Value Management for the Chemical Companies (Part 4) – NPV & IRR Estimation
Ola, boa tarde!
That is Part 4 of the blog article series I would like to describe the Value Management Approach for Chemical companies.
- The Part 1 with common overview of the approach is here: https://blogs.sap.com/2022/10/24/value-management-approach-for-the-chemical-companies-part-1/
- The Part 2 with KPI list and baseline description is here: https://blogs.sap.com/2022/11/04/value-management-approach-for-the-chemical-companies-part-2/
- The Part 3 with explanations of expected benefits calculation and defining of the high-level roadmap is here: https://blogs.sap.com/2022/12/05/value-management-approach-for-the-chemical-companies-part-3-define-roadmap/
Today I will continue with the common approach and for doing this I should remind the process overview diagram.
In previous Part # 3 I explained the common approach of the estimation of the expected benefits value, and the high-level definition of the transformation roadmap based on previous analysis.
All these parts are necessary for upcoming steps – estimation of the transformation program returns in terms of ROI, NPV & IRR. In this Part 4 I want to explain the common approach how to estimate these values.
Estimate the program costs | Step 7
To start the evaluation of the investments returns, we need to estimate two cash flow streams: positive and negative. Positive means expected benefits in USD, and we calculated in Part 3. Negative means costs of program realization, and to make it lets look again at our program defined as the outcome of Step 6.
We require costs estimation for each program phase and workstream and these costs could be defined via document like “Request for Information” (or RFI) with price estimation. To initiate the RFI the Company Business Architecture team should prepare the high-level architecture, functional requirements, and any other required questionnaire documents.
To prepare these documents I recommend contacting the software vendor (SAP and/or others) or to independent consulting company to get the assistance from the Architecture and Value Experts.
Solution high-level architecture
The possible high-level architecture to build the SAP Solution for the Program and Value realization phases with the integrated Value Management approach might look like this:
With high-level architecture the RFI should contain also other parameters work cost estimation like:
- Business processes list,
- Functional requirements, including requirements to build:
- KPI data collection and monitoring solution,
- Solution for Personal KPI Assignment and Compensation for Executives and Mid-level Management responsible on these KPIs,
- Business Processes Monitoring & Insights Solution,
- Investments Projects Management Solution with Projects Outcomes Monitoring,
- Organizational scope,
- System deployment preferences (ex. Preferred Cloud Hyperscalers Provider),
- Integration scheme,
- Matrix with segregation of works,
- Desired Program Timing,
- Change Management,
- Post-live support,
- … and other requirements.
The detailed approach about RFI preparation is out of the scope of my blog article, but if you are interested you can contact your favourite consulting services partner for detailed explanation of the procedure and Services Expert Team will be happy to guide you through the process.
Request for Information Outcome
As a result of RFI you should be provided with the high-level estimation of costs in terms of future payments distributed by quarters and years. This distribution is important for Cash Flow estimation and subsequent NPV and ROI calculation.
The payments estimation might look like this table:
Important DISCLAIMER: amounts presented in this table are abstract for demonstration and calculations explanation only, these digits are not real and do not relate to any real costs of SAP software subscription, partners services, and / or any other costs. Please consider these digits only as the demo content for calculations explanation.
What is important in the table above:
- Time horizon is 5 years from the program initiation point,
- Costs will continue after go-live (at least cloud subscriptions),
- Different costs in different lines,
- Costs distributed by Quarters and Years
After we received the Costs Estimation and Distribution table, we can perform estimated calculation of the transformation program outcomes: NPV and IRR. This leads us to the Step 8.
Roles and responsibilities for the Step 7:
Step 7 should be performed by company’s Business Efficiency (BE) team with assistance and advisory of SAP Value Advisory team (SAP VA) and with participation and approval of business executives (CXO), and Software and Services providers (Service Partners and Cloud Hyperscalers).
Outcomes for the Step 7:
As the result we got the estimation of the program costs by time for the 5 years horizon.
Estimate the NPV and IRR | Step 8
Step 8 provides the valuable outcomes of all preliminary activities – the estimation of expected business effectiveness of the transformation program. It allows executives and board to make an informed decision and get a clear explanation why the transformation program should start now and what outcomes should be.
Of course, the digital transformation is not only about the calculated outcomes. It´s also about future perspective, changing business models, adoption and overcoming to new challenges and getting all the best using new trends. But “good old things” like EBIT margin still matter and make sense because it can be measured “in digits” objectively.
Let´s look again at the data we have collected already:
In Step 4 (described in Part 3) the expected outcomes have been estimated – by years, based on example of the one KPI (DII MRO). In real estimations most of KPIs and their outcomes should be considered, but for explanation illustrative example I use that one KPI only.
I will provide the expected outcomes table here once again with highlighted outcomes by years for the whole company:
Estimated spends by year have been provided already in this blog article – Picture 4 in Step 7.
There are two important constants: Revenue Tax Rate and Cost of Capital. These parameters may vary for different countries and regions and even companies, for our example I take following values:
- Revenue Tax = 20%,
- Cost of Capital = 5%,
Calculation overview table
I would like to start the explanation of the overall calculation logic from the following overview table:
The most important task of the table is to compile all financial data in one timely (early) dimension. It´s important because costs or spends are started earlier (in 2022, lines # 4 … 13) than we expect the benefits (in 2024, line #3), and the program outcomes should be calculated considering this time lag.
Now let´s look at the table on Picture 6 deeper.
Details section of the Calculation overview table (lines 0 – 12)
- Line 0
- Calculation parameters (Revenue Tax, Cost of Capital) which are required and be used for the calculation logic.
- Line 1
- Number of period (year), starting from 0. Period #0 means current year when program starts. # Of period also required for the following calculations.
- Line 2
- Calendar Year
- Line 3
- Total expected benefits for the respective year, which have been taken from the table on Picture 5
- Line 5
- (OPEX) cost of Cloud Subscription Services for each year (all digits and values here and below are not related to the real values and presented for example explanation logic only) – provided by cloud software vendor
- Line 6
- (CAPEX) cost of Implementation Services for the program realisation – provided by service partner
- Line 7
- (CAPEX) Depreciation of intangible asset – business management solution created as a result of implementation services provided (revenue tax rate 20% in our example from the summary if intangible asset value of previous year)
- Line 8
- (OPEX) cost of Hyperscalers’ service provider for the cloud data centre for cloud software deployment
- Line 9
- (CAPEX) Cost of additional hardware required to the program realization – in our example there are mobile devices for maintenance and warehouse workers
- Line 10
- (CAPEX) Depreciation of tangible assets – mobile devices
- Line 11
- (OPEX) cost of additional services for hardware (network infrastructure, etc)
- Line 12
- (OPEX) cost of internal employees involved into program realization for part or full time
Summaries section of the Calculation overview table (lines 13 – 15)
- Line 13
- Total costs for the year – sum of lines from 5 to 12, with negative sign
- Line 14
- Net cash flow before revenue tax for the year – line 3 plus line 13 (red where negative)
- Line 15
- Net cash flow after revenue tax for the year – line 14 value for the respective year with decreased revenue tax (minus 20% from the Line 14 value) where Line 14 value for the year is positive
Results Section of the Calculation overview table (lines 16 – 18)
- Line 16
- Net Present Value (NPV) on the respective year.
This important line should be explained in detail. The NPV mathematically reflects on the economic idea “Cash today more valuable than cash tomorrow”, so the calculation shows you the decreasing the value of your cash assets for future years. Cash is losing its future value yearly for % of the cost of capital, and that value decreasing is described via formula:
Number # of the Year starts from 0 (Line 1)
Example for the calculation of Value for the Year 2024 in Line 17:
NPV(2024) = 4 915 607 / (1 + 0.05)2 = 4 458 601
Sum on the latest year (2026 in our example) shows the total expected monetized effect on the respective year in currency.
- Line 17
- Sum of Net Present Values (NPVs) on the respective year
- This summary calculation of all NPVs for each year (from start to current) shows the moment when the investment program will return all the investments (or when it generates positive Cash Flow in the future)
- This calculation shows when program provides positive effect
- Line 18
- Internal Rate of Investments (IRR) – the economic indicator which is showing the % value of the positive effect
- The IRR value can be calculated using the Excel embedded (=IRR) formula
- Line 15 (Cash Flow after revenue tax) should be used as parameter for the MS Excel formula =IRR(D15:H15)
Now, when all calculations done, I recommend representing it using diagrams. This visualisation be very useful for the program representation for board and business executives.
What data on the presented diagram?
- Vertical columns of the red colour – costs for the year (Line 13)
- Vertical columns of the blue colour – benefit for the year (Line 3)
- Green Line – Net Cash Flow (after revenue tax) by Year (Line 15), represents the Positive cash flow starting 2024
- Violet Line – total NPV for the year (Line 17), represents total effect of the program in money considering all costs and effects and cost of capital for the future value reflection. Point when Green Line crosses the 0 means moment of investments payback, after this moment company will get the positive impact on EBIT margin from the program realisation.
Investments project management for the future reference
All these investments project definitions with all calculations should be entered to the SAP Portfolio & Project Management (SAP PPM) during the Program Realization phase. This part is required for the upcoming project management and control activities when transformation program will be launched to production or live phase. Please refer Picture 3 for the recommended architecture.
There are two purposes why I used MS Excel for this blog.
First – for the illustration and your ability to repeat all these calculations easily. Second – I assume that program is not started and there is no working SAP PPM solution at the program initiation phase.
After the transformation program be realised and launched to production, I recommend performing all upcoming investments project calculation and management in SAP PPM.
After we calculated the project parameters and estimate the positive cash flow and NPF for the program we can make a reasonable decision about investments. That leads us to the Step 9 and further.
In this article which is Part 4 in the series I described all the required calculations to ensure that we may expect the positive outcome from the transformation program of the Chemical Company.
In the next article I will touch the program initiation with focus on lifetime value realization (actuals vs expected).
I hope these thoughts were interested to Chemicals community and not only. Please share your feedback or thoughts in a comment and I’d be happy to answer.
You might also be interested to read other Chemicals industry related topics here.
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