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The proof of the benefit of a Lean Six Sigma team’s solution will be found in the measured change in the process performance. The calculation quantifies this impact.

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Calculating Business Benefit

The proof of the benefit of that the Lean Six Sigma team’s solution will be found in the measured change in the process performance.  The calculation quantifies this impact.

When to use

Traditionally, the cost-benefit calculations are done in the Define phase using estimated values for costs and benefits and then refined in the Control phase with the actual value.  The analysis can then be used by operational managers to budget and plan future costs and benefits.

Instructions

The cost-benefit analysis is the combination of all costs and all projected benefits.  The time-dependent costs and benefits should use the time period specified by the stakeholders.  If they did not specify one, I use one year for the time period on small projects and three years for larger projects that have capital assets being purchased. 

Payback Period

One common form of analysis is called the payback period where all of the costs and benefits are included in an equation with the time dependency for recurring costs and benefits. The equation is then solved for the time when enough benefits have accumulated to pay all the accumulated costs.   See below:

Proj Cost + Implementation Cost + (New Operations Cost * t) =

(Reduced CoQ + Gross Profit from new sales + Reduced Operations Costs) * t

Then solve for time (t). I normally use Payback Period with small projects where most of the project costs were the time of the Lean Six Sigma team members.

Net Present Value

The Net Present Value (NPV) is commonly used with large projects, especially those with the purchase of capital assets. The NPV calculation returns a value in the currency used for the calculations. To conduct an NPV calculation, the team must determine the costs and benefits due to the project activities in each fiscal year. The first year or two will have the project costs. The benefits start when the project ends and an annual estimate is made for the benefits for each year to be included in the NPV calculation. All total annual cash flow for all future years is discounted using a discount rate provided by Finance that is based on the organization’s cost of capital.  The stakeholders and Finance will determine the number of years to be used in NPV calculation. The discounted annual cash flows are summed together to get the total NPV for the project.  This calculation is an easy calculation for spreadsheet software. The key is to create the annual cash flows.


Hints & tips

  • If doing a payback calculation, make sure you use the same time units in all factors.
  • Make sure you translate all benefits into monetary terms.  Consider how the operators or process change behavior and monetize the change.
  • Make sure that in future years, you include cost savings in all operations, gross profit from additional sales, and any cost increases that would occur in operations.
  • If the product life cycle for a product is showing profit margin erosion, that effect should be included in the NPV annual cash flows.
  • The IRR method uses the NPV formula, but instead of fixing the discount rate and calculating a value, it sets the value to zero and determines the interest rate needed for that condition to occur.
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  • 00:05 Hi, I'm Ray Sheen.
  • 00:06 We've discussed the categories of cost and benefit, now let's look at
  • 00:10 the calculations, so we can determine if the project was worth the investment.
  • 00:15 Cost benefit analysis is a catch all term, that can be used for a number of different
  • 00:19 analytical approaches, all of them follow the same principle.
  • 00:23 Determine all the costs due to the project and
  • 00:26 all the benefits gained from the project,
  • 00:28 compare the two categories to determine if the benefits outweigh the costs.
  • 00:32 The different techniques used are different ways to account for
  • 00:36 the business environment.
  • 00:38 One of the major business issues that affect Lean Six Sigma projects,
  • 00:42 is that many of the costs and benefits are not a one time event, but
  • 00:46 rather they keep going on and on.
  • 00:48 If you add a new test, we have to pay for that test for
  • 00:51 every product that's made from now on.
  • 00:54 If we eliminate three steps and therefore reduce labour,
  • 00:57 that savings will be in effect as long as we are building the product.
  • 01:01 So for these types of costs and benefits, we have to determine a cost or
  • 01:05 benefit rate that is being applied over a period of time, and
  • 01:09 then we have to determine what is the time period that should be used.
  • 01:13 The time period selected will have a direct impact on the total amount of cost
  • 01:17 and benefit.
  • 01:18 For these types of cost and benefits, Normally, the stakeholders in finance will
  • 01:23 tell the project team how much time they can use in their calculations.
  • 01:27 In my experience on Lean Six Sigma projects, it's often about two years of
  • 01:32 costs and benefits that we can accumulate and use in our calculations.
  • 01:36 In fact, there are several techniques that are used with the accumulated costs and
  • 01:41 benefits to determine a value for the project, one technique is to just subtract
  • 01:45 the accumulated costs from the accumulated benefits.
  • 01:48 That is an easy calculation, however, it avoids the issue of the time value of
  • 01:53 money for a small project with immediate benefits and a short time horizon,
  • 01:58 it works really well.
  • 01:59 Another tech Is referred to as the payback period,
  • 02:02 this technique calculates how many weeks or months of benefit are needed to
  • 02:07 accumulate enough benefit to offset the accumulated costs.
  • 02:11 This is a very commonly used technique with Lean Six Sigma projects.
  • 02:15 However, large projects may take years to pay back and
  • 02:19 a more common technique with those is net present value known as NPV, or
  • 02:23 its first cousin, the internal rate of return known as IRR.
  • 02:27 I'll talk more about those techniques in a few minutes, but first,
  • 02:31 let's take a deeper look into payback period.
  • 02:34 As I stated, we accumulate the costs and the benefits over time and
  • 02:38 seek out an instant in time when they are equal.
  • 02:42 Some of the costs are one-time costs, such as project costs,
  • 02:45 of the Lean Six Sigma project and the solution implementation costs,
  • 02:49 such as buying new equipment or training operators.
  • 02:53 In many cases, there are new operational costs that did not exist before
  • 02:56 the solution was implemented.
  • 02:58 Things like new inspection instruments to calibrate or
  • 03:01 equipment with new maintenance to be done,
  • 03:03 these costs will be expressed as a formula with time as the variable.
  • 03:07 Most of the benefits will also be a formula with time as the variable,
  • 03:11 these include the cost of quality impacts of reduced scrap, reduced rework,
  • 03:16 reduced returns and repairs, this is estimated as a weekly or monthly benefit.
  • 03:21 And in some cases where the primary CTQs were due to external customers,
  • 03:25 there can even be benefits of increased sales, however, in those cases,
  • 03:29 make sure you're using the gross profit, not the entire revenue.
  • 03:33 You do need to subtract out the product cost for those new sales in order to get
  • 03:38 the gross profit ,and there may be benefits of shutting down a product
  • 03:42 line or facility that's no longer needed with the new process.
  • 03:47 As we look at those costs and benefits, we see that some of the factors were
  • 03:51 formulas with the variable of time in them.
  • 03:54 Set the costs equal to the benefits, and then solve for
  • 03:58 the value of time that makes those It's two equal, that's your payback period.
  • 04:03 Now let's discuss the net present value,
  • 04:06 we use this with large projects that have long-term impact.
  • 04:09 We recognize that a value in today's dollars is probably worth more than
  • 04:14 the same dollar amount a few years from now,
  • 04:17 that's due to things like inflation and the loss of use of that money over time,
  • 04:22 so we want to understand the long term value for the project.
  • 04:26 To do that we set up annual cash flow estimates, this show what the expenses and
  • 04:31 benefits will be due to the project in each of the years.
  • 04:34 In the first few years, there's usually project costs that are one time costs and
  • 04:39 after the project cost is complete, we start the benefits,
  • 04:42 which usually keep going on year after year.
  • 04:45 In fact, they may grow or they may shrink on a yearly basis.
  • 04:49 We sum up all the yearly costs and benefits to get a net value for that year,
  • 04:54 next we discount the future years to express them in terms of the equivalent
  • 05:00 value in time today's dollars, that discount rate is set by finance.
  • 05:05 Now, you may want to argue with them that based upon your particular project
  • 05:09 a different discount rate should be used.
  • 05:12 Feel free to do so, make your case, just understand you will lose.
  • 05:17 Finance sets that number and
  • 05:19 based upon what they've determined is the cost of capital.
  • 05:23 Now you add up the discounted cash flows for the number of years that finance and
  • 05:28 stakeholders will let you use in your calculation.
  • 05:32 The result is the net present value, a positive number says that you made money
  • 05:36 with the project, a negative number says you've lost money on the project.
  • 05:40 You can see in the formula that R is the net cash flow in then-year dollars for
  • 05:45 a particular year, and that value is divided by 1 plus the discount rate raised
  • 05:51 to the power of the number of years to get the net present value for that year.
  • 05:56 This provides a business-level perspective on the financial return of the project,
  • 06:01 this is often used to evaluate the goodness of the project.
  • 06:05 Also, the same formula can be used to find the internal rate of return.
  • 06:10 In that case, the cash flows in the then-year dollars are created in the same
  • 06:15 way, but in the IRR equation, we set the NPV value to zero and solve for
  • 06:20 the interest rate, that interest rate is our internal rate of return.
  • 06:25 These calculations provide a measure of the financial success or
  • 06:29 failure of a Lean Six Sigma project.

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