Decisions, decisions. Organizations have many options when it comes to picking a project. But before they consider taking on one, they must determine if it’s profitable. The process of calculating profits may be dire for some, but it comes as no surprise that it’s an essential part of creating a business plan and executing it well.
What is Economic Value?
How much money would you be willing to pay for a product or service? In the center of that question lies economic value, which is the number of goods or currency that is measured as equal to the value of something else. In other words, the value being measured is compared to what a consumer is willing to give in return for a good or service. This trade doesn’t take the form of money only. People can measure various types of value that can either increase or decrease the pockets of those who invest in them.
Examples of Economic Value
Capital: Capital value is the durable good that is used to create products and services. The value of capital is based on the revenue that the capital can generate
Talent: This value is measured by the capabilities and talents of an individual. For example, a firm will value the skills of an executive who can consistently impress clients over one that underperforms. This could lead to a promotion or a salary increase in exchange for more services.
Brand Value: Brand value is measured by the brand’s worth through factors like recognition and brand image. Easily recognizable brands have the potential to generate future revenue.
Assets: These are economic resources, that like capital, have the potential to generate revenue or satisfy customer needs. If a family buys more property, for example, they have a higher chance to see monetary returns if they ever sold it again or rented it out.
Economic Cost vs. Economic Value
In everyday language, cost and value might be used interchangeably, but they represent different things. The cost of a product will always be understood from the purchaser’s point of view. It translates to the amount of money needed to purchase something (good or service).
When project managers discuss the economic value of a company’s rebrand, they are considering the usefulness and desirability of the decision before they invest money and time in completing the project. They will ask themselves: What is this worth to the company?
When it comes to that question of worth, understanding different ways to evaluate the economic value of a project will come in handy at any given phase of a business plan.
How to Calculate the Economic Value of a Project
So, first things first. How can you determine which project will guarantee a promising return? By assessing and comparing the project’s benefits and revenue.
This technique includes three major economic value models that help a team compare and determine what project will be the most profitable.
1. Payback Period Analysis
This is a primary method used to assess your project’s economic value. This method generally answers the question, “When will the original amount of the investment (money spent on the project) be recovered through benefits?” The result of this analysis will be the time it took to recover the total amount invested in the project.
This method typically measures monthly to yearly periods, so projects with a shorter payback period benefit the most from this economic model because they can see faster returns of investments. The calculation can look something like these:
Net cumulative benefits of project – Total cost of the project
Suppose a company invests $100,000 for a rebranding project, and the payback period is six months. This means the outcome of the project can bring that amount in six months. After that period, it will start to make a profit.
The downside is that payback period analysis ignores the time value of money (TVM), and it’s biased toward long-term projects. Yet, the model is easy to understand and can be adjusted when a team isn’t sure about the project’s future cash flows.
The model also favors liquidity (cash), and it’s a useful tool for companies that do business overseas and need to estimate when they’ll see a return of investment. This is especially true if they deal in countries with volatile political environments.
2. Net Present Value
The main question a financial analyst will likely raise when using the net present value (NPV) model is, “How much money could be saved (or made) by completing this project?” A net present value’s calculation is the following:
Present value of total benefits (revenue or income) – cost over many periods
Companies benefit from this model when they need to effectively evaluate projects and investments to determine the return. When a businesses’ analyst completes calculations and the net present value of the project is more significant than zero, the project will make a profit. Under this formula, only investments with positive NPV value should be prioritized.
Payback Period Analysis vs. Net Present Value:
- Present value is calculated by discounting the expected cash flow or cash amount to the present using a discount rate
- Net present value is the amount remaining after the present value has been offset by the amount of the initial project cost or investment
3. Internal Rate of Return
The internal rate of return (IRR) is like NPV, but its discount rate reduces the NPV of an investment to zero. So, it’s always negative because it represents an outflow or subtraction instead. IRR answers the question: “How quickly will the money invested in the project be returned?” This model is used to compare projects that have different lifecycles or amount of required money.
For example, the model could be used to compare the expected profitability of a two-year project that requires a $40,000 investment with that of a four-year project that requires a $90,000 investment. Projects with the highest IRR will ensure better benefits, respectively. Despite its usefulness, the model does make too many assumptions about reinvestments and capital distribution.
Examples of Economic Models
Although the three economic models can be used in conjunction, some companies will benefit from one specific model more if it answers their most pressing needs. Additionally, teams should also take into consideration the following factors:
- Different resources needed for each project
- Amount of funding (when these are limited)
- Other resource needs and company limits
The IRR model is mostly used, according to Yahoo Finance, to figure out which investment to fund. For example, a factory plant may use the IRR model to determine if it’s better to build a new plant or to renovate and expand an existing one.
On the other hand, the NPV is mostly used to determine how much an investment is worth since it considers all revenues, expenses and timing of cash flows. In other words, it considers the time value of money, which is a good approach for most investment process.
Although the models are generally used by corporations, people can take advantage of some of them. For example, while payback periods are useful in financial budgeting, businesses and homeowners can use them to calculate the return on energy-efficient technologies, as well as maintenance services.
Whether you own a business or need to understand financial processes due to your profession, learning about economic value models for project selection can position you to be a strategic decision-maker in your organization. If you’re interested in improving your management skills, learn more about Florida Tech’s MBA in Project Management 100% online.