As the prices for energy and raw materials put renewed pressure on economies, cost cutting has rarely been so critical to manufacturers large and small. Here are some basic ways to analyze business costs and potential benefits. Warning: If mathematical equations frighten you, turn back now.

Cost cutting, of course, allows you to take the resultant savings and reallocate them toward other needs. If you use petroleum merely for gasoline and heating, you have some alternatives. You can switch to natural gas and coal as a power source, and you can replace larger vehicles with smaller ones. However, if petroleum is a raw material required for your derivative products, you can only hope others will conserve oil in substantial ways, and then you’ll have to pass along price increases for your products.

To cut costs, you’ll probably have to make changes. But before putting the changes into effect, a cost benefit analysis (CBA) enables you to start with the ones that will have the greatest return on investment.

Listing all the costs and all the potential benefits is the easy part of starting a CBA. If you’re unsure you’ve identified all costs and all possible benefits, ask a colleague to list them. After he or she has done so, compare your list with your colleague’s to ensure your list is as comprehensive as possible.

Some benefits may not be quantifiable. In this case, consider ranking them in importance. Once the non-quantifiable benefits are ranked among themselves and among the quantifiable benefits, assign a value to the non-quantifiable benefits based on the ranking. You can use a spreadsheet for this. (Though it’s not directly related, you can see an oldie-but-goody example of a decision-making spreadsheet at The Fabricator.)

Now time and its effects should be brought into the equation. Costs often occur in the early part of a change project; benefits typically come later. Moreover, inflation will most likely occur, and you’ll want to account for that, too. The Energy Information Administration figures it will be about 2 percent on average between now and 2030, with a range of 1.5 percent to 2.5 percent.

Therefore, you’ll need to use net present value. The formula is: f = 1/(1 + R)^m. Here “f” is the discount factor; “R” is the discount rate (<1); and "m" is the year considered.

For those who might've dozed off during Econ 101, the discount rate is the interest rate used in calculating the present value of expected yearly benefits and costs. The discount factor is the factor that translates expected benefits or costs in any given future year into present value terms. The discount factor equals 1/(1 + i)^t. Here “i” is the interest rate and “t” is the number of years from the date of initiation for the program until the given future year.

If the real rate of return is 10 percent and we look three years out, then f = 1/(1 + 0.1)³ = 0.751.

The cumulative discount factor over “n” years becomes:

c = 1 – (1 + R)^-n /R or c = 1 – (1 + 0.1)^-3 /0.1 = 2.48 for three years into the future.

Finally, the present value of annual savings is given by: PV = annual savings x c.

So PV = expected yearly savings x 1 – (1 + discount rate)^{-year considered/discount rate}.

To bring the benefits of smart-investment-based cost cutting into focus, consider that if a conventional fan motor consumes 322 kW but a more efficient one uses only 133 kW, the savings is 189 kW. Also, assume the cost per kWh is 12 cents and your annual hours amount to 8760 (continuous operation). Now your yearly savings per fan is $198,676.80 by replacing the conventional fan motor with the energy-efficient one.

“The annual cost of the energy it takes to run an electric motor continuously can be about six to eight times the purchase cost of the motor,” according to the Sacramento Municipal Utility District. The premium-efficiency fan motor may cost 25 percent more than a conventional motor, but the extra expense is well worth it if annual operating cost savings more than pay for the higher initial cost.

Not all equipment used in manufacturing plants will have such attractive outcomes when considering high energy-efficiency items and automation devices, but the process of considering future benefits adjusted for inflation and the passage of time enables plant managers and maintenance personnel to create a priority list of replacement items that will ensure cost reductions. You can see how one company invested $23 million to “green up” various buildings during a five-year period but is now saving $38 million by reading this PC World feature.

Resources

Build it or buy it?
by Christian Litke and Michael Pelletier
The Fabricator, March 28, 2002

Annual Energy Outlook 2007 with Projections to 2030
Energy Information Administration

Accounting for Inflation in Financial Planning: A Comparison of Two Solutions to Complex Planning Problems
by Thomas Eyssell, Ph.D., CSA
Journal of Financial Planning

Case Study 36 Variable Speed Drives Reduce Energy Consumption in HVAC Applications
Global Development Research Center

High Efficiency Fan Motors
Sacramento Municipal Utility District

Intel’s New 45 nm Penryn Plant Goes Green
PC World, Oct. 30, 2007