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Where to include investment cost in structure

Anonymous A asked on Oct 08, 2018

When doing a case where there is an investment in say new technology. Where in the structure should I include the investment costs? Should I have three sub branches under costs: investment, fixed and variable? Any other way of including it in the structure?

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Sidi
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replied on Oct 08, 2018
McKinsey Engagement Manager & BCG Consultant | Interviewer at McK & BCG for 7 years | Coached 90+ candidates secure MBB offers
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I would never put investment together with operational costs! Simply because it's entirely different categories. The truth is, many candidates struggle to conceptually separate investments from fixed costs:

  • Investments are typically non-recurring expenditures that are needed to start performing the operations which underlie the service or product that the company sells In economic terms, investments need to be recouped by operational profits over the company's inverstment horizon.
  • Operational costs are costs that recur every year and can be split into fixed costs (rent, leasing, salaries etc.) and variable costs (COGS, transportation cost, etc.)
  • Operational profits is the difference between revenue and operational costs. Operational profits over the company's investment horizon need to be bigger than investment costs, in order for a certain venture to make economic sense.

So a structure should be something like:

[I] Operational profit * [II] Investment horizon >> [II] Required investment

where [I] Operational profit = Revenue - Operational cost

Cheers, Sidi

Am I right in taking operational costs as opex, and investments as capex? — Kristian on Oct 10, 2018

Absolutely. — Sidi on Oct 10, 2018

Benjamin replied on Oct 09, 2018
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Hi,

You defintely have to separate investments from ops cost.
If you need to do a P&L, you would put investment under fixed cost without forgetting to depreciate it over a certain duration (defined by the nature of the invstment itself).

Let's take an example to be clear.
Assuming we produce chocolate bars, that we sell at 10$ (such a luxury !), the cost of producting this is 2$ (chocolate + prod related cost), and we need to invest upfront in a molding machine of 100 000 $. If we sell 10 000 chocolate bars the P&L would look like :

- Revenue is 10 x 10 000 = 100 000 $

- Operatig cost is 2 x 10 000 = 20 000 $

- Operating margin = Revenu - ops cost = 80 000 $

- investment is 100 000$ assuming that we depreciate the machine over 5 years would be 20 000 $ / year

- So annual Profit (befor tax) would be : 80 000 - 20 000 = 60 000 $

If you are prompted to calculate the break even volume this would then be done differently :

Break even volume = 100 000 $ / (10$-2$) = 12 500 units > so based on the previous volume investment would be paid back in 2 years.

Hope this helps

Best

Benjamin

Vlad replied on Oct 08, 2018
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Hi,

It's really hard to help you without knowing the objective of the case. Is it a certain NPV, ROI, Profits, Market share, etc?

Depending on the objective it may be either e separate subbranch (e.g. NPV formula) or a part of a bigger bucket with the size of the investment, terms, investment horizon, risks.

Best