Right Tools Aid Capital Planning
Part 2: More Advanced Tools Can Help Sell Projects
More Advanced Tools Can Help Sell Projects
By Christopher P. Hodges - May 2011 - Facilities Management
Since simple payback and ROI have limitations, the facility manager would be better served by using more comprehensive financial tools that are aligned with the financial community. Net present value (NPV) calculations, internal rate of return (IRR), and other financial tools have the ability to take a number of economic factors and risks into account. Tapping into these methods and assessing life-cycle will appeal to the financial managers in organizations.
In developing a comprehensive capital budget that incorporates sustainable initiatives, there are often several options to consider for each capital project. Financial analysis often compares the life-cycle costs of several options, using as the status quo or baseline case replacement with a system that is equivalent to the existing system. For example, a new energy-efficient chiller is compared to replacing an existing chiller with a comparable model of like size and efficiency. The like model is considered the baseline case. The more efficient option may cost more, but return greater energy savings and other efficiencies over its service life.
Most financial officers are more interested in present value in determining future financial obligations and returns. The reason for this is that it takes all of the variables and options and puts them in common terms that are more easily understood — today's dollars. A NPV calculation involves the sum of all future inflows and outflows of cash over the life of the asset. Most capital purchases in facilities do not generate cash inflows in and of themselves. However, when compared to the status quo or baseline case, there may be financial inflows that can be quantified. The most frequent cash inflow is the energy savings generated by a sustainable equipment purchase. The present value of the energy savings is considered a positive cash inflow to the life-cycle model. Although this is not real cash inflow — it is actually cost avoidance — it has a definite advantage over a less efficient option.
Picking the Winner
In financial terms, the option that has the most positive NPV is considered the winner (the most efficient use of cash). NPV calculations can also help take some of the forecasting risk out of a capital investment by taking into account the potential rise in energy, maintenance, and other costs such as the decrease in efficiency in equipment over its lifetime.
Another important tool in capital budgeting is the determination of internal rate of return, or IRR. Simply put, the IRR is that rate of return on a series of cash inflows and outflows that equal the present value of the investment — NPV equals zero. In other words, it's the discount rate that makes the investment pay for itself over its service life. All NPV and IRR calculations need to assume a discount rate in order to estimate what the present value of a series of future costs is. The discount rate is “cost of money” to an organization. In other words, it can be considered the rate of return an organization could expect to get out of an investment if it were to use its capital to make a different investment.
A simple way to think about this might be to think of what a homeowner would do when considering the purchase of energy efficient replacement windows. The internal rate of return for the window replacement project would be the amount of money the homeowner could make investing in mutual funds in lieu of buying those energy efficient windows. If the IRR of the window project was greater than the amount of money the homeowner could make by investing in the mutual funds, the window replacement project would “win” and the homeowner should make the investment.
Although the use of financial accounting tools is not always upper-most in the hearts and minds of facility managers, it is a skill that is even more in demand in difficult financial times. And it doesn't look like facility managers will be moving away from those difficult financial times anytime soon.
All of these financial tools are not as complicated as they seem, but they do take some practice to master. A facility manager's ability to use these tools and effectively communicate these to upper management can mean the difference between success and failure of sustainable capital projects.
Christopher P. Hodges, P.E., LEED AP, is a founding principal of Facility Engineering Associates, with over 30 years of experience in building operations and facility management. He is an IFMA Fellow and has authored numerous articles and guides on Sustainable Facility Management. Reach him at email@example.com.
Tell Your Story
Students of leadership have undoubtedly come across an article or two about the skill sets of some remarkable leaders who relied on their story-telling skills to motivate others to action. A good leader's ability to tell his or her story in a way that relates to the audience is an invaluable skill.
There is no reason that finance should be any different. In order to defend facility management budgets, gain the confidence of the organization, and make better business cases, facility managers should learn to tell the story of the risks and rewards of sustainability initiatives. The way to tell that story is by taking the audience through the entire life of the initiative, but doing so in financial terms.
In facility management language, that means outlining initial costs (design and construction — installation), operations and maintenance costs, potential operational savings (vs. the alternatives), and the cost to dispose of or replace. Once these things are known, facility managers can better relate the potential risks and rewards to the audience — greater energy savings, increased occupant satisfaction, and lower operational and maintenance costs.
— Christopher Hodges