Pumps & Systems, May 2007
How to Talk to Managers
Most financial decisions of any consequence at your facility are made by managers; Plant Managers, Project Managers, Operations Managers, Financial Managers, etc. If you want to sell your ideas and recommendations to these decision makers, you must learn to talk to them in the financial language they understand. The most common financial tools for evaluating investment options are net present value, NPV, Payback, and internal rate of return, IRR. NPV, Payback, and IRR are all acceptable financial measures to aid in the making of economic decisions. NPV returns a dollar value, Payback returns a duration until investment is recouped, while IRR returns a rate of return value for the investment. All other factors, such as personal preferences and initial cost, should be secondary to these three financial parameters throughout the pump selection process. This article will address only NPV.
A Simple NPV Example
Let's consider a simple example. Let's assume you are considering purchasing a new air conditioning unit for $8000. The seller of the unit predicts you will save about $200 per month due to the improvement in efficiency. He also estimates you'll save about $1000 per year in maintenance for the next five years, resulting in a $3400 per year saving or cost avoidance. This begs the question: Does this investment make good economic sense?
To determine this, you have to answer a few questions and make a few assumptions:
- What is the project life? 5, 10, 20 years
- What is the rate of return that I can get for a zero risk investment in lieu of the purchase? 4%, 6%, 8%
- What is an acceptable NPV?
For this example, let's assume a 5-year project life, a 4% zero risk rate of return, and positive value for the NPV is an acceptable financial measure. The NPV in this example represents how much more (or less) you can expect to realize from your investment in present dollars.
Table 1. Analysis of an air conditioning upgrade.
I ran this example on an Excel spreadsheet using its NPV function and arrived at a value for the NPV of $6861. This result tells me that my $8000 investment will earn $6861 more than keeping the money in the bank earning 4% over the next five years. So, if you plan to stay in your home for more that 5 years, a new air conditioning unit makes good financial sense. Generally, any option with a positive NPV is deemed acceptable and the greater the NPV the better the option is. Because no one measure is conclusive, many companies place additional constraints on the decision, such as Payback of less than 2 or 3 years, to assure they are using their capital the most efficiently.
Pump Life Cycle Cost (LCC) Evaluations:
When evaluating pump selections for your facility, you should use similar financial evaluations. However, industrial decision making includes additional factors such as taxes, depreciation, spare part storage costs, etc. We call the cash flow analysis of the initial pump costs, energy costs, and maintenance costs "life cycle cost" analysis. This detailed economic evaluation, which typically returns the net present value of a pump under consideration, is the most important pump calculation you will ever make.
To properly evaluate a single or group of pumps, you need to know:
Cost of the pumps
Cost of installation
Annual energy costs
Annual cost of maintenance
Any other recurring cost
Discount rate ( Risk Free Rate)
Corporate tax rate
A Real-World Pump Example
In the following table, you will find the results of an analysis from the PumpCalcs.com expert calculator entitled, "Life Cycle Cost Analysis." By inspection, you will see that Pump #1 has a lower purchase price, but requires more horsepower and is less reliable that Pump #2. (Note that I assumed Pump #2 would have a 48 month mean time between repairs (MTBR) due to its superior design as compared to the 24 month MTBR for Pump #1.) Also included in this analysis is the effect of a more efficient motor on Pump #2.
Table 2. Comparison of two centrifugal pumps.
To complete the analysis, we have to compare the NPV's of these pumps. The pump with the least negative or most positive NPV should be considered the least costly pump to own over the project lifetime. I have decided to use Paul Barringer's "Life Cycle Cost" worksheet to do these calculations, which can be downloaded free from http://www.barringer1.com/lcc.htm.