This is typically where things start to break down in many organizations. For the companies that are using Agile as a means of answering the tough questions, this part is usually skipped. There is a mentality that Agile will provide a "Build it and they will come" utopia where the product is magically produced and the revenue begins flowing just as quickly. Let me say now that this is NOT the case. Before an organization invests any time or money into a product or service, a number of questions should ALWAYS be answered. They are:

  1. What is the Net Present Value (NPV) for the life of the product or service?
  2. Is the NPV greater than zero?
  3. If NPV is greater than zero, what is the payback period?
  4. What is the Internal Rate of Return? (IRR)
  5. How does the IRR compare to other projects being considered?

While these may be difficult questions to answer in some cases, they none-the-less must be answered. Let's look at some basic examples of how to answer these questions using Cost Accounting. In one of the next articles I will answer these questions a bit differently using Throughput Accounting.

What is the Net Present Value (NPV) for the life of the product or service?

For this example, we will take the case of a company that builds software widgets. This company has been building these widgets for a number of years and knows the market well. Sales and marketing estimates the market price for the new widget to be $199 and can sell 1000 a year for 5 years. Let's also assume we can build the widget in 6 man-months with resources costing $100K annually. That gives us a one-time cost of $50K. We will also assume that the product won't be sold until development is complete. (in 6 months)

If we define the following:

Where:

T=Number of periods (years in this case)

C0=Starting cash flow (initial investment)

Ct=Period cash flow

r=Interest rate (taking into account inflation and risk)

 

This is rolling up our Present Value and Benefit/Cost Ratio analysis into one simple calculation. Using this definition with and interest rate of 10% and the data from our example we see:

Is the NPV greater than zero?

So we can see from the above that a $50K investment will yield $704K over the next 5 years…probably worth doing. Probably? Read on…

If NPV is greater than zero, what is the payback period?

This is a pretty simple calculation which determines when the investment is returned in the form of revenue.

So in our example:

What is the Internal Rate of Return? (IRR)

Let's look at another complementary metric, Internal Rate of Return (IRR) or discounted cash flow rate of return. IRR is a good measure of the quality of the investment. IRR is defined as r where:

It is the interest rate that makes NPV of future cash flows equal to zero. This is an easy calculation using Microsoft Excel's IRR function. If we plug in our cash flows and use the equation IRR(B1:B6) we see from Figure 1 that the IRR for our example is 398%.

Figure 1 - Microsoft Excel IRR calculation

How does the IRR compare to other projects being considered?

This is one question that often gets overlooked. If we are resource constrained, it behooves us to use the resources optimally. Let's assume that our sales and marketing team discusses another widget with us that we estimate can be developed in 5 man-months, be sold for $180 and will sell 1100 a year for the same 5 years. Which project should we choose? If we look at the raw revenue numbers, 1100 units a year at $180 is $198,000 vs. the $199,000 from the first example. Using the numbers from widget number two, we calculate our NPV and get $708,909 with an IRR of 475%. It is clear from the numbers that we should build widget number two.

Summary

NPV and IRR are some handy tools for evaluating and comparing projects. I know that I've skipped over a bunch of things and made some assumptions, but I wanted to introduce NPV and IRR. In future articles I will cover other tools that can be used to estimate and evaluate a project as well as go into more detail.