Eric Berglund has thrown down the gauntlet, and being one to respond to challenges, I am rising to the occasion. In his comment to my blog entry posted on 1/22/10, Eric said, “Patricia, here's an ambitious goal for your blog: Teach us enough finance that we'll know when employee training is the right thing for a company to do.” So, you be the judge and let me know how I do…
First, a little about finance:
- My favorite finance textbook, Brealey & Meyers’ Principles of Corporate Finance, states that “Finance is about money and markets, but it is also about people. The success of a corporation depends on how well it harnesses everyone to work to a common end.” I love it when numbers guys recognize that it’s not just about numbers, but also the people who generate those numbers!
- Most of the time, the managers of a company are not the owners of the company. A financial concept known as “Net Present Value” (NPV) provides for the efficient separation of ownership and management, where managers who allocate resources to “positive NPV” assets or projects (as opposed to “negative NPV” assets or projects) serve the best interests of the owners
- NPV is based on the concept of present value as a way of valuing assets, where cash flows are discounted at a rate that reflects the risk of the cash flows. The discounting process recognizes two facts: first, a dollar today is worth more than a dollar tomorrow, and second, a safe dollar is worth more than a risky dollar.
So, how does this all work when a manager is considering an investment in employee training? Let’s start with a personal example, as I am a big believer that many of the financial decisions we face in our professional environment are similar to those we face in our personal lives.
My oldest daughter is graduating from college this spring with a BS in finance (the apple doesn’t fall far from the tree). She has been offered a job with a starting salary of $51,000 per year. She is considering working for a year, and then going back to school—her heart is set on a JD/MBA program at Northwestern University, where she will graduate with her Juris Doctor and MBA in three years. She has asked me whether that makes economic sense. This is the way that I look at it:
- She is comparing two options: (1) Current State—stick with the BS degree and start down the career path, earning $51,000 the first year with annual escalations (hopefully) until retirement in 44 years; or (2) Proposed State—work for one year, and then spend another three years in school before starting down an alternate career path (corporate law?).
- The crux of which option makes the most economic sense lies in how much more she will make in the Proposed State (her “incremental earnings”) compared to how much it will cost to get that degree (her “investment”). In other words, we need to calculate the NPV of the Proposed State relative to the Current State. If the NPV is positive, the benefit of pursuing the Proposed State is more than the required investment, indicating that the investment would generate value. If the NPV is negative, the opposite would be true—the investment would cost more than the benefits it would generate. In that case, the rational person would decline the opportunity.
Following is an excerpt from the spreadsheet that demonstrates this analysis, as well as the underlying assumptions (there are several!).
If all assumptions hold true, my daughter’s investment in a JD/MBA would generate value, as indicated by an estimated NPV that is positive. Spreadsheets facilitate the NPV analysis, so I would advise anyone in business (including learning professionals) to gain familiarity, and yes, even become comfortable with them.
The application of this type of analysis can easily be extrapolated to a professional situation. Assume that you are the CLO of a manufacturing company, and one of your plant managers has requested that you implement a training program designed to reduce the scrap rate of one of the production lines. You and the plant manager have met with one of your prime vendors, who estimates that the cost to develop the training program will be $20,000. Your plant manager has determined that the value of the reduced scrap at current manufacturing levels is approximately $5,000 per year, and that the benefits of the training program should extend through the useful life of the manufacturing equipment (approximately 5 years).
As the spreadsheet attached to this blog entry (“Training Application”) indicates, the investment in the training program would not make sense if manufacturing levels are expected to remain level over the next 5 years (“Case 1”). The economic benefit of the investment is expected to be less than the cost of the training program, resulting in a negative NPV. As the CLO of this company, you would pass on this opportunity. If, however, manufacturing levels are expected to increase at the rate of 3% per year (“Case 2”), investment in the training program would make sense. As the CLO, you would support the opportunity because the economic benefit of the investment is expected to exceed the cost of the training program, resulting in positive NPV.
These examples illustrate the framework used to evaluate financial decisions, as well as some of the considerations. You’ll need to let me know if, as Eric requested, I demonstrated enough finance so that you’ll “know when employee training is the right thing for a company to do.” Feel free to post a comment to this blog or send an email to pae@tmiwebmail.com. I look forward to hearing what you have to say!
