You’ve outlined the retrofit project, discussed the benefits, showed them before-and-after shots of previous projects, and provided case studies. Then, the CFO speaks up, asking whether this project makes financial sense.
Whether you’re the lighting retrofit company, or the internal champion lobbying to get a project approved, this is the make-or-break moment. If you can prove value to the people holding the purse strings, you’ve conquered the biggest hurdle in your path.
This seems simple enough. But many retrofit companies get it wrong. How? By focusing on the most popular metrics out there instead of the proper ones. This mistake can paint an inaccurate or unclear picture of the project’s true financial merits.
Here’s an example. An aluminum windows and doors manufacturer almost didn’t approve a lighting retrofit because the proposal suggested it would take 4.2 years to recoup the project’s first cost. Fortunately, they were able to justify the long payback by emphasizing another important benefit: improved workplace safety. The day after the new lights were energized, the enterprising shop foreman noted that the better lighting drove a 25% reduction in aluminum scrap. As one would expect, people could more clearly see the metal they were cutting, drilling and assembling into finished windows and doors! Adding this massive benefit of avoided aluminum scrap to the denominator of the simple payback period calculation meant that the project actually paid for itself every 39 days. Because the initial estimate of a 4.2-year payback so dramatically understated the value, the retrofitter had nearly lost the project, which would have deprived the customer of an astonishingly good financial return.
There are six key financial metrics typically used to evaluate expense-reducing capital projects. Three are what I call “popular” metrics: Simple Payback Period (SPP), Return on Investment (ROI), and Internal Rate of Return (IRR). The other three are what I call “proper” metrics: Modified Internal Rate of Return (MIRR), Net Present Value, and Savings-to-Investment Ratio (SIR).
If your goal is helping your customers make the best decisions as they deploy their capital, you should be migrating the conversation away from the popular—but misleading—metrics and toward the proper ones. Doing so will allow you to make a clearer case for solutions with higher cost, higher efficiency, a longer life, and probably a larger profit margin for the seller to boot.
In this installment, we’ll look at the three “popular” metrics and reveal the significant shortcomings that make them less than ideal yardsticks. In the following installment, we’ll cover the three “proper” metrics and explain how to leverage them to get more long-simple-payback-period solutions approved.
Three Lighting Retrofit Metrics to Avoid
1. Simple Payback Period
Simple Payback Period (SPP) attempts to answer the question, “How quickly will I get my money back via savings?”
Seems straightforward—and it is, but that’s the problem. This grossly oversimplified metric does not account for a host of other factors that determine the true financial value of a project:
- For example, this metric completely ignores how the value of money changes over time. Let’s say you invest $1,000 on a project, and you get back $200 a year. The SPP metric would have you believe that the investment will pay for itself in 5 years. But is the $200 you receive in Year 5 worth as much as the $200 you receive in Year 1? Depending on your “discount rate,” which incorporates your opportunity cost, inflation, and other factors, a dollar you receive in a future period could be worth considerably less than a dollar you receive today. So, it’s not as simple as dividing your first cost by your first-year savings to derive the number of years you’ll have to wait to recover your initial investment. And by the way, in situations where the returns move up (thanks to inflation) or down (due to losses in efficiency) over time, simply dividing the first cost by the first year’s savings can be of questionable value.
- Another problem with SPP is that it ignores any returns that occur after the payback period. Assume you’re evaluating the relative merits of two projects, both of which claim to have a 2-year SPP. One project’s lights last 2 years and one month. The other’s last 10 years. Are those two projects equally desirable? Hardly.
- SPP is misleading in another sense as well. Approvals are often based on a “maximum two-year payback” rule of thumb, which is both arbitrary and ridiculous. To produce a two-year payback, your investment would have to return 50% per year. Can you think of any other investment right now that guarantees you a 50% rate of return? If there were one, we’d all be investing in it, right?
Some retrofitters use variations of the Simple Payment Period metric. They offer only slight improvements on Simple Payment Period:
Cumulative Payback Period considers all the cash flows you’re anticipating, whether they’re going up or coming down over time, to calculate a more accurate payback period. However, it still ignores the present value of the cash inflows you’re expecting. And, like SPP, it’s blind to how long those financial benefits might continue after the Cumulative Payback Period.
Discounted Payback Period determines the present value of incoming cash flows using the timing of each one and your discount rate. For example, this metric knows that dollars you receive in Year 5 are worth less than dollars you receive in Year 1, and it doesn’t consider your investment fully recouped until the sum of the discounted values you receive over time equals your first cost. Unfortunately, it still ignores how long you will continue to receive financial benefits after the Discounted Payback Period.
Bottom line: Simple Payback, Cumulative Payback, and Discounted Payback are variations on a theme, and although they may be popular (especially SPP), their shortcomings make them misleading yardsticks for selecting expense-reducing capital projects.
2. Return on Investment
When it comes to Return on Investment (ROI), most people look at the simplest way of calculating it: If you invest $1,000 in a retrofit that returns $200 in the first year, they say the project has a 20% ROI. This simplest version of ROI is essentially the reciprocal of SPP. It also shares many of the same flaws: not accounting for the time value of money, being blind to how many years the savings will persist, etc. Additionally, the “annual ROI” might very well increase over time as inflation raises the value of the energy savings.
Another version of ROI is derived by simply adding all of the cash inflows you receive over the entire multi-year analysis term, subtracting the original investment from that sum, and then expressing the “Total ROI %” as that “net return” divided by the original investment. Again, many of the above-referenced shortcomings of SPP come into play.
These two methods of calculating ROI are popular. However, they’re both misleading. Why? Well, for one, they completely ignore the concept of compound interest.
To figure out the true annualized ROI, you should calculate the compounded interest rate you would need to earn on your investment to create a sum that is equal to the total amount of returns accumulated over the entire analysis term less the amount you invested. Calculated that way, you see that the annualized ROI percentage on our example above is much lower than the current year ROI percentage.
Interestingly enough, as the investment analysis term is extended to include more years, the annualized ROI percentage typically goes down. Why? Because with more years of compounding, you’d need a lower compounded annual rate of return to equal the sum of the cash inflows less your investment, even though the analysis term includes more years of cash inflows. To some observers, that characteristic of annualized ROI percentage can be counterintuitive.
Bottom line: If you’re going to cite an “ROI” percentage, you should think about using annualized ROI, rather than Current Year ROI or Total ROI.
3. Internal Rate of Return
Internal Rate of Return (IRR) is defined as the discount rate at which the present value of the sums invested equals the present value of the sums received, which results in a net present value of exactly zero.
This popular metric has two principal flaws that make it less than ideal for investment decision-making.
- In situations where the stream of cash flows has multiple changes in sign (i.e., positives and negatives), you open the possibility of getting multiple right answers. So, for example, if you invested $1,000 (a negative cash flow), received $200 per year in savings for three years (each one a positive cash flow), but then had to reinvest $201 the following year for a relamping (a negative cash flow since that $201 expense would overwhelm the $200 in savings, resulting in a subtotal of negative $1 that year), you’d have three changes in sign (-$1,000 at the beginning, $200 for three years, then -$1 in the fourth year). That’s why Excel asks for your “guess” as part of the IRR function. If there’s a possibility for multiple right answers, Excel wants to return the answer that is closest to your expectation. Many professionals are unaware of that nuance of Excel’s IRR function since it automatically assumes that your guess is 10% if you don’t enter a guess in the function! Don’t believe me? Check out Excel’s “Help on this function” footnotes on IRR.
- While the possibility of multiple right answers described above can be unsettling, there is a second shortcoming of IRR that is the real reason I don’t consider it to be a useful metric for evaluating the efficacy of expense-reducing capital projects. The answer generated by the IRR function is only correct if the investor can reinvest every dollar returned by the investment at the calculated IRR percentage from the time the dollar is received until the end of the analysis term. Assume your project has an IRR of 22%. Do you really think your investor will take his/her utility savings and reinvest them in another project at 22%? Not going to happen. In fact, as far back as 2004, the McKinsey Quarterly posted on CFO.com that IRR was a terrible way to assess capital projects for this very reason and provided a great case study to prove the point.
Bottom line: IRR incorporates faulty assumptions about reinvestment rates and opens the door to multiple right answers when cash flows involve multiple changes in sign over time.
So, as you can see, while the metrics above may be popular, they simply do not provide an accurate representation of your project’s financial merits. By setting them aside and using what I call “proper” metrics, you can present a clear-eyed picture of precisely how your project will benefit your customer. In the second part of this series, we’ll examine those proper metrics and how you can use them to your advantage.