Return on Investment
Return on Investment is a financial calculation to determine whether the business benefit of an investment is worth the cost.
When to Use Return on Investment
Return on Investment (ROI) is a term used in many connotations. For our purposes, it is being used to determine whether the business should spend money on a project or activity. An ROI calculation is normally included with the Business Case for a project or initiative. Occasionally an ROI for a project that has been approved may be reviewed and updated. This normally occurs when something significant in the project or business conditions has caused a major change in the costs or benefits used in the ROI calculation.
The way in which we are using the term ROI is as an analysis to determine if a project will create enough profit so as to offset the cost of the project. When resources are not a constraint, then every project with a positive ROI should be done since it will ultimately yield profit. However, resources are always a constraint. Therefore a company will typically use ROI to rank order projects and decide which one will generate the most profit. The company then begin to fund projects according to their ranking until all available resources have been allocated.
In order to calculate the ROI, two estimates are required – the estimated cost of the project and the estimated incremental value of the project benefit. In both estimates, there is both an amount component and a time component that must be estimated. For example, the project cost estimate includes how long the project will be underway before it starts to create a benefit. And the benefit estimate will often change from year to year as sales increase or the business operations change.
Because of this time component in the cost and benefit estimates, the ROI techniques are more complex than just a ratio of benefit divided by cost. These ROI techniques will approach this analysis from different perspectives. The four primary techniques are listed below and an entire module in this course is devoted to each technique.
This ROI technique emphasizes time – in fact the calculation yields a time value. The calculation determines how much time (usually in months or years) are required for the benefits to accumulate until there is enough money to offset the cost of the project.
This ROI technique has a sales and marketing focus. It is used when the project is developing a new product or modifying an existing product. In this case the answer will be in the units of number of products sold. This technique determines how many units must be sold in order to generate enough profit to offset the cost of the project.
Net Present Value (NPV).
This ROI technique is not focused upon that point when the project costs are offset. Rather this technique will accumulate all the benefit over some time period – typically several years. It will subtract from that the project costs and incremental costs caused by the project during those years. Finally it will convert those into the value of today’s money using a time value of money calculation. Essentially what the calculation provides is the total value of the project to the business.
Internal Rate of Return (IRR)
This ROI technique is similar to the NPV technique in that it considers the total effect of the project and not just the effect until the project costs have been offset. This technique though emphasizes the investment aspect of the project costs. It essentially calculates what the equivalent interest rate would need to be if the money used in the project were invested in some other investment and yielded the same return.
Most finance organizations have a form or spreadsheet in which they do these calculations. Generally the project costs are entered by some major cost category such as the department or project phase. The project benefits are also listed. I separate the benefits first by the impact on operating expenses and then the impact on sales. When providing the benefits, I will put each category of benefit (or cost) on a separate line in the spreadsheet so as to keep track of how the total benefit number was derived. The costs and benefits are spread across the time periods in the spreadsheet, normally either months or years. The total spending or benefit can then be calculated for each year and a cumulative total from the beginning of the project can be determined. The table below is an example of a simple version of this spreadsheet.
Hints and Tips
- Be certain to use incremental costs and incremental benefits. For example if a project is a product cost reduction project; the benefit gained from the sale of each unit is not the total profit, rather it is the incremental reduction in variable cost on each product.
- In some cases, the new project will cause losses to occur, such as cannibalization of an existing product line or an additional maintenance or licensing fee. Be sure to include these costs that may extend out over many years.
- Different techniques can create different project priorities. (The project to payback the fastest may not have the best IRR) Use the technique, or techniques, your company considers to best represent the company interests.
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