From the course: Supply Chain and Operations Management Tips

Calculate payback period and NPV

- Operations managers are constantly evaluating projects to improve their supply chain, and before you invest in a project you want to know two things, how long will it take to earn your money back and how much money will it make you in the long run. In this video, we'll look at two closely-related financial calculations that help you answer those questions, the pay-back period and the net present value. To give us an example, let's consider whether to buy a piece of equipment that will take a year to install and will last for four years. We'll need to pay $100,000 at the end of the first year but then we expect to generate annual benefits of $45,000. The benefits minus the investments each year equal the cashflow. Money loses value every year, in part because of inflation, so you need to reduce or discount the value of future cashflows to determine their equivalent value in today's dollars. This gives you the net present value or NPV. The formula for finding the NPV is kind of complicated, but the good news is that it's built into Excel and that makes it easy to do this calculation. For our project, let's use a discount rate of 5%. We said that we'll need to spend $100,000 at the end of Year 1. Because that's a year in the future, it gets discounted by 5%. In other words, $100,000 a year from now is equivalent to $95,238 at the present moment. It's sometimes easier to understand NPV if you turn that around and say $95,238 today will be worth $100,000 in a year. As you look at the discounted cashflows, notice that the discounting compounds each year, so even though you're still earning $45,000, the value of that cashflow in today's dollars get lower and lower the further into the future you go. Once we've calculated the discounted cashflows, we can add them up to find our accumulated discounted cashflow. In Years 1 through 3, you see that the accumulated discounted cashflow is still negative, but in Year 4 it becomes positive, which means we'll break even on the investment we made. In other words, this project has a four-year payback period. If we plot the accumulated discounted cashflow on a graph, the payback period occurs when the line crosses above zero, which is almost halfway into the fourth year of this project. For a closer look at using Excel to calculate an NPV, check out Curt Frye's course Financial Functions in Depth. Supply chain projects can have lots of benefits, from reducing costs to increasing revenues to avoiding future liabilities. The important thing to understand is that a shorter payback period and a higher NPV will make any investment more attractive. Translating operational benefits into financial metrics will help you be more successful as an operations manager and help you excel as a true supply chain leader.

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