Procurement Practice#3: NPV Analysis and Opportunity Cost



Financial analysis in procurement negotiation strategies

In our earlier posts, we discussed the applications of the NPV analysis method and opportunity cost in developing strategic procurement insights. We aim to showcase the combined use of financial analysis in procurement to craft your negotiation strategies. 

Base Scenario: Upgrade of a Key Component

This business case presents the opportunity for a financial decision analysis of upgrading a key component in a new product line over three years. The focus is on calculating the Net Present Value (NPV) of such an upgrade and comparing it with alternative investment opportunities.

Scenario Overview (3 Years):

Implementation Costs: $500,000 (one-time)
Original Component Cost: $50/unit
Upgraded Component Cost: $70/unit
Annual Volume: 100,000 units
Sales Increase Due to Upgrade: 5%
Potential price increase: 2%
Supply Chain Risk Impact: 10% probability of $2M impact
Current annual product revenue: 100M
Profit margin: 20%
Discount Rate: 10%

Detailed NPV Calculations (3 Years):

Incremental Cost Per Year = 100,000 * ($70-$50) = $2M
Total NPV of Incremental Costs (3 years) = NPV (10%, 2000000, 2000000, 2000000) = $4.97M (we used the NPV formula in Excel just as presented.)
NPV of Supply Chain Risk (3 years) = NPV (10%, 200000, 200000, 200000) = $0.5M
TOTAL COST = $4.97M + $0.5M +$0.5M (implementation)= $5.97M

NPV of Increased Sales (5% Increase, 3 years) = NPV (10%, 1000000, 1000000, 1000000) = $2.49M
NPV of Price Premium (2% Increase, 3 years) = NPV (10%, 400000, 400000, 400000) = $0.99M
TOTAL BENEFITS = $2.49M + $0.99M = $3.48M
Net NPV Impact: $3.48M - $5.97M = -$2.49M

Alternative Scenarios and Opportunity Cost

Let's go one step further than declaring the negative NPV of the base scenario and hence our recommendation not to pursue it.
Before jumping to conclusions, we will review three alternative scenarios and calculate the opportunity cost.

Alternative Scenario #1 "Marketing Campaign to Boost Sales of Existing Products."

Cost: $2.7M (one-time)
Estimated Revenue Increase: $4M per year
Profit Margin: 20%
NPV of Profits Over 3 Years = NPV (10%, 800000, 800000, 800000) – $2.7M = -$0,71M
Opportunity Cost: $-0.71M - (-$2.49M) = $1.78M

Alternative Scenario #2 "R&D for a New Product"

Cost: $4M (one-time)
Estimated Revenue Increase: $18M (over 3 years, we assume it’s $5M in year 1, $6M in year 2, and $7M in year 3)
Expected Profit Margin: 25%
NPV of Profit After 3 Years = NPV (10%, 1250000, 1500000, 1750000) - $4M = - $0.3M
Opportunity Cost: -$ 0.3M - (-$2.49M) = $2.19M

Alternative Scenario #3 "Cost Reduction Initiative"

Cost: $2M (one-time)
Savings Per Year: $1M
Profit Margin: 20%   
Savings @ 20% profit margin = $1M (profit)
NPV of Profits Over 3 Years = NPV (10%, 1000000, 1000000, 1000000) – $2M = $0,49M
Opportunity Cost: $0.49M - (-$2.49M) = $2.98M

Financial decision analysis

The NPV analysis of upgrading a key component over 3 years shows a net negative NPV impact of (—$2.49M). 
The opportunity cost of not pursuing alternative investments (like the marketing campaign or R&D) ranges from $1.78M to $2.98M.
Given the significant negative NPV impact and the high opportunity costs, the technical upgrade may not be the most financially sound decision. 
Alternative investments with positive NPVs and lower opportunity costs should be considered unless there are strategic reasons to justify the upgrade.

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More information on this and other exciting topics can be found in "The Technology Procurement Handbook." It represents 23 years of experience, billions of dollars worth of successful sourcing projects, and 1000s hours spent on research, analysis, and content creation for the most demanding professional readers.
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