Cost Benefit Newsletter No. 28, 1st September 2002: ´All Eyes on ROI´

Despite its popularity, not everyone using the term ROI has a clear idea of what that means. Lack of clarity on ROI "details" leads to missed expectations and faulty decisions.

There are a few words you can use almost anywhere in the world, anytime, and be understood: "Hotel", "Okay," and "Taxi" belong to this class. Lately, among business people, so does the word "ROI." In today's economic climate, cautious managers everywhere treat "Return on Investment" and its acronym "ROI" as words to live by. When a major proposal is on the table—infrastructure upgrade, marketing program, changes to the product line, or anything else that calls for significant spending—the normal response from the top is often something like this: "We'll invest only if we're sure that it comes comes with a good ROI. Show us the ROI first, then we'll talk about funding".

ROI thinking has become especially central to information technology (IT) planning and spending. During the 1990s, IT decision makers focused on "Total Cost of Ownership" (TCO). TCO analysis assumes that the expected benefits ("returns") from different options are more or less the same, and the better decision is the one with the lower total cost. Now, however, there's growing awareness that costs should be weighed against investment returns. According to a March 2002 CIO Insight survey of IT executives, 44.4% of all IT spending is now assessed with ROI, and more than six out of ten executives say the pressure to "prove" ROI before acting is increasing.

Despite its popularity, however, not everyone using the term ROI has a clear idea of what that means. The concept itself is deceptively simple, but lack of clarity on the following "details" can lead to missed expectations and faulty decision making.

Define your Terms

When you're asked to produce an "ROI" or when you're presented with "ROI" results, it's a good idea to be sure that everyone understands ROI the same way. Most people who use the term have in mind "simple" ROI: Incremental gain over incremental cost (by that reckoning, a $2 bet at the race track that wins $3 has an ROI of 50%).

In a business setting, however, major investment costs usually come early while returns run long into the future—maybe across 3 to 5 years. This means that ROI-producer and ROI-user have to agree whether or not to discount the cost and return figures. If the returns are farther in the future than the costs, discounting lowers the ROI figure. Is discounting the right approach? That's a judgment call for ROI producer and ROI user; you may choose to apply discounting if more distant future returns are considered risky.

ROI producer and user also need to stipulate the time period in view: do you mean ROI over 1 year? Over 3 years? Something else? Different time periods for the same investment bring different ROI figures.

Simple ROI, moreover, is by no means the only ROI metric in use. "Average rate of return," "return on assets," and "return on equity," are just a few of many other terms sometimes used interchangeably with "ROI." When the ROI discussion gets underway, make sure that everyone understands which ROI, over what time period, and whether or not it will come from discounted figures.

There's more to Life than Cost Savings

Need help producing your own ROI? Dozens—if not hundreds—of sites on the World Wide Web offer ROI templates, ROI tools, and ROI consulting services. I've noticed that many of these look for "returns" only in terms of cost savings.

It's true that many acquisitions or investments do have cost savings as a major objective, but most organizations and companies make investments for other purposes as well. Are you investing (spending) in order to reach strategic objectives such as shorter time to market, better quality of service, improved employee skills, or enhanced company/organizational image?

If so, you need to put more into the "R" of "ROI" than cost savings in order to understand the value of your investment. (See, for example, our whitepaper "Business Case Essentials").

What's missing here?

Other things being equal, the investment with the better ROI is the better investment. In the real business world, however, other things are never equal. When ROI alone is used blindly as the sole decision criterion, other factors are overlooked:

The ROI metric itself says nothing about risk. A winning lottery ticket has an ROI of many millions percent, for instance. Is playing the lottery a good "investment?".
ROI metric says nothing about the magnitude of the returns. A projected ROI of 300% sounds nice, but what if the net gain is only $10, while another investment's 20% ROI means a net gain of $1,000? Which is the better investment?
The ROI metric as usually calculated (with non-discounted cash flow) ignores the time value of money.

There's nothing wrong with the basic ROI logic: carefully calculating returns before spending is solid common sense. When significant money is involved, however, it's also good common sense to use ROI only in the context of a more complete business case analysis, where results are also evaluted in terms such as net present value and payback period, and where a serious risk and sensitivity analysis measures the uncertainty behind projections.