have gained solid buy-in on the outline, fill in the details and dates. Be sure and allow for unforeseen circumstances and build contingency time into the schedule.

You must convince the decision-makers that your project is well planned and you have the ability to make it happen. The time you spend writing a good proposal and implementation plan is worth the effort. A well-written proposal can be used as a yardstick to document your success on the project.
Write the proposal for your reader – not yourself. Use strong, assertive headlines. Emphasize key ideas by repeat- ing them. At the same time, do not create a wordy document that will not be read. Scale your proposal appro- priately for this type of project at your company. Superfluous fluff and technical jargon should be edited out or included in an appendix.

When your project proposal is finished, have it reviewed by someone outside of the project. The proposal should stand on its own and be clear to people not intimately familiar with the project.

Getting Started

Real productivity gains and cost savings are the keys to successfully cost justifying capital projects. Unlike some technologies, automated data collection is one of the easiest technologies to cost justify. A number of proven techniques for quantifying savings and the return on a capital project have been outlined. Follow these steps and your project will not only get approved – it will be considered a much needed and profitable investment. Remember our proposal is the way you set expectations for your project. Set reasonable expectations and deliver more than expected and you will join the ranks of those who have made their companies more profitable with automated data collection.

Look into specific data collection and asset management systems at http://hiveta.com/Solution/New-Asset-Management.

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