A few years ago Rob thought it might be time to install solar panels at their house in the Australian countryside. Rob and his wife Paula wanted to do something to offset their carbon footprint for some time, but were struggling to make a decision with reducing (and now eliminated) subsidies available from the power company, declining costs of installing solar PV, and questions over the future level of feed-in tariffs (the price at which the electricity company buys from you when you generate excess power at home). Was now the right time? He decided to approach it in the way he had learned at McKinsey and started with the hypothesis, “We should install solar PV now.” He hadn’t reached a conclusion by framing it this way, nor was he setting out to confirm it without regard to the facts. He was using the hypothesis to bring forth the arguments to either disprove it or support it.

Rob felt that the hypothesis would be supported if the following criteria could all be sustained:

• If the payback on the investment was attractive, something less than 10 years.
• If the decline in the cost of panels was slowing down such that he should not wait and make the investment later at substantially lower cost. Rob felt that if solar panel costs were going to continue to decline and be significantly cheaper in three years he’d consider waiting.
• If the reduction in his CO2 footprint was material, by which he meant 10% or more (other than air travel he is required to do and can offset independently).

Rob knows that constraining the scope of the problem with clear boundaries makes problem solving more accurate and speedy (step 1).

Step 1: Define the Problem

This kind of problem sounds quite complex at first, a jumble of unfamiliar terms like feed-in tariffs and avoided carbon. A logic tree helped Rob see the structure of his problem in one picture, and helped him break up the analyses into manageable chunks. He started by laying out the reasons and supporting facts that he would need to resolve the issue. You can also think of it this way—for Rob to answer the question affirmatively what would he have to be convinced of? What are the major reasons for going ahead and installing solar panels?

Exhibit 1.5 is a first cut of Rob’s logic tree (steps 2 and 4).

Exhibit 1.5

The first part he tackled was payback, because if the economics didn’t work, the two other questions didn’t need answering. Payback is pretty straightforward: the cost of the installed solar panels and inverter, divided by the annual electrical cost savings. The denominator in this analysis includes both estimating net savings from the installation from avoided electricity charges because he was using his own power, plus income from supplying electricity to the grid via feed-in tariffs. Most of this analysis can be done by online calculators that solar installers offer, once you know the size of the system, roof orientation, solar electric potential and the efficiency in power generation. Rob simplified the analysis by leaving out battery storage options that add to cost but provide the opportunity to replace peak power charges. With an annual cost savings of around $1,500 and investment costs of just over $6,000, payback was attractive at about four years (step 5).

Finally, he wanted to estimate how much of his CO2 footprint he would reduce by going ahead. This depends on two things—one is what fuel source he is displacing (coal or gas in this case) and the second is the kilowatt hours (kWh) he is generating compared to his electricity use, which he knew from the first step. Rob simplified the analysis by looking at the carbon footprint of the average Australian citizen, and found that the avoided carbon from his little solar project could reduce his footprint by more than 20%. Since the payback as an investment is very solid in this case, Rob really could have pruned off this branch of the tree (step 3) and saved some time—but he and Paula had multiple objectives with this investment.

Whenever you do this kind of analysis it is worth asking what could go wrong, what are the risks around each part of the thinking? In this case there is a chance that the power company would reduce the subsidies for installing solar PV. This can be mitigated by acting quickly. The power company could also reduce the feed-in tariff rate at which it purchased any excess power produced by Rob—and in fact they did that later. But with a four-year payback the exposure is reasonably limited.

With only a bit of online research, Rob was able to crack a relatively complicated problem. Rob should install solar panels now: The payback is attractive, and likely cost declines to install later are not enough to offset the savings he could earn now. As a bonus, Rob and Paula were able to reduce their carbon footprint by nearly 30% (steps 6 and 7).

The core of this good result was asking the right questions and disaggregating the problem into straightforward chunks.

The company also evaluated whether it could achieve the same result by reducing its fixed overheads or taking manufacturing in-house. With few costs other than a lean staff and rent, the first was not an option. With limited current cash resources, investing in its own extremely expensive manufacturing presses and assembly also didn’t make sense (step 3). On balance a small price increase to restore unit margins was worth the risk (step 6 and 7).

This kind of financial tree is particularly useful for solving problems that involve monetary trade-offs of alternative strategies. You can use it to track almost any kind of business problem.