Real life practices


Let’s look at the process of implementing an active noise reduction system to a production plant. We will go step by step through the decision-making process at the financial level. Presented model will be simplified and will only show the first look at the project from the value side.

Step 1 Getting familiar with the performance characteristics of the production system of the factory X in terms of production and economic.

Each of the production processes has its own performance and characteristics, which translates into production results. In order for these processes to be measurable, they should be previously measured with metrics. On the basis of knowledge about the process and data which are determined using these measures, it is worth determining the level of process efficiency in two perspectives; production and economic. The first one will determine the level of productivity of the human-machine team, while the second will look at the performance problem in the perspective of profits or losses. Very often at this stage many factors that determine the efficiency of specific processes are being changed. It is worth to prepare reports on the state of production efficiency at this time.

Step 2 Technical and economic assumptions

The basis for determining the assumptions will be a report on the performance characteristics of the process. Thanks to it, we will be able to determine the least and the most efficient processes. The purpose of this assumptions is to set current goals for people who are in charge of specific processes. In the technical area, the assumptions most often relate to the optimization of production for most difficult processes, while in the economic area, attention should be focused on cost optimization which is the result of the maintenance cost accounts under management accounting. The technical and economic assumptions are the basis for the implementation of innovative solutions because they allow changes that should be made to make the process profitable.

Step 3 Incomes and investments outlays forecast

We should proceed to the prognostic test. Its aim is to show what distribution in time incomes and capital expenditures will have, those which were incurred for both implementation and later operation of the system in industrial conditions.

 

Analyzing the results above, we come into conclusion that the implementation of the active noise reduction system should be able to stabilize fluctuations in income over time.

Based on the analysis of previous periods, trend clearly shows the cyclicality and the linear tendency to have both increased and decreased. Stabilization goes along with the implementation of the described system. It can be associated with a constant additional increase in production capacity related to the implementation of the system to the production process. Hence the conclusion, that the improvement of production efficiency results in stabilizing income over time.

On the other hand, the level of expenditures is higher if the system is implemented. Despite it, this level has a downward trend. It may be related to the fact that such an innovative system adapts in real time to the ambient conditions. The reason for the higher level of expenditures are the costs of device maintenance, but this is unavoidable in case when we introduce further assets for use. Based on this data, we are able to calculate the basic measures of investment profitability. At this point, we are also carrying out introductory calculations, aimed at bringing income and expenditure to one moment in time. This procedure will allow you to calculate the discount rate and allow you to forecast future investments periods.

Step 4 Assessment of investment effectiveness with static methods

We calculate the investment profitability measures to see if investing our capital will bring us adequate and satisfying profits. Investing in such solutions is necessary, when we have a significant competition. Of course, the decisions made can tip the scales in two ways. Increasing profits, lowering costs and a stronger position on the market are some of the many positive aspects of investing. There is also the other side of the coin. Bad decisions, based mostly on unprepared analyses, or even the lack of such analyses are often associated with lost profits, often we generate alternative costs. Even more often reckless investment moves cause the company’s value to decline.

In static terms, there come the following indicators:
  • Annual rate of return
  • Accounting rate of return
  • Simple period of return

In the discussed example i.e. the implementation of the active noise reduction system, we are talking about the annual and accounting rate of return at the level of about 200% of the value. The payback period fluctuates at less than a year. It is connected with a large disproportion between the expenditures incurred at the stage of implementation of the system and the stage of benefits of its implementation. However, in order to be sure about an implementation, the most recently updated net value (NPV) and internal rate of return (IRR) should be calculated. They will determine the efficiency of investments over the subsequent periods under examination.

Step 5 Assessment of investment effectiveness with dynamic methods In this part, it should be considered how effective the investment is and how it affects its future value. Therefore, the following indicators will be calculated:
  • NPV (Net Present Value)
  • NPVR (Net Present Value Ratio)
  • IRR (Internal Rate of Return)

The calculation of the updated net value (NPV) will indicate the benefits that the system implementation can generate. The results for active noise reduction in a specific case may reach approximately PLN 100,000. Internal Rate of Return (IRR) directly examines the level of profitability and the risk of an investment project. To express this indicator, the current value and the future value of expenditures should be made dependent on time dynamically. In case of this example, it fluctuates around 130%.

Taking into account both static and dynamic methods, we can be sure that  investment in the implementation of the Active Noise Control system is profitable at every stage. That is because of the short payback period of the investment, which fluctuates within one year, the high NPV rate and the high level of the discounted rate of return. The management’s decision to implement the system turns out to be accurate. They can increase their income by engaging the ANC system with small funds by taking advantage of economies of scale. This is also due to the fact that the production system is very efficient and can be easily improved.


Is it worth to make preliminary calculations of investment profitability?


The answer is yes. They help in decision-making processes. They are the first information for decision-makers and help them with initial selection of profitable and unprofitable investments. At the moment, the management is able to determine the projected profitability that they are able to generate at the operating level of the business. Responding to the loss of productivity, the bosses are able to bring back some sources of income and react to potential technological novelties. The preliminary assessment of profitability is a helpful tool in making accurate and objective decisions.