A NEW APPROACH TO ASSESSING THE COST EFFECTIVENESS OF MANAGEMENT INTERVENTIONS: THE CASE OF EARLY RETIREMENT CO-AUTHORED EQUALLY BY: ASSA BIRATI AHARON TZINER School of Business Administration NETANYA ACADEMIC COLLEGE BAR-ILAN UNIVERSITY School of Business Administration 52900, Ramat Gan, Israel 2100, Netanya,Israel Tel: 972-3-531-8906 Tel: 972-9-861-0369 Fax: 972-3-535-3182 Fax: 972-3-921-3364 E-Mail: firstname.lastname@example.org E-Mail: email@example.com August 1998 2 A NEW APPROACH TO ASSESSING THE COST EFFECTIVENESS OF MANAGEMENT INTERVENTIONS: THE CASE OF EARLY RETIREMENT Firms today operate in a world of unprecedentedly intense global competitive pressures resulting, among other factors, from rapid technological advances and changing market conditions. In order to survive in this milieu, commercial entities must continually enhance their effectiveness, forcing them to adjust, often within a relatively short time, to modifications of their methods of operation or even total reform of their organizational structure. Options for improving a firm’s standing may include interventions such as company restructuring/downsizing, training programs or early retirement programs. In view of the plethora of possible plans of action, there is an obvious need for tools to evaluate the efficacy of the various alternatives. The present paper advocates the use of the capital budgeting procedure as a viable means to help management reach a sound decision. Our basic premise is that any major organizational intervention or program can be regarded as an investment, i.e. a measure that requires substantial cash outlay at the initial stage in the hope that it will result in future financial benefits (cash inflows). Moreover, these plans can be ranked in order of their relative long-term potential financial desirability, so that non-profitable projects can be rejected (or delayed) and the most promising alternatives adopted. This approach will enable management to utilize in a more efficient spendings manner its limited periodical resources for capital. The procedure we propose is illustrated below by means of the case of early retirement. 3 THE CAPITAL BUDGETING PROCESS The capital budgeting process usually refers to the steps taken to evaluate investment alternatives before the purchase of fixed assets such as plants or equipment. The process entails either assessment of the post-tax internal rate of return of a proposed project (in inflation-adjusted terms), or evaluation of the after-tax net present value of the cash outflows and inflows resulting from investment in it, the purpose being to try to estimate its absolute and relative financial desirability. It is our conviction that certain major human-related decisions that show features of an investment should also be treated in a similar fashion. Naturally, the procedure must also consider the particular characterstics of human behavior in organizations, especially with respect to the operational risks associated with such projects. THE EVALUATION OF INVESTMENT DECISIONS The first step in the evaluation of capital projects is to assess the net-of-tax real cash outflows at the initial stage, and the after-tax net cash inflows that the project will yield. Assessment of the present and future cash flows will include the exact time of each event so that the time value of each flow can be estimated. From this cash-flow data, the post-tax internal rate of return (in inflation adjusted figures) will be calculated. Once this rate is found, it can be compared to the after-tax real cost of capital to the firm as of the planned date of the investment. Only if the internal rate of return (R) exceeds the firm’s cost of capital (K), i.e., R > K, should the project be further evaluated. 4 If R > K, the next step is to rank all potential projects (including all other investment options for the current period) according to their rate of return (R). Given a limited annual budget for capital spending, only those projects (investments) that promise the highest yield at an acceptable risk level should be approved. Thus under this capital budgeting procedure, even projects which promise a potential return (R) that exceeds the cost of capital (K) to the firm may be rejected (or delayed), due to the constraint of limited annual capital budget. CALCULATION OF THE INTERNAL RATE OF RETURN (R) The internal rate of return (“R”) represents the rate of profitability of a given project and can be calculated by means of the following formula: n C-∑ Ft = 0 (1) t=0 (1 + R)t where “C” is the total initial cash outflow (the investment) and “Ft” is the net cash inflow for each future period (“t”). Both “C” and “Ft” must be represented on an after-tax basis and in inflation-adjusted terms. The following sections consider the variables that relate to the estimated cash outflow “C” and the net cash inflows, “Ft” , for an early retirement program. 5 THE DECISION TO APPROVE AN EARLY RETIREMENT PROGRAM The management decision to retire some of the work force prior to traditional retirement age (e.g. 65) may be a very costly move that is economically justified if, and only if, the present value of future savings exceeds the cash outlays, or the expected internal rate of return is in line with other investment options (with similar risks). Birati and Tziner (1995), for example, present guidelines for assessing the maximum post-tax cost to the employer of the financial package to be offered to the early retiree, summarizing the calculation in formula #4. They define the total compensation (or cost to the employer) as the sum of the maximum potential losses incurred by the firm because of early retirement relative to the earnings generated by these employees if they left at the “normal” retirement age. This net of tax outlay totals the present value of several variables, including net salaries foregone during the “idle” years, reduced pension savings, reduced future social security payments and the subjective value of employees’ quitting the job. THE COST OF EARLY RETIREMENT TO THE EMPLOYER - “C” The actual cost to the firm of retiring a group of employees prior to traditional retirement age will differ from case to case. For example, the 1997 AMA Survey indicates that during the 1990’s, among the firms sampled that were engaged in job elimination, about one third paid early retirement benefits and 41% to 46% paid enhanced severance pay. Other major outlays included: a. outplacement services (65% to 84%), b. extended health coverage beyond the normal policy, and, 6 c. job retraining (10% to 18%). It should be emphasized that the above data relates to the expenditures of firms that were engaged in all types of job elimination (not only early retirement). In the case of early retirement, payments of this sort represent direct costs to the employers. In addition firms may also bear indirect costs that may affect future cash flows. THE INDIRECT COST OF EARLY RETIREMENT The indirect cost of retiring employees early may include some or all of the following factors: a. losses resulting from any delay in production due to the reduction in the experienced labor force, b. loss of employees that are valuable to the firm, c. a negative effect on the morale of the remaining employees. The assessment and quantification of all the variables included in “C” (particularly the indirect factors) are often difficult. Nevertheless, given the significance of these factors, they must be estimated and incorporated into the evaluation of the desirability of launching an early retirement program. Thus, the total cost of the program, “C”, should include the present value of all the direct and indirect costs related to the early retirement project. Moreover, “C” should be represented in post-tax inflation adjusted terms. 7 THE SAVINGS TO THE FIRM FROM EARLY RETIREMENT (“Ft”) Many firms offer select groups of employees (usually those close to traditional retirement age) early retirement packages in the hope of eliminating jobs and saving future payroll costs. For example, AT&T is now offering early retirement benefits in order to eliminate 15,000 to 18,000 positions in the next two years (see Kazel,1998). A similar step was taken by Allstate Insurance Co. in a desire to phase out approximately 700 of its home office employees and save about $30 million annually (Cox, 1994). The future savings from job elimination through early retirement are generated mainly by the decrease in direct and indirect costs associated with the reduction in the work force. Thus, the cost savings in equation #1 (“Ft” ) consist of the total after-tax savings in each future period (“t”) resulting from this reduction. Moreover when people must be hired to replace early retirees, but this can be done at a lower cost, these savings should also be included in the calculations. CONCLUSION The present paper advocates a financial approach to the assessment of the desirability of organizational interventions. The case of early retirement has been used as an illustration. The assumption is that major operational change, such as early retirement programs, should promote the long term objectives of a profit-seeking firm, namely, to increase the wealth of the shareholders by advancing the long-term profitability of the firm. The model treats early retirement projects in a manner similar to the handling of any other projected investment. The steps taken should incorporate careful 8 consideration of all the financial variables affected by the expected reduction in the work force, including: a) estimation of all the after-tax cash outflows at the initial stage (investment in the early retirement program); b) assessment of the net, post-tax real cash inflows (savings) from the project for the expected time span during which the benefits will prevail; c) calculation on the basis of (a) and (b) above, of the real after-tax rate of return on the project and its comparison with the post-tax cost of capital to the firm. Only projects which promise a return that exceeds the cost of capital should be considered. Finally, projects should be ranked according to their relative profitability and compared with all other investment alternatives. Assuming a limited capital budget for each period, only the most promising projects should be approved. Needless to say, future empirical investigations are needed to explore the tenability of this approach as well as its advantage over early retirement programs undertaken in a non-systematic manner (that is, in the absence of apriori evaluation of the extent to which R > K). 9 REFERENCES Birati, A., & Tziner, A., “Successful Promotion of Early Retirement: A Quantitative Approach”, Human Resource Management Review, 5, pp. 53-62. American Management Association, Corporate Job Creation, Job Elimination and Downsizing, 1997 AMA Survey, Summary of Key Findings, American Management Association, New York, NY, USA. Kazel, R., “AT&T Offers Enhanced Benefits in Effort to Reduce Workforce”, Business Insurance, Vol. 32, 5, Feb. 1998, pp. 2, 37. Cox, B., “Early Retirement Offered to 700 Allstate Workers”, National Underwriter, Vol. 98, 40, October 1994, p. 59.
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