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Where and how to include Initial investment costs in (cost or profit comparison)

cost structure
New answer on Feb 01, 2022
2 Answers
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Anonymous A asked on Jan 31, 2022

Hi Guys,

I am a bit confused on how to inlcude Initial Investment Costs in Cost and Profit Comparisons. 

In a case where they compare the cost savings of two trucks they inlcude via depreciation.

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-1643627933-mrk4bc1zhupc.png

 

But in the Military Helicopter Case (here on Preplounge), where they compare in the end the profit, in the Total Cost they include the initial Cost directly.

-1643627608-478kgz0f8qs9.png

 

From my understanding when calculating the profit or when doing the Cost Comparison one should always use only the depreciation amount as it shows up on the income statement.

Anybody has an explanation in which cases (profit or reveneu calculation vs cost comparison) one should include which cost (depreciation or initial investment cost)

Thanks in advance :)

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Pedro
Expert
 replied on Feb 01, 2022
30% off in April 2024 | Bain | EY-Parthenon | Roland Berger | Market Sizing | DARDEN MBA

In the first case, you are calculating annual costs. So you take the initial investment and turn it into an yearly cost dividing it by the expected useful life of the asset.

In the second case, you are comparing the total lifetime costs. So you just take the total initial cost as it is.

Now understand this. If in the first case you wanted to compare the total lifetime costs (which would also be perfectly fine) - there would be no need to annualize the initial cost. On the other hand, you would need to take all the yearly costs and multiply them by the useful life of the asset to get to the total cost. 

Why isn't this the suggested answer? Simple: it would require more calculations. So the real reason why you use the annual cost in the first case is not a technical reason (both are fine), but a practical one: it's the  fastest way to get to the answer.

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Anonymous A on Feb 01, 2022

Thanks for the explanation Pedro! Makes total sense now :)
Moritz
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Content Creator
 replied on Jan 31, 2022
ex-McKinsey EM & Interviewer | 7/8 offer rate for 4+ sessions | 90min sessions with FREE exercises & videos

This is a good question because candidates often mix investment costs (CAPEX) with operating costs (OPEX), which can get really messy.

CAPEX and OPEX are of course linked in the sense that any investment is depreciated in the P&L and becomes an operating expense. So basically, both approaches are fine:

  • If it's ROI you're after, keep operating profit separate from investments and compare the two for ROI calculations i.e. do not transfer investment via depreciation into P&L
  • If it's profit you want to focus on then calculate net profit over time i.e. capture investment as depreciation expense over time

It's just important to not double dip. Corresponding NPVs have to be the same - otherwise something is not right.

Hope this helps!

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Anonymous A on Jan 31, 2022

Hi Moritz, Thanks for reaching out and clarifying. Just to make sure I understand it, in calculating ROI why not to use depreciation in OPEX: ROI = (profits from investment – Cost of investment) / Cost of investment • depreciation should not be included in OPEX as I would then use it in calculating the profits from investment • Further I also subtract the cost of investment in calculating ROI as a own variable directly So I would include the investment costs to often – right ?

(edited)

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