The primary responsibility of business management is to increase shareholder value. In order for management to accomplish this goal, they must understand all of the costs and benefits associated with an investment in efficiency, and make decisions based on whether the company's total net benefits are greater than total net costs. I intentionally refer to an investment in efficiency, rather than specifically in energy efficiency or pollution prevention, because of the interrelatedness of these subsets of efficiency. It is critical that all savings related to such projects — energy and non-energy — be included in the financial analysis so that management understands the complete financial ramifications of an efficiency project.

The financial analysis of an efficiency project is the basis for making the investment decision. The financial analysis may range in sophistication from a simple payback (investment/annual net savings) or rate of return (average annual net savings/total investment) to more accurate calculations, such as net present value (NPV) or internal rate of return (IRR), which take into account the time value of money. Regardless of which calculation is used, the most important part of a financial analysis is the estimation of project costs and benefits, as discussed below.

Calculating Costs

There are numerous phases in a project, each with several cost components:

• project identification,
• technology identification and project design,
• financial analysis,
• purchasing and procurement,
• financing,
• installation,
• startup and training, and
• ongoing maintenance.

If investment incentives are offered to the company (e.g., investment tax credits or utility or government incentives), they reduce the company's total cost and therefore should not be included in costs to the company when performing a financial analysis.

When estimating project costs, only those costs that are incremental as a result of the project should be included when determining the financial ramifications of the investment on the company. In other words, count only those costs that arise as a result of the project and would not exist if the project were not pursued. These costs are, in general, dominated by direct costs, such as:

• engineering fees,
• equipment purchases,
• supplies,
• installation contractor fees,
• costs of off-site training for employees,
• lost production resulting from disruption of production during project installation and learning curve, and
• ongoing maintenance of new equipment.

Costs that do not change as the result of an investment decision are irrelevant to the decision. For example, overhead costs that may be allocated to a project, but which would exist regardless of the project should not be included in a financial analysis because they are not incremental costs. Examples of these costs are internal staff time to:

• identify and evaluate the project and its design,
• win management approval for the project,
• finance the project either internally or externally,
• identify, select, contract, and coordinate with engineers and contractors, and
• identify sources for and procurement of project equipment and supplies.

The internal staff that performs these functions will exist whether or not the investment is made. Although these non-incremental overhead costs, often referred to as transaction costs, are not included in a financial analysis, they are still barriers to efficiency because there is an opportunity cost associated with taking staff time away from other projects. Therefore, to the extent that efficiency advocates — whether they be government or non-government organizations, or even corporate environmental managers — can minimize these barriers by making efficiency easier to understand and implement, more efficiency will occur.

Another type of cost that should not be considered in an investment decision is a "sunk cost." A sunk cost is one that has already been incurred and will not go away if the investment is not made. For example, if $10,000 were spent on a feasibility study that recommends an additional $50,000 investment in efficiency, the $10,000 sunk cost is not part of the costs that are included in a financial analysis that will determine the investment decision. Thus, the investment decision is based on costs going forward, not looking back.

Calculating Benefits

As with project costs, project benefits should reflect any and all net benefits that are incremental to the project. For industry, benefits can come in several categories:

• energy savings,
• reduced costs of environmental compliance,
• improved worker safety (resulting in reduced lost work and insurance costs),
• reduced production costs (including labor, raw materials, and energy),
• reduced waste disposal costs,
• improved product quality (reducing scrap and rework costs and improving customer satisfaction)
• improved capacity utilization, and
• improved reliability.

The importance of quantifying all benefits is exemplified by many of the cases presented here in which energy efficiency projects' non-energy benefits far exceed energy savings. Since each project is unique and uniquely interacts with other aspects of the manufacturing operation, it is difficult to accurately estimate average total benefits that result from energy efficiency projects. However, it is a critical step in the corporate capital-investment decision-making process to estimate all costs and benefits related to a proposed investment before the investment is made. Enhanced corporate image is one benefit that a company will probably not attempt to quantify, but it will still be taken into account qualitatively when making decisions with environmental benefits.

Tax Implications

Many financial analyses of efficiency projects erroneously neglect tax implications. Both costs and benefits need to reflect tax implications when making an investment decision. For example, if a project saves $4,000 a year in lower energy costs and $16,000 from improved operations and maintenance, a company's taxable income increases by $20,000. The result is that it pays more taxes and the cashflow benefit is reduced accordingly.

Taxes also affect costs by way of depreciation. Although depreciation is a noncash charge, it is treated as an expense, which lowers taxable income. Thus, depreciation must be subtracted from incremental pre-tax profits to arrive at the taxable income, and then be added back to after-tax profits to reflect actual cashflow. Because each company's tax rate differs and depreciation calculations can be complex, involving issues such as early write-offs of old equipment, it is best to leave this portion of a financial analysis to a financial analyst.

Time (years) 0 1 2 3 4 5 6 7 Revenues (increased productivity) + + + + + + + Operating Savings: Energy + + + + + + + Materials + + + + + + + Labor + + + + + + + Reduced scrap/rework + + + + + + + Improved reliability + + + + + + + Operating Expenses: Engineering fees - - - - - - - Training - - - - - - - Disruption of production - - - - - - - Maintenance (new equip.   - - - - - - - New equipment depreciation   - - - - - - - Pre-tax Profits   x x x x x x x xTax   - - - - - - - xAfter-tax Profits                 xNew equipment depreciation   + + + + + + + xCapital Expenditures (equipment) -               xAfter-tax Cashflow z xz xz xz xz xz xz xz Net Present Value (NPV) $$ Internal Rate of Return (IRR)  %

Incremental Cashflow Analysis The culmination of gathering all of a project's costs and benefits is to input these data into an incremental cashflow analysis (see box example for project with seven-year life). Incremental costs and benefits are taken into account over the life of a project (e.g., life of efficient equipment installed), with capital investments normally taking place up-front (time zero). After-tax cashflows, which reflect the depreciation tax shield, are used to calculate a Net Present Value or Internal Rate of Return. The complexity of these calculations merit the attention of a financial analyst. However, the most important component of a cashflow analysis is the calculation of costs and benefits, which are best estimated by technical and engineering staff. Granted, the process of estimating costs and benefits may not be an easy one, however, it is a necessary exercise that will add value to the company and further environmental goals.