Understanding the process of backsourcing: two cases of process and product backsourcing in Europe 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 Understanding the process of backsourcing: two cases of process and product backsourcing in Europe case study

At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. Understanding the process of backsourcing: two cases of process and product backsourcing in Europe case study is a Harvard Business School (HBR) case study written by Julia Kotlarsky, Lars Bognar. The Understanding the process of backsourcing: two cases of process and product backsourcing in Europe (referred as “Backsourcing Process” from here on) case study provides evaluation & decision scenario in field of Technology & Operations. It also touches upon business topics such as - Value proposition, Operations management.

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 Understanding the process of backsourcing: two cases of process and product backsourcing in Europe Case Study

Backsourcing, defined generally as bringing services outsourced to a third party back in-house, is now a growing phenomenon. The decision to backsource has several significant implications for an organization, as it requires the organization to manage organizational change, reintegrate knowledge, and develop new capabilities and competences. Taking into account there is very limited empirical evidence of how to successfully accomplish the backsourcing process, two case studies included in this teaching case offer additional insight into the process of backsourcing. To prepare students for case analysis, this teaching case starts by describing the backsourcing phenomenon, followed by an overview of the backsourcing trend, and includes a brief review of the relevant literature that mainly focuses on backsourcing decisions and touches on critical success factors for implementing a backsourcing initiative. This is followed by two case studies that describe two essentially different examples of backsourcing. The first case study (MediaCorp) deals with the example of backsourcing IT hosting services, which is considered a business process, whereas the second case study (ITServCorp) talks about bringing an IT product development back in-house. However, regardless of the nature of the backsourced activity, analysis of these two cases allows deeper understanding of the process through which the backsourcing initiative has been implemented. Therefore, while each case can be used separately to analyze different aspects of backsourcing, they also can be analyzed in a comparative manner to better understand the process of backsourcing.

Case Authors : Julia Kotlarsky, Lars Bognar

Topic : Technology & Operations

Related Areas : Operations management

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Calculating Net Present Value (NPV) at 6% for Understanding the process of backsourcing: two cases of process and product backsourcing in Europe Case Study

Years	Cash Flow	Net Cash Flow	Cumulative     Cash Flow	Discount Rate @ 6 %	Discounted Cash Flows
Year 0	(10017686)	-10017686	-	-
Year 1	3454391	-6563295	3454391	0.9434	3258859
Year 2	3975197	-2588098	7429588	0.89	3537911
Year 3	3962326	1374228	11391914	0.8396	3326845
Year 4	3225340	4599568	14617254	0.7921	2554771
TOTAL			14617254		12678387

The Net Present Value at 6% discount rate is 2660701

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

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 Backsourcing Process 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. Backsourcing Process 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 Understanding the process of backsourcing: two cases of process and product backsourcing in Europe

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 Technology & Operations 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 Backsourcing Process 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 Backsourcing Process 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	(10017686)	-10017686	-	-
Year 1	3454391	-6563295	3454391	0.8696	3003818
Year 2	3975197	-2588098	7429588	0.7561	3005820
Year 3	3962326	1374228	11391914	0.6575	2605294
Year 4	3225340	4599568	14617254	0.5718	1844099
TOTAL					10459031

The Net NPV after 4 years is 441345

(10459031 - 10017686 )

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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	(10017686)	-10017686	-	-
Year 1	3454391	-6563295	3454391	0.8333	2878659
Year 2	3975197	-2588098	7429588	0.6944	2760553
Year 3	3962326	1374228	11391914	0.5787	2293013
Year 4	3225340	4599568	14617254	0.4823	1555430
TOTAL					9487656

The Net NPV after 4 years is -530030

At 20% discount rate the NPV is negative (9487656 - 10017686 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Backsourcing Process 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 Backsourcing Process has a NPV value higher than Zero then finance managers at Backsourcing Process 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 Backsourcing Process, then the stock price of the Backsourcing Process 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 Backsourcing Process 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 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.

Understanding of risks involved in the project.

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.

What can impact the cash flow of the project.

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 Understanding the process of backsourcing: two cases of process and product backsourcing in Europe

References & Further Readings

Julia Kotlarsky, Lars Bognar (2018), "Understanding the process of backsourcing: two cases of process and product backsourcing in Europe Harvard Business Review Case Study. Published by HBR Publications.