2. ECONOMIC JUSTIFICATION
When considering the economic value of a decision, one method is the payback period.
Simple estimates for the initial investment and yearly savings are,
There are clearly more factors than can be considered, including,
- changes in material use
- change in inventory size
- material handling change
The simple models ignore the conversion between present value and future value. (ie, money now is worth more than the same amount of money later)
Quite often a Rate of Return (ROR) will be specified by management. This is used in place of interest rates, and can include a companies value for the money. This will always be higher than the typical prime interest rate.
So far we haven't considered the effects of taxes. Basically corporate taxes are applied to profits. Therefore we attempt to distribute expenses evenly across the life of a project (even though the majority of the money has been spent in the first year). This distribution is known as depreciation.
Methods for depreciation are specified in the tax laws. One method is straight line depreciation.
Consider an assembly line that is currently in use, and the system proposed to replace it. The product line is expected to last 5 years, and then be sold off. The corporate tax rate is 50% and the company policy is to require a 17% rate of return. Should we keep the old line, or install the new one?
