Applying ROI and Payback Principles

When you present a PIP to a Box Two manager, what questions can you anticipate?

• What is the net present value of this deal? To get the answer, the manager discounts your proposal's future cash flow projections at the rate of his company's cost of capital. The manager then calculates the cumulative value of these cash flows in terms of today's dollars in order to arrive at their present value. Finally, the manager subtracts the investment you are asking from the present value to learn the net value.

• What is the return on investment from this proposal? To get the answer, the manager multiples margin by expected turnover. If margins have been declining and you propose to improve them, you can leave the rate of turnover alone. If you cannot increase margins, the manager looks to see if you are proposing to increase turnover.

• What is the payback period on the investment that is being proposed in the PIP? Payback calculates the return of the investment, not the return on it. The manager wants payback as soon as possible in order to limit risk and usually calculates it by dividing the initial investment by the projected cash flows. Alternatively, each period's cash flows may be added together until the investment has been covered.

Customer managers use a business shorthand to appraise your PIPs quickly in order to qualify them for serious consideration. They use two criteria in rapid-fire order to make a quick study of the key things they have to know up front:

1. How much money can they most likely earn if they invest in your proposals?

2. How soon will they be able to realize it?

These two quick screens tell them if they are interested in going further with you, which means finding out how sure they can be about the "muchness" and "soonness" you are proposing.

Criteria of "How Much"

Customer managers use three criteria of muchness to determine how much they will get out of an investment in one of your PIPs:

1. Net present value (NPV) indicates the net value of all the future cash flows you will help them earn over the commercial life of your proposals, discounted back to their present value today so they have a common denominator of value. Bringing future values back to their present value, which discounts them, is made necessary by the time value of money. A dollar in the managers' hands today is always worth more than the value of the same dollar in their hands tomorrow. All managers have a minimum NPV standard for accepting proposals. You must PIP them above the standard to merit consideration.

   Net present value is the prime index of value. Consultative Selling is NPV selling. The improved profits that a consultative seller sells are improved NPV. Nothing else tells the seller or a customer the true value of what is going to be returned on the customer's investment.

   Net income by itself, representing cash flow, ignores the cost of the assets required to generate added revenues. Revenues by themselves ignore their costs. Return on investment by itself can inflate the perception of the return when the investment is comparatively small.

2. Return on investment (ROI) indicates the ratio of a customer's total profit improvement to the total investment required to generate it. In order to do a deal, ROI must equal or exceed a customer's minimum hurdle rate for incremental investments—generally two-thirds or more of the customer's cost of capital.

   ROI is a ratio of the dollar income generated by a PIP compared to the dollars invested. IRR (Internal Rate of Return) is the form of ROI that is most commonly used in PIPping. It shows the average annual percent return from each dollar invested over the commercial life of a PIP, adjusted for the impact of time.

3. Aftertax cash flows indicate a proposal's profit after subtracting for taxes and adding back depreciation and other noncash outlays. Cash flow is net income, commonly referred to as the bottom line. Cash flow is vital to every business. It can be even more important than profits because it pays for the continuity of ongoing operations. Depreciation is the reduction in asset value from use or obsolescence. It is based on periodically writing down a portion of an asset's original value so that it can contribute to the reduction of taxes, thereby influencing aftertax cash flow.

Criterion of "How Soon"

Customer managers use payback as their criterion of soonness to determine how soon they will be able to recover their investment in your proposals. The payback period is computed by dividing the total amount of an investment by the expected aftertax cash flows. Payback is an important determinant of the relative merits of competitive proposals. Once payback has occurred, the customer managers are "clean," removed from risk. From that point on, their interests focus on the net present value, accounting rate of return, and aftertax cash flows of your proposals.

Criteria of "How Sure"

The soonness of payback is a key indicator of how sure a customer manager can be of receiving the muchness and soonness of a PIP's proposal. The sooner the payback, the surer the deal. The major contributors to sureness beyond payback are your norms, which validate your track record, and your PIPs' Cost-Benefit Analyses, which prove your Prescriptions.

ROI is an analytic tool that has three qualities in its favor for your purposes: (1) it is a fair measurement of profit contribution; (2) it is helpful in directing attention to the most immediate profit opportunities, allowing them to be ranked on a priority basis; and (3) it is likely to be readily understood and accepted by financial managers as well as sales and marketing managers of your customer companies.

Figure 8-4 represents the two formulas for calculating ROI. The formulas relate the major operating and financial factors required in profitmaking to the rate used to measure the profit that is made: the rate of profit per unit sales in dollars; the rate of turnover of operating funds, the funds required to finance business operations; and the total investment of capital employed, including working assets, plants, and facilities.

Figure 8-4: Return-on-investment formulas.

The customer's sole economic justification for investing in your profit-improvement projects is to earn a superior rate of return on the funds invested. This truism must be interpreted in two ways. One is in terms of income gained. The other is in terms of costs avoided in obtaining investment funds, costs of retaining such funds, and costs suffered by denying their use for alternative, potentially more profitable, projects.

Diagnosis is the heart of consulting. Diagnostic techniques based on ROI are the heart of diagnosis. As Figure 8-4 shows, ROI is the product of the rate of operating profit expressed as a percentage of sales and the rate of turnover. Any time you want to improve a customer's ROI, you must first diagnose a problem in the customer's operating profit rate or an opportunity to increase the customer's turnover.

Part A of Figure 8-4 shows the ingredients of ROI expressed as turnover. If you examine each of those ingredients, you will find profit opportunities that can improve turnover. You can, for example, recommend a project to reduce your customer's receivables. This reduces the amount of funds invested in working assets, thus reducing the customer's total investment base. As a result, you can improve your customer's profit without increasing sales volume.

Part B shows options for diagnosing profit improvement if your objective is to increase operating profit. You can recommend a project to lower the customer's cost of sales. This reduces total costs and enables the customer to show an increase in operating profit.