Lousy ideas sneak through approval processes by hiding in the folds of great ideas.
Internal Rate of Return (IRR) and Return On Investment (ROI) are essentially averages – and averages are wonderful hiding places for mediocre and subpar ideas.
A business urgently needed to improve product quality. Technological advances were creating an ever-widening gap between their competitors’ specifications and their own. Price reductions and eroded profit margins were looming if they couldn’t bring their quality up to a competitive standard.
The $12 million proposal promised a grocery list of benefits, minimal risks, and a 22% return. It appeared destined to breeze through the approval process… until we took a scalpel to the valuation and carefully dissected the project into individual parts.
When the team was asked the question: “What’s the least expensive way to solve just the quality issue?” they had a brilliant, out-of-the-box solution that cost only $4 million, protected margins, and generated a 60% return.
But as so often happens, an enthusiastic attitude of “while we’re messing around in there…” had attracted additional nice-to-have ideas. It wasn’t obvious to the project team that these secondary components generated breakeven or below cost of capital returns. This fact was obscured by IRR’s averaging effect.
Viewed as a bundle, that 22% return seemed fine. Incrementally, it represented more than $8 million in ideas that sounded good but generated mediocre to below cost of capital returns – slackers lurking behind very high returning ideas.
When those slacker components were yanked from the project scope, $8 million was freed up for more worthy projects elsewhere in the business.
Hunting For Slackers
It is imperative to apply effective valuation techniques. Only then can decision-makers be confident that slacker components are scrubbed from proposals. At a minimum:
- Teams must answer the question: “What’s the absolute minimum spending that can solve the core problem or opportunity?” In the case related above, $4 million would solve the quality issue.
- Apply analytical techniques that use the lowest costs solutions as a base, then scrutinize the incremental returns of more expensive project alternatives. When properly administered, slacker components (that hidden waste) stand out like sore thumbs.
The rewards for this discipline and diligence are higher returns on projects as well as more capital remaining for all the other great ideas for growing profits. In the case of the example above, we enjoyed an $8 million saving that was redirected to support other priorities.
© 2012 Verax Point Consulting, LLC