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The Art of Building the Business Case, Part 5 of 5
Yes, this is part 5. And SafetyXChange articles aren't supposed to run longer than four parts. I feel a little bit like the guy in Spinal Tap whose guitar goes to 11. So, I'll use this singular privilege to finish my analysis of the concepts for selling the economic value of safety initiatives to your CEO.
Replacement Analysis
Replacement analysis, which provides an economic comparison of two asset choices - a defender (the current assets) vs. a challenger (asset being considered for purchase) - is usually used to determine whether to replace an existing asset with a new or more efficient one or to compare different options of procuring equipment, such as buying vs. leasing. The costs and expenses associated with the assets are converted into an EUAC. This determines how much expense will be associated with a given asset in one years time, thus providing a uniform benchmark for comparison. Once the EUAC has been determined, all the company needs to do is choose the lowest cost option.
For example, to determine which is more feasible, buying or leasing a particular asset the formulas below can be used. Here the defender formula is used to perform the purchase option and the challenger formula to calculate the lease option.
| The formula for the defender is: | The formula for the challenger is: |
| EUACd = P - SV + AOC | EUACc = L + AOC |
| Where: P = Purchase cost of the asset SV = Salvage value of the asset AOC = Annual operating cost |
Where: L = Lease cost of the asset AOC = Annual operating cost |
This is a function of:
- Initial cost of the asset
- Salvage value (if any) of the asset
- Annual operating cost
- Lease cost.
Retirement Analysis
Retirement analysis is the method used to find the lowest EUAC of an asset based on the number of years it will be used. This method allows the company to decide the most economical length of time to utilize an asset.
The formula for the defender is:
| EUACd = P - SV + AOC |
| Where: P = Purchase cost of the asset SV = Salvage value of the asset AOC = Annual operating cost |
This is a function of:
- Initial cost of the asset
- Salvage value (if any) of the asset
- Annual operating cost.
Cost-Benefit Analysis
Cost-benefit analysis is used to analyze the effects of making a change in a process. Typically, cash flows of present procedures are compared against predicted cash flows incurred under the change. The advantage of using the cost-benefit analysis is the ability to monetize costs of intangibles (e.g., good will, reputation of a company, the cost of a life, cost of future injuries, decreased turnover, decreased training, etc.). The estimates used must be accompanied by realistic, conservative accounting assumptions. Without realistic assumptions to force the solution to the worst-case scenario, errors could occur which invalidate the estimate basis.
This is a function of:
- Decrease in legal liabilities, legal fees, settlements
- Decrease in OSHA citations
- Increase in good will (e.g., company reputation, union negotiating, etc.).
The cost benefit analysis can be cynical in its assignment of economic value to human life. For a striking example of this, see the cost benefits analysis in the Tools section of SafetyXChange recounting how Ford Motor Company decided what to do to respond to the rollover danger presented by the Pinto.
Tying the Cost to Lost-Time Accident Savings
Another way to justify the cost of your program is to tie the reduction of Lost-Time Accidents (LTAs) to cost savings. Let's assume that the cost of a Lost Time Accident is $40,000 and that recent history indicates two LTAs/year. The annual costs for the safety department is $100,000.
What I tell management is that whatever it costs to get from an incident rate of 5 to 2.5, double the cost to get from 2.5 to 1.5. To get from 1.5 to one double that figure again. The cost increase is for equipment, staff, resources and rewards for achieving the postulated goal. Weigh the goal so that you assume the risk of not achieving early on but the company assumes more of the risk as you approach your goal.
For example, if you get to one year without a Lost Time accident and a sustained incident rate of 2.5, the payback is 0.5 times the cost to get from 5.0 to 2.5. As you approach 1.0 that multiplier increases to 0.75, 0.85 and may reach as high as 1.0. As you can see, the payback can increase quite rapidly.
| Goal | Cumulative Safety Dept. Budget | LTA Averted Cost | Cumulative LTA Averted Cost | Payback to Safety Dept. | |
| IR | LTA | ||||
| 2.5 | One Year without LTA | $ 100,000 | $ 80,000 | $ 80,000 | 0.5 x $80,000 = $40,000 |
| 1.5 | Two Years without LTA | $ 200,000 | $ 80,000 | $ 160,000 | 0.75 x $160,000 = $120,000 |
| 1.0 | Three Years without LTA | $ 300,000 | $ 80,000 | $ 240,000 | 0.85 x $240,000 = $204,000 |
| 0.5 | Four Years without LTA | $ 400,000 | $ 80,000 | $ 320,000 | 1.0 x $640,000 = $320,000 |
If this mechanism is hard to swallow, I use the chart that I have seen referenced in several finance-related articles regarding accident costs and the relationship to profit and profit margin.
Justifying Safety Using Sales and Profit Margins
In times of keen competition and low profit margins, safety may contribute more to profits than an organization's best salesman. The Table below shows the dollars of sales required to pay for different amounts of costs for accident losses based on profit margin. Thus, for example, assuming an average profit margin of 3%, to pay the costs of $50,000 in annual losses from injury, illness or damage, a salesman would have to sell an additional $1.667. The amount of sales required to pay for losses will vary with the profit margin.
The formula:
Sales to Offset Sales = ($ losses x 100)/Profit Margin (%)
| YEARLY INCIDENT COSTS | PROFIT MARGIN | ||||
| 1% | 2% | 3% | 4% | 5% | |
| $1,000 | 100,000 | 50,000 | 33,000 | 25,000 | 20,000 |
| 5,000 | 500,000 | 250,000 | 167,000 | 125,000 | 100,000 |
| 10,000 | 1,000,000 | 500,000 | 333,000 | 250,000 | 200,000 |
| 25,000 | 2,500,000 | 1,250,000 | 833,000 | 625,000 | 500,000 |
| 50,000 | 5,000,000 | 2,500,000 | 1,667,000 | 1,250,000 | 1,000,000 |
| 100,000 | 10,000,000 | 5,000,000 | 3,333,000 | 2,500,000 | 2,000,000 |
| 150,000 | 15,000,000 | 7,500,000 | 5,000,000 | 3,750,000 | 3,000,000 |
| 200,000 | 20,000,000 | 10,000,000 | 6,666,000 | 5,000,000 | 4,000,000 |
| SALES REQUIRED TO COVER LOSSES | |||||
Conclusion
The overarching formula to keep in mind:
top management commitment = safety program success
To review, to secure top management commitment, you should use applicable safety and health standards, engineering-worker's compensation and financial principles. Require sign-off for risk acceptance. You should even go so far as to befriend an accountant, CPA or Comptroller in the Accounting Department. That person can make your life a lot easier, especially when performing these gymnastic calculations. In any event, do your homework and calculate the dollars and sense of your safety and health programs. This will make it easy for management to say "YES" and hard to say "NO" to your proposed initiatives.
SELLING SAFETY
 |
| Why do companies spend money on safety? |
What Motivates Companies to Abate Hazards?
Why do companies decide to manage hazards in the workplace? Is it to avoid OSHA liability? To save money on workers' compensation? To attract and retain workers?
This is the question that a study from the RAND Corporation sets out to answer. First published as a student's doctoral dissertation in 1998, the study analyzes data from a survey of 2,000 members of the National Federation of Independent Business. Here are some of the findings:
- Decisions about hazard abatement are driven more by internal variables such as the size of the enterprise and riskiness of its operations than by external factors like fear of liability and the desire to reduce workers' compensation costs;
- The bigger the firm, the more likely it is to spend money on hazard abatement;
- The riskier the firm's industry, the more likely it is to spend money on hazard abatement;
- Changes in OSHA policies and the fear of inspections have limited impact on management decisions about whether to spend on safety; and
- Among external influences, financial incentives under workers' compensation are far more effective than fear of OSHA.
SOURCE: Sims, "Hazard Abatement as Function of Firm Size," RAND Graduate School, Nov. 1998, http://www.rand.org/pubs/rgs_dissertations/2008/RAND_RGSD227.pdf
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