A solutions selection matrix is exceptionally effective at finding the best potential solutions for implementation when teams involve the right people in the process. Teams should be ready to produce a cost benefit analysis because project champions and leadership councils frequently request more information about the costs and benefits anticipated for a solution. After the measure and analyze stages, Six Sigma Belters often have many of the elements necessary for such an analysis. However, teams could also collaborate with accounting, finance, or business planning departments to obtain the required financial information to establish the cost benefit analysis
Cost benefit analysis compares the costs of putting a solution into practice with the predicted financial gains from the solution. The cost of a solution’s implementation also takes into account any losses brought on by disruption, as well as costs for developing or purchasing software, purchasing equipment, extending or renovating buildings, recruiting more people, paying for training, and buying additional supplies. Examples of advantages include a rise in product margin, a surge in revenue, a reduction in costs or avoidance of costs, and intangible benefits like a rise in employee morale or customer retention.
Six Sigma teams typically aren’t equipped to undertake in-depth cost benefit analyses like those that a qualified accountant may conduct. However, they can understand cost benefit correlations using the payback method of accounting. This is the easiest way to conduct such an analysis and gives leadership an idea of how long it will take for a project to “pay off.”
Payback, or Pay Off, Analysis
Six Sigma teams need to know the project’s estimated cost and the projected annual financial gain to perform a payback analysis. Keep in mind that economic benefits go beyond simply higher revenue. Each year, benefits can be attributed to cost reductions, gaining new clients, or reducing client loss. The team also needs to be aware of an improvement’s yearly projected running costs.
The formula for this analysis is:
(Cost of implementing solution)/(Annual financial benefits-annual costs)
If a project costs RM50,000 to implement and RM2,000 per year in extra labour, and the team expects the project to generate RM15,000 in financial benefits each year, then the calculation is:
Or approximately 3.84 years until the project pays for itself.
Organizational leadership naturally seek payback calculations that are as quick as feasible. However, if the solution will address a significant issue or provide the groundwork for outstanding success in the future, a longer payback time doesn’t automatically rule it out.
Net Present Value
The Net-Present-Value, or NPV, is a more thorough method of cost benefit analysis. Because future cash flow will be less valuable than present cash flow due to inflation and other economic reasons, the NPV adjusts benefits and costs over time. Expected returns, interest rates, or inflation rates can all be used to compute the discount rate for different endeavours. Corporate finance departments can frequently give Six Sigma teams the discount rate the organization uses for NPV. Below is a straightforward NPV model.
In this model, the team invested RM50,000 in implementing a solution and anticipates RM2,000 in annual labour costs related to the solution. For the first two years, the solution’s estimated benefits are documented; for the third year, all benefits and expenses are tallied. The final amount in the bottom right cell is RM2,850 after the NPV is reduced by 5%. This project meets the objective of a positive NPV.
Hence, the Six Sigma Belters can use either the Pay Off analysis or NPV method in justifying the solutions that will be implemented in the project. However, as highlighted in the article Cost of Poor Quality, the improvement team must use the cost of poor quality to establish a good project budgeting.
Learn how to strategize and implement Lean Six Sigma in your organization with our signature Lean Six Sigma courses with our experienced consultant’s guide.