12/17/2011
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?
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)
-
Project life
-
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.
After downloading the worksheet, you must input the "Total Cost of the Installed Pump(s)" result from the expert calculator into Barringer's "Capital Acquisition Cost" cell and the "Total Annual Recurring Costs" result from the expert calculator into Barringer's "Annual Recurring Cost" cells from year 1 to year 20. (In this analysis, I have selected a 20 year project life and a discount rate of 8%. I also chose to include a 3% inflation rate into the annual cost for realism.) Once the data was entered, the worksheet returned an NVP of -$977,120. The negative sign indicates an outflow of money in the NPV equation. Excluding any revenue realized from the project, Pump #1 costs $977,120 (in today's dollars) to own for 20 years.
If we conduct a similar analysis for the Pump #2, we get an NPV of -$861,627. Comparing results we can clearly see that Pump #2 costs about $115,493 less to own than Pump #1. This is in spite of the fact that Pump #1's purchase price is less that Pump #2, as seen in Table #3.
Table 3. Breakdown of Pump #2 Life Cycle Costs
Breaking Down the Costs
Let's look at the life cycle costs of Pump #2 in more detail. By rerunning the Barringer analysis to find the NPV numbers for pump costs, pump installation costs, energy costs, and repair costs separately, we can determine, on a percentage basis, the relative value of each component. A summary of Pump #2 can be found in the figure below.
You can easily see, the most prominent (82.4%) cost of ownership is energy cost, with the cost of installation coming in a distant second at 12.3%. You may be surprised to see the cost of pumps represents only 4.1% of the total NPV and pump repair costs only 1.3% of the NPV.
