Calculating payback of warehouse projects is critical to prioritizing resources. This applies to projects ranging from getting a forklift to building a new site. In this post we’ll review a few ways to do this as well as some limitation to payback calculations.
Why Calculate Payback
Warehouse projects can be very large or small. They include process changes, policy changes, implementation of new technology, or multiple changes at once. Examples might include:
- Adding cobots to your picking operation
- Changing the layout or configuration of a storage area
- Having receivers prepare the product for putaway differently
- Buying or renting more forklifts and hiring more staff for seasonal volume
- Changing to a new product marking scheme for more efficient putaway
- Implementing a Warehouse Management System (WMS)
- Making system changes to the existing WMS
- Updating signage and flow on the inbound dock to help receive
- And so on
Warehouses often have tens or hundreds of opportunities for improvement projects. There are more possible projects than there are people or time to execute them. How do you pick which ones to prioritize?
This is where calculating payback comes in. It may be called different things in different organizations, but the key idea is to determine how much bang for the buck you get if you do one project instead of another. This allows you to prioritize what to do.
Costs and Benefits
To calculate payback, you’ll need to understand the costs and benefits of the change. Then you can weigh the costs and the benefits in a relative and absolute comparison to help make a decision.
Let’s talk about costs first.
Project costs will fall into two broad financial categories and several functional categories. It’s important to understand each one to get a full picture of the costs. A starting template is below.
Facilities expenses might include modifications to the building. Operating expenses might include utilities costs and extra maintenance staff required.
IT Systems costs should include the cost of any analyst work (such as requirements and specifications), development or configuration, testing, and deployment. IT operating costs should include any ongoing licensing and support requirements. Likewise, IT Infrastructure costs would include capital costs of any new equipment plus operating costs of licenses or support.
Warehouse equipment cost would include the price tag of the equipment to make the change plus any spare parts. Then for operating costs, include the maintenance costs and any service packages.
Staffing and resourcing will include any additional headcount to operate the change plus the cost of recruiting and training.
Other changes may required spending in other categories. The above are the most common areas of impact but it’s important to consider all aspects of the cost impact, not just the equipment CapEx against labor savings.
And don’t forget about tax and shipping. These categories are often not included in the vendor’s quote but can add up to between 5% and 15% of the equipment price tag.
Types of Benefits
But enough about costs. Let’s talk about the fun part, the savings or benefits. Consider two types of benefits: Hard savings and soft savings.
Hard savings are quantifiable, credible savings that will reflect in the operational Profit & Loss (P&L) statement. Because labor is the warehouse’s primary operating cost, hard savings are often directly related to efficiency gains and direct function headcount reduction. Occasionally they may be related to efficiency gains in utilities reduction, consumables reduction, or other areas. Top examples here include improving picking efficiency, putaway efficiency, reducing outbound shipment load times, and so on.
Soft savings are benefits that will accrue to the organization that are difficult to quantify, difficult to attribute directly, and are often not reflected in the P&L. Improvement in safety record, reduction in turnover, “better morale”, and quality improvements often fall into this bucket of items. (Yes, we know that quality has hard cost impacts, but many organizations cannot directly attribute and quantify, say for example, the savings in going from 95% inventory accuracy to 99% inventory accuracy).
Hard savings is what to build the payback calculation on. Now, it’s not entirely fair to disregard soft savings. Sometimes there is an organizational mandate to do things that don’t “pay back” quickly, because doing the thing is aligned to the organization’s values. But most often the justification for projects is built on quantifiable, credible business assumptions.
How to Quantify Benefits
So we want to have quantified, credible benefits. How do we get them?
First consider the current state or how the operation is performing now. It is helpful to have some recent historicals on the performance metrics you think will improve with the change. The numbers to look at include rates, or how many things per labor hour the operation is processing; or overall cost-per-unit to process. This can be at a whole-facility level or within a particular department. Cost per unit is the best target to go after, but since there are many inputs to CPU it may be difficult to isolate the effect of the change you’re planning.
So having stable records of performance rates in a target area may be more practical to identify and communicate. This is your baseline.
Now determine what the effect of the change is. Will it improve your pickers rates by 3 picks per hour? Will it help your loaders load trucks in 45 minutes instead of an hour? Perhaps you have the vendor demo the equipment and take time studies with it, or use customer references to identify comparable gains, or you do a local time study with the layout change to determine the improvement opportunity.
Then you can calculate how the impact of the change. If new scanner equipment improves picker productivity by 10% then you would need 10% fewer picker hours in the building to achieve your goals. These would be cost savings.
These calculations can be very simple studies or complex. Calculating labor payback on new equipment might be straightforward but calculating payback on more racking might require more assumptions and forecasting.
However, keep in mind that big changes don’t necessarily need complex analysis with lots of inputs. Making a change to go from an unslotted inventory configuration to a stratified, A/B/C forward picking area may require only a few assumptions and some simple math to verify the savings.
If, for example, you determine that the average pick cart travel distance in the unslotted warehouse is 500 feet and that the distance shrinks to 200 feet after reslotting, the math is straightforward to determine labor savings. (Distance savings * # carts per period * hourly rate * picker speed).
Or you could pay for a consulting service to run a simulation to confirm it.
The key is to think about what processes are improved after the project. These can include the direct processes or even indirect such as inventory control, so long as the impact on the processes can be articulated.
Match Benefits with Costs
Once you have identified the costs and the benefits, put them in rows along a time-series. Use 5 or 10 periods or whatever makes sense depending on the length of time of the investment.
Subtract the costs from the benefits to arrive at a period cash flow. Then keep track of cumulative cash flow over the project analysis period. A sample table is below.
Note that OpEx may include items like maintenance, supplies, and so on. The Investment is the capital cost of the project, like equipment. Only hard savings of labor cost are included here, but there could be other less-quantifiable benefits to identify in the business case. Other things like depreciation, replacement cost, or other financial considerations can be included in the analysis for forecasting purposes but may not be needed to make a decision on the project.
Run the net present value (NPV), Internal Rate of Return (IRR), and payback period calculations. These calculations help you and the finance team compare projects and make decisions.
Calculating payback is an important part of managing projects in the distribution center and warehouse setting. While some projects don’t need an identified payback or business case, most larger equipment or software initiatives do. Large projects, like warehouse startups or automation implementations, definitely do.
To help get your projects scoped and approved, consider both the costs and the benefits over time. Cost models supported by other business considerations provide strong reasons for choosing one option over another. Build a model with value, rate of return, and payback period to help the decision-makers understand the alternatives and support your plan.