Over several glasses of Traminette the other evening my brother and I discussed the decision-making process that is used by winemakers: What grape to plant? Should I buy more hardware? Do I host social events in the vineyard?
That conversation got me to thinking about the low-cost tools which are readily available to assist the winemaker in making business decision.
Two powerful tools are Net Present Value (NPV) analysis and Return on Investment (ROI). Both are quite simple to create and evaluate but don't let their relative simplicity stop you from using them.
Net Present Value is a good tool when you need make one choice from a series of options. Let's compare a situation where you have three options: Option 1 provides for a uniform series of increased profits. Option 2 provides for a large immediate profit followed by no additional profits and Option 3 provides for no profits in the near term with a large profit in the out-years.
Net Present Value does not simply add up the values in the cell - it discounts the value of future cash flows by a user-defined discount rate. (Note: I always use 4.25% in any NPV analysis as this rate is a historical average from 1929 to the present.)
Using the NPV workbook function in MS Excel (=NPV(Interest Rate, Value1, Value2, Valuen)) you are able to evaluate the PRESENT VALUE of all three cash flow streams. In this case, Option 1 turns out to be the most profitable choice among the three choices. Option 3 is the least advantageous as its payout is deferred the longest and the impact of the discount is the greatest.
Return on Investment is a way to calculate the profitability of an investment. In order to calculate the ROI you need two pieces of information: 1) Total Return, and 2) Cost of Investment. Let's use the numbers in the NPV calculation and add the following information: the cost of investment for all three choices was $450.
The ROI calculation is as follows: ROI = ((Total Return - Cost of Investment)/ Cost of Investment).
The total return for Option 1 is $552.75 and the cost of investment is $450. Working through the equation we have ROI = (($552.75 - $450)/$450) or 22%. For Option 2 it is ROI = (($525.68-$450)/$450) or 16%. For Option 3 ROI = (($448.60-$450)/$450) or -.03%.
In this example Options 1 and 2 provide a positive rate of return with the ROI with Option 1 having the best return over the 5 year period. Choose Option 1.
Bottom line: Both NPV and ROI provide powerful insights into business decisions with a few simple steps.