Understanding Key Financial Management Terms
Part two of a three-part column on financial management
Many happy returns
Two key concepts are crucial to understand for managers starting the process of making a financial case for a project or purchase.
ROI is a financial calculation that evaluates the consequences of a project in terms of the magnitude of the cash outflow versus the time it takes to break even or achieve the expected returns. The calculation is simply the initial investment divided by the initial investment plus the expected return. The break-even point can be estimated to be some time before returns are realized.
Internal rate of return (IRR) is a measure used when projecting budgeting for a capital project and the profitability of the potential investment. IRR is a discount rate that makes the net present value (NPV) of all cash flows from the capital expenditure equal to zero.
Financial types in organizations need a sense of security when considering any large-scale project. For that reason, it is essential for managers to include as much detail, supporting documentation, and analysis as possible in proposals.
Managers should use both of these calculations as a means to measure a proposal’s risk and return. Incorporating benchmarks, milestones, and timelines ensures that the project is trending as expected and that no surprises are hiding around the corner.
A long, cost-effective life
Life-cycle costing (LCC) identifies the most economical means of financing capital projects for the long-term expense of owning and operating a building. One recent study found that 15 percent of the total cost of ownership is procurement or acquisition. Another 45 percent is related to energy costs, 35 percent goes for maintenance, and 5 percent is classified as “other.”
When it comes to buildings and grounds projects, the numbers change slightly. The initial cost represents an average of 50 percent of the total cost, energy costs are 38 percent, maintenance is 10 percent, and “other” is 2 percent.
Why do so few organizations understand life-cycle cost analysis (LCCA) or apply it when a significant percentage of the costs are wrapped up in energy and maintenance expenses?
When managers consider this question, they consistently cite two reasons for not using LCCA: It is too complicated, and they are not sure how to calculate it. Simply put, LCCA is used when considering several alternatives to appropriately select the most cost-effective option that would yield the greatest benefit at the lowest total cost over its useful life.
Managers can easily and quickly find many examples on the internet of calculating LCC, as well as available software to help with the calculation. They can research the options and choose the tool that will best meet the needs of their organizations’ financial types.