In Six Sigma projects, we use financial measures to analyse the wider effects of our efforts. Looking at the number of defects is ideal for identifying issues. However, it’s very low level and narrowly focused. It doesn’t help us measure the final impact of process changes. It also won’t mean much to stockholders and board members. That’s why we also need to use financial measures.

There are two basic types of financial measures we can use:

• Forward looking measures: These help us figure out whether a project will be worthwhile.
• Backward looking measures: These help us to measure the financial effect of our recent projects.

## Returns

This category of metrics look at the income received vs the effort made and the assets owned. They’re backward looking measures. In other words, they’re generally calculated after a project ends.

### ROI

Return on Investment (ROI) = Gain realized / Effort spent.

This metric measures how efficient and profitable an endeavor (project, program, etc) is. You could be building a valuable product, but spending too much money to get it.

`ROI = ((end value – cost) / cost)`

where:

• ROI = Return on Investment.
• End value = Final value of the project.
• Cost = the amount of money spent on the project.

#### Example ROI calculation

For example, a software company is creating a piece of software. It pays four developers and testers for a year to complete the product, at a cost of \$250,000. It pays a marketer \$50,000 for six months to create the marketing campaign. 300 customers subscribe to pay \$200 a month for access to the software in the first year after the product is released.

```ROI = (end value – cost) / cost
ROI = ((300 x 200 x 12) - 300000) / 300000
ROI = (720000 - 300000) / 300000
ROI = 420000 / 300000
ROI = 1.4 = 140%```

### ROA

Return on Assets (ROA) = Income / Assets.

This metric measures how efficient management is in turning its holdings into earnings. It compares the company’s income with the assets it owns. Is it using those assets effectively to gain more income?

`ROA = (income / assets)`

Where:

• ROA = Return on assets.
• Income = The company’s net income.
• Assets = The current valuation of the company’s assets.

#### Example ROA calculation

The software company in the example above owns a server farm that delivers its software. Its current valuation is \$200,000. So we plug that figure and its earnings into the ROA formula.

```ROA = income / assets
ROA = 420000 / 200000
ROA = 2.1 = 210%```

### Using ROI and ROA

ROI and ROA are useful in Six Sigma because they help us gauge the success of completed projects.

## Cost-Benefit Analysis

This is a forward looking measure. It involves looking at the projected costs and returns of a project. It gives us data that we need to decide whether a project is worth doing. But it’s not just useful within a team. You can use a cost benefit analysis to demonstrate the value of a project to people outside your team, like upper management.

From a financial standpoint:

• If the cost is greater than the benefit, the project isn’t worthwhile.
• If the benefit is substantially greater than the cost, the project is worthwhile.

### How to conduct a cost-benefit analysis

There are three basic steps to conducting a cost benefit analysis:

1. Calculate the expected costs of the project. Include one time costs like design and implementation resources, ongoing costs like training and new equipment, and cost of capital expenses.
2. Calculate the projected benefit of the project. This might include new one time revenue like customers buying a product, or ongoing benefits like reducing hours per week spent on specific tasks, at \$/hr.
3. Determine the cost vs benefit ratio.

### Cost-Benefit Analysis formula

`CBA = (Cost / Benefit)`

Where:

• Cost = the projected cost of the project
• Benefit = the projected return of the project

#### Example cost-benefit analysis calculation

We can conduct a retrospective CBA on the software company that we looked at earlier.

```CBA = Cost / Benefit CBA = 300000 / 420000 CBA = 0.714 = 71.4%

```

Learn more about cost benefit analysis here and how to perform one here.

## Net Present Value (NPV)

Projects rarely deliver only simple, one time costs and returns. Often the costs and returns associated with a project will continue for years. The value of these costs and returns will change each year, thanks to inflation. One dollar today will be worth more than one dollar in five years’ time.

We use NPV to calculate the present value of future costs and returns.

### Net Present Value formula

`NPV = Rt / (1 + i)t`

Where:

• NPV is the net present value.
• Rt is the net cash flow for the period.
• i is the discount rate: the return that could be made on an investment with a similar risk profile.
• t is the period of time.

## Internal Rate of Return (IRR)

We can use the Internal Rate of Return for the cash flow each year to determine the projected percentage return from a project.

The higher the IRR, the better. Generally, a company will compare the IRR to expected return from an investment with a similar risk profile. If the project’s IRR is a lot higher than the comparison investment return, it’s a winner. If it’s lower, then from a financial perspective, it doesn’t make sense to proceed.

Note: Expected financial returns aren’t the only reason to go ahead with a project. There might be social or environmental returns that outweigh the financial aspect. However, most organizations will need to thoroughly understand the financial measures.

### IRR formula

` 0 = P0 + P1/(1+IRR) + P2/(1+IRR)2 + P3/(1+IRR)3 + . . . +Pn/(1+IRR)n `

Where:

• P0 = the immediate cash flow (usually a negative figure).
• P1 = the projected cash flow in the first year.
• P2 = the projected cash flow in the second year.
• P3 = the projected cash flow in the third year.
• Pn = the projected cash flow in the nth year.
• IRR = the Internal Rate of Return.

This is pretty complicated to solve manually, but Excel has inbuilt IRR formulas that you can utilize.

### Example IRR scenario

A company is considering moving its software product into the cloud. It’s calculated that the initial cost would be around \$50,000, and annual maintenance and upgrade costs would be about \$10,000 thereafter. But it’s also figured that it would no longer need to maintain a bank of servers to host the development and production environments (a saving of around \$100,000 over five years) and would save around \$5000 a year currently being offered in discounts to customers when server outages occur.

Its IRR equation would look something like this:

`0 = -50000 + 15000/(1+IRR) + 15000/(1+IRR)2 + 15000/(1+IRR)3 + 15000/(1+IRR)4 + 15000/(1+IRR)5  `

In Excel, we’d add the key data:

Then we’d use the following Excel formula to calculate the IRR:

`=IRR(B2:B7)`

Which Excel calculates as 15%.

A fair investment return for 5 years is 10%. So a 15% projected return gives extra value, and will probably be accepted as a worthwhile venture.

## Payback Period

Payback is one of the useful capital budgeting methods. It is generally used to evaluate the project considering the associated risks before investing. Payback calculates the number of years after the initial invest amount will be recovered from a project’s net cash inflows. In other words, the length of the time initial outlay of investment reaches a breakeven point. Invest in a project where payback is less than the maximum allowed time.

### Payback period formula

The formula for payback period depends on fixed and irregular cash flow.

• Case1: Fixed cash inflow: Payback period = Initial investment/Net cash inflows per period
• Case 2: Irregular cash inflow: Payback period = Last time period with negative net cash flow+ (Net cash flow at the time of last negative value/ cash flow of the consecutive year)

### Payback period example

Example1: Fixed or even cash flow Method:  A manufacturing plant is planning to start a new project with an initial investment of \$115 million. Management expecting returns of \$20 million per year in net cash flows for 8 years. Calculate the payback period of the new project.

Initial investment = \$115 million

Cash flow per year = \$20 million

Number of years = 8

Payback period = Initial investment / Net cash flow per period = \$115/\$20 = 5.75 years.

Example 2 : Irregular or uneven cash flow method: A manufacturing plant is planning to start a new project with an initial investment of \$80 million. Management expecting returns of \$15 million in the first year, \$ 20 million in the second year, \$25 million third year and \$35million in the fourth year, and \$20 million in the fifth year. Calculate the payback period.

Payback period =Last time period with negative net cash flow+ (Net cash flow at the time of last negative value/ cash flow of the consecutive year)  = 3+(20/35) = 3+0.57=3.57 years

### Advantages of Payback period

• Payback method is very easy to understand and calculate the period
• It considers the organization liquidity, helps to find the project that provides quick returns
• Favours with ranking and accounts the inherent project risks

### Disadvantages of Payback period

• Payback does not consider the time value of money
• It does not account for the cash flows after the payback period

## Six Sigma Green Belt Certification Financial Measures in Six Sigma Questions:

Question: A shoe manufacturing firm learned through a Lean Six Sigma project their boot soles could be made of a different material requiring two less steps in the process. Removal of these two steps yielded a monthly cost savings of \$7,500. Therefore the reported financial savings for this LSS project were:

A) \$45,000

B) \$75,000

C) \$90,000

D) \$120,000

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## Six Sigma Black Belt Certification Financial Measures in Six Sigma Questions:

Question: A six sigma team has gathered data for a project proposal and is using the following notations:

I = Initial investment
C = Periodic maintenance cost
B = Benefits to be accrued

On the basis of the information above, which of the following is the criteria used to select a project? (Taken from ASQ sample Black Belt exam.)

• (A) `B / (I+C) > 0`
• (B) `B / (I+C) > 1`
• (C) `B / (I+C) <= 1`
• (D) `B / (I+C) <= 0 `

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Question: A six sigma project to reduce billing statement expenses has shown the need to hire two additional mailroom clerks. Based on this information, which of the following metrics should be used to measure the financial benefits of the project? (Taken from ASQ sample Black Belt exam.)

(A) Cost of poor quality
(B) Return on investment
(C) Net present value
(D) Internal rate of return

B: ROI. The problem states that there is a cost of our project – the additional headcount needed. We want to compare that against the project’s proposed savings before going forward.

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Alex Gianopoulos says:

Hey, so as I understand it, the Cost/Benefit Analysis seems to be the inverse of the Return On Investment. I am wondering in your example of CBA what exactly does the result of “71.4%” exactly mean if you were to phrase that in a sentence? How would you put that figure in Layman’s terms?

Your ROI example is clear and can be articulated. In your example, “if you invested \$300,000, you would get a gross return of \$420,000 which would be 140% return on your investment.”

I don’t know how your CBA example would be used in an every day situation.

Thanks

Alex Gianopoulos says:

* I meant to put “Net return” instead of gross return. Sorry

Hi Alex,

Thanks for the question. On the surface of the calculations you are correct. Let me add detail.

In general a CBA is more far-reaching than a ROI calculation. The CBA calc there is generally all that is typically asked in questions on the exam but you can consider CBA as part of evaluating a portfolio of possible projects / programs. Here’s more.

Barbara Hyde says:

In general a CBA is more far-reaching than a ROI calculation. The CBA calc there is generally all that is typically asked in questions on the exam but you can consider CBA as part of evaluating a portfolio of possible projects / programs. Here’s more.

Hello Ted, the “here’s more” link you provided says that ” Like an ROI calculation, the result of CBA is a ratio expressed as a percentage, and economic attractiveness is determined the same way: above zero is attractive, and below zero is not. The equation is the same, although more costs and benefits are included. That is the essential difference between the two methods. But the sample ASQ question you provided, gave the answer as greater than one, not greater than zero. Pasting it here from above:Question: A six sigma team has gathered data for a project proposal and is using the following notations:

I = Initial investment
C = Periodic maintenance cost
B = Benefits to be accrued

On the basis of the information above, which of the following is the criteria used to select a project? (Taken from ASQ sample Black Belt exam.)

(A) B / (I+C) > 0
(B) B / (I+C) > 1
(C) B / (I+C) <= 1
(D) B / (I+C) 0
(B) Benefits / (investment+cost) > 1
(C) Benefits / (investment+cost) <= 1
(D) Benefits / (investment+cost) <= 0

It seems that it’s clearly an ROI question. We would reject c & d because we want the return to be positive – we don’t want to lose money here! Similarly, we know the ROI has to be greater than 1 for us to make money on the deal. Anything less than 1 means that the total costs outweigh the benefits, so the answer cannot be a. Option B is correct.
Can you please tell me which is the correct answer? Isn't 50 cents more than zero? is 1 considered a dollar? is that where my thinking is confused. I've seen this answer be different before as well, so look forward to getting clarity, kind regards, Barbara

Hi Barbara,

The key difference is in how the ASQ question above states the equation and how the PDF linked to state it. ASQ infers total benefits while the PDF states NET benefits.

The ASQ question states Benefits / (Investment + Costs) and infers total benefits.

If you are using a Net Benefit ROI equation you would select any positive number.

If you are using a Total Benefit ROI equation, like in the one above, you would use any # > 1.

Best, Ted

Ahmed Majed says:

Hi,

I have a concern about the last question, I believe that NPV and ROI can both be metrics to calculate the benefits.

Can you explain the reasoning why the answer is ROI?

Thanks,

Hi Ahmed,

You are correct that both could be metrics to calculate benefits. I like the following explanation.

NPV measures the cash flow of an investment; ROI measures the efficiency of an investment. (Source)

Best, Ted

Richard Fletcher says:

Isn’t income in your ROA example 720,000?

Ramana PV says:

Hello Richard

ROA = Net Income/ Avg total assets

Net income is the amount of total revenue that remains after accounting for all expenses. Hence it is 420000 only.

Thanks

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