Business Case Analysis -
What a Project Manager should know: Part 3
In part 2 of this article we looked at the various components of the Business Case that should be considered. In this part we dive into the various aspects of Business Case costing, and highlight important considerations.
When is a savings not a savings: Cost transfers and cost avoidance or “there ain’t no such thing as a free lunch”(tanstaafl)
Every project manager should have the word tanstaafl pinned to the wall in front of them as they are preparing their business case as a reminder that if a cost is not completely eliminated it goes somewhere. The following are three brief examples of cost transfers. Several years ago, the rage in manufacturing was a concept called “Just in time” (J.I.T). It was a great cost cutting measure because a company significantly reduced its inventory and carrying costs — by transferring these costs to their suppliers. With J.I.T. a true cost reduction for all parties couldn’t be obtained until a firm instituted such things as EDI (Electronic Data Interchange), automated billings and piggybacked deliveries, which they many of them ultimately had to do to keep their vendors from raising prices to cover the costs the company shifted over to them.
A second example of a cost transfer is one seen frequently on proposals to convert from an existing mainframe system to a user supported client server system. The allocated cost of the mainframe system often serves as the only cost savings on the proposal without taking into account that unless the system being replaced will allow for the elimination of the mainframe and its support staff, mainframe operating costs will remain the same and will simply be reallocated to the other systems remaining on the mainframe. The overall impact of this system proposal is a net cost increase for the company.
The third example goes back to the earlier scenario of eliminating accounts payable by allowing receiving to authorise payment. Some portion of those costs were not really saved because the work simply moved from a centralised location to a decentralised location. When this happens, it may not be noticeable since the incremental additional work may be absorbed by displacing some lower priority assignment. Also based on actually seeing this concept implemented at a client, it is also very unclear how much work moved from an accounts payable clerk being paid a clerical wage to mid-level manager. The cost per unit of activity in most cases would have risen on a full cost basis but since management overtime is free, there was a direct savings to the bottom line.
Rule of Thumb: Make sure your system completely eliminates a cost and does not just transfer it. If a cost transfer is unavoidable make sure to include these cost as ongoing costs of the new system.
Cost Avoidance – On the scale of possible justifications for a system, cost avoidance is generally considered the weakest. The thought process appears to be that since the company is currently not incurring any of these costs it’s impossible to say they really will incur them in the future. The key to using cost avoidance as a justification is to do the right job quantifying the factors that would drive the increase in current cost. A system proposed in response to an impending regulatory change that would require increased record keeping would be an example of cost avoidance but in this instance, there is a clearly defined outside factor that is driving the increase in cost.
Rule of Thumb: Turn cost avoidance into cost savings where ever possible. If it isn’t possible make sure that there is a clearly definable cause driving the cost increase.
One time project costs
This is usually the most critical component of the business case for the project manager because it’s the most measurable. In fact at one Fortune 100 company the project managers have just been informed that their performance reviews will be based on their ability to stay within the financial targets defined in the business case for their project.
One-time costs may include the following major categories:
Period Expense- Development
- personnel costs (both internal and external personnel) for the life cycle of the project. Cost components for these charges consist of salaries and direct non-wage (training, supplies, travel, etc.). It also consists of benefits and square meterage charges for facilities.
- operating costs during system development, including computer processing time, network charges, space allocations, and lease or rental of specific equipment used in system design or development
Period Expense — Implementation
- start-up costs, such as disruption of business processes due to the conversion to the new system or new business processes; extra work hours required to compensate for lower productivity in the start-up phase. These expenses should be estimated to determine total project cost for the business case. In reality they are virtually impossible to track and should not be included in the projects operating budget.
- Restructuring Expense costs of reorganization toward the new business processes: job redesigns, hiring or reassigning people, developing new policies, developing and deploying new systems.
- start-up training or retraining costs.
- acquisition costs of package software including software, installation services, vendor training and support upgrades to other software components and documentation
- acquisition costs for equipment, including all hardware, software, operating systems, etc. that will become part of the system or that will be used to support the system development or training (for example, equipment for computing, data storage, communication, printing, scanning or sensing)
The meaning of period expenses and capital expenses should be fairly clear cut. Restructuring expenses though are a hybrid category that has become much more common recently. When a company is facing a major disruptive reorganisation that they feel will negatively impact operational performance for some period of time in the future (usually two to three years), they will often opt to establish a restructuring reserve by taking a onetime write-off to the income statement. This will give them an immediate tax advantage and will eliminate the long-term damage to the share price that several years of substandard operating profits would entail. The existence of such a reserve does not directly affect the overall cost shown in the business case, but it may have a strong impact on the makeup of individual cost components.
Rule of Thumb : If your company has a restructure reserve make sure you know the rules and comply with them. Actual project cost might be somewhat higher than under alternate sources of funding (often contract labour is eligible for reserve funding while employee labour is not) — but your odds of getting funding are tremendously higher.
In part 4 of this article we look relevant metrics and indicators of a Business Case.
Rules of Thumb Source: Donna Fitzgerald (Donna Fitgerald internet presentation)