Demystifying Return On Investment (the ROI)

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Categories: Investment, Return, ROI


Preface

Why I chose the subject title as Demystifying ROI? What is there in it to demystify?

Return on Investment is a widely used tool in assessing the performance of money spent on projects by the executive management. PMO or Project Managers in their capacity has to supplement information or go across using the concept of ROI in some way or the other. The concept of ROI involves complicated financial jargon such as IRR or hurdle rate, Net Present Value, Cost Of Investment, Return etc., which is quite difficult for a non finance manager to understand, hence the financial terminology needs clarification/simplification for ease of use of the non financial managers/ project managers.

 

An appropriate understanding of concepts involved in ROI process by a Project Manager or PMO helps them: Winning projects by calculating and  projecting ROI appropriately; ROI as a tool offers tremendous capabilities for comparison among projects so it enhances financial visibility and decision making of PMO.

 

I had picked up the best of explanations from the available knowledge resources on ROI, mixed them with my practical experience, and tried my best to present a simplified reading through this article.

 

Defining the term ROI

Let's analyse a few definitions.

According to investopedia Return On Investment is:  "a performance measure used to evaluate the efficiency of an investment".

 

isixsigma  defines the ROI as:

"ROI is an indicator used to measure the financial gain/loss (or “value”) of a project in relation to its cost. Typically, it is used in determining whether a project will yield a positive payback and have value for the business."

 

Terms used in these definitions of ROI entail a lots of confusion which are explained/clarified  in the later part of this article, these are-Payback, Payback Period, Financial gain/loss, Efficiency of an investment, Cost and Value for business.

 

In context of a project, ROI is a measure which is used to gauge efficiency or effectiveness of your investment in a project. Monetised value of quantified future benefits is calculated and compared with a normally expected rate of return, which gives you a result which is either positive or negative and used for decision making for about go or not go for a project, this sums up the whole ROI calculation process.  ROI as an indicator of gains (return-cost) over your investment generally expressed in terms of % or is presented as a ratio.

 

ROI formula:

 

               (Return- Cost of Investment)

ROI = ---------------------------------------- X 100

                       Cost of Investment

 

Where, Return: A sum on money received in terms of increased revenue or cost savings

 

Cost Of Investment: Money spent on project ( inclusive of the direct/indirect expenses, cost of implementation, cost of hardware, cost of software etc.) In context of a project, there is going to be spending of which the return will start coming after elapse of time so it is important to know when the venture has recovered the cost and started producing profits.

 

PMBOK® asserts that, in many projects predicting and analysing the prospective financial performance of the projects' product is performed outside of the project, but for other projects such as capital facilities projects,  ROI calculation becomes part of the plan cost management knowledge area under planning process group, thus importance of ROI as a tool as been acknowledged here.

 

Demystifying?

 

Yes, let's get it done here!

 

As the concept of ROI is complicated and is subjective to the area of application such as an IT infra project, ERP Implementation, Capital Investment Project in manufacturing etc., it's imperative to clarify and explain the terms and methodologies for ease of use in project management environment.

 

First demystifying idea is about the basis of calculation, i.e financial gains/profit vs cash, there is a lots of confusion about the concept of return, some consider the profit which appears on the profit and loss statement of an organisation to be return.  But prudent practice would be cash not the profit,  because the expenditure incurred on the project are cash spent so this must be compared with the incoming cash to be an appropriate comparison. Harvard Business Review advocates an ROI calculation based on capacity/incurrence of inward cash flow as a benefit from the product of the project received by the organisation during the expected period of realisation.

 

Efficiency of investment connotes a criteria that explains how much more beneficial an investment in a project is from the other(s). This can be evaluated in totality as well periodic value of ROI. As the ROI connects project performance with the business objectives it proves beneficial to the management in avoiding investment in projects which are not worthy to the business.

 

The process of calculation of ROI involves four generic steps in calculation of the ROI, as has been explained in an Harvard Business Review article by Joe Knight:

 

  1. Determine Initial Capital outlay

  2. Forecast Cash from Investments

  3. Determine minimum return required by your company

  4. Evaluate your investment 

This process is generic and can be used in calculating ROI in any context, for purposes of this article project specific calculations and elaborations have been considered.

 

First step in determining the ROI is the calculating capital outlay, which means how much of money need to be spent in order to implement a project. Cost of Investment or in a typical IT environment its known as TCO ( Total Cost of Ownership), which consists of all Direct Costs- Costs which are specifically spent on project by acquiring equipments or other resources to be engaged on the project exclusively and Indirect Costs, which are share of overheads from general services such as Finance and Accounts, Shared Infra such as Phone and Internet etc. which are not specifically installed for the project but the project uses these facilities so a charge is essential on the project costs. For example sake, let's examine components of cost of investment:

Direct Costs: Million $ Indirect Costs: Million $
Hardware   Shared services costs  
Servers $5.00 Share of Infrastructure overheads $1.00
Network components $1.00 Share of PMO Costs $0.50
Other costs $0.50 Share of Executive supervision costs $0.50
Total Hardware costs $6.50 Total Shared costs $2.00
Software      
Licence fee $5.00    
Development/customisation $2.00    
Upgrade/maintenance costs $0.50    
Total Software costs $7.50    
Management      
Admin $1.00    
Hosting etc. $1.00    
Total Management costs $2.00    
Support      
Support staff $1.00    
Total Support costs $1.00    
Implementation      
Development/Customisation/Integrating $5.00    
Total Implementation costs $5.00    
Total Direct Costs $22.00 Total Indirect Costs $2.00
Total Cost of Investments $24.00

*Remember costs are cash outlays and must therefore be compared in terms of prospective cash inlays so as to calculate the ROI.

 

Second step is forecasting cash from the investment which is often known as benefits, this is the toughest most aspect of ROI determination.  Benefits in totality constitutes  the Business Value  which comprises of Tangible as well Intangible benefits, but for ROI calculation purposes only tangible benefits (which can be computed in incoming cash to the organisation) are considered. The benefit types are explained here below:

 

Tangible benefits- where benefits of the project can be measured in clear financial terms. These are:

 

A. Future savings in the Costs- Comparative costs of operations before and after implementation of the project and these can be categorised into:

                IT Labour/Services TCO Savings- Savings in number of Error Instances, Number of machine breakdowns etc. which can be directly quantified in financial terms.

                Other Direct Cost Savings

                User Productivity Benefits- Saving in terms of labour rate applied to number of transaction processed before and after the project implementation.

 

B. Future incremental revenues- Growth in the revenue in comparison with the numbers before and after project implementation offers easily measurable benefits. These can be categorised into:

                                Revenue Growth- by handling more number of sales orders, this can be computed by number of sales orders processed in AS-IS and number of sales order processed in TO-BE  

 

Intangible Benefits- these are variables which can't be quantified in direct relationship with a project but essentially contributes towards future benefits such as:

                Growth in market capitalisation by incrementing share prices

                Incremental Goodwill/ Business value

Customer satisfaction

 

Third step is determining IRR (Internal Rate Of Return) or Hurdle Rate, this is the minimum expected return which the stakeholders would expect their investment to fetch. There are many factors which impact the IRR such as market prevailing interest rates, opportunity costs of investing in other instruments/projects, Cost of Capital and the Risk involved in the project etc. Finance department or CFO'S office would not like sanctioning funds for any such project which is fetching future benefits below IRR. So IRR is very important threshold value for determination of ROI.

 

Fourth step is to Evaluate your investment, there are 4 parameters to evaluate your investment by  ROI  calculation and analysis. These parameters  are Payback, Net Present Value or NPV,  The Payback Period and Internal Rate of Return or IRR. 

 

Here Payback equals to cost of investment and ROI calculation establishes how soon the investment made in any project be recovered. This period of recovery is known as  Payback Period. The payback period of a given investment or project is an important determinant of whether to undertake the project, as longer payback periods are typically not desirable for investment. Any unit such a month or a year can be considered for denoting the payback period, whatever you choose must facilitate your internal reporting and information consideration of the management. Internal Rate of Return,  is the benchmark figure on which the calculated periodic ROI is compared in order to find if the project is fetching  over or under the internally expected return. IRR is periodic rate and thus facilitates a more even comparison of the benefit.

Net Present Value is the present value of future cash benefits after considering a discounted rate for reducing effects of inflation and erosion of monetary value of the benefit.

 

Evaluation of investment process:

 

1. Some managements are interested in the Payback in terms of money spent in simple terms, profitability of project benefits thereafter is considered as a part of normal operations gains/loss. The time value of money/Opportunity costs are not taken into account in calculating ROI using Payback method. So its a simple bland way of judging how soon your costs will be recovered from the date of the project implemented, and doesn't offer too much to facilitate decision making, this method is mostly suitable to in-house technology upgrade and maintenance projects which are not driven by strategy  or long term plan. Also the fact that the investment will continue to bring benefits even after the payback period is ignored by payback method, which doesn't give true picture of real gains can be fetched by the project.

 

2. Some companies are more concerned about return on investment for total period of their holdings, so they shall be interested in knowing the gains over this period. There applies the criteria of calculating net gains from the revenue achieved which is enough to recover the payback plus minimum expected return (IRR), the investor would be very happy receive anything over and above this

 

3. To perfect the analysis and determination of return in true financial terms, it is important to consider the Net Present Value of future cash benefits. In an inflationary economy, money erodes its value over a period of time, suppose we are calculating Return for over a 5 years period in today's date, we must consider deduction from this sum on account of inflation, to come about to a real figure for comparison of current investment value of money.

 

4. Further step to ROI calculation and evaluation of investment is comparison of the return with the IRR, the management is not interested to spend on projects which do not have a potential of earning less than the expected internal rate of return.

 

Limitations of ROI:

One must be careful in their assessment of ROI for their projects as it has certain limitations,  firstly if the payback period is not considered then the ROI decision might lead to erroneous conclusions. Best way to analyse ROI is to divide total ROI with the number of periods it will take to arrive, this will give you a periodic ROI which is easier to compare with the IRR. Project with a higher period ROI will be selected over another because  it will take lesser periods of time to arrive at desired return.

 

Secondly, certain criteria in quantifying the benefits are subjective the situation and nature of the business, hence the people involved in the calculation process must acknowledge the complexity and situational variables so as to arrive at a best result. Anyone responsible with the calculation of ROI, should be cautious of not exaggerating benefit calculation.

 

Conclusion:

A speedy recovery of their investments is the top priority of the management, and when  you start having a positive return that is a great deal of an accomplishment. As the ROI happens to be the key criteria of project selection hence it is very keenly followed up by the management, any negatives on this count has a potential to kill future prospects of the performing organisation, whereas a positive and early ROI can help achieving best of a credential and a future reference for a PMO. The project management team must be helping the management to highlight the key benefit areas appropriately correlating this to the monetary calculations and tying it with Business Objectives, a determination of an appropriate ROI and payback period helps projects securing stakeholder buy-ins contributing to a health project organisation.

 

I have given utmost attention to un-complicate the whole process involved in ROI, but still in case you feel that the subject needs further elaboration/ clarification, please do write to me ssatishsharma@hotmail.com I shall get back with the relevant clarification/explanation.

Posted on: January 24, 2017 02:11 AM | Permalink

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Thanks for sharing, good explanation and presented in simple terms.

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