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.
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.
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)
- 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%
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)
- 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.
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:
- 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.
- 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.
- Determine the cost vs benefit ratio.
Cost-Benefit Analysis formula
CBA = (Cost / Benefit)
- 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%
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
- 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 Net Present Value 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.
0 = P0 + P1/(1+IRR) + P2/(1+IRR)2 + P3/(1+IRR)3 + . . . +Pn/(1+IRR)n
- 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:
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.
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:
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.)
B / (I+C) > 0
B / (I+C) > 1
B / (I+C) <= 1
B / (I+C) <= 0
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