Should You Outsource Analytics? Net Present Value (NPV) / MBA Resources

Introduction to Net Present Value (NPV) - What is Net Present Value (NPV) ? How it impacts financial decisions regarding project management?

NPV solution for Should You Outsource Analytics? case study

At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. Should You Outsource Analytics? case study is a Harvard Business School (HBR) case study written by David Fogarty, Peter C Bell. The Should You Outsource Analytics? (referred as “Bpos Analytics” from here on) case study provides evaluation & decision scenario in field of Strategy & Execution. It also touches upon business topics such as - Value proposition, Operations management, Strategy.

The net present value (NPV) of an investment proposal is the present value of the proposal’s net cash flows less the proposal’s initial cash outflow. If a project’s NPV is greater than or equal to zero, the project should be accepted.

NPV = Present Value of Future Cash Flows LESS Project’s Initial Investment

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Case Description of Should You Outsource Analytics? Case Study

This is an MIT Sloan Management Review article. The surge of interest in big data has led to growing demand for analytics teams. Assembling such teams, however, is difficult. For one thing, many companies lack the in-house knowledge and experience needed to put together a world-class analytics team. What's more, the labor market for analytics professionals has grown increasingly tight. The shortage of analysts -particularly those capable of developing and leading world-class teams that can enable a company to create a competitive advantage from its data and analytics -is driving organizations to consider outsourcing their analytics activities. Analytics is the latest in a string of activities companies are outsourcing to business process organizations (BPOs). It draws heavily on mathematics and statistics knowledge, and many analytics-oriented BPOs have operations in India. Although some companies have world-class analytics capabilities in-house, the authors posed the question: Can an analytically naA?ve company "buy"world-class analytics functions by hiring outside experts? The authors studied both four multinational companies that used one or more offshore analytics BPOs and four analytics BPOs. Two of the client companies had skills that were judged to be "analytically superior"; the other two were judged to be "analytically challenged."The analytically challenged companies saw analytics BPOs as a way to obtain the resources and training needed to manage and execute their analytics and to gain quick access to important insights. By contrast, the analytically superior companies wanted to expand their internal analytic capabilities, in part because they wanted to preserve their ability to develop and protect intellectual property; they tended to use offshore BPOs to perform low-level analytics. According to the authors, the best analytics BPOs have core competencies that go beyond what most companies can perform on their own with internal teams. They advise companies working with analytics BPOs to be clear about who does what, who owns what, how each party can use the information it has and what happens to the information and knowledge in the event that the BPO is acquired.

Case Authors : David Fogarty, Peter C Bell

Topic : Strategy & Execution

Related Areas : Operations management, Strategy

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Calculating Net Present Value (NPV) at 6% for Should You Outsource Analytics? Case Study

Years	Cash Flow	Net Cash Flow	Cumulative     Cash Flow	Discount Rate @ 6 %	Discounted Cash Flows
Year 0	(10020538)	-10020538	-	-
Year 1	3447562	-6572976	3447562	0.9434	3252417
Year 2	3954041	-2618935	7401603	0.89	3519082
Year 3	3945481	1326546	11347084	0.8396	3312702
Year 4	3231287	4557833	14578371	0.7921	2559482
TOTAL			14578371		12643683

The Net Present Value at 6% discount rate is 2623145

In isolation the NPV number doesn't mean much but put in right context then it is one of the best method to evaluate project returns. In this article we will cover -

Different methods of capital budgeting

What is NPV & Formula of NPV,
How it is calculated,
How to use NPV number for project evaluation, and
Scenario Planning given risks and management priorities.

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Capital Budgeting Approaches

Methods of Capital Budgeting

There are four types of capital budgeting techniques that are widely used in the corporate world –

1. Internal Rate of Return
2. Payback Period
3. Net Present Value
4. Profitability Index

Apart from the Payback period method which is an additive method, rest of the methods are based on Discounted Cash Flow technique. Even though cash flow can be calculated based on the nature of the project, for the simplicity of the article we are assuming that all the expected cash flows are realized at the end of the year.

Discounted Cash Flow approaches provide a more objective basis for evaluating and selecting investment projects. They take into consideration both –

1. Timing of the expected cash flows – stockholders of Bpos Analytics have higher preference for cash returns over 4-5 years rather than 10-15 years given the nature of the volatility in the industry.
2. Magnitude of both incoming and outgoing cash flows – Projects can be capital intensive, time intensive, or both. Bpos Analytics shareholders have preference for diversified projects investment rather than prospective high income from a single capital intensive project.

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Formula and Steps to Calculate Net Present Value (NPV) of Should You Outsource Analytics?

NPV = Net Cash In Flowt1 / (1+r)t1 + Net Cash In Flowt2 / (1+r)t2 + … Net Cash In Flowtn / (1+r)tn
Less Net Cash Out Flowt0 / (1+r)t0

Where t = time period, in this case year 1, year 2 and so on.
r = discount rate or return that could be earned using other safe proposition such as fixed deposit or treasury bond rate. Net Cash In Flow – What the firm will get each year.
Net Cash Out Flow – What the firm needs to invest initially in the project.

Step 1 – Understand the nature of the project and calculate cash flow for each year.
Step 2 – Discount those cash flow based on the discount rate.
Step 3 – Add all the discounted cash flow.
Step 4 – Selection of the project

Why Strategy & Execution Managers need to know Financial Tools such as Net Present Value (NPV)?

In our daily workplace we often come across people and colleagues who are just focused on their core competency and targets they have to deliver. For example marketing managers at Bpos Analytics often design programs whose objective is to drive brand awareness and customer reach. But how that 30 point increase in brand awareness or 10 point increase in customer touch points will result into shareholders’ value is not specified.

To overcome such scenarios managers at Bpos Analytics needs to not only know the financial aspect of project management but also needs to have tools to integrate them into part of the project development and monitoring plan.

Calculating Net Present Value (NPV) at 15%

After working through various assumptions we reached a conclusion that risk is far higher than 6%. In a reasonably stable industry with weak competition - 15% discount rate can be a good benchmark.

Years	Cash Flow	Net Cash Flow	Cumulative     Cash Flow	Discount Rate @ 15 %	Discounted Cash Flows
Year 0	(10020538)	-10020538	-	-
Year 1	3447562	-6572976	3447562	0.8696	2997880
Year 2	3954041	-2618935	7401603	0.7561	2989823
Year 3	3945481	1326546	11347084	0.6575	2594218
Year 4	3231287	4557833	14578371	0.5718	1847499
TOTAL					10429420

The Net NPV after 4 years is 408882

(10429420 - 10020538 )

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Calculating Net Present Value (NPV) at 20%

If the risk component is high in the industry then we should go for a higher hurdle rate / discount rate of 20%.

Years	Cash Flow	Net Cash Flow	Cumulative     Cash Flow	Discount Rate @ 20 %	Discounted Cash Flows
Year 0	(10020538)	-10020538	-	-
Year 1	3447562	-6572976	3447562	0.8333	2872968
Year 2	3954041	-2618935	7401603	0.6944	2745862
Year 3	3945481	1326546	11347084	0.5787	2283264
Year 4	3231287	4557833	14578371	0.4823	1558298
TOTAL					9460393

The Net NPV after 4 years is -560145

At 20% discount rate the NPV is negative (9460393 - 10020538 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Bpos Analytics to discount cash flow at lower discount rates such as 15%.

Acceptance Criteria of a Project based on NPV

Simplest Approach – If the investment project of Bpos Analytics has a NPV value higher than Zero then finance managers at Bpos Analytics can ACCEPT the project, otherwise they can reject the project. This means that project will deliver higher returns over the period of time than any alternate investment strategy.

In theory if the required rate of return or discount rate is chosen correctly by finance managers at Bpos Analytics, then the stock price of the Bpos Analytics should change by same amount of the NPV. In real world we know that share price also reflects various other factors that can be related to both macro and micro environment.

In the same vein – accepting the project with zero NPV should result in stagnant share price. Finance managers use discount rates as a measure of risk components in the project execution process.

Sensitivity Analysis

Project selection is often a far more complex decision than just choosing it based on the NPV number. Finance managers at Bpos Analytics should conduct a sensitivity analysis to better understand not only the inherent risk of the projects but also how those risks can be either factored in or mitigated during the project execution. Sensitivity analysis helps in –

What can impact the cash flow of the project.

Understanding of risks involved in the project.

What are the key aspects of the projects that need to be monitored, refined, and retuned for continuous delivery of projected cash flows.

What will be a multi year spillover effect of various taxation regulations.

What are the uncertainties surrounding the project Initial Cash Outlay (ICO’s). ICO’s often have several different components such as land, machinery, building, and other equipment.

Some of the assumptions while using the Discounted Cash Flow Methods –

Projects are assumed to be Mutually Exclusive – This is seldom the came in modern day giant organizations where projects are often inter-related and rejecting a project solely based on NPV can result in sunk cost from a related project.

Independent projects have independent cash flows – As explained in the marketing project – though the project may look independent but in reality it is not as the brand awareness project can be closely associated with the spending on sales promotions and product specific advertising.

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Negotiation Strategy of Should You Outsource Analytics?

References & Further Readings

David Fogarty, Peter C Bell (2018), "Should You Outsource Analytics? Harvard Business Review Case Study. Published by HBR Publications.