A capital cash flow idea to justify new equipment
By Julie Sturgeon • Bankrate.com

When Boeing subsidiary Jeppeson Sanderson applied traditional business-school formulas to the idea of replacing its offset printing equipment with digital printers, the status quo won. In calculating the new investment's cost relative to expected revenue, the existing system's capacity provided enough for the flight manual publisher to cover its demands.

Meanwhile, weekly revisions to international airport approach and landing routes, GPS coordinates and radio frequencies averaged 2,000 new map pages sent to roughly 300,000 pilot subscribers. Of course, that volume varies, sometimes shooting to 10 times that number. And because offset printing demands that the operator burn a plate, print it and collate that paper, information sent on Tuesday put a serious kink in a Friday delivery date. Customer service deteriorated as late orders rose to 35 percent in 1997.

Jeppeson executives turned to a team of experts for help. The solution offered by Elena Katok, Ph.D., assistant professor of management information systems at Penn State's Smeal College of Business, and Bill Tarantino, currently at the Center for Army Analysis, won the Operations Research and Management Sciences' Franz Edelman Award for Achievement in 2000.

It also green-lighted Jeppeson's digital printer purchase, which reduced late orders to zilch and helped save the company $1 million.

Flexibility is key
These hands-on professors zeroed in on what most small-business owners omit when justifying a capital purchase: flexibility.

Figuring whether an expenditure is worth it looks easy to grasp on paper. First, lay out your current cash flow without the new capital equipment. Then estimate the additional cash flow the new resource will generate by modeling possible scenarios. The difference between the two sets of figures can be attributed to the new resource. If the value of the additional cash flow exceeds the cost of the new resource, you've got yourself a deal.

"Unfortunately, there won't be a simple formula you can plug in every time to approximate the value of flexibility," says Katok. "The idea is to look into the future and forecast whatever is uncertain in your environment."

It helps to think of this forecasting as brainstorming "a bunch of scenarios," something managers regularly do. "You think in terms of worst case, best case, and make five-year plans," she points out. "So the information you need is available or can be acquired."

The hard question is, "How can I accurately predict how my system will perform?" The answer lies in running the scenarios through a computerized optimization model that covers what's important to your business's operation, such as production scheduling and employee hours.

Katok teaches this skill in her decision support system classes; the nearest university department might find your plight a useful learning tool. If you must pay for this service, "it can be done fairly inexpensively by using off-the-shelf databases like Microsoft Access on the front end," she says.

Then there's IT
The flexibility model is easier to grasp when you apply it to a tangible machine, Katok admits. Technology purchases (think laptops, software, databases) drag their own shaky resumes into the picture.

"It's actually not clear exactly how to quantify the benefits of that kind of technology," she says. Yet IT spending between 1995 and 1999 accounted for one-third of all real economic growth and half of all productivity growth, the Wharton School of the University of Pennsylvania says in its studies. Professors at this university suggest these approaches to technology buys:

• Business Value Index: According to the Wharton newsletter, Intel is piloting a qualifying method that asks managers to assign values between one and four to intangible benefits. This means someone's subjective opinion counts, too.
• Real Option Theory: Imagine technology investments as a game of seven-card stud poker. "On each deal, the player antes up to see his next card -- and his opponents'. If he doesn't like what he sees, he folds," says Martin Curely, director of IT people, intellectual capital and solutions at Intel, in the newsletter. "As opportunities present themselves, managers can place small bets, or investments, on a variety of IT projects and see how they play out. As one becomes more likely to yield gains, the 'betting strategy' becomes more clear."

"Whatever kind of model you use to capture this illusive [factor], the main insight is that you should not ignore the value of flexibility," says Katok. "That can be substantial."

Julie Sturgeon is a freelance writer based in Indiana.

-- Posted: Dec. 10, 2001