When proposing a Six Sigma project to management, it's essential to speak the language of finance and provide the necessary information to help them make a decision. In this post, we will be discussing financial measures and how to use them to evaluate Six Sigma projects. Common financial measurements include return on investment, payback period, net present value, internal rate of return, and benefit-cost ratio. Let's take a closer look at these measures and how they can be used to evaluate a project.
Return on Investment (ROI)
Return on investment (ROI) is a measure of the income generated by an investment compared to the cost of the investment. To calculate ROI, we divide the revenue generated by the investment by the cost of the investment, then multiply the result by 100% to express it as a percentage. For example, if we invest $2000 in a project and receive $1000 each year for the next five years, our ROI would be 250% ($5000 in income / $2000 in cost x 100%). This is a good return on investment, and management will likely approve the project based on this measure alone.
Payback Period
The payback period is another crucial measure to consider when evaluating a project. This measure tells us how long it will take to recover the initial investment. In our example above, we invested $2000 and received $1000 each year for the next five years, so our payback period would be two years. This means that we will have recovered our initial investment after two years. While the payback period is a valuable measure, it doesn't consider the time value of money, which is the idea that money is worth more today than it is in the future.
Net Present Value (NPV)
To account for the time value of money, we can use the net present value (NPV) measure. This measure considers that money is worth more today than it is in the future. To calculate NPV, we need to know the discount rate, which is the interest rate or return we could have earned by investing the money elsewhere. Let's say our discount rate is 10%. To calculate the NPV, we take the income generated by the investment and discount it by the discount rate each year. Let's take an example where we invested $2000 today, and that project provides a profit of $5000 in the fifth year. In this example, the NPV would be $1104.61 ($5000 in income / (1 + 0.1)^5 - $2000 in cost). This is a positive number, meaning the project is a good investment.
Internal Rate of Return (IRR)
Another measure that considers the time value of money is the internal rate of return (IRR). This measure tells us the rate of return that the investment is expected to generate. To calculate IRR, we need to know the initial investment and the cash flows generated by the investment each year. In our example above, the IRR would be approximately 20%. This means the project is expected to generate a return of 20% each year.
Benefit-Cost Ratio (BCR)
The final measure we will examine is the benefit-cost ratio (BCR). This measure tells us the ratio of the benefits generated by the investment to the cost of the investment. To calculate BCR, we take the income generated by the investment and divide it by the cost of the investment. In our example above, the BCR would be 2.5 ($5000 in income / $2000 in cost). As you would have noticed, we are not considering the time value of money in this example.
Summary
In summary, when evaluating a Six Sigma project, it's important to consider several financial measures to help make an informed decision. Some commonly used measures include return on investment, payback period, net present value, internal rate of return, and benefit-cost ratio.