Is the Optimum Choice Always the Choice with the Largest ROI?

Recently a student stated that the best (optimum) choice of investment was always the choice with the largest ROI.  Is this really the case?  ROI is a statement of fact about an investment, but is it always the best basis on which to make a choice?  Simply saying we choose A over B because A has a higher ROI may be correct but is also fraught with potential pitfalls.

Consider an example:  If A and B have the same investment, then choosing the higher ROI is always appropriate.  However, suppose I have ﹩1M in a box.  If I do nothing with the box, it will still have ﹩1M in it 1 year from now (i.e., ROI = 0).  Suppose I have the following two (and only two) options:

1. Take only ﹩1 from the box and invest it in something (leave the other ﹩999,999 in the box).  At the end of the year I will get ﹩2 back on my investment.  ROI is 1 (or 100%) on this investment.
2. Take the whole ﹩1M and invest it in something.  At the end of the year I will get ﹩1.3M back.  ROI is 0.3 (or 30%) on this investment.

Which is better?  Obviously the second option, but it has a lower ROI, why?  There is a fallacy here, in reality, I have led you astray by incorrectly calculating the ROI of the first case.  In the first case the entire ﹩1M is effectively invested, not just ﹩1, (﹩1 to the investment and ﹩999,999 stays in the box).

The correct calculation is:

1. Investment = ﹩1M, Return = ﹩1,000,001, ROI = 1x10^-6
2. Investment = ﹩1M, Return = ﹩1,300,000, ROI = 0.3

So, choosing case 2 (the higher ROI) would, in fact, be the best choice - just make sure you calculate the ROI consistently when you compare the two cases.

Net Return

An alternative (and possibly more appropriate) treatment of this case would be to determine the net return (or net present value).  Net return = gross return – investment.  ROI is not the same as net return.  The optimum from an accounting point of view means maximizing the net return, not the ROI.  The optimum is going to be the case that maximizes the return less the investment (i.e., the net return).  Calculating the net return for these two cases gives:

1. ﹩1,000,001-﹩1,000,000 = ﹩1
2. ﹩1,300,000-﹩1,000,000 = ﹩300,000

ROI fails when it is applied in a way that is inconsistent with the mission of the organization.  If the organization is a for-profit company, the mission is to maximize the wealth of its owners by maximizing the net present value of all existing and projected investments. The goal, is not the maximization of ROI, but to maximize the difference between the capital that put or left in the organization and the present value of the cash flow that can be taken out of it.

Maximizing the ratio of market value-to-invested capital (ROI), is not the same thing as maximizing the difference between market value and invested capital (the net return).

Levelized Cost of Energy (LCOE)

Despite the prevalence of its use in the world of energy analysis, and its apparent simplicity, the formulation of common forms of the levelized cost of energy (LCOE) is rarely addressed and the meaning of its parameters is often misstated.

The levelized cost of energy, also known as the levelized cost of electricity, or the levelized energy cost (LEC), is an economic assessment of the average total cost to build and operate a power-generating asset over its lifetime divided by the total power output of the asset over that lifetime. LCOE is often taken as a proxy for the average price that the generating asset must receive in a market to break even over its lifetime.  LCOE is appealing because it is a first-order economic assessment of the cost competitiveness of an electricity-generating system that incorporates all costs over its lifetime: initial investment, operations and maintenance, cost of fuel, and cost of capital.

In the following, we derive the most common form of the LCOE.  The LCOE is the cost that, if assigned to every unit of energy produced (or saved) by a system over the analysis period, will equal the TLCC (total life-cycle cost) when discounted back to the base year [1].  This definition of LCOE is represented by,

                                                                                              (1)

where

r           = discount rate (per year)

i           = year

n          = number of years over which the LCOE applies

E_i         = quantity of energy produced in year i

TLCC  = total life-cycle cost.

Discrete compounding has been assumed in Equation (1).  Since LCOE is by definition constant (not dependent on the year i), we can factor it out of the summation and rewrite Equation (1) as,

                                                                                                      (2)

Equation (2) is the most common form of LCOE in use today.  Note, the denominator of Equation (2) appears to be discounting the energy (and some references refer to it as "discounted energy"), however, only costs can be discounted; the apparent discounting is actually a result of the algebra carried through from Equation (1) in which revenues (the product of E_i and LCOE) were discounted.

The total life-cycle cost (TLCC) can include several contributions depending on the application.  Commonly it is formulated as,

                                                                                  (3)
where

I_i          = investment expenditure in year i including financing (this assumes that either the investment cost is paid over time or it is allocated over time using a depreciation schedule)

M_i       = operations and maintenance expenditures in year i

F_i         = fuel expenditures in year i (for renewable energy generation, e.g., wind or solar, this may be zero).

Typically, the LCOE is calculated over the lifetime of an asset, which is usually 20 to 40 years.  However, care should be taken when comparing different LCOE studies and the sources of the information as the LCOE for a given energy source is highly dependent on the assumptions, financing terms and technological deployment analyzed.

[1] Short, W. Packey, D.  J. and Holt, T. (1995). A Manual for the Economic Evaluation of Energy Efficiency and Renewable Energy Technologies, NREL/TP-462-5173, March.  http://www.nrel.gov/docs/legosti/old/5173.pdf Accessed April 28, 2016.

Sustainment and Sustainment-Dominated Systems

Many people have a preconceived notion that “sustainment” and “sustainability” only refer to environmental sustainability, which is unfortunate.  Sustainment and sustainability are concepts that are much older and broader than just the environmental context that the popular media most often relates them to. 

The origin of the word sustain is the Latin word sustenare, which means “to hold up” or “to support”.  The modern use of the word sustain is to keeping something going or to extend its duration, [1], where the most common synonym for sustain is maintain.  It is not uncommon for sustain and maintain to be interchangeably used, however, maintenance usually refers to activities that are targeted at correcting problems, while sustainment is a more general term referring to the management of system evolution.

The concept of sustainability is connected to nearly every discipline [2], e.g., environmental sustainability, business or corporate sustainability and technology sustainment, however, in this blog we are interested in technology sustainment.  Although sustainability and sustainment are closely related in a semantic sense, environmental sustainability organizations almost never refer to what they are doing as sustainment or sustainment engineering.  However, organizations that maintain systems (sustainment organizations) use both sustainment and sustainability to describe what they do.

Technology sustainment refers to all activities necessary to [2]: a) keep an existing system operational so that it can successfully complete its intended purpose; b) continue to manufacture and install versions of the system that satisfy the original requirements; and c) manufacture and install revised versions of the system that satisfy evolving requirements.

Sustainment Definition

The most widely circulated definition of sustainability is attributed to the Brundtland Report [3], which is often paraphrased as “development that meets the needs of present generations without compromising the ability of future generations to meet their own needs.” This definition was created in the context of environmental sustainability, however, it is useful and applicable for defining all types of sustainability.  For example, for technology sustainment, “present and future generations” in the Brundtland definition can be interpreted as the users and maintainers of a system.  Unfortunately, the definition of sustainability has been customized by many organizations to serve as a means to an end, and in some cases it has been abused to serve special interests and marketing.

A good general definition of sustainment is [4]: “development, production, operation, management, and end-of-life of systems that maximizes the availability of goods and services while minimizing their footprint”.  In this case the terms in the definition mean:

• “footprint” could represent any kind of impact that is relevant to the system’s stakeholders, e.g., cost (economics), human health, energy required, environmental, and/or other resource consumption (water, materials, labor, expertise, etc.)
• “availability” represents the fraction of time that a good or service is in the right state, supported by the right resources, and in the right place when the customer requires it
• “customer” could be an individual, a company, a city, a geographic region, a specific segment of the population, etc.

Note that this definition is consistent with both environmental and technology sustainment concerns.

Sustainment-Dominated Systems

A sustainment-dominated system is defined as a system for which the lifetime footprint significantly exceeds the footprint associated with making it [2].  Where "footprint" has the same definition as above. Defining sustainment-dominated systems provides the opportunity to make a distinction between high-volume, low cost consumer products and more complex, higher-cost systems such as airplanes, infrastructure, and institutions. Non-sustainment-dominated products, which tend to be high-volume products, have relatively little investment in sustainment activities and the total time period associated with the product is short (short manufacturing cycle, short field life).  Alternatively, sustainment-dominated products, which tend to be relatively low-volume expensive systems, have large sustainment costs and long manufacturing and/or field lives (see my "More Than Acquisition Costs - F-35" blog post in December 2016).

[1] Sutton, P. (2004). What is sustainability? Eingana, 27(1), pp. 4-9.

[2] Sandborn, P. and Myers, J. (2008). Designing engineering systems for sustainability, in Handbook of Performability Engineering, K.B. Misra, Editor, pp. 81-103 (Springer, London).

[3] Brundtland Commission (1987). Our Common Future, World Commission on Environment and Development.

[4] Sandborn, P. (2017). Cost Analysis of Electronic Systems, 2nd edition, World Scientific.

Sustainment Vicious Circle

A vicious circle or cycle is when a bad situation feeds on itself to get worse.  Many “systems” (social, economic, ecological, technological) are comprised of chains of events that form feedback loops that can under some circumstances reinforce the previous cycle (positive feedback). 

It is not uncommon for sustainment-dominated systems (see my January 2017 blog post) to get caught in a “sustainment vicious circle” (or “vicious cycle” [1]).  In this case, more money is going into sustainment (maintaining the systems) at the determent of new investment, which causes the systems to age, which in turn causes more money to be required for sustainment, which leaves less money for new investment, and the cycle continues.  The sustainment vicious circle is a reality for militaries of many of the world’s countries, civil infrastructure, and can also appear for systems owned by individuals.  For example, individuals might face this dilemma with their automobile – fixing your existing car is expensive, but it is less expensive than buying a new car; after several such repairs one is left to wonder if purchasing a new car would have been less expensive, but there is no turning back, too much has been invested in repairing the old car (the funds that could have been used to purchase a new car have been spent).

Setting aside your used car, in this blog we are primarily talking about large, complex, expensive systems, like a fleet of aircraft, a fleet of buses, rail infrastructure, the water/sewer system in cities, etc.  These things are massively expensive to replace or upgrade (and massively expensive to sustain).  Let’s be clear, not every large, complex, expensive system suffers the sustainment vicious circle – many are well managed and correctly funded.  However, the evidence of sustainment vicious circles are all around you – look at the neglected portion of a city’s aging infrastructure.  The cause of the sustainment vicious circle is often the inability or unwillingness of system’s owners (which may be the public) to budget appropriately for sustainment (operation and maintenance), which is exacerbated by unanticipated life extensions of the system requiring it to last longer than it was designed (or funded) to last.  The money to build new things is always easier to get than the money to sustain old things AND old things always end up having to be supported longer than anyone anticipated.

How do you get out of a sustainment vicious circle?  Either the system reaches its breaking point (literally, possibly catastrophically) and simply must be replaced, or the system has to be transitioned to a more “vital cycle” that would reduce the sustainment costs of legacy systems, and provide for modernization. Pursuing the “vital cycle” is not cheap (customers have to be willing to pay) and it usually comes with one key caveat: any action taken cannot adversely affect the customer’s needs in the short term.

Corollary to the Vicious Circle – The Upgrade Trap [3]

Related to the vicious circle is the “upgrade trap”.  A common version of the “upgrade trap” is forced upon consumer electronics users.  How often have you been forced to buy a new device because none of your software would run on your old hardware?   The upgrade trap is indiscriminant, even users that derive no actually benefit from higher-performance hardware or greater functionality software, are forced to “keep up” whether they want to or not.  Even systems that are seemingly disconnected from commercial interests such as military systems are impacted, e.g., if these systems contain COTS (Commercial Off-The-Shelf) application software, the continued support of the application may require hardware upgrades that are not otherwise needed or wanted.  Is the upgrade trap by design – certainly, it is a form for planned obsolescence (see my February 2017 blog post).

The one thing that is worse than being caught in the upgrade trap, is not being caught in the upgrade trap, i.e., being caught in the “sustainment vicious circle”.

[1]  Achieving an Innovative Support Structure for 21st Century, PSB 96 (10-13-97)

[2] Sustainment, Proceedings of the Sustainment Team of the Industry Affordability Task Force, Report Number 98-SS1A, National Center for Advanced Technologies, January 1999  http://www.ncat.com/sustain.pdf

[3] P. Sandborn and J. Myers, "Designing Engineering Systems for Sustainment," Handbook of Performability Engineering, ed. K.B. Misra, Springer, pp. 81-103, London, 2008.

Cost Avoidance Based Return on Investment (ROI)

The determination of the ROI allows managers to include quantitative, readily interpretable results in their decision-making.  While the formulation of an ROI associated with investing money in a financial instrument is straightforward, the calculation of an ROI associated with the generation of an increase in the customer base, cost savings, or a future cost avoidance is less straightforward. 

ROI is a common performance measure used to evaluate the efficiency of an investment or to compare the efficiency of a number of different investments. To calculate ROI, the benefit or gain associated with an investment is divided by the cost of the investment and the result is expressed as a percentage or a ratio:

                (1)

An ROI of 0 represents a break-even situation--that is, the value you get back exactly equals the value you invested.  If the ROI is > 0, then there is a gain; if the ROI is < 0, there is a loss.  Equation (1) is relative to the no-investment case (e.g., burying the cash in the ground).

Cost Avoidance ROI
Cost avoidance is a reduction in costs that have to be paid in the future.  Cost avoidance is commonly used as a metric by organizations that have to support and maintain systems to quantify the value of the services that they provide and the actions that they take.  See my May 31, 2017 Blog post for more about cost avoidance.

Cost avoidance ROIs are a bit more difficult to calculate than the financial ROIs.  As an illustration, consider the determination of an ROI for the addition of some sort of improvement to a system.  This improvement will result in a future cost avoidance (maybe it reduces the future maintenance costs).  Is the investment in the improvement worth it? 

To formulate the ROI for adding this improvement to a system, we first have to decide what we are measuring the ROI relative to.  For our example, we could measure the ROI relative to maintaining the system without the improvement.  The ROI from Equation (1) becomes, [1]:

                             (2)
where

C_wo = the life-cycle cost of the system managed without the improvement

C_w  = the life-cycle cost of the system managed with the improvement

I_w    = the investment in the improvement

If C_wo is larger than C_w then there is a positive ROI.  The nice thing about Equation (2) is that the numerator is the difference of life-cycle costs, i.e., one only has to be able to determine the difference between the two cases (the actual values of C_wo and C_w, which are much harder to determine, are not needed) – see my November 2016 blog post on absolute vs. relative costs.  Note that C_w is a life-cycle cost that therefore includes I_w within it.

Another challenge with this ROI calculation is determining the investment cost (the denominator of Equation (2)).  For cost avoidance cases it is not always clear what costs are the investment and what costs are the result of an investment.  For example, if my improvement converts corrective maintenance actions (due to system failures) to preventative maintenance actions (taken before failure), the improvement could result in more (but less expensive) maintenance actions and the need for more spare parts.   Is the cost of the extra spare parts accounted for in the investment (I_w)?  The extra spare part cost in this case would not be included in the investment cost because the extra spare parts are the result of the improvement (i.e., the result of the investment) and are reflected in the life-cycle cost C_w.

General Comments about Calculating ROIs

1. Constructing a business case for an activity does not necessarily require that the ROI be greater than zero; in many cases, value is not fully quantifiable in monetary terms, or the activity is necessary in order to meet a system requirement that could not otherwise be attained, such as satisfying a system availability requirement.  
2. The calculation of ROI can be modified to suit the situation depending on what you include as returns and investments.  This means that ROIs are easy to calculate but can be deceivingly difficult to get right.  Financial investment ROIs are straightforward, but when evaluating the ROI of a cost savings, market share increase, or cost avoidance, the difference between costs that are investments and those that are returns is blurred.
3. ROIs have to be relative to some clearly defined situation.  Most often ROI for cost avoidance is measured relative to “business as usual”, i.e., the management of the system if no investment was made.
4. ROI is not independent of the cost of money (discount rate).  The discount rate will impact the life-cycle costs in Equation (2).
5. ROI can fool you, be careful.  The largest ROI solution may not represent the best option for an organization – see my February 6, 2020 Blog post.

[1] Feldman, K., Jazouli, T. and Sandborn, P. (2009). A methodology for determining the return on investment associated with prognostics and health management, IEEE Transactions on Reliability, 58(2), pp. 305-316.

Should-Cost

Should-cost is the result of cost modeling done by a customer to determine what it should cost them to purchase a product, service or system support [1].  Should-costing is based on the customer’s accounting and their understanding of the product or service. When a customer knows a product or service’s should-cost, then they know what they should pay for it.

Why is should-cost a thing?  For many common products, market competition protects the customer from significant overpayments (assuming the customer shops around or allows the market compete for their business).  However, for unique products and services (e.g., military programs, contracted services, etc.), where there is no market competition that sets prices at fair levels, knowing the should-cost is critical when a customer wishes to guard against overpayment.

A common alternative to should-costing is strategic sourcing, which is the process of comparing price quotes from different sources.  Alternatively, should-costing would start from an analysis of labor, materials, overhead, profit margin, etc., to estimate what the price should be.  Strategic sourcing is used for commodity items (e.g., if you are going to buy a washing machine, you shop around), while should-costing is used for highly engineered systems and services where there are few suppliers (e.g., a new aircraft carrier).  A commonly used example is the purchase of a car.  A strategic car buyer goes to multiple dealers to see who will give them the best price.  A should-cost buyer researchers the dealer’s invoice price and how dealers determine their markups and then tells the dealer what price they will pay for the car.

The car buying example aside, in the real world should-cost should be thought of as leverage, not a prediction [2].  Any should-cost analysis you perform will be wrong – there are thing you simply don’t know.  Most people have the expectation that the predictive power of should-cost alone will have the strength to cause the negotiated price to equal the price determined from the should-cost estimate - this is a great goal, but it is not typically realistic.  The point of should-cost is that it gives you leverage to push a quoted price toward your should-cost estimate.

[1] Carter, A. B. and Mueller, J. (2011).  Should cost management: Why? How?, Defense AT&L: Better Buying Power, Sept-Oct, pp. 14-18.

[2] Hiller, E. A. (2012), “Your Should-Cost Number is Wrong, But it Doesn’t Matter,” Industry Week, October 21, http://www.industryweek.com/procurement/your-should-cost-number-wrong-it-doesnt-matter  Accessed July 17, 2017.

Cost Avoidance vs. Cost Savings

In the case of manufacturing processes, it is reasonable to characterize the value of process, equipment and yield changes as cost savings.  However, the value of life-cycle management activities (i.e., sustainment) is usually quantified as a cost avoidance.  “Cost avoidance is a cost reduction that results from a spend that is lower than the spend that would have otherwise been required if the cost avoidance exercise had not been undertaken” [1].  A simpler definition of cost avoidance is a reduction in costs that have to be paid in the future to sustain a system [2].  

Cost avoidance is commonly used as a metric by organizations that have to support and maintain systems to quantify the value of the services that they provide and the actions that they take.  These organizations do not like to use the term “cost savings” since a savings implies that there is unspent money, whereas in reality there is no unspent money, only less money that needs to be spent.  Another way to put it is, if you told a customer that you saved 100 dollars, the customer could ask you for the 100 dollars back; if you told a customer you avoided spending 100 dollars there is no 100 dollars to give back.

Unfortunately, making business cases based on a future cost avoidance argument is often more difficult than business cases that are based on cost savings, therefore, there is a greater need to be able to provide detailed quantification of sustainment costs.  Requesting resources to create a cost avoidance is not as persuasive as making a cost savings or a return on investment argument. 

[1] Ashenbaum, B. (2006). Defining Cost Reduction and Cost Avoidance, CAPS Research.

[2] Sandborn, P. (2017). Cost Analysis of Electronic Systems, 2nd edition, World Scientific.