As a business owner, you’ll want all of your planned projects to succeed. The problem is, not every project is created equal. While some may become a success, others may not turn out exactly how you wanted it. But how do you know which project will produce the greatest gains for your company?
Many companies calculate the project profitability index to help them decide which projects to pursue. This article will discuss what the profitability index is, why it matters, and how to calculate it. We’ll also discuss how to interpret the results, so you’ll be able to make more informed decisions for your company.
Let’s dig in.
Project Profitability Index Defined
A profitability index (PI) provides a way for business owners and managers to determine a particular project’s profitability. It shows how much profit is generated per unit of investment. With this information, the business owners can decide whether the project is worth investing or not.
As a general rule of thumb, a profitability ratio that is greater than 1 indicates that the project is more likely to be profitable and is worth pursuing. A profitability index of less than 1 means that the project won’t be worth investing in. A PI of 1 is considered the base point. Business owners should only consider projects with a PI of 1 when the alternatives have a PI of less than that.
Other terms for profitability index include profit investment ratio (PIR) or value investment ratio (VIR).
Why it Matters
Businesses should continuously explore opportunities that would allow their business to scale in a competitive environment. While strategizing, the company’s committee could come up with multiple projects or ideas to help boost the company’s profitability. However, as the company could only shell out a limited amount of investment, they may have to choose one or two projects that they can execute. Naturally, they would want to select a project that will yield the most profit.
This is the time where the profitability index comes in handy. The profitability index helps business owners and investors rank projects based on their attractiveness and profit-generating potential. When there is a multitude of possible projects, calculating the profitability index allows businesses to determine which project is best to invest in.
How to Calculate Profitability Index
In calculating the profitability index, you need to know two things: the net present value and the project’s initial investment.
Here’s a step-by-step guide on how you can calculate your profitability index:
Determine the initial investment the project requires based on the project requirements. It could be the capital expenditure associated with equipment use or other costs, which could also be capital in nature.
Next is to determine the possible cash flows that will come from the project. The discounting factor (represented as “r”) is identified based on the returns of a project of a similar nature, thus holding the same level of risk. You can then use your discounting factor in calculating the net present value (NPV).
The net present value (NPV) is the difference between the present value of cash outflow and inflow over a specific period. It’s a helpful metric to track when it comes to capital budgeting or project planning.
You can obtain the NPV by using this formula:
Net Present Value (NPV) = Cash flows/ (1+r) x t
Cash flow = difference between cash inflow and outflow
R= discount rate
T= time period
Once you have the numbers, add the net present value to the initial investment and initial investment and divide the result by the initial investment. Here’s how the formula looks like:
Profitability Index (PI) = (Net Present Value + Initial Investment) / Initial Investment
You can also use the alternative formula in computing a project’s profitability ratio. Here’s how it goes:
Profitability Index (PI) = Present value of future cash flow / initial investment
From there, you can decide whether you should go with the project or abandon it entirely. Remember, your project’s PI should be greater than 1 to be considered as profitable.
Advantages of Calculating Profitability Index
There are several advantages of using a profitability index to rank your projects based on their profitability. Here are some of them:
- It’s straightforward and easy to understand
Calculating a project’s profitability index doesn’t require the business owners to use a complicated formula. The system only uses a simple division. As long as they know the value of their cash flow, investment, and discounting rate, they can rank projects according to their profitability.
It’s also easier to interpret the result of your computation. If you get a result of less than 1, it would be best to skip the project and try other projects. A PI result of greater than 1 means that the project has a high potential. A PI equivalent to 1 is a breakeven point.
- It considers all the cash flow involved in the project
Unlike other investment tools that only use published cash flows, the profitability index considers all the project’s cash flow, even those that haven’t reached the books. These are essential data to consider to calculate the NPV, or the net present value. With more data to consider, the better picture you’ll get when determining the value of the investment.
- Provides information about how an investment impacts the firm’s value
A project’s profitability index allows you to determine whether a particular project will contribute to your company’s bottom line. For example, if project A gets a profitability ratio of less than 1, then the investors and managers would turn down the project as it won’t contribute to its success. Instead, they should for projects with a profitability ratio greater than 1, as it will yield a greater return of investment.
The Bottom Line
If you’re faced with different projects and don’t know which one would contribute best to your company’s growth, calculating your profitability index will help. As much as possible, consider all the cash flow data from a project and create multiple calculations using different estimates. This will help you make the most informed decision as to which projects will lead to the greatest return of investment for your company.