Financial Evaluation

Six Sigma is about making money. It is about profitability, although improved quality and efficiency are immediate by-products. The financial benefits of six sigma projects are the measurements that create a link between philosophy and action. Financial benefits and associated risks are the factors used to evaluate, prioritize, select, and track all six sigma projects.

Cost-Benefit Analysis

Project cost-benefit analysis is a comparison to determine if a project will be (or was) worthwhile. The analysis is normally performed prior to implementation of project plans and is based on time-weighted estimates of costs and predicted value of benefits. The cost-benefit analysis is used as a management tool to determine if approval should be given for the project go-ahead. The actual data is analyzed from an accounting perspective after the project is completed to quantify the financial impact of the project.

The sequence for performing a cost-benefit analysis is:

• Identify the project benefits

• Express the benefits in dollar amounts, timing, and duration

• identify the project cost factors including materials, labor, and resources

• Estimate the cost factors in terms of dollar amounts and expenditure period

• Calculate the net project gain (loss)

• Decide if the project should be implemented (prior to starting)
  
  OR

• if the project was beneficial (after completion)

If the project is not beneficial using this analysis, but it is the management’s desire to implement the project, what changes in benefits and costs are possible to improve the cost-benefit calculation?

Return on Assets (ROA)

Return on Assets is equal to Net Income divided by Total Assets

Where the net income for a project is the expected earnings and total assets are the value of the assets applied to the project. Additionally, a calculation of the return on investment is widely used:

Return on Investment (ROI)

Return on Investment is equal to Net Income divided by Investments. Where: net income for a project is the expected earnings and investment is the value of the investment in the project.

Net Present Value

Net Present Value is equal to the summation of t is equal to zero ton, CFt divided by one plus r to the power of t. Where n is the number of periods, t is the time period, r is the per period cost of capital for the organization (also denoted as I if the annual interest rate is used) and CF, is the cash flow in time period t.

Note that CF, cash flow in period zero is also denoted as the initial investment.

Payback Period Method

The payback period is the length of time necessary for the net cash benefits or inflows to equal the net costs or outflows. The payback method generally ignores the time value of money, although the calculations can be done taking this into account. The main advantage of the payback method is the simplicity of calculation. It is also useful for comparing projects on the basis of a quick return on investment. A disadvantage is that cash benefits and costs beyond the payback period are not included in the calculations.

Organizations using the payback period method will set cut-off criteria, such as 1, 1-1/2, or 2 years maximum for approval of projects. Uncertainty in future status and effects of projects, or rapidly changing markets and technology tend to reduce the maximum payback period accepted for project approval. if the calculated payback period is less than the organization’s maximum payback period, then the project will be approved. Thus, the Payback period is equal to Initial (& Incremental Investment) divided by Annual (or Monthly) Cash Flow.