Logistics investment opportunities - Assessment of program costs and benefits: an economic analysis

Economic analysis is a formal assessment of the costs and benefits associated with a program or project. The objective of economic analysis is to assess whether the capital outlays (costs) in the current period and the projected benefits for some investment opportunity net an economic advantage to the organization. The intent is to optimize investment decisions by picking worthy projects. In the corporate world, economic analysis is referred to as capital budgeting.

Economic Analysis and Logistics

Application of economic analysis to logistics is receiving increasing emphasis in professional circles. A major focus of recent workshops sponsored by the Logistics Institute at the Georgia Institute of Technology has been financial logistics and economic analysis of logistics investments. (1) Professional logistics organizations, such as the Council of Logistics Management, are now including tracks relating to the financial and economic dimensions of good logistics practices in their annual conferences. (2)

Sound economic analysis is critical because decisions relating to investment projects chart the course of an organization for many years and, in a sense, define the future. Certainly decisions involving a systems engineering tradeoff relating to a Logistics Support Analysis (LSA) task or decisions relating to investing in logistics facilities and other infrastructures, new logistics technologies, or logistics information systems will define a logistics system's efficiency, flexibility, and service levels for many years.

The Time Value of Money

Fundamental to a good economic analysis is the well-established principle that money has a time value. The time-value-of-money principle applies any economic analysis that involves time-distributed benefits or costs. For example, cost avoidance over 5 years in a pattern of, say, $20M-$10M-$10M-$10M-$10M, is clearly preferred over a pattern of $10M-$10M-$10M-$10M-$20M. The first pattern has greater value to the decision-making entity.

Does money have a time value in the public sector as it does in the private sector? Absolutely. In an economic context, funds extracted by the government from the private sector have alternative uses and foregone returns. These resources are not free. The foregone return is the cost of capital and reflective of the time value of money. The society providing funds to government is better served by an investment in system supportability, for example, that returns savings earlier as opposed to later.

In a Federal finance context, the Government's financial resources on the margin generally come from Treasury borrowing. In this context, the Treasury's borrowing rate is reflective of the time value of money. The time-value-of-money concept for the Government is officially recognized by Office and Management Budget (OMB) Circular A-94. (3)

Discounting and the Cost of Capital

Discounting is a technique for comparing, on an equivalent basis, alternative courses of action that have varying cost-and-benefit flows. The equivalent basis is the present value of these flows, discounted by the cost of capital.

The three dimensions to an economic analysis using present value are assessing the magnitudes of the relevant cost or benefit flows, determining the period over which these flows will occur, and selecting the appropriate discount rate.

For defense logistics analyses, the appropriate discount rate is the cost of capital to the Government, which is the Treasury's borrowing rate on marketable securities of comparable maturity to the period covered by the economic analysis. The discount rates to be used are published each January in Appendix C to OMB Circular A-94. (4) Appendix C issued in January 2003 lists a discount rate of 4.2 percent for a 10-year economic analysis period (nominal rate as opposed to a real rate.) (5)

Alternative Decision Rules for Economic Analysis

A logistics economic analysis typically is done in one of two contexts: accept or reject an investment opportunity (buy or not buy a piece of labor-saving equipment, pursue or not pursue a redesign for an additional increment of reliability, as examples) or choose among competing alternatives (for example, test stand A versus test stand B or contractor support versus organic support). In the first context, the structure of the decision rule is to compare the results of the economic analysis to a predetermined accept or reject decision threshold; in the second context, the preferred alternative among the mutually exclusive options is the one for which the decision analysis yields the highest value (or lowest value as appropriate) for the decision rule at hand.

This article surveys six alternative approaches to an economic analysis of logistics investment opportunities: payback, naive rate of return, average rate of return on investment, internal rate of return, net present value, and benefit and cost ratio. The nature, merits, and shortcomings of each of these approaches are considered, with particular emphasis on whether the time-value-of-money concept is incorporated in the decision rule.

Payback

Payback is the straightforward calculation of determining the number of years required to recover the initial investment. In the context of an independent investment decision, if procurement of a piece of support equipment for $200K saves $50K a year in labor costs, the payback period is 4 years. This payback period is compared to the predetermined decision threshold (say 5 years) to make the accept or reject decision.

In the context of mutually exclusive alternatives, the option with the fastest payback is selected.

Payback traditionally has been very popular in the defense community, as it has been in the corporate world. As a decision rule, payback has three distinct advantages. It is easy to calculate; it is widely understood by commanders and others in top management; and it answers an intuitively appealing question: if we approve this project, how long will our funds be at risk'?

However, payback has three consequential problems. First, the technique completely ignores returns after the payback period. Consider, for example, one piece of equipment, which, if purchased, avoids $50K in operating and support (O&S) costs over a 5-year useful life and an alternative piece of equipment with the same initial investment, which avoids $40K in O&S costs over an 8-year useful life. The payback rule will select the first piece of equipment even though a rational logistician would likely view the second option as better.

The implication of using payback is clear. The decision-maker, perhaps by default, is emphasizing short-run gains to the exclusion of long-term cost optimizing. (6)

Second, theory provides no basis for choosing an accept-or-reject threshold. For example, the Air Force Fast Payback Capital Investment Program of prior years required that a proposed purchase of investment equipment have a 2-year payback to qualify under the program. Why 2 years? Why not 1.9 years or 5 years? What is the logic? What is the theoretical underpinning for the decision threshold?

Third and most significant, payback ignores the cost of capital. The method disregards patterns in cost and benefit flows over time (the time-value-of-money concept). Under payback, a logistics investment that returns, say, $50M-$50M-$10M is not preferred to one that returns $10M-$50M-$50M.

Consider a decision rule that a logistics investment must return 4 to 1 within 5 years. (7) Such a rule is a payback, specifically a fourfold payback in 5 years. Why fourfold? Why 5 years? Why ignore returns beyond 5 years? Why is cost of capital disregarded? Such a rule is not sophisticated; rather, it is flawed. (8)

Naive Rate of Return

Decision analysts who employ payback often mirror the concept in terms of a rate of return. They speak of the reciprocal of the payback period as a percent per year rate of return. For example, a project with a 4-year payback would, under this concept, reflect a 25-percent-per-year rate of return.

Because the concept ignores the compounding effect of a true rate of return and does not consider returns beyond the payback period, the literature dubs the concept naive rate of return. (8) It has precisely the strengths and shortcomings of the payback method albeit embellished as a percent per year rate of return concept.

Average Return on Investment

Decreasing in popularity, but still encountered, is the concept of dividing the average return (cost avoidance or other dollarized benefit measure) net of depreciation expense over a project's life by the average investment [defined as (initial investment less salvage value)/2].

For example, a $20M investment with a 10-year life and zero salvage value yielding average cost avoidance, less depreciation expense of $1M per year, would yield an average return on investment (AROI) of 10 percent.

The advantages to average return on investment are that it is easy to understand, does not ignore any benefit periods in the project life, accounts for salvage value as applicable, and reflects a more plausible rate-of-return concept than does the naive rate of return.

The key criticism of average return on investment is that it, too, completely disregards the time value of money and, consequently, is a distortion of a true return-on-investment concept. Hence, a comparison of an AROI calculation to an interest rate or a yield on a financial instrument is not meaningful.

Internal Rate of Return

The internal rate of return (IRR) is a clear and precise concept: what interest rate equates the present value of the expected benefit flows over time to the initial investment?

The internal rate of return is found by solving the following equation for r:

[MATHEMATICAL EXPRESSION NOT REPRODUCIBLE IN ASCII]

The value of r, which causes the stream of benefits [B.sub.t] (from period 1 to period N), discounted by interest rate r to equal the initial investment (I), is defined as the internal rate of return; that is, the solution value of r in the equation above is the internal rate of return. (Alternatively, the I term could be subtracted from each side of the equation. Then, the r value, which causes the net present value (NPV)--the modified term on the left of the equal sign--to equal zero, would be the internal rate of return.)

Why is the particular value of r, which equates the investment cost of a project with the present value of its future benefits, of interest? It allows us to compare a project's internal rate of return to the Government's cost of capital and becomes the basis for accepting or rejecting the project.

Consider a process design change that requires a major investment in sustaining tooling that also reduces production costs over time. The interest rate that makes the discounted flow of expected cost reductions exactly equal to the new investment in tooling is the internal rate of return for that tooling investment. Suppose the analysis yields an internal rate of return of 8.7 percent. Is such an investment in new tooling warranted? If the Government's cost of capital is 4.2 percent, absolutely. Taxpayers are well-served by having their nonfree, Government-confiscated capital invested in a project that returns 8.7 percent when the cost of that capital is only 4.2 percent.

For competing alternatives to an investment requirement, the project with the highest internal rate of return is selected.

The internal rate of return is conceptually superior to the previous methods. It accounts for the time value of money, its decision rule ties to the cost of capital, and it does not ignore any periods in the project's life. Furthermore, the IRR result can be meaningfully interpreted.

Purported shortcomings of the internal rate of return include the potential for multiple and ambiguous solutions under certain circumstances. (10) Also, the method is computationally challenging without a computer since the IRR solution is found with trial and error.

Net Present Value

The net present value takes all the concepts and advantages of the internal rate of return and packages them into a more usable and, to most analysts, more intuitively appealing approach to decision analysis.

To use this approach, one identifies the cost of capital, discounts the benefit stream by the cost of capital, and subtracts the initial investment. The result is the net present value (net because the initial investment is subtracted, present value because the stream of benefits is discounted by the cost of capital).

The equation for the net present value is similar to the IRR equation:

[MATHEMATICAL EXPRESSION NOT REPRODUCIBLE IN ASCII]

where [B.sub.t] is the stream of benefits over N periods and I is the initial investment.

Here the discount rate, c, is given (it is the cost of capital), and the analyst solves for net present value. (In the case of the IRR equation previously reviewed, the net present value is set at zero, and the discount rate that satisfies the equality is sought as the internal rate of return.)

The decision rule for independent investments in this case is to accept any project that has a net present value greater than zero. For competing alternatives, accept the project with the highest net present value.

The advantages to the net present value as a decision rule in economic analysis include all the advantages given for the internal rate of return, plus the fact it is easier to apply than the internal rate of return since the solution is straightforward (not trial and error) and the potential for ambiguous solutions is nonexistent.

Why is the net present value intuitively appealing? The NPV calculation reflects the computed amount by which the proposed investment will add or subtract financial value to the decisionmaking entity.

Does the net present value, a decision rule of exceptional clarity in concept and intent that incorporates the cost of capital and considers all periods of the project's life, have any shortcomings? Three possibilities are sometimes mentioned:

* NPV solutions hang critically on the value assigned to cost of capital. For example, an investment opportunity that has cost avoidance accruing later than sooner is severely penalized if a comparatively high discount rate is used as the cost of capital. This begs the questions of how measurable is the true cost of capital and how accurate is the estimate of the cost of capital? (11)

* The net present value, being sophisticated, may not be applied easily by lower levels of the organization or as easily understood as payback at the very highest levels of the organization.

* The net present value, as a ranking criterion, can distort comparisons among competing projects of unequal investment size. (12)

The next decision rule addresses this latter concern.

Benefit and Cost Ratio

This ratio is simply the present value (net present value plus initial project investment cost) divided by the initial project investment cost:

Benefit and cost ratio =

PV/I = NPV + I/I

Clearly, if the definition of an acceptable project under the net present value is one with an NPV > 0, then an acceptable project must have a benefit and cost ratio > 1.0.

At first glance, one would think that the benefit and cost ratio is simply an alternative approach to expressing the very information of the NPV calculation. This is true for the pure accept or reject decision. However, this is not the case if the analyst is addressing alternative and mutually exclusive solutions to some logistics problem. In this latter context, the benefit and cost ratio is a more robust tool.

Consider two competing logistics investments. Project Alpha involves designing, acquiring, and implementing an automated storage-and-retrieval system to replace the existing materiel-handling system at a repair depot. Project Beta reflects minor upgrades to the existing materiel-handling system. Project Alpha has an initial cost of $1M and generates cost avoidance (a reduced labor force) of $300K per year for 10 years. Project Beta requires an investment of $100K, just 10 percent of the outlay required for Alpha, and generates a cost avoidance of $100K per year for 10 years. Neither project has a salvage value at the end of the 10-year period. Using a hypothetical cost of capital of 15 percent, the net present value for Alpha is $505.7K; for Beta, $401.9K.(13) Under the net present value, Alpha is the preferred project.

The problem here is that the $103.8K extra return on an incremental investment of $900K is only an 11.53-percent yield. But the cost of capital is 15 percent.

This problem only arises with regard to ranking mutually exclusive alternatives and only then when alternatives being compared are of a substantially different size in initial investment. It has no bearing on the legitimacy of the net present value as an accept or reject decision rule for an independent project.

The benefit and cost ratio incorporates all the advantages of the net present value as a decision rule and corrects the ranking problem for projects of unequal investment size.

In the case of this example, the benefit and cost ratios are as follow:

Alpha $1,505,700/$1M = 1.5057

Beta $501.9/$100K = 5.019

Whereas the net present value gives preference to Alpha, the benefit and cost ratio gives preference to Beta, the alternative with the higher ratio. Why is Beta preferred? The return on investment is much better on Beta, given the proportionate size of the investment.

Conclusions

Logistics decisions frequently focus on assessing alternative strategies or courses of action (reflected in LSA tasks, for example) or accepting or rejecting some investment opportunity. Both situations require more than cost accounting. These are investment decisions requiring economics analysis: upfront costs must be accessed against future benefits or cost avoidance. Decision rule candidates for an economic analysis of alternative actions include the traditional methods of payback, naive rate of return and average return on investment, and the sophisticated methods of internal rate of return, net present value, and benefit and cost ratio.

The traditional methods of economic analysis, particularly the payback rule in its various forms, continue to enjoy popularity in both industry and the Department of Defense (DoD) because these decision rules are simple and straightforward.(14) However, these methods are conceptually flawed because they fail to incorporate the time value of money.

Payback, in particular, is flawed on three fronts. It not only ignores the time value of money but also fails to account for returns after the payback period, and the accept or reject threshold (the required payback period) is arbitrarily set with no theoretical underpinnings.

Because money has a time value in the public sector, valid logistics decision rules in DoD must account for the Government's cost of capital by discounting time-distributed costs and benefits. The internal rate of return, net present value, and benefit and cost ratio incorporate the time-value of-money concept. Each of these approaches to economic analysis is conceptually valid and sophisticated, although the NPV rule is probably the most intuitively appealing and useful for the accept or reject decision for an independent logistics investment. When the decision is made in the context of mutually exclusive alternatives, the benefit and cost ratio is the superior decision rule.

Logisticians, in facing the need for an economic analysis, should be deliberate in incorporating an appropriate rule when time-distributed costs or benefits are involved.

Notes

(1.) [Online] Available: http://tli.isye.gatech.edu. The Logistics Institute, Georgia Institute of Technology also hosts seminars presented by FinListics Solutions, lnc, a training firm whose niche is measuring the impact of changes in logistics practices on overall financial performance and measuring and managing logistics capital investments in an organization.

(2.) [Online] Available: www.clml.org. Visit this site for information on the supply chain finance track of the Council of Logistics Management Annual Meeting in Chicago, Illinois, 21-24 Sep 03.

(3.) OMB Circular A-94, Guidelines and Discount Rates for Benefit-Cost Analysis of Federal Programs, 29 Oct 92. This policy is implemented in DoD Instruction 7041.3, Economic Analysis for Decisionmaking, 7 Nov 95.

(4.) [Online] Available:http://www.whitehouse.gov/ombIcirculars/a094/ a94_appx-c.html, Appendix C, updated each January.

(5.) The real rate of interest is the opportunity cost of capital independent of inflation. A nominal rate is the real rate, plus the rate of inflation. Each year, Appendix C of OMB Circular A-94 lists the real cost of capital to the Government and also lists the President's economic assumptions on inflation rates (Gross Domestic Product deflator) in the outyears. The addition of the inflation rate to the real rate defines the nominal rate. Decisionmakers in the Government, in making an economic analysis, are to use the real rate if costs and benefits of the project are expressed in constant dollars. If costs and benefits are measured in current (inflated) dollars, then the nominal discount rate should be used.

(6.) Some proponents of payback argue that the rule is employed by design to emphasize the importance of liquidity in an investment decision (fast return of the investment). See J. Fred Weston and Eugene F. Brigham, Essentials of Managerial Finance, 10th ed, Fort Worth, Texas: The Dryden Press, 1993.

(7.) "Select only LSA [Logistics Support Analysis] tasks that ... project at least a 4-1 savings to investment ratio over a 5-year period of operation...." This proposed decision rule appeared in Lt Col Samuel Craig, "Logistics Support Analysis," Program Manager, Vol XV, No 1, Jan-Feb 86, 9-18.

(8.) An improved approach to payback, discounted payback, has been developed. Under this scheme, the payback ratio is calculated with the present value of time-distributed net benefits in the numerator. This approach corrects for the criticism that payback ignores time value of money but the other shortcomings of payback remain. See Colin G. Hoskins and Glen A. Mumey, "Payback: A Maligned Method of Asset Ranking?" The Engineering Economist, Vol 25, Fall 1979, 53-65.

(9.) Anthony F. Herbst, Capital Budgeting, New York: Harper and Row, 1982.

(10.) Richard L. Meyer, "A Note on Capital Budgeting Techniques and the Reinvestment Rate," The Journal of Finance, Vol XXIV, Dec 75, 1251-1254.

(11.) Doing an economic analysis in Government requires the employment of discount rates as specified by OMB. Nonetheless, the analyst should be aware of the debate as to what constitutes the true cost of capital to the Government. For instance, many economists consider the inflation rates in the President's economic assumptions (which must be used to convert real rates to nominal rates if the analysis requires nominal rates) to be more political than realistic. Additionally, most economists would argue that the discount rate appropriate for public sector economic analyses should reflect the social cost of capital concept and not the Treasury's borrowing rate. See Stephen H. Russell, "Discounting in Defense Decision Analysis," The Air Force Comptroller, Vol 19, No 3, Jul 85, 4-9.

(12.) This shortcoming was first noted by C. G. Hoskins, "Benefit-Cost Ratios Versus Net Present Value: Revisited," Journal of Finance and Accounting, Vol 1, No 2, Summer 1974, 249-265.

(13.) This example is adapted from Herbst, 82-83.

(14.) An example of a continuing captivation with the payback concept is a 23 Oct 01 news release by CACI International, Arlington, Virginia, entitled "High Payback Opportunities for Future Logistics Investments: CACI Selected for $47M Multiple Award Contract with Naval Supply Systems Command.'"

Dr Russell, Lt Col, USAF, Retired, is permanent professor of logistics at the Goddard School of Business and Economics, Weber State University, Ogden, Utah. He is currently visiting professor of economics, Brigham Young University-Hawaii.

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