The Simple Return on Investment
Return on investment is frequently derived as the “return” (incremental gain) from an action divided by the cost of that action. That is “simple ROI,” as used in business case analysis and other forms of cash flow analysis. For example, what is the ROI for a new marketing program that is expected to cost $500,000 over the next five years and deliver an additional $700,000 in increased profits during the same time?
For more illustrations of ROI calculations and other business case financial criteria, download the Free Spreadsheet Tool, Financial Metrics Lite. For a more complete covereage of financial metrics such as ROI, including strengths, weaknesses, and working templates, see Financial Metrics Pro.
Simple ROI works well in situations where both the gains and the costs of an investment are easily known and where they clearly result from the action. In complex business settings, however, it is not always easy to match specific returns (such as increased profits) with the specific costs that bring them (such as the costs of a marketing program), and this makes ROI less trustworthy as a guide for decision support. Simple ROI also becomes less trustworthy as a useful metric when the cost figures include allocated or indirect costs, which are probably not caused directly by the action or the investment.
Business investments typically involve financial consequences extending several years or more. In such cases, the metric has meaning only when the time period is clearly stated. Shorter or longer time periods may produce quite different ROI figures for the same investment. When financial impacts extend across several years, moreover, the analyst must decide whether to use discounted (net present value) figures or non discounted values (for more on the consequences of calculating ROI with discounted cash flow figures, see Financial Metrics Pro or the Business Case Guide).
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Business Case Essentials, 3rd edition
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