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Build Your Business Case, Part 1: Logic |
PUBLISHED SEPTEMBER 2015by Mark Rodgers, Principal, Peak Performance Business Group Having someone say Yes to your ideas, offers, and suggestions ranks among the greatest achievements in the business world. But persuasion requires intellectual heavy lifting, and part of that heavy lifting entails making a solid business case for what you’re proposing. In the process, you won’t just get the content you need to convince others. You will also learn more about your target and be better able to ensure that the proposal makes sense for both of you. A solid business case requires two primary building blocks: logic and emotion. The old saw “Logic makes you think, and emotion makes you act” has been around so long because it works. If you want to appeal to logic, you need quantifiable measurements, as explained in what follows. Advice about appealing to emotion will appear next month. Knowing the NumbersFinancial literacy is a must for building a compelling business case. You need to know how to read and understand the basics of an income statement, a cash flow statement, and a balance sheet. You also should appreciate that financial figures can be an interpretive art form. Imagine that you work for a biofriendly consumer products company that makes natural surface cleaners for use in kitchens. Now, imagine that you invested $100,000 in a marketing initiative that generated $1,000,000 in kitchen cleaner sales. Was your return $1 million, or was it $900,000? Or was it yet another number? Well, actually, the answer depends on who’s doing the math. Financial reporting and forecasting are open to interpretation, judgment, and approximation, as are generally accepted accounting principles (GAAPs). In this example, salespeople may claim a return of $1 million; the marketing team may argue the return is $900,000; and your accounting group may have other ideas. Even seemingly simple concepts such as revenue (sometimes called “sales revenue” or “gross revenue”) aren’t etched in stone. For example, revenue might be “recognized” (meaning “counted”) when the purchase order is signed, when the goods are delivered, when the invoice is sent, or when the money hits the company’s bank account. Much like social and corporate culture norms, financial norms must be determined and adhered to. More than likely, you won’t have sole responsibility for actually performing calculations for your company (that’s what financial analysts are for), but you should know how numbers are generated and what they mean so you can ask more insightful questions and use information to create more compelling quantitative cases for your persuasion priorities. As you build each case, consider as many benefits as you can: If your initiative could boost product market share in the Northeast by 8 percent, what might it do in other regions? Are there international implications? And don’t forget multiplicity. If your idea would increase employee efficiency, thereby saving the company dollars, make sure you apply that savings to as many people as appropriate. Are there tangential benefits? If you sell more of product A, will increased sales of product B follow? Then make sure you understand each of the concepts outlined below. Return vs. Return on Investment (ROI)What’s your initiative’s worth to the organization? What’s the ROI? By definition, ROI is always a ratio—some kind of “return” or “profit” divided by the investment that generated it. Many people think of the return portion of ROI as the ROI. This is technically incorrect but you don’t need to point that out; just understand that someone who claims the ROI is a particular dollar amount is talking about the return portion of the “return on investment.” The dollars returned calculation is pretty straightforward: How much did you invest, and how much did you receive in return? Let’s use our earlier example: You invested $100,000 in a marketing campaign, which generated $1 million in sales, or gross revenue. Gross revenue ($1 million) – marketing costs ($100,000) = dollars returned ($900,000). Simple, right? But we haven’t yet taken the costs of goods sold (CoGs) into consideration. The most obvious CoGs are wholesale costs required to produce or acquire a product, as well as sales commissions from selling that product. Your project may or may not have CoGs, depending on whether it’s a product or a service. But if CoGs are involved, it is imperative you include these costs in your calculations. So, assuming that our CoGs to produce and sell are $500,000: Gross Revenue – CoGS – Marketing Investment = Dollars Returned ($1 million –$500,000 – $100,000 = $400,000). The dollars returned in this example can be considered gross profit. If you want to appear reasonable, conservative, and responsible to senior management, use the gross profit number as the basis for your dollars returned. Now what about ROI? As mentioned, ROI by definition is always a ratio, demonstrating the quantitative relationship between two numbers. In our example, the project has a $400,000 return and a $100,000 investment. The most elegant way to write this is with a colon, 4:1. For ROI ratios, whatever you invest is typically simplified to 1. But the return can be shown in fractional amounts. So, if the marketing campaign cost $150,000 instead of $100,000, you would divide $400,000 by $150,000, find the quotient to be 2.666 and round up to the nearest tenth, making your ROI ratio 2.7:1. Expressing return as a percentage is even more common and, perhaps, even more persuasive. Using the same figures:
400 percent can seem much larger than 4:1. Obviously, you want a positive ROI number. Some companies specify ROI minimums for taking on a project. If your ROI number is negative, it’s no good for your organization, and you should reconsider. The challenge with return and ROI calculations is establishing what’s included and what isn’t on both the costs and the benefits sides of the equation. Do you calculate the hours spent by salaried employees on your initiative and include that as a cost? Do you attempt to quantify improved morale and represent that as a benefit? As with all measures, it’s valuable to consider every reasonable inclusion and exclusion. And as already stated, every company has different ways of looking at the numbers. One final note about return and ROI calculations: If you use them to forecast anticipated ROI, you may want to run a few different scenarios, such as these: What if sales are off by a particular percentage? What if the cost of goods sold is higher than anticipated? What if the product launch is delayed? Taking multiple obstacles into consideration will show others in your organization that you thought your proposal through. Payback PeriodAs its name suggests, a payback period is the length of time it takes an organization to recoup its costs on an initiative. Staying with our example of a biofriendly company, imagine that you want to obtain approval from your executive team to bring a new kind of ecofriendly paper towel to market. Internally dubbed the Owl Towel, it uses recycled materials and is more absorbent than others on the market, and you think it will do good things for both your company and the environment. Working with all the necessary parties, you’ve estimated that the cost of bringing this new product to market would be $1 million and that the Owl Towel’s yearly revenues will be $350,000 for at least the next four years. To determine the payback period, simply divide the investment ($1 million) by $350,000. This straightforward calculation tells you that your payback period on the Owl Towel will be 2.86 years. Because the payback calculation is useful, fast, and easy to communicate, it offers a solid way of looking at your initiative. But it does have some limitations. Why? Because $350,000 four years from now may not be worth what it is today. Here’s where the financial tool called Net Present Value comes in. Net Present Value (NPV)Net Present Value reflects what your multiyear project is worth in today’s dollars. It answers the question: What is this cash stream really worth to the organization? To understand NPV, you need to break the term into its component parts: “net” and “present value.” Subtract your initiative’s total outgoing cash flow from its total incoming cash flow to get the net. The “present value” part of this calculation (sometimes referred to as “PV”) enables decisions about longer-term initiatives on the theory that tomorrow’s money is worth less than today’s money, given the costs of capital, earning potential, inflation, and so forth. To calculate Net Present Value, start by using what is known as a “discount rate.” This is the rate at which future earnings for your project are, well, discounted. Unless you are a financial analyst, you’re going to need input from a trusted colleague in the company’s finance group on what an appropriate discount rate should be. Let’s look at NPV by building our Owl Towel financial case for the executive team: We know it will cost $1 million to bring it to market, and we conservatively estimate that we’ll realize a payback of $350,000 per year. The suggested discount rate is 8 percent (0.08). I’m going to walk you through what some might call old-school calculations to help you completely understand them. Then we can talk shortcuts. First, we use our discount rate to find a discount “factor” for determining the current value of the money realized by your new Owl Towel. The equation to determine your discount factor is: 1 ÷ (1 + r)t with r representing your discount rate, and t representing the number of years. For example, our discount factor equation for the first year of our Owl Towel project would be 1÷ (1+ .08)1—i.e., 1 divided by 1.08, which equals .9259259 (or .926 rounded to the nearest thousandth—which is accurate enough for this illustration). So to find out the Present Value of our first year’s Owl Towel earnings, we multiply the cash flow of $350,000 by .926 to discover that the PV of Year One earnings would be worth $324,100. And, just so you get the hang of this, we’ll do one more. The calculation for the second year of our Owl Towel project would be 1 ÷ (1+.08)2. Since the superscript stating 1.08 to the second power is mathematical shorthand for 1.08 × 1.08, you get 1.1664. Divide 1 by 1.1664 to get .857. This is your discount factor for Year Two. Multiply $350,000 by .857, and you’ll see that the second-year Owl Towel cash flow is worth $299,950. You could continue using this formula for each year of your forecast. See how quickly the value drops? This is why Net Present Value is such an important calculation. Of course, doing the math to determine your discount factor is considered antiquated, but you should know how it works. Today, a quick Internet search for “Discount Factor Tables” or “Net Present Value Tables” offers an easy way to obtain the discount factors you’ll need. Using them, you would find that the total Present Value of the Owl Towel project is projected to be $1,159,200. Subtract today’s $1 million investment, and the NPV of the Owl Towel proposal is actually $159,200. That is what your project is worth in terms of today’s dollars. As you can see, the Net Present Value is a more accurate indicator of Return on Investment than payback calculation is. In the example that ignored the time value of money, we forecast the payback period to be slightly less than three years. Now we know from using NPV that we won’t see payback on the project until sometime between Years Three and Four. Depending on the threshold of acceptable payback for your company, you may have to do more work to build your case. Another term you should be familiar with is hurdle rate, which is the minimum return your company will accept on an initiative before investing in it. Sometimes the discount rate and the hurdle rate are the same number. Your credibility will skyrocket when you can demonstrate to others that you understand these powerful financial concepts and factor them into your business cases. Breakeven CalculationsThis is another term you need to understand. The breakeven calculation answers the question, “How many units do we need to sell to recoup our investment?” For example, say you want to convince the buyer of a large retail chain to carry Owl Towels and you intend to offer it 100 pallets of the towels at a special price of $14,000 each. You know that it will cost the chain $1,000 in expenses (shipping, stocking, commissions) to sell the towels on each pallet, and a single pallet of Owl Towels will retail for $20,000. How many pallets will the chain need to sell in order to break even? To find out, first calculate your buyer’s initial investment and then divide that by the gross revenue (i.e., total cash in-flow) of one unit sold at full retail. Your buyer’s initial investment, therefore, is calculated thus: Price Per Pallet × Number of Pallets = Initial Investment ($14,000 × 100 = $1.4 million). This is referred to as a fixed cost. Next, find what is referred to as a “contribution margin.” How many dollars will your buyer have left after selling your product? If this retailer sold a pallet of Owl Towels for $20,000 and had $1,000 of expenses, the per-pallet contribution margin would be $19,000. Finally, divide that $1.4 million fixed cost by the $19,000 contribution margin to determine the breakeven point for this opportunity—73.68 pallets, or, said more simply, 74 pallets. Breakeven calculations are valuable because they can help keep an organization headed toward a recognizable goal. And they are a favorite with sales and marketing teams because they simplify the objective and act as a powerful persuader; everything after the breakeven point is profit. What It All MeansIf you learn the above measures and can use them to build a business case for any initiative, you’ll be in the 90th percentile for global business acumen. Business today is all about becoming smarter, faster. And financial literacy is essential. If you want to be taken seriously, you’ll want to speak the financial language of your organization. That being said, never position yourself as something you are not. If you are not a financial expert, do not purport to be one. It is perfectly okay (in fact, it is encouraged) to say such things as, “I’m no financial expert, and we should certainly have the finance guys review these numbers. But my back-of-the-envelope calculations tell me . . . ” Better yet, establish relationships with your colleagues in the finance department and swing by their offices to see what they think. They may educate you about another measure you might use, the Internal Rate of Return, which is related to Net Present Value, and answers the question, What rate of return will the organization receive on this project? (The resulting number can be used internally to compare projects and make informed decisions, such as whether your case is strong enough to convince the organization to say Yes.) In any event, you can honestly say, “You’re the experts. Tell me what you think about this initiative from a numbers perspective.” Then invite them to your next meeting. Mark Rodgers is a principal partner of the Peak Performance Business Group, which helps clients improve their ability to persuade. He has conducted more than 1,500 sales and persuasion workshops. This article is derived from his book Persuasion Equation: The Subtle Science of Getting Your Way, published by AMACOM Books, a Division of the American Management Association; © 2015 Mark Rodgers. All rights reserved. To learn more: amacombooks.org; PersuasionMatters.com. |