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Understanding the Impact of Volume, Mix and Rate on Manufacturing COGS Variance

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During any financial review, variances against plan are always items of intense discussion and require in-depth analysis. Any accounting or finance professional will tell you that the window of time to unearth the cause of variances is critical. And, of course, this analysis usually occurs during the month-end close process, when things are most hectic.

Variance analysis usually involves comparison of many time periods or benchmarks. However, in this article, we’ll cover COGS variances (i.e., variances to costs of goods sold) versus the annual budget.

Although it would be nice if actual results during the year matched what we initially planned, we all know that business changes are typical after budgets are established, leading to variances and necessary explanations.

Three Components of COGS Variances

Cost of Goods Sold (COGS) refers to the direct costs of all components used during the manufacturing process. Researching COGS variances without a complete understanding of where to look (or without the right tools) can lead you down long and time-consuming paths.

Three main components make up a COGS variance: volume, mix and rates.

  1. Selling more volume of any or all products than planned will generate a volume variance and affect overall cost. You will see when we talk more about volume variance analysis that as simple as this calculation may seem, you’ll need to take a few steps to separate out the mix component to truly see volume variance.
  2. Mix occurs when a variety of products are sold at a different volume than planned. Mix variance analysis looks at how the product is weighted, or distributed, amongst its total population. For example, let’s say we sold 100 cans of corn in the total sales volume of 1,000, or 10%, while the plan called for a sale of 8% of canned corn. This mix change of 2% at the canned corn level creates an unfavorable cost variance, or as we say, mix variance. 
  3. Rate fluctuations happen for a variety of reasons and are typically unexpected. These changes can occur, for example, with increases or decreases in vendor pricing on material purchases or in transportation and warehousing costs. Based on the bill of material (BOM), these rates can affect some or all products and have a direct impact on overall costs, which would create a rate variance.

It’s very likely that the impact of a COGS variance is driven by all three components. Over the next few sections, I will outline how to calculate volume, mix and rate. This should help you determine how costs changes are affected by multiple cost drivers.

COGS Variance Component 1: Volume Variance Analysis

Breaking down the impacts that volume, mix and price have on COGS variance adds more complexity and enhances analysis. It also allows you to decompose the volume and pricing performances by product type between budgets and actual values.

Before we explore volume variance, let me first explain the meaning of volume. In the manufacturing industry, volume is most often used to either describe the level of production units produced or sales units sold. Production units produced drives total cost of production (COP), which flows to the balance sheet until sold. In our discussions here, we will be referring to the sales units produced, which drives COGS and appears on the profit and loss statement. Therefore, an increase in sales volume equates to higher COGS, which will have a direct impact on gross margins and company profits. (As a note, keep in mind that there is a latency between a unit that is produced and sold, which can be anywhere from 2-4 months due to logistics constraints, shipping time, customs, etc.)

Naturally, more or less units sold will drive COGS up or down accordingly and reflect on the profit and loss statement, which will result in a variance. To determine the key drivers behind the variances, we must first break down the volume sold by product type and analyze both budget and actual. This will help us see the variances for each product type.

Once we have analyzed it in this way, we then calculate the volume variance using this formula:

Volume Variance = (Plan Quantity – (Total Actual Quantity * Plan Mix)) * Plan Rate

Volume Variance Analysis Example

In the example below (Illustration A.1) from ABC Canning Co., we see a condensed P&L with COGS in an unfavorable variance from budget totaling -$6.7M or -28.2%. This alarming, unfavorable variance will inevitably lead to questions.

Illustration A.1: Condensed P&L with COGS Variance

As mentioned previously, explaining COGS variances is best approached by analyzing the impact by volume, mix and rate, which will help explain the driving factors. When seeing a COGS variance, the questions to ask are:

  • How much of the additional cost is related to volume?
  • How are the different weighting of product types having an impact on mix?
  • And what is the cost impact on the fluctuations on rates and cost changes?

The chart below (Illustration B.1), further analyzes COGS variance by product type, showing volume, cost and price rate for both budget and actual, revealing the total variance of -$6.7M.

Illustration B.1: COGS Variance by Product Type

To determine how much of the -$6.7M is related to volume, we apply the calculation described above to each product type as shown in the chart below (Illustration B.2). As the chart below shows, of the total -$6.7M COGS variance, the total volume impact is -$3.8M.

Illustration B.2: COGS Variance by Product Type with Volume Impact

The logic behind the volume variance calculation is to separate:

  1. Actual mix by applying the actual volume with budget mix, and
  2. Actual rate by applying the actual volume with budget rate.

To analyze further, if there is no volume change, then there is no mix impact, because the sales volume and mix were at planned levels. However, if total volume is the same, but the individual product volume differs from plan (i.e., creating a mix), then there would be no volume impact, but the individual products would have a mix impact.

COGS Variance Component 2: Mix Variance Analysis

The purpose of mix variance analysis is to see how much of your total COGS variance is due to producing products at a volume different from what was initially planned. The objective is not to compare total volume sold, but instead compare the distribution percentage, or weighting, across all the products that were sold in the time span.

It’s important to note that mix variance will not exist when there is only one product type. With only one product type, variance would come from volume, not mix or rate. Mix variance is created whenever two or more products are included in a product group.

In this analysis, we’ll use budgeted price rate to better isolate actual rate differences and see the true mix impact. This approach reflects the fact that not all products are created (i.e., sold ) equal. A higher or lower sales volume from plan will change the mix in comparison from plan and have a direct impact on COGS. To summarize this concept:

  • Selling a higher volume than planned of higher-cost products will generate a high mix and have a negative impact on COGS.
  • Selling a lower volume than planned of lower-cost products will generate a low mix and have a positive impact on COGS.

When performing this analysis, use this mix variance calculation:

Mix Variance = (Actual Quantity * (Actual Mix – Plan Mix)) * Plan Rate

Mix Variance Analysis Example

Using a similar data set below (Illustration B.3) for ABC Canning Co. and using the calculations noted above, we can see mix has an impact on COGS totaling -$228K. Canned corn is causing most of this mix variance at -$252K.

Looking further into this product, we see that the planned mix was 38% and actual sales mix was 39%, resulting in a 0.6% increase. Applying this mix increase in our mix calculation shows the change in volume impact was -445K units, which we then multiply against the budget rate of $0.57, resulting in our final mix impact of -$252K.

Illustration B.3: COGS Variance by Product Type with Mix Impact Calculations

The logic behind mix variance analysis is to keep total actual volume as-is and focus on the additional costs as it relates to the products’ actual sales distribution in comparison to plan.

COGS Variance Component 3: Rate Variance Analysis

The third and final variance analysis, Rate Variance, is the change in rate and its impact on cost. If the cost of a product is higher or lower in a given period than what was planned, then this higher or lower rate is a Rate Variance.

The calculation for deriving a Rate Variance is as follows:

Rate Variance = (Planned Rate – Actual Rate) X (Actual Quantity)

As noted previously, rate fluctuations can occur for several reasons, including:

  • Vendor price increases on material purchases,
  • Transportation fee increases on driver wages,
  • Higher demurrage charges and
  • Warehousing cost increases.

These rate changes have a direct impact on overall costs and will create a Rate Variance.

Rate Variance Analysis Example

By returning to our example from ABC Canning Co. below (Illustration B.4) and laying out costs for both budget and actual, we see the different rates by product type. Canned corn, for example, was budgeted to cost $0.57/can, while the actual cost was $0.65/can, or a $0.09/can increase. Although it may sound immaterial, when applying these rates against the millions of units sold, we create a large variance that would cause concern for both management and shareholders.

Overall, the actual cost of goods sold totals $30.3M and is over plan by $6.7M. How much is related to rate changes? Applying our calculation above results in a total rate impact of $2.6M, which is simply the difference in rate x actual units sold.

From the list of products below, it appears that canned corn has the highest impact. As mentioned before, the rate increase of $0.09/can result in a cost increase of $2.6M (or 39%) of our total $6.7M variance. It appears that this is where most of the focus needs to be moving forward. But what exactly is causing the cost on canned corn to spike?

Illustration B.4: COGS Variance by Product Type with Rate Impact

The logic behind rate variance analysis is simple and requires no special calculations, as we saw above.

We simply:

  1. Find the rate difference between plan and actual, and
  2. Multiply the difference against the actual volume.

Note: If the actual rate had no change, then there wouldn’t be a rate variance.

As mentioned previously, all three variances (i.e., volume, mix and rate) can also exist. Nevertheless, no matter how many variances exist, the summation of all the variances must equal the total COGS variance. The chart below (Illustration C.1) illustrates this by showing how the variances for volume, mix and rate total to the COGS variance of $6.7M.

Illustration C.1: COGS Variance Chart with Summation of Variances

The graph below (Illustration D.1) also represents the variance impacts of volume, mix and rate by demonstrating a “variance walk” from plan to actual. This is another useful visual tool to present to management to help guide and explain the breakdown of the COGS variance. To go further, additional commentary can be explained on each. For example, we might comment on rate analysis based on our above finding that the price on canned corn increased $0.09/can, resulting in a total cost variance of $2.6M or 39% of the overall COGS variance.

Illustration D.1: COGS Variance Chart with VMR Variance Walk

Conclusion

Understanding the impact that volume, mix and rate can have on COGS variance—and leveraging modeling tools like the ones described above—will help any finance professional during the month-end close, which is a crucial time for any business. These analysis steps are important for any manufacturing company that desires to fully understand the extent of the COGS variance.

It is easy to simply point at volume as a cause for the additional cost, but as we see in the analysis above, volume is not always the cause. Like an onion, we need to peel away the layers and separate out the causes so that management can better understand fluctuations, ask better questions and make more informed decisions.

Interested in learning more? Explore manufacturing finance and accounting topics in these related posts from our team of consultants:

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Recorded Music Forecasting: New Data and Methodologies

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The recorded music industry is one of the fastest changing industries, and as a result, recorded music forecasting methodologies change constantly. The popularity of physical music ownership gave way to digital ownership of recorded music, which gave way to the streaming era and a new level of data and forecasting complexity. In the current environment, the challenge of bringing streaming data in-house in a scalable, usable way provides the FP&A department with a great opportunity. They have the chance to increase recorded music forecast accuracy in less time than previously possible.

In light of the expansion of data and complexity in this space, let’s review some of the new data available and how it impacts recorded music forecasting methodologies.

Data Needs and Opportunities

The most common data that already exists in any music company is traditional ERP or accounting system data. This data usually provides the units sold, the wholesale price and net revenue. FP&A needs some other data inputs from outside vendors to better generate a forecast.

Music Connect Data provides unit sales through retail stores and streaming services. Although Music Connect Data provides digital sales data, most music companies rely on royalty statements provided by digital vendors (e.g., Spotify, Amazon, Apple, etc.) because they have more detailed data. Digital vendors can provide units, price and the amount owed the music company for each sale. This data is very valuable for forecasting because it allows us to calculate historical Earnings Per Play Rate (EPPR), which is the average rate paid to the music company per stream of a song.

We need EPPR because streaming companies do not pay music companies per stream—because the customer pays a flat fee for unlimited streaming of a streaming company’s catalog. The streaming company then calculates the percentage of total times a song was streamed, and then it pays out based on that percentage of the total revenue collected and the royalty rate for that song.

EPPR helps make the forecast more accurate because we are not assuming a rate, as we don’t have easy access to the data. It allows us to have different rates for different streaming companies and change rates as necessary. This will help us better explain performance—now that we have detailed pricing per song.

In the past, FP&A departments would have to ask for help from the Marketing department to help get one static data dump of streaming data to build their pricing forecasts. Now, with new user-facing tools (e.g., Tableau, Looker), FP&A departments can get the detail they need to improve forecasting.

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Challenges to Getting Data

As is often the case, the hardest part with collecting this data is convincing Management that this is necessary and cost effective. To collect data on every stream requires ingesting a very large amount of data as it has different formats per streaming company.

Another challenge will be parsing the data so that it can be linked with internal metadata for each song. Without the linking of internal metadata, it will be difficult to leverage the data collected. Examples of metadata that is needed to leverage streaming data include ISRC, UPC, MPM and Customer ID.

Another difficulty is collecting this data in a way that it can best serve all the stakeholders. Marketing’s needs won’t necessarily line up with Finance’s needs. By including FP&A departments early in the development of their data strategy, FP&A departments can increase their forecasting accuracy.

Want to learn more about stakeholder management? Check out this related article: “Sprechen sie Stakeholderitsch?” A Finance Consultant’s Notes on Stakeholder Management

Benefits from FP&A Inclusion in the Company’s Data Management Strategy

There are numerous benefits to including FP&A needs early into the company’s data management strategy. I have personally witnessed this approach improve forecast accuracy by 22% (Year Over Year), when comparing actuals to forecast accuracy. I’ve seen it improve music catalog forecasting by 36%, as we have increased visibility into the category via higher quality data queries. Also, variances are much easier to explain, as the new model is an all-in-one solution across all partners and revenue types. Actuals take about 70% less time to run into the file, as it is flattened out and keyed for ease when applying lookups with minimal to no further mapping required.

Since the forecast model has proven over time to be both accurate and transparent, it is currently used to calculate our annual stretch targets at the all-in level and as the source from which our international territories are building their guidance. Due to the speed with which the forecast can be generated, it gives everyone time to analyze and provide context to the forecast. This is in stark contrast to the past, where only the numbers were provided by the deadline. Generally, the FP&A Department spends much less time in a reporting mindset and far more on the analysis side. This allows us to provide much more added value than previously possible.

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Office Leasing Strategy in the New Normal

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With companies scrambling to determine Return to Office (RTO) strategies amid ongoing uncertainties, increased employee desire/demand for flexibility and even fully remote opportunities, management should no longer assume the next office lease will be anything like the last negotiation. Before thinking through typical considerations associated with office leasing strategy (e.g., location, lease term, layout and design, etc.), suitability of traditional leases should also be on the checklist.

After a substantial upturn in commercial office fundamentals, especially on the West Coast, the current economic and real estate environment has finally shifted leverage in the tenants’ favor. According to a recent CBRE research, most major office markets are still seeing demand meaningfully below 2018–2019 levels, and Marcus & Millichap is not expecting the office market returning to pre-pandemic levels until 2024. At the same time, the concurrent proliferation of flexible working space and abundance of sublease inventory have broadened tenant options, each with its own unique set of benefits and considerations.

#1 Direct Office Leasing

In a typical direct office lease, the length of the term can range between five to seven years—although some can run as short as three years and some longer than ten years. A traditional lease often also requires tenants to pay for common area maintenance (CAM) and other building expenses, on top of the agreed-upon rent and tenant improvement. (Tenant improvement, also known as TI – the upfront capital investment for space planning, furniture and other fixtures prior to moving in – and is partially subsidized by the landlord as an incentive.)

In the current tenant-friendly environment, tenants looking to enter into new leases or extend existing leases should feel confident in exercising their leverage. Per Cushman & Wakefield, effective office rents (which factors in free rent and TI subsidy) are down around 13% from the peak. While contractual rental rates are holding firm, concessions are rising sharply. Renting quality space in major markets can come with six to twelve months of free rent plus a TI subsidy of well over $100 per square foot. Bowing to tenant needs for flexibility, average terms have trended shorter, and some existing tenants have opted to renew on a month-to-month basis to carefully reassess their real estate needs before making a firm commitment going forward.

In short, the traditional lease structure offers a good balance between flexibility and stability. Depending on the particular RTO strategy, tenants have the luxury to:

  1. Negotiate more favorable terms,
  2. “Wait-and-see” with shorter leases, and/or
  3. Redesign space through large TI subsidies.

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#2 Flexible / Coworking Office Leasing

Long considered a niche offering, flexible workspace has become a widely accepted product. JLL was already predicting 30% of all office space will be flexible by 2030 back in 2019. While specialists such as WeWork, Industrious and Regus/Spaces continue to dominate the market, traditional landlords (e.g., studio by Tishman Speyer) and real estate services firms (e.g., Hana by CBRE) have also invested heavily into the product.

Unlike traditional leases, coworking space can be leased monthly or even on-demand if necessary, and often comes with concierge services handling parcels, printing, audio/visual equipment and other needs (some do require additional costs). For companies that are growing rapidly or remote-centric, this type of arrangement offers immense flexibility in managing real estate footprint. The product can also serve as a temporary bridge or permanent solution in establishing regional hubs as management teams evaluate where to best source talent and address emerging employee preference toward lower-cost, suburban centers.

The main downside to utilizing coworking space is the relative financial costs and certain restrictions. Although no capital investment is required, expect to pay a meaningful markup in rent relative to traditional lease. In addition, tenants have limited influence in the design, layout and utilization of the space since flex spaces are designed with high reusability across various tenant types over a long horizon.

#3 Subleasing

Companies looking for a cost-effective, short-term real estate solution should also consider entering into a sublease. In most instances, the existing tenant has already fully built out the interior but wishes to modify its footprint for a variety of reasons. As such, most of the time a meaningful discount can be had for space that is ready for move-in. According to Cushman & Wakefield, as of Q3 2021, there remains over 130M SF of sublease availability in the U.S., with asking rents representing 10% to 50% discount relative to a traditional direct lease. Moreover, most sublease tenants can successfully negotiate the rights to access amenities and onsite services provided by either the landlord or the tenant at reduced costs (or free), and they can avoid CAM and other unpredictable fees and charges. A sublease is also, for the most part, easier to qualify and execute. In the case of a fully vacant space available for sublease, the subtenant also has the flexibility to increase the footprint within the premise as needed, enjoying the flexibility without paying for it. Should the subtenant wish to take the entire space when the original lease expires, the party is also well-positioned to negotiate a direct lease with the landlord.

However, the financial savings do come with operational limitations. The in-place lease will dictate the terms and allowed uses, and in most cases, the subtenant must use the space as-is (for subtenants able to lease the entire space, occasionally unused TI allowance as agreed upon in the original lease may be available). In addition, any repair and maintenance (R&M) request may need to go through the actual tenant prior to landlord approval/action, causing unwanted delays. Moreover, a poorly negotiated sublease can leave the subtenant exposed to legal or financial consequences should problems arise between the landlord and the tenant. In a worst-case scenario, the tenant may default on the lease and/or declare bankruptcy, and the subtenant may be evicted with little recourse.

Office Leasing Strategy Summary

office leasing strategy chart showing financial costs and operational flexibility of direct office leases, flexible office leases and subleases.
The above chart offers a simple summary of financial costs and operational flexibility of direct office leases, flexible/coworking office leases and subleases.

Final Thoughts

The “New Normal” should also require new thinking regarding office space needs. A traditional direct lease may no longer fit the organizational needs, be it operational flexibility or financial constraints. Each of the options outlined above has its own set of tradeoffs between benefits and risks, which needs to be carefully considered. Depending on organizational scale, needs and growth trajectory, all three options should be explored.

A quick sidenote for management teams that have the financial wherewithal to acquire an office building. Outright ownership offers additional benefit in full operational control, allowing management to better cultivate the culture and identity through highly curated design, planning and selection of onsite retail tenants, but it comes with asset management “tuition costs” that may present misalignment against a company’s core competency as well as potential distraction. Financially, the upfront costs can be significant along with the burden of ongoing maintenance, frequent renovation costs and annual property taxes. That said, institutional-quality buildings can be financed with 3% to 5% mortgage (usually up to 80% LTV), and depreciation, interest and applicable tax credits can help to shelter income. While not a commonly undertaken route, companies that strongly believe in their local presence and have ample excess liquidity can also examine such possibility.

If you’d like support in your return to office planning, we offer both business stabilization and contingency planning services and have a team of financial planning and analysis consultants who can help. To improve your planning, you might also consider downloading our 5-year strategic planning timeline template:

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Lessons Learned from Building Dashboards in Tableau

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As data becomes more readily available than ever before, we’re met with the challenge of drawing easily digestible and meaningful insights from a sea of numbers. Fortunately, wherever demand exists, the market scrambles to find a solution: data visualization tools. These platforms can be your new best friends, and with them, you can create the reports that your team will want to refer to regularly. However, the process of creating those reports can be complicated. In the time I’ve spent building dashboards in Tableau, I’ve made a few mistakes and learned a few lessons.

In this post, I’d like to share some tips to help focus your efforts and improve your results. This is not a how-to blog; this is an overview of some of the challenges I faced and the lessons I learned when things went wrong. Without further ado, let’s go over five things to remember when building dashboards in Tableau.

1. Tableau is a data visualization tool, not a database tool.

When you start building dashboards in Tableau, the first step is learning every report starts with a data source. That data source can be the general database into which all new data feeds, or it can be a specific one built for your project. The benefit of a generic data source is its availability, uniformity and reliability. It’s there when you need it, contains a broad range of data points and has been tried and tested. However, one downside is that a generic data source might not capture the nuances you might need for more niche requests. If you are tasked to create a dashboard with that level of nuance, then you might find that despite your best effort to manipulate the generic data source in Tableau, it will be all for naught.

In my case, it was more effective to create a specific data source for the project. If you’re leaning toward that option, then I suggest the following:

Do as many of the calculations you can on the back end using SAS, R, Python or other coding language.

You might need to build a year-over-year (YoY) comparison view by week, only to realize that key sales periods such as holidays show significant variances. There are shifts in weekdays in each calendar week every year, and as minor as those one or two days might seem, holiday sales can show a drastic YoY change by week based on specific days. In cases like this, it could be worth the extra effort of normalizing the calendar weeks by date, instead of weekday. You can accomplish this on the back end when creating a data source.

Minimize the number of groups or “calculated fields” you make in Tableau to avoid long load time.

While some changes need to be made in the back end and others can be done within Tableau, making changes to the data in Tableau is not necessarily recommended. Perhaps you need to build a dashboard for a specific portfolio of titles or products during a given time range and categorized in designated groups. You can go about creating groups or using “contains(),” filtering specific product IDs or leveraging other formulas. However, every formula or group added to the dashboard will slow the dashboard down on the server and require more spool space and higher computing power. It’s better to apply these changes on the back end and save the processing power for more meaningful formulas, parameters and filters.

2. When combining multiple data sources, always verify the integrity of the merged data.

Although data has become more thorough than ever before, we are sometimes faced with the challenge of pulling bits and pieces from segmented data sources for a more complete picture. While data merging might seem simple and straightforward, it is a very delicate process that requires a lot of attention to detail. Even the smallest mismatch between data sources can sacrifice the integrity of the data and deem the report meaningless.

I learned one important lesson in my attempts at combining multiple data sources:

Unless the linking happens at the lowest common denominator, you can risk losing the integrity of your data.

You might have one data source that shows units and another data source that shows cost per unit, and together you can calculate total cost. One simple approach is loading both data sources individually and linking them in the report building interface.

However, after linking the two data sources, the totals might not add up to what you expected. One common cause might be that either your primary or secondary data sources are missing some product IDs that aren’t being captured in the total. This can be remedied by either adding the missing product IDs to the code on the back end or selecting the data source that contains all product IDs as the primary data source. Another common issue is duplication. For example, if you are linking based on product ID, account, product type and year—but don’t realize that there is a subgroup of any of those categories—you run the risk of duplication. Tableau will count each data point based on the lowest subgroup it can find. It is key that you link at the lowest common denominator.

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3. Clearly define the level on which to filter your data.

Going back to filtering, as illustrated in the example above, some filters can slow down Tableau. However, you won’t always have the option to update the data source and may need to leverage filters. Here are some tips for optimization if you find that you need to filter your data:

Try filtering at the data source level.

This trick can help speed up Tableau and prevent potential errors from arising in your dashboard. If you are working with a very large data source but only need a much smaller range of information, you can add a data source filter after you generate a data connection. This allows you to select the fields you want included in your dashboard and disregard the rest.

Test context filters.

When adding filters to Tableau, the default is to compute each filter independently. However, you might need one filter to be applied before processing the rest. The simple, yet underused, solution is to select the filter and “add to context.” This tells Tableau to calculate the context filter independently and all other filters dependent on the context filter. Since the context filter narrows the data from the onset, this too will reduce load time and speed up your dashboard.

4. When building dashboards in Tableau, formatting is king.

Entertainment and media companies live by the quote “content is king.” Though perhaps not exactly tantamount to content, in the world of reporting, formatting is king. When building dashboards in Tableau, even if you have the most useful material displayed, if the formatting is sloppy, your viewers won’t absorb the amount of information they would if you spent extra time polishing your work.

Publish a Tableau dashboard, not a report.

Publishing a dashboard gives you the opportunity to publish by format (e.g., desktop, laptop, tablet, phone, etc.) Because dashboards also include layout containers, you can format your dashboard based on a vertical, horizontal, floating, etc., layout and have more control over the spread of your report.

When building dashboards in Tableau, try whatever you would do in PowerPoint.

Give your report a cosmetic touch up. Whether it is a crosstab, chart or other visual, take the time to adjust your font, bold your totals, lose the lines, choose your colors coherently, scale your titles, format your numbers, edit your axis panels and more.

The same steps you take to polish a presentation can be done on Tableau, and it’s a good idea to try them! Attention to detail can not only elevate a dashboard visually, but also make it easier to digest. Our eyes are drawn to changes, and so if you really want the focus to be on the totals, then something as simple as bolding or changing the color of the text can really highlight what you are trying to showcase. If you want to show different business segments broken out in a bar chart, then color coding them in a stacked chart can show more detail than a monochromatic chart would.

5. Research online templates and resources.

You might be stuck on a formula that won’t work, a chart that doesn’t seem to come together just the way you want it, or a type of formatting that you can’t figure out. I have the solution for you: Google it.

A simple Google search might give you the answer you need to complete your project. It is unlikely that you’re the only person who’s ever faced this problem. I found that reading through those types of posts often helped me reorganize the way in which I was considering data, offered more effective routes to my objectives, revealed that my idea was more effort than it was worth or gave the solution to my problem.

Below are three very simple solutions to common hurdles you might need help overcoming.

  • Download ready built templates available online and adjust to your needs. There is a myriad of Tableau dashboards available to download for free. Even if it doesn’t solve your problem, exploring another dashboard can provide ideas for your next project.
  • Take online formulas and tweak them to fit your dimensions and measures. Tableau has a very strong and active community of users that help each other out on forums. Search whatever formula problem you are running into, and you will likely find the answer in any one of the community forums.
  • Watch YouTube tutorials on practically anything you might need help on. When I first started using Tableau two and a half years ago, I watched online tutorials paid for by my previous employer. After the training license expired, I resorted to free tutorials, namely on YouTube. As someone who has watched the premium and free tutorials, I can assure you that both are extremely helpful, and one is not better than the other. So, if you feel stuck and don’t have paid resources, do not shy away from YouTube or other free tutorials.

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If you’d like to learn more about financial planning & analysis, explore our related content below. If you need project management, supplemental or interim financial management support in your accounting or finance functions, then our team of 90+ consultants can help. You can learn more about our FP&A services by visiting our service page:

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Building By-Title Ultimates: Best Practices from the Field

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An ultimate is an entertainment industry-specific forecasting model that is an all-encompassing P&L from a title perspective. In other words, for a specific entertainment asset (e.g., film, TV show):

  • What are all its potential revenue streams?
  • What are all its associated costs?
  • How profitable do we expect it to perform over its lifecycle?

Ultimate forecasting models are necessary tools for entertainment companies to gauge investment profitability scenarios for both future concept and existing projects.

In a recent project, I had the opportunity to support an entertainment company in building a model to run scenarios for by-title ultimates. When constructing a bottoms-up, by-title ultimate model, you should include obvious considerations such as release windows and production costs, but less-obvious considerations will help to fine-tune the forecasting ability your model. Let’s go over some of those less-obvious considerations now.

Use Comparable Title Release Data to Get Out of the Model and Into the Real World

If a production company has a new intellectual property concept for a film, how can it successfully gauge its expected profitability at the box office? Many factors can go into forecasting box office performance, including seasonality of release, number and location of theaters, level of competition, the praise or criticism of others and the brand equity of key cast members. If you are a huge studio like Warner Bros., you can probably leverage data from your deep release library to take an educated guess, but what if you are a small- to mid-sized production company with only a handful of releases under your belt? Or what if it is the first film a company is producing? 

The answer to building a reliable forecast lies in leveraging comparable title release data. Entertainment industry data companies likes Nielsen and ComScore can provide reports on by-title revenue across a variety of release windows, including theatrical box office. But which titles should be selected as the most comparable titles for your project? You should work to identify 3-5 comparable titles to your film by answering the following questions:

  • Which films have lead actors with a similar market reach to that of your film’s lead actors?  Leverage tools such as the celebrity “e-scores” from E-Poll Market Research to uncover comparable celebrity reach. Then, leverage websites such as imdb.com to find recent films that these comparable lead actors have starred in.
  • Which of the recent films containing comparable actors also have a similar level of investment (production budget) with a similar release date as your film? Leverage free online tools such as the-numbers.com to discover titles with similar budgets and release dates.

Taking an average of box office receipts across comparable titles will offer a great foundation to begin forecasting theatrical release window profitability for a new title.

Related Posts:

Apply Decay Curves to Release Windows to Improve Scenario Analysis

Once you have sized up expected revenue within each release window for a given asset, how do you forecast the allocation of revenue among the periods within each window?

A nuance about by-title ultimate cost amortization is that capitalized production costs are amortized based on a current period’s proportionate share of ultimate revenue, so it is important to consider the timing of expected revenue. This is where the almighty “decay curve” comes into play.

The flow of revenue often follows a decay-curve pattern within a given release window: After an influx of sales or transaction revenue at release and shortly after, the revenue exponentially declines with time. A good ultimate model should have a decay curve for each release window to toggle scenarios of how ultimate revenue could be collected—and in turn, how capitalized production costs should be amortized.

Learn more about scenario analysis:

Allocate Your SG&A Across Multiple Projects Equitably

If you are a smaller production company in a growth period, you face the challenge of appropriately allocating your corporate overhead to a by-title P&L ultimate as you move from being singularly focused on one project to producing multiple titles in tandem.

A time allocation approach can be leveraged to do this equitably. Those employees actively involved with producing or publishing assets (e.g., producers) can forecast how they would split their time among projects within a given forecast period. Then their overhead (i.e., their fully burdened compensation), plus the general company overhead (including the compensation of supporting shared-service functions, such as Finance and Human Resources employees) can follow this forecasted by-title time allocation. Labor is usually the largest cost line item on a P&L, so it is crucial to have a basis to equitably gauge what share of this burden should be allocated to a particular project.

Embrace Nuance and Flexibility

No one can predict the exact ultimate profitability of a new project with 100% certainty, but a good ultimate forecasting model paves the way to derive a sense of comfort in your investment. An ultimate model allows you to run multiple scenarios to sensitivity test a given investment versus its expected performance over time. Due to all the nuances in releasing an entertainment asset through various windows, it is important to incorporate multiple tools within your model to provide flexibility in forecasting different outcomes.

If you’d like support, we have entertainment finance and accounting consultants who can help you through the process. You can learn about how we work with our clients in our media and entertainment finance services guide.

You can also download our free ebook, which explores how operational finance can be employed to make your entertainment company more effective:

guide to operational finance in entertainment

Real Estate and Construction Finance Whitepaper

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Our whitepaper offers insights on diagnosing common finance and accounting pain points in real estate and construction businesses. Learn about software solutions, read case studies and discover signs you might need external support.

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Three Principles of Effective FP&A

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Financial Planning & Analysis is a wide discipline that covers budgeting, forecasting, analysis and planning to support businesses. Effective FP&A can drive significant business impact, but what drives effective FP&A? I believe companies with best-in-class FP&A functions center their approach on three key principles: philosophy of budgeting, participation and involvement, and impact. These principles set the foundation for frameworks that can drive businesses upward and onward.

Effective FP&A and the Philosophy of Budgeting

Let’s start with philosophy and its impact on effective FP&A. Budgeting can be done in a variety of ways, but a general target needs to be set first.

I have seen companies budget in three different fashions:

  1. They set a hardline, make-or-break target. If the team doesn’t meet or exceed the budget, it feels like they might not be there for next year’s budget.
  2. They set a reasonable target. They work together and come up with a reasonable scenario that is most likely achievable and realistic.
  3. They have a stretch target that may not be achievable but will propel the company and the team to higher levels than what otherwise might be accomplished. In this case, it’s important to set expectations and align incentives early, so that the team has a proper mindset.

A company needs to really understand the goals and then manage their incentives around them. Each of the approaches has costs and benefits, so the team must consider and weight each cost and benefit as they work through a budget process. Personally, I am a fan of the stretch target propelling companies forward to new levels of growth and success. However, even the stretch target may discourage a team who doesn’t believe it is possible, so the incentives must tie a large bonus to the target and a reasonable bonus even below the target. Some of this is an iterative process, but considering the philosophy at the outset helps confirm a path forward.

Participation and Involvement Begets Effective FP&A

The second principle of effective FP&A is the participation and involvement of the overall team. Budgets and forecasts are often managed by the finance team. However, I have seen cases where too little involvement from the rest of the company results in less useful processes and structures. For example, a VP of Sales told the CFO at one of my companies that the budget contained the CFO’s and his team’s goals—not the VP’s or his team’s goals. Ouch. That was a large misalignment particularly in the tough times of the Great Recession.

For a proper process, the finance team must work hand in hand – and line by line – with the responsible parties. Each line on the income statement must have an owner: the buck stops with this person or that person, or it stops with no one. Everyone must understand and agree with the projections and work to compile a budget. The icing on the cake added by the finance team is making sure that the projections are reasonable and achievable.

For example, there was always a significant demand for engineers during my time with Panasonic Avionics. I would work with the engineering leaders, and they would compile a hiring budget that centered on hiring 20 people a month for the next 6 months. So I would ask:

“But you have added 40 total in the past six months. What is going to change for you to triple your hiring rate?”

Because I also had financial responsibility for the Human Resources department, I knew the HR team wasn’t going to add recruiters. I would counsel the engineering leaders to also realize some employees would leave, and we had to get to a reasonable forecast for net headcount growth. That target became a net increase of seven people per month, which worked out on average to be remarkably accurate. Perhaps a long story, but it shows the interaction necessary across multiple personnel to develop accurate inputs.

Learn More in This Related Content

Effective FP&A Drives Measurable Impact

Impact is the last (but not least) part of budgeting and forecasting, and it’s where the rubber meets the road. I’d like to share several examples here of the impact of Financial Planning & Analysis.

First, there was an action taken unilaterally at a major partner of Panasonic Avionics, and the initial impact was forecasted to be additional cost of $20M. There was no way around the change, but this presented a great opportunity to push the team to adjust their approach to minimize the impact and consider new ways of thinking. Leadership pushed over and over that each cost increase was too much, until the team presented an approach with $2M of impact. That one was the winner.

At Hawker Beechcraft, an aircraft manufacturer, the business was significantly challenged by the Great Recession. With the structure to build 750 aircraft annually, a volume drop of half is a major structural impact. I led finance for a project that was tasked with reducing $200M in cost out of the business on an annual basis. As we worked through various initiatives, it was important to accurately measure, forecast and achieve savings in a disciplined manner. I had to work with personnel wanting to claim savings for having finance stop paying an expense and then having HR pay for the expense. One division also claimed a savings for laying off three people—even as another division hired them back. That was a good win for the affected employees, but it didn’t impact the cost profile of the company. Unfortunately, the company took on more than it could achieve, despite its best efforts, and ended up in bankruptcy.

Last was the cash forecast at Ardmore Home Design. As COVID hit, I started the process of scenario planning and ensuring our access to cash. It was a receipts-and-disbursements process to track all activity at a detailed level. That process, along with switching banks to gain access to a Paycheck Protection Program loan and a 100% increase in our credit line, put us into a great starting position. As our sales took off in the following months, the cash forecast timed our available cash for a warehouse/office space investment to double our space in the City of Industry, the purchase of a Dallas showroom and an expansion of our Atlanta trade show space.

Learn More About Improving Your FP&A

These examples hopefully show the power of Financial Planning & Analysis and the impact it can have with the right philosophy and investment from the team. Now is a great time to get started planning for 2022 and beyond. If you’d like to leverage our team to support your FP&A objectives, reach out to us! We’d be happy to help.

You can also learn more about the process of financial forecasting by downloading our free guide:

financial forecasting process guide

About the Author

Bob has 25 years of finance and accounting leadership experience serving companies from the Fortune 500 to the middle market. Prior to 8020 Consulting, Bob led finance and accounting as the Vice President of Finance for Ardmore Home Design, a high growth wholesale luxury furniture company. He has leadership experience with TechnipFMC (oil and gas equipment and technology), Panasonic (in-flight entertainment and communication), Hawker Beechcraft (general aviation) and Ford Motor Company. Bob also worked with the CapAnalysis Group as a litigation consultant supporting attorneys and clients with finance, accounting and economic analysis. Bob holds an MBA in Finance and Accounting from the Ross School of Business at the University of Michigan and a B.S. in Economics from the W.P. Carey School of Business at Arizona State University.

Tools for Building Financial Models for New Products and Services

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As we scroll on our phones to pass time, we constantly get flooded with targeted ads for new products. Whether it’s for the latest iPhone or a knife so sharp that it can cut through pennies, the appetite for new products and services is a common, daily pang. The level of demand has no ceiling, which is essential to keep the gears moving in companies and innovation thriving.

One of the key responsibilities of Finance professionals is to run the litmus test on potential new offerings. By partnering with key stakeholders and building financial models, they can assure offerings are financially sound and will have sustained value through healthy operating profit streams and alignment with company strategy.

In working with many Product Development and Marketing teams, I’ve seen many an excited Engineer or Marketing Director charging towards me with a gleam of excitement in their eye. They have an idea(!) for the next product that will be a growth catalyst for the company. It is important to keep the excitement but imperative to understand and evaluate how that idea will be successful. As the famous C.D. Jackson noted, “Great ideas need landing gear as well as wings.” In this article, we will shed light on some key tools to help navigate through new offering decision points.

Building Financial Models: Understanding the Size of the Prize

Analyzing the market space and competitive landscape is the proper origin for building a financial model to explore the potential for a new offering. Often in pitching a new product, a Board or Investment Group would first seek to understand the size and characteristics of the market. The market can give an indication of how much the company would need to scale to support the product—or even offer signals to how long the product lifecycle would be in the given market.

Three measures to help understand any market are TAM, SAM and SOM:

Total Available Market (TAM): Annual Revenue x Companies in the Market

TAM represents the total market for your product or service. In most industries, the potential product should feel like a small fish in a large pond with this measure. This gives an idea of the space that the new offering can expand and how freely it can transform within the industry bounds. Investors look at this measure to understand how much the company would need to scale to be a key player in the industry and support the product.

Serviceable Available Market (SAM): Target Segment of TAM x Annual Revenue

SAM starts to filter down to a more specific audience you are trying to reach with your offering. Most of the time, this is filtered to a region or segment level. There is usually a significant decrease between the TAM to SAM measure. The SAM is a vision of the possible market share the company can gain over a period of time and evolution.

Serviceable Obtainable Market (SOM): SAM x Prior Year Market Share

SOM narrows the SAM market to the space that you can obtain with your current operating model, which includes current resources, competition and pricing thresholds. SOM is often modeled as the top line in financial growth calculations.

Understand Market Share: Key Metrics

total addressable market, serviceable addressable market, serviceable obtainable market diagram

Build vs. Buy

In the Tech industry, the question of “Build vs. Buy” is integral in deciding how to launch a new product. The question has often come up in my experience, particularly with software companies. There are many components that drive this decision, with the top factors being:

  • Budget – Modeling the most cost optimal solution that doesn’t sacrifice the quality and timing is key. If there are current resources that have adequate utilization to create your new offering, you might be leaning towards Build. More and more, we see firms partnering and working with third parties in lower-cost geographies to create a low-cost ecosystem in a Buy view. If a company decides to go the Buy route, it is imperative that clear service level agreements are set, so the milestones and timelines are met.
  • Scale – One must ask, “Is the company on its own equipped to create and support the new offering?” People usually think scale is only tied to personnel, but other factors, such as infrastructure, also come into play. I’ve had one experience where a partner company was chosen to provide the “Scale” work and ultimately became a possible candidate to be acquired, which can be very beneficial to the growth and lifecycle of the product and branching out into further offerings.
  • Quality – If the company does not have the skillset to launch the new product, and it will be too time consuming to hire a team, they might lean on a third party to provide the skillset. Specialized skillset companies can be quite pricey, so it all must be managed to the budget.

Building Financial Models: Cost Categorization

In most cases when building financial models (e.g., ROI analysis, cash flow forecasting) in the immediate timeframe, quite a few different types of costs would align with an income statement or project analysis statement (e.g., engineering, marketing, materials, rent). It is beneficial to the stakeholders to categorize costs as One-Time and Run-Rate:

  • One-Time Costs represent the expense to get the offering off the floor, which can span from the first year to even the three-year mark. These costs are not repeatable when the product goes to a steady state.
  • Run-Rate Costs would be the ongoing costs to keep the product at a steady state. The goal is to maximize efficiency in your run-rate state to benefit profit.

Companies are segregating their investment into this model (especially PE- and VC-backed firms) as this method approaches these costs as investments, which benefit and maximize the Run-Rate EBITDA for optimal valuation.

Related Posts:

Pricing

Establishing pricing on new offerings is a balancing act that is tied to the market share analysis mentioned earlier. This takes significant collaboration with the Sales and Marketing team. I’ve seen the pricing from both sides of the coin. Sometimes the pricing is extremely high as there is elevated customer demand, deep pockets and companies have exclusivity in terms of supply. On the other side, pricing starts out lower than usual to penetrate into segments and geographies to build credibility.

It’s important to model pricing in a phased approach that can follow the product lifecycle, noting gross margin could be lower than anticipated due to discounted pricing to gain customer traction (unless efficiencies are found in COGS). Running a pilot on pricing scenarios and offerings will also help get a feel for the market’s reaction to your new offering. Commercial pricing structure is more important these days, as most companies are aligning to a subscription model or negotiating on payment terms. This approach helps the company understand how to align with the demand and marketplace.

Partnering with companies on creating new products has been a great experience for me, as it’s an interesting sandbox in which a Finance professional can merge his or her financial toolbox with creativity. It is truly a team effort to lead a product to success. As we see product lifecycles shorten, and demand for the next shiny object grow, the role of a Financial partner will become more crucial in understanding and nurturing an innovative idea into a successful offering.

Learn More About Building Financial Models

To learn more about the process of building financial models, you can download our financial forecast process guide. If you’d like support from our team of finance and accounting consultants, you can also contact us to start a conversation. We’d be happy to help!

financial forecasting process guide

About the Author

Romesh has 15+ years of experience in leadership positions for multiple global companies encompassing Technology, Market Research, Food & Beverage and Financial Services industries. Prior to joining 8020, Romesh had financial ownership of the Cloud Ethernet testing and Security Solution Divisions. During Romesh’s time at JD Power, he was a key lead of the $1+ billion sale to private equity firm XIO Group from S&P Global, which included complete carveout and standalone workstreams. His areas of expertise include P&L management, financial planning & analysis for business units and corporate consolidation levels, strategic planning, acquisitions including carveout and integration, investor relations and operational finance (e.g., Sales, Marketing, Product Development, Treasury). Romesh also has experience working directly with company boards and private equity firms. Romesh holds a bachelor’s in Business Administration from Pepperdine University.

How to Create Better CAPEX Business Memos

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At some point in time, all businesses will need to invest in new equipment, undertake a large project or take on several strategic initiatives to improve efficiency or generate additional revenues. Capital expenditures (CAPEX) are an inevitable part of growing and maintaining a competitive business.

Over the years, I have been involved in various CAPEX projects, both as a budget manager (or customer) requesting money for a new Business Intelligence tool and as the Finance Business Partner, supporting various divisions and teams requesting significant money for very large equipment purchases in excess of $50M. Through this experience, I have picked up some best practices around the process of requesting funds for CAPEX, the approval process, how to integrate the new equipment or initiative into a company’s current process and the subsequent reporting needed to maintain effective communications with the relevant project sponsors and the management team as a whole.

I’ve also developed an approach to a capital expenditure report that I’ve found to be particularly effective in communicating with management.

Let’s start by building a picture of what a typical CAPEX project used to look like.

Early on in my career, the typical CAPEX process resembled something like this:

  1. The manufacturing, operational or other specific group that identified the need would submit a request to the Finance team in the form of an e-mail or possibly a conversation detailing how much they expected to spend and the reason for the request (e.g., aging or obsolete equipment that needed to be repaired constantly).
  2. The Finance team would then put the request into a formal document, such as a Business Case, presenting this information for the CFO, CEO and Board (i.e., the budget approval committee) including the price, expected timing of the spend and the business rationale for requesting the funds.
  3. The budget approval committee would review the formalized Business Case proposal and make a decision, which would then be communicated back to the project sponsor of the department in question.
  4. The project manager then could start spending money.

This used to be the typical process and is likely similar across many organizations across the country.

Finance needs to be involved at the outset (and ideally continuously).

As mentioned earlier, the need for CAPEX typically originates at a functional or team level. To use manufacturing as an example (though it could be any function in the company), these are the folks that are a key part of the day-to-day production process. In an ideal world, they are already working closely with the Finance partner in managing their operating budget and identifying process improvements to integrate into the process on a continuous basis. If this partnership is functioning effectively, then discussions around potential capital investments are happening at this level between both teams.

The benefits of this cannot be understated. As Finance is working in the trenches with the business, very close to the underlying processes that need to be transformed or invested in, key questions become part of the conversation that leads to a CAPEX proposal.

  • If purchasing new equipment is the answer, does this improve the rate of production?
  • If so, can we approximate by how much?
  • Can the existing equipment be repaired to improve its longevity – and if so, is this financially feasible over the longer term?
  • If equipment is being replaced, can we eliminate some of our fixed costs (like maintenance personnel or spare part inventory)?
  • Will down time be reduced?

These questions and the conversations they start will help add a higher level of scrutiny that executives will appreciate. They also help prepare the team to articulate their needs in a more clear and logical manner.

Seek bids from multiple vendors.

CAPEX projects by nature involve significant costs as well as time commitment for the company in question. Part of the procurement process should involve seeking RFPs (requests for proposals) or quotes from three separate vendors at a minimum if this is possible. (In some cases, there are a limited number of manufactures for certain pieces of specialized components/equipment.)

Seeking multiple bids will not only ensure a robust process where a company can become educated about the investment required, it also raises further questions that may not have been identified internally by the company – particularly when the price quotes are significantly beyond the expectation of the company seeking the proposals. Vendors can provide valuable information about the key bottlenecks to avoid and advice on best practices given their unique position providing services to competitors.

Package the findings in a concise capital expenditure report.

The most critical aspect of the CAPEX process is the formal presentation to the executive team. In many instances, this may not even occur in person. Sometimes the executive of the function or division seeking the funding will get an opportunity to present their request formally to the rest of the executive team – and possibly the board.

Given that you may not have an opportunity to present your request in person, it’s critical to present all the salient features of the proposal in a concise capital expenditure report document. Emphasis should be on keeping it brief (ideally within 2 pages), as executives are invariably quite busy, without compromising on comprehensiveness in answering the main lines of inquiry. A format that has proven to be effective for me consistently is the following structure:

1. To/From/Subject

The document should be addressed to specific Executives and have a subject line. The approval committee are often reviewing multiple requests, so having a document for each helps provide specific insight and organize meetings.

2. Project Summary

Write a brief explanation of the background of the project, expected cost and benefits and potential risks. This should be no more than two paragraphs long.

3. Financial Summary

Offer a summary of the cost and accompanying ROI for the project with the main assumptions used. I have found adding a payback calculation is also very helpful for executives.

4. Transition Period Risk Management

What are the risks involved? How will the company manage these risks to reduce and/or eliminate them?

5. Strategic Opportunities

What are the main benefits of spending this money? Will the company reduce production times? Will there be savings in labor or other areas? Will specific KPIs improve?

6. Measurement/Reporting

Outline the expectations for when the Finance team will be conducting a post-mortem once the project has been completed. For many CAPEX initiatives, there are ongoing assumptions about savings in perpetuity (i.e., versus an older, relatively inefficient process). Describe the expectations for how long these savings are expected to accrue (in collaboration with the respective team or department) and how often will reporting need to be developed to review the actual savings versus those initially presented in the proposal. The expectation should be for the Finance team to prepare these reports with input and verification from the functions in question. (This is another reason why it’s critical for Finance to be involved from the outset – to document and be a central repository for this process as it evolves over time.) This is critical when tracking performance many months or years after the project has been delivered and the funds have been spent. (There’s more on this in the next section.)

7. Next Steps

What is specifically required from the approval committee and by when? It is also worth highlighting any lead times from vendors since they usually have an impact on the company – particularly when approvals take inordinately long to be processed.

Consider these metrics within your capital expenditure report.

Net Present Value (NPV)

The net present value (NPV) is also referred to as the discounted cash flow approach. It is generally the most widely used and simplest method for capital budgeting, and it’s also considered a measure to gauge the profitability or attractiveness of a capital investment. With this method, the company’s discount rate (or minimum required rate of return) must be a known input to derive the project’s NPV. To compute the NPV, all cash flows are discounted to their present value (hence the term net present value) and then aggregated.

A positive NPV indicates a project’s cash flow will exceed its cost. Conversely, a negative NPV indicates a loss of income/value, and such a project should not be undertaken (i.e., it is earning below the required rate of return for the company).

Given this logic, the higher the NPV, the more attractive a project – so the NPV method can be used to rank projects which can be very helpful when the company has limited capital to deploy and needs to optimize its investment decision-making.

Internal Rate of Return (IRR)

The internal rate of return (IRR) is another common financial measure for how attractive a capital investment project is. As a measure, it is considered one of the most practical approaches because it does not require having a hurdle rate (sometimes referred to as the company’s cost of capital) up front unlike the NPV approach. This method also discounts the project’s cash flows; however, since no discount rate is needed, the IRR provides the discount rate as an output.

Specifically, the IRR method computes the rate at which the NPV is zero. Said differently, the IRR calculates the maximum cost of capital that a project can bear for a capital project to break even.

There are a few considerations worth mentioning when using the IRR method. Generally, the IRR and NPV methods will provide similar if not identical analysis. Although if projects are mutually exclusive or have non-conventional cash flows, the IRR can be misleading. When the results conflict, the NPV is generally the most superior method to follow, although in practice, the IRR is more popular because it provides a percentage figure that can be compared to a hypothetical rate of return more directly rather than a dollar amount.

Communicate progress regularly.

Providing status updates to senior management is critical to ensure transparency and a robust process that senior executives can be confident with. This also provides valuable goodwill for the project sponsors (and Finance) that will be needed when further projects need to be discussed and reviewed for potential additional CAPEX. I have been involved in projects where future larger requests have been approved rapidly because executives are comfortable with the pace and regular updates on the previous projects (via e-mail or in weekly meetings). This helps executives also anticipate and field questions they may get from outside stakeholders, investors and the Board.

These are just some of the key steps that have proven to be very effective in getting capital expenditure projects off the ground seamlessly and over time they can be further refined to address specific processes (not just CAPEX) within the company.

Download our example capital expenditure report for more.

We’ve put together an example capital expenditure report for free download. It features an example CAPEX business case, so you can learn a little more about the process of putting together your own report and get a sense of what an effective memo looks like:

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You can subscribe to our blog to receive email notifications when we post new articles and resources. And if you’d like to learn more about working with our team of financial planning & analysis consultants, we invite you to contact us. We’d be excited to discuss how our team of 90+ consultants can support your goals.

About the Author

Ebrahim has 17+ years of experience in finance across diverse industries including a global shipping terminal conglomerate, logistics, manufacturing, retail and consumer product companies. His experience spans mid-sized, Fortune 500 and private-equity-owned companies in England and USA. He has established FP&A processes from the ground up, spending most of his time in the trenches working with Operational and Financial Executives to understand performance through a range of analytical tools and by leveraging his deep experience in leading Operational Finance. His experience encompasses strategic planning, budgeting, forecasting, management and Board commentaries/reporting, financial/operational modeling, FP&A, P&L review/management, system design and process re-engineering. He has led the implementation of a company-wide BI system for an international terminal operator. He holds an MBA in Supply Chain from CSU Long Beach, an MS in Finance from Henley Business School. He is a Chartered Accountant (UK) and Certified Management Accountant.

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CAPEX Business Case Memo Example

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Get our sample capital expenditure report to learn how to put together your own documents. It offers key sections to include in your reports, as well as a focus on brevity, without compromising on comprehensiveness in answering the main lines of inquiry.

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