Posted by John Stoddart
Something mildly technical this time round. We’re going to talk about sacrifice costs, which are the incremental costs of delaying a decision to do something different. Typically, that would be the costs associated with delaying implementing a new IT system.
Best explained by example:
If, for example, a company were considering changing / updating their ERP system and they decided to do that in 12 months time. There might be some very good business reasons – available capacity to undertake the project, for example – why the project is not done immediately.
However, in order to keep their current system in place during that time, they needed to pay for maintenance contracts, a small update (which they needed to get an external contractor to help with) and they needed to back everything up off-site. Now, in addition to this, the new system is more functionally rich and allows them to downsize their department by one head. Additionally, as a SaaS system, it is held off-site with a reduced requirement for back-up. Lastly, it is said that the new system is easier to use, connects better with other systems (such as a new online expenses system) and it also provides information into the payroll system (for expenses and commissions).
The calculation is the Sacrifice Cost. Effectively, it is the incremental cost of not taking a decision.
For me, sacrifice is not having a second chocolate biscuit. Why is this important?
Sacrifice costs generally indicate a way of measuring a lack of efficiency in financial terms. In some ways, it is a way for IT consultants to sell things earlier. But, it allows a business to understand the cost of inaction (which is generally thought to always be £0). Sacrifice costs clearly demonstrate that inaction is not free and managers need to see something tangible to make this real for them. It allows you to take better decisions based on something a bit more rational.
Let’s break down Sacrifice costs a bit more
We showed some factors to be considered in the example and we’ll break these down a bit further here:
- Maintenance contract for current system. Unavoidable and must be included
- Small system update including consultant cost. Again unavoidable and must be included
- Off-site back up for 12 months. Again unavoidable and must be included
- Cost, including on-costs, of the additional head that would be lost. The whole benefit would not be received during the implementation phase so you should probably include 50-75% of the total cost
- Reduced need for off-site back-up. This would need to taken into account. Full price of the downsize should be identified and included
- The increased efficiency is a much more difficult saving to be identified. Generally speaking it would be expressed as a reduced headcount. If there is some change (or additional work taken on) then this can be included in the calculation. Expect to come under pressure on this one
This is a possible argument that a new system will also reduce risk for the business. While this is definitely something you want, it is notoriously difficult to express this in financial terms because it’s just a bit too abstract (unless there is something like a reduction in your liability insurance, for example).
You don’t need to take account of the implementation costs because they will apply irrespective of which year you implement (unless the price varies dramatically one year to next).
You’ve got your cost. What happens now?
Two things probably. The CTO and the CFO can use this to come to review whether this is a project that is done in 12 months or, actually, it is something important enough to accelerate and do earlier. It is also something which a business can use to negotiate a better price from a supplier (they always want to do projects sooner rather than later). Suppliers are likely to adjust their price more if you can show the point when you will make a decision (for example, you might be able to say “we’ll do the project now if you can price at $25k but if you stay at $32k then it will not start for 12 months”). It allows them to decide whether it is important enough to discount.
Anything else to think about?
If you decide to delay then you might want to think about fixing the future price (if the supplier will allow you to do that). Might be worth making a small up front payment to secure that price.
One thing. You will be making a more rational business decision based on better information using Sacrifice Costs.