How Abc Was Used In Capital Budgeting Summary
Believe it or not there are companies out there that make $50 million dollar mistakes. “How ABC Was Used in Capital Budgeting” examines how one Fortune 500 company almost made what could have been an extremely devastating $50 million dollar mistake by carrying out a “cybermall” project based on favorable business case forecast results. Luckily, upper management was willing to allow their Chief Financial Officer to conduct further analysis before making this investment decision.
This article examines an industry leader that, in the 1990s, was looking for the next big business opportunity in the electronic market place. With nothing else out there like a “cybermall” bringing buyers and sellers together in the comfort of any television marketplace, senior management believed their “speed to market” with this project would really give them an edge. …show more content…
Revenues would be generated from the rents charged to sellers in this marketplace, as well as advertisers that wished to place their advertisements on the site. Capital investments of $50 million were expected over the initial 10 years of implementing this project, mostly for infrastructure and network development, database and application development, and other minor deployment related activities. Based on a simple overview, or a business case forecast, this “cybermall” project appears to be a good investment with healthy expected profits and positive net cash flows, which initially appeared enticing to upper management.
The CFO being all too familiar, however, with the overly optimistic picture that can be painted by a broad strategic analysis insisted this projected be broken down, tactically translated and analyzed for risk potentials. The CFO didn’t employ just any method of analysis; he used an activity based cost (ABC) model (with benchmarking) to forecast business activities, revenues, and operating and capital costs more precisely then had been done with the business case forecast. The ABC model used complex deployment schedules and highly sophisticated transactional volume data to project revenues, operating expenses, and capital requirements necessary to carry this project out through completion. Additionally, the ABC model developed a value chain detailing the necessary business processes need for a “cybermall” and their associated costs. It was identified the key processes were the seller relationship, application development, content production, operations, marketing, and network distribution. These processes were further broken down into the major activities that make up each process, the cost key cost drivers of each, and the process expenses in order to determine exactly what the cost of each process is per deployment initiative.
Through the careful analysis of these revenue streams, operating and start-up costs, the CFO and his team were able to come up with a forecast that depicted a more conceivable outcome of moving forward with this project.
The ABC model forecasts a 10% decrease in total revenues, 20% increase in capital expenditures, and 20% decrease in net cash flows versus the business case forecast; depending on the cost of capital, with the ABC forecast, there are some very low to unfavorable NPVs possible. The ABC analysis confidently modeled initial revenues were going to be too low to support the higher than anticipated start-up costs; additionally, operating leverage didn’t become probably until around halfway through the project, which was simply too risky. Based on this information, various other key operating statistics, and multiple pro forma financial statements, the management team had the information they needed to make a final, educated decision as to go forward with this project or not; the ultimate decision was to reject this project and to focus efforts in business opportunities other than the
“cybermall”.
Based on the lack of interest in interactive TV-based “cybermalls” in the last 15 years, I’d say this CFO saved this company from years of embarrassment, and a possible loss that could have resulted in irreversible damage to this company and its financial situation. The way we use earned value management (EVM) to make meaningful comparisons between actual and planned schedule and costs, we can use activity based costing to help determine if a project is worth initiating by methodically breaking down data to make meaningful forecasts . While activity based costing will generally give management a better understanding of business practices, it can be very labor intensive and very costly. When a significant project investment with sufficient risk associated is being considered, it is more than appropriate to conduct an ABC analysis; this complex model will give management what they need to see the high potential for cost overruns and overall project underperformance, or to reinforce that a profitable project is being pursued.
This article examines an industry leader that, in the 1990s, was looking for the next big business opportunity in the electronic market place. With nothing else out there like a “cybermall” bringing buyers and sellers together in the comfort of any television marketplace, senior management believed their “speed to market” with this project would really give them an edge. …show more content…
Revenues would be generated from the rents charged to sellers in this marketplace, as well as advertisers that wished to place their advertisements on the site. Capital investments of $50 million were expected over the initial 10 years of implementing this project, mostly for infrastructure and network development, database and application development, and other minor deployment related activities. Based on a simple overview, or a business case forecast, this “cybermall” project appears to be a good investment with healthy expected profits and positive net cash flows, which initially appeared enticing to upper management.
The CFO being all too familiar, however, with the overly optimistic picture that can be painted by a broad strategic analysis insisted this projected be broken down, tactically translated and analyzed for risk potentials. The CFO didn’t employ just any method of analysis; he used an activity based cost (ABC) model (with benchmarking) to forecast business activities, revenues, and operating and capital costs more precisely then had been done with the business case forecast. The ABC model used complex deployment schedules and highly sophisticated transactional volume data to project revenues, operating expenses, and capital requirements necessary to carry this project out through completion. Additionally, the ABC model developed a value chain detailing the necessary business processes need for a “cybermall” and their associated costs. It was identified the key processes were the seller relationship, application development, content production, operations, marketing, and network distribution. These processes were further broken down into the major activities that make up each process, the cost key cost drivers of each, and the process expenses in order to determine exactly what the cost of each process is per deployment initiative.
Through the careful analysis of these revenue streams, operating and start-up costs, the CFO and his team were able to come up with a forecast that depicted a more conceivable outcome of moving forward with this project.
The ABC model forecasts a 10% decrease in total revenues, 20% increase in capital expenditures, and 20% decrease in net cash flows versus the business case forecast; depending on the cost of capital, with the ABC forecast, there are some very low to unfavorable NPVs possible. The ABC analysis confidently modeled initial revenues were going to be too low to support the higher than anticipated start-up costs; additionally, operating leverage didn’t become probably until around halfway through the project, which was simply too risky. Based on this information, various other key operating statistics, and multiple pro forma financial statements, the management team had the information they needed to make a final, educated decision as to go forward with this project or not; the ultimate decision was to reject this project and to focus efforts in business opportunities other than the
“cybermall”.
Based on the lack of interest in interactive TV-based “cybermalls” in the last 15 years, I’d say this CFO saved this company from years of embarrassment, and a possible loss that could have resulted in irreversible damage to this company and its financial situation. The way we use earned value management (EVM) to make meaningful comparisons between actual and planned schedule and costs, we can use activity based costing to help determine if a project is worth initiating by methodically breaking down data to make meaningful forecasts . While activity based costing will generally give management a better understanding of business practices, it can be very labor intensive and very costly. When a significant project investment with sufficient risk associated is being considered, it is more than appropriate to conduct an ABC analysis; this complex model will give management what they need to see the high potential for cost overruns and overall project underperformance, or to reinforce that a profitable project is being pursued.