The Long-Tail Strategy of IT Outsourcing 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 The Long-Tail Strategy of IT Outsourcing case study

At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. The Long-Tail Strategy of IT Outsourcing case study is a Harvard Business School (HBR) case study written by Ning Su, Natalia Levina, Jeanne W. Ross. The The Long-Tail Strategy of IT Outsourcing (referred as “Tail Outsourcing” from here on) case study provides evaluation & decision scenario in field of Leadership & Managing People. 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 The Long-Tail Strategy of IT Outsourcing Case Study

Today's rapid technological changes have transformed the role of global IT outsourcing in companies'strategies. Traditionally viewed as a cost-saving measure, IT outsourcing is also increasingly being leveraged as a strategic tool for acquiring cutting-edge innovation. This pursuit of emerging technologies and capabilities, however, has elevated the complexity of managing supplier portfolios. In this article, the authors introduce the "long-tail"strategy, an innovative IT outsourcing model that combines a few key partnerships with a dynamically changing number of smaller contracts with other suppliers that can deliver specific value propositions beyond the capabilities of the key partners. Representing a dynamic, diversified, yet disciplined approach toward outsourcing, the long-tail strategy embraces and even fosters a flow of new suppliers, so companies are continually acquiring new capabilities that enable them to prosper in turbulent business environments. The authors'extensive in-depth interviews with major companies in financial services, business services, technology, manufacturing, and energy suggest that the long-tail strategy can help diverse organizations achieve their business goals. For example, the long-tail strategy helped a major global bank establish and maintain technological leadership in the financial-services industry, and allowed Toyota Motor North America to realize rapid innovation. In order to implement the long-tail strategy successfully, companies should institute five key practices: (1) distributing responsibility within the company for scanning for new technologies; (2) nurturing relationships with new "long-tail"suppliers; (3) encouraging sales pitches from suppliers; (4) governing the entire outsourcing portfolio; and (5) designing for integration. When implementing these practices, organizations should seek to create a more proactive, entrepreneurial, and dynamic culture in IT outsourcing. If executed well, the long-tail strategy can transform IT outsourcing into a driver of innovation and value creation in an age of globalization and digitization. This is an MIT Sloan Management Review article.

Case Authors : Ning Su, Natalia Levina, Jeanne W. Ross

Topic : Leadership & Managing People

Related Areas : Operations management

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Calculating Net Present Value (NPV) at 6% for The Long-Tail Strategy of IT Outsourcing Case Study

Years	Cash Flow	Net Cash Flow	Cumulative     Cash Flow	Discount Rate @ 6 %	Discounted Cash Flows
Year 0	(10027312)	-10027312	-	-
Year 1	3446910	-6580402	3446910	0.9434	3251802
Year 2	3956586	-2623816	7403496	0.89	3521347
Year 3	3957833	1334017	11361329	0.8396	3323073
Year 4	3245037	4579054	14606366	0.7921	2570373
TOTAL			14606366		12666595

The Net Present Value at 6% discount rate is 2639283

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. Profitability Index
4. Net Present Value

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 Tail Outsourcing 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. Tail Outsourcing 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 The Long-Tail Strategy of IT Outsourcing

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 Leadership & Managing People 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 Tail Outsourcing 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 Tail Outsourcing 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	(10027312)	-10027312	-	-
Year 1	3446910	-6580402	3446910	0.8696	2997313
Year 2	3956586	-2623816	7403496	0.7561	2991747
Year 3	3957833	1334017	11361329	0.6575	2602339
Year 4	3245037	4579054	14606366	0.5718	1855360
TOTAL					10446760

The Net NPV after 4 years is 419448

(10446760 - 10027312 )

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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	(10027312)	-10027312	-	-
Year 1	3446910	-6580402	3446910	0.8333	2872425
Year 2	3956586	-2623816	7403496	0.6944	2747629
Year 3	3957833	1334017	11361329	0.5787	2290413
Year 4	3245037	4579054	14606366	0.4823	1564929
TOTAL					9475396

The Net NPV after 4 years is -551916

At 20% discount rate the NPV is negative (9475396 - 10027312 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Tail Outsourcing 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 Tail Outsourcing has a NPV value higher than Zero then finance managers at Tail Outsourcing 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 Tail Outsourcing, then the stock price of the Tail Outsourcing 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 Tail Outsourcing 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 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 are the key aspects of the projects that need to be monitored, refined, and retuned for continuous delivery of projected cash flows.

What can impact the cash flow of the project.

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

Understanding of risks involved in 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 The Long-Tail Strategy of IT Outsourcing

References & Further Readings

Ning Su, Natalia Levina, Jeanne W. Ross (2018), "The Long-Tail Strategy of IT Outsourcing Harvard Business Review Case Study. Published by HBR Publications.