ROI Return On Investment
Return on Investment (ROI) is a straightforward financial tool that measures the economic return of a project or investment. ROI measures the effectiveness of the investment by calculating how many times the net benefits (benefits from investment minus initial and ongoing costs) recover the original investment. ROI has become one of the most popular metrics used to understand, evaluate and compare the value of different investment options.
There are multiple variations of the ROI equations that have emerged over the years catering to individual company or industry needs. The standard ROI equation is presented below along with a discussion on the definition of its terms:
Net benefits are the difference between the benefits of the project and the associated costs used to generate those benefits.
Net Benefits = [Benefits – Costs]
The net benefits in the ROI equation can be calculated before or after taxes and depreciation. If the ROI is considered after taxes and depreciation, the result will be a lower value obtained from the ROI equation. One could argue that including the depreciation and taxes in the ROI equation would yield a more accurate number; however, this may not be necessary the case, since the result would depend on the tax rate as well as the depreciation schedule.
Benefits can also be defined as the overall first year's profit or as the weighted average profit during the lifetime of the project. Some companies even use some type of hurdle rate to discount future profits to today's value. The hurdle rate is used in the same manner as in the Net Present Value (NPV) calculation. Basically, the hurdle rate adjusts for the time value of money given the cost of capital of the company.
The denominator in the ROI equation captures all costs incurred to obtain the benefits of the project or investment.
The costs term in the equation can be subject to the same considerations as the Net Benefits term in the numerator of the ROI equation. The costs or invested capital for some companies are defined as the first year capital expenditure while other companies may include recurring or periodic costs such as software updates or future integration costs. These costs are included as the weighted average invested capital during the lifetime of the project, or as the discounted cost given the hurdle rate of the activity.
The time period to estimate the benefits and costs varies creating some complexity in the interpretation of the results. Some companies only use one year, approving only those projects that are able to recover their value on the first year of operations. Other companies discount the cash flows of benefits and costs to complete the calculation. This array of options has created variations of the standard ROI equation described in the ROI Equations section.
Depending on the application of the ROI equation; there are also differences in the actual terminology of the equation components. For example in the numerator, the net benefits may be referred to as future income, profits, or earnings. In the equation denominator, the costs may be referred to as invested capital, invested assets, or total project costs. There are more meaningful differences that go beyond the nomenclature as explained in the sections above.
The goal of a Return on Investment Model is to establish the value of the project by calculating its expected return. A return on investment model can be developed by looking at all the inputs and assumptions that go into the ROI equation. To start, one has to look at the two main inputs in the ROI calculation: benefits and associated costs.
The benefits of the project are classified as tangible or intangible. Tangible benefits can be measured and are easily observable. Intangible benefits are more difficult to observe and cannot be easily determined as the output may be dependent on many variables. For example, customer satisfaction is dependent on variables such as customer service, product quality, price, company reputation, etc. Making a discrete correlation between customer satisfaction and a particular improvement in one of these areas is not a trivial task.
The idea is to complete the Return on Investment Model with the tangible benefits first to save time and effort. If the ROI is sufficient, then one can note the additional benefits as an added benefit in the financial evaluation of the project. However, if the ROI is not as expected, the intangible benefits will have to be included in the calculation to justify the project. Depending on the project, these intangible benefits are usually calculated through statistical modeling of the input variables.
Once the benefits of the project have been calculated, the next step is to identify and calculate the costs. The idea is to fully capture not only the cost of starting the project, but also the cost of maintaining and supporting the project during its lifetime. Costs are much simpler to calculate than benefits as these are easily observable and can be obtained fro vendors or suppliers.
The Return on Investment Model is completed by plugging the benefits and costs into the ROI equation. In summary, the challenge in building the model is not in the calculation itself but in the inputs that go into the equation. The assumptions that go into establishing the benefits and costs in the Return on Investment model is the critical step in obtaining an accurate representation of the value of the project