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Return on Investment is a financial calculation to determine whether the business benefit of an investment is worth the cost.

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Quick reference

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. 

Instructions

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.

Payback Period.

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.

Breakeven Point.

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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  • 00:02 Hi, I'm Ray Sheen.
  • 00:03 It's now time to introduce the concept of Return on Investment, or ROI.
  • 00:07 Our focus will be the ROI for business projects.
  • 00:11 The concept of Return on Investment, or ROI, is very simple.
  • 00:17 It's analysis of how much money I will make in the future if
  • 00:19 I spend some money now.
  • 00:21 The focus of our discussion will be on business projects.
  • 00:25 The same term is used for all types of investments, from stocks and
  • 00:28 bonds to venture capitalists.
  • 00:29 We will focus on business projects.
  • 00:32 ROI calculations will show whether or not the business should do a project.
  • 00:37 If resources are unlimited, whenever there's a positive ROI, and
  • 00:41 the project aligns with business strategy, do the project.
  • 00:44 But resources are not unlimited.
  • 00:46 They typically are constrained, so in that case we use ROI to prioritize projects.
  • 00:51 The projects with the best ROI is done first.
  • 00:54 Then the next project and the next, until we've used up our resources.
  • 00:58 When using ROI in this manner, we need to ensure that everyone is calculating it in
  • 01:02 the same way, so that the comparisons between projects is fair.
  • 01:07 All project ROIs start with two estimates.
  • 01:10 The first is the cost of the project.
  • 01:12 In this case, we use an incremental cost to the project.
  • 01:15 So doing the project means that we add $1 million in cost to the business, but
  • 01:19 remove $100,000.
  • 01:20 Then the incremental cost is only $900,000.
  • 01:23 The second estimate is the incremental benefit that comes from doing the project.
  • 01:28 This could be new sales or productivity cost reduction.
  • 01:32 When determining both the project costs and benefits, the estimated amount and
  • 01:36 the timing of when it will occur are required.
  • 01:39 Let's look at the ROI techniques used for evaluating business projects.
  • 01:43 There are four techniques used by companies for evaluating projects.
  • 01:46 Each technique focuses on different aspects of the benefit.
  • 01:49 Depending upon which technique is used,
  • 01:51 the priority of business projects could change.
  • 01:53 I will briefly introduce the four techniques here.
  • 01:56 But there's an entire module in this course focused on
  • 01:58 each of these four techniques.
  • 02:00 First, the Payback period technique.
  • 02:02 It provides an answer in units of time.
  • 02:05 The emphasis is how fast until the project benefit
  • 02:08 is able to return the project cost that was invested.
  • 02:11 Next is Break-even point This is used with projects that create or improve products.
  • 02:16 It's focused on marketing and sales.
  • 02:19 It calculates how many units must be sold to create enough profit to pay for
  • 02:23 the project investment.
  • 02:25 The third one I will mention is Net Present Value.
  • 02:28 Instead of looking for the point in which the benefit equals the cost,
  • 02:31 this technique accumulates all the cost and
  • 02:33 the benefits due the project over some time period.
  • 02:37 And determines the total value of the project during that time.
  • 02:41 The final method is Internal Rate of Return.
  • 02:44 This one is the closest to the investment bankers' meaning of Return on Investment.
  • 02:48 In this case, an equivalent interest rate is calculated.
  • 02:51 The interest rate,
  • 02:52 if applied to the total value of the project cost, would provide the same
  • 02:56 benefit as the project is estimated to provide over the same time period.
  • 03:00 Although the four methods give different answers, time, units, money, or
  • 03:04 interest rate, they all use the same information.
  • 03:08 When I'm about to do a project ROI calculation, I collect the project cost
  • 03:12 and benefit data in a spreadsheet structured like this.
  • 03:15 I can use this spreadsheet with any of the four techniques.
  • 03:19 Your business may have its own form of spreadsheet.
  • 03:21 Use it.
  • 03:22 They're probably structured in a similar manner.
  • 03:24 So let me go through this spreadsheet.
  • 03:26 One of the ground rules in this spreadsheet, costs are negative numbers.
  • 03:29 And benefits are positive numbers.
  • 03:32 The rows are cost or benefit categories.
  • 03:34 The top part of the spreadsheet is the categories of project cost.
  • 03:38 These can be organized by phase, department, or deliverables.
  • 03:41 Frankly, it could all be summarized and only the total shown.
  • 03:44 However, I find that using the categories is a great way for
  • 03:47 me to document what went into the assumptions about project costs.
  • 03:50 For convenience, I break the total of these cost categories
  • 03:53 into the columns of Personnel, Purchased Item, and Other.
  • 03:57 This section is a set of costs that the project manager and
  • 03:59 project team will control.
  • 04:01 The next set of rows is Operational Expense Costs and Benefits.
  • 04:05 If the project changes any Operational Expense category, such as maintenance,
  • 04:08 systems or personnel head count, I captured the impact in these rows.
  • 04:13 I have a different row for each category of cost or benefits.
  • 04:16 These are categories that are not managed by the project team.
  • 04:20 Rather, these are impacts that the business managers will realize
  • 04:23 once the project is complete.
  • 04:25 Depending upon the project, there may not be any impacts in this area.
  • 04:29 The first set of rows is for the impact of the project on products and
  • 04:32 services that are sold.
  • 04:34 I normally show this as the benefit of the value of new sales,
  • 04:37 less the cost of making those products that are sold.
  • 04:40 And the loss of the value of sales that will no longer occur.
  • 04:43 If for instance a product is being obsoleted, and
  • 04:46 the benefit of not building those products that will no longer be sold.
  • 04:49 Again, I might have several lines for
  • 04:51 sales to document sales through different channels.
  • 04:54 Lastly, all of these categories and
  • 04:56 benefits from all the rows must be spread out over time.
  • 05:00 The additional columns are normally years.
  • 05:03 If the project is a multi-year project, a portion of project costs
  • 05:06 will be in the first column, and a portion in succeeding years.
  • 05:10 The benefit from the operational expenses or
  • 05:12 new sales will start when the project completes.
  • 05:15 Typically, these benefits will ramp up and
  • 05:17 the amount of benefit can change from year to year.
  • 05:20 Estimating the time as best you can, this spreadsheet can be a big help
  • 05:24 to judge risk sensitivity of some of your assumptions.
  • 05:27 Once the spreadsheet is set up, you can vary the amount or
  • 05:30 timing of an assumption and quickly see the impact on ROI.
  • 05:36 >> Whichever technique you use, you'll need to estimate costs and benefits.
  • 05:39 With that information,
  • 05:41 you can help the business make a wise decision on how to spend their resources.

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