Return on Investment (ROI): definition, equation, benefits, limitations

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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 the number of times the net benefits (benefits minus 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.

Many variations of the ROI equations have emerged over the years, tailored to individual company or industry needs. The standard ROI equation is presented below along with the definitions of the equation’s terms.

net benefits = [benefits – costs]

In the ROI equation, Net Benefits can be calculated with or without taxes and depreciation. If taxes and depreciation are factored into the equation, the resulting ROI will be a lower value. One could argue that including the depreciation and taxes in the ROI equation would yield a more accurate number; however, this may not be necessarily the case, since the results can vary according to which tax rates and depreciation schedules are used.

Net Benefits can also be defined as the profit for the first year or as the weighted average profit during the lifetime of the project. Some companies use some type of hurdle rate to discount future profits to today's value. 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 Net Benefits of the project or investment.

The Costs term in the ROI equation can be subject to the same considerations as the Net Benefits term in the numerator. Some companies define Costs as the first year’s capital expenditures, while other companies include recurring or periodic Costs such as software upgrades, and maintenance. The recurring costs are calculated as a weighted average of invested capital during the lifetime of the project, or as a discounted cost that includes 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 use one year, approving only those projects that are able to recover their value in the first year of operations. Other companies determine the final ROI of the investment according to discounted cash flows using the hurdle rate of the activity. These variations of the standard equation are described in greater detail in the ROI Equations section.

There are several variations of the Return on Investment (ROI) equation, given the multiple interpretations and applications in different industries. This lack of consistency in the definition of ROI causes confusion when comparing the ROI values of several projects.

Below are the most common variations of the ROI equation:

*Definition of Terms *

net benefits: Benefits minus costs.

costs: Initial and recurring (or ongoing) costs.

Time Period: The standard ROI equation is usually calculated for the first year of the investment. A one-year time period has become an industry standard since companies seek to recover their investment on the first year of operations of the project. This rule of thumb may not be applicable across organizations but it can give a first estimate of the benefits of a project.

*Definition of Terms*

NOPAT: Net operating profit after taxes.

invested capital: Initial and recurring (or ongoing) costs.

This equation accounts for the time value of money or the interest derived from an investment with similar risk. The Present Value is discounted according to the cost of capital to the company or the rate at which the company could borrow money in the marketplace, given its risk level.

*Definition of Terms *

NPV (net benefits): Present value of benefits minus present value of costs.

*Definition of Terms*

Profits: Net income. Net Income is defined as gross profits less deductions for depreciation, interest payments, and taxes.

Firm Assets: Company resources, including cash, accounts receivables, inventory, and properties.

The ROI equation above assumes the best possible scenario resulting in larger ROI values. All the benefits are included in the numerator and only the startup costs are calculated in the denominator. This equation is usually used by software vendors who do not include recurring or operating costs.

*Definition of Terms *

total net benefits: Benefits minus initial costs.

costs: Initial startup costs.

The main benefit of using Return on Investment (ROI) and the reason for its popularity is the simplicity of its calculation. ROI estimates the return of an investment by looking at the benefits and costs associated with the investment. ROI is particularly easy to calculate and understand when compared to other financial tools such as Net Present Value (NPV), Internal Rate of Return (IRR), and Payback Period. Although the calculations for these financial tools are more complex, the results are arguably more accurate. Nonetheless, ROI is an appropriate first step for estimating the economic return of an investment.

ROI is also a useful vehicle to communicate the return of an investment to those who have varying degrees of financial knowledge. The ROI concept allows managers to speak the same language when communicating project goals in financial terms across several departments in a corporation. Likewise, Information Technology (IT) vendors use ROI as a sales tool to easily convey the economic value of their products.

In addition to being useful as a communications vehicle, ROI can be used as an initial filter in the evaluation of projects. For example, ROI can be calculated for all the projects in a corporation and only those projects that exceed a minimum ROI are further analyzed. Thus, ROI can identify worthwhile projects without using considerable resources.

Other ROI benefits include the use of the tool to establish an initial framework of assumptions to ultimately determine the value of the project. The ROI calculation forces a thorough thinking of investment variables such as intangibles, risk, and timing. These assumptions are as important as the ROI calculation itself because they are the inputs that will ultimately impact the overall ROI result.

Due to the benefits described above, the ROI concept has become particularly popular in the evaluation of IT projects. At times, ROI has almost become synonymous with financial analysis for IT investments. To avoid any confusion in our discussions, we consider the ROI concept as just one of the financial tools available. There are other financial and modeling techniques that can be used in combination with or instead of ROI, such as NPV, IRR, and Payback Period.

In summary, ROI presents the following benefits. ROI is:

a relatively simple, easy-to-use financial tool to evaluate the return of a project or investment.

easily understood across functional organizations and industries.

a first pass in estimating the return of a project without using considerable resources.

a method that allows managers to better identify and understand the project assumptions and dependencies and their overall impact on ROI.

To understand the benefits and potential of using the ROI methodology, one also has to understand its limitations. Managers having a clear understanding of the limitations can take full advantage of the methodology without overextending its value as a financial evaluation tool.

The ROI calculation does not take into account the time value of money or the risk associated with a project or investment. The time value of money concept says that a dollar earned today is worth more than a dollar earned tomorrow. This is particularly true when considering other investment alternatives and the effect of inflation from a macroeconomic perspective.

In addition, the risk of the project needs to be accounted by incorporating all the possible financial outcomes associated with the project. These possible outcomes include the possibilities that the project will not yield the expected results because of the inherent risks of the project.

The fact that risk and the time value of money are omitted in the ROI calculation may cause managers to mistakenly reject projects that otherwise should have been approved. This is particularly the case if projects with different risk profiles were compared using the ROI methodology. The ROI value of the project with the higher risk should be reduced to account for the broader range of outcomes when compared with a project with lower risk. This reduction in value can be accomplished by using one of the modified ROI Equations or by using one of the financial evaluation tools that account for the time value of money such as Net Present Value (NPV) and Internal Rate of Return (IRR).

ROI calculations may over-value investments since the equation favors short-term savings and overlooks long-term costs such as maintenance, support, and software upgrades. This problem is the result of using a one-year time span in the standard ROI calculation to determine the value of the project. Therefore, projects having large costs in the future may incorrectly appear to give a higher return because the future costs are not included in the calculation.

The fact that ROI can be calculated several different ways creates a problem of consistency. Few companies have developed a single ROI methodology, thus making it difficult to accurately compare and evaluate the economic return of several projects.

This problem is accentuated when comparing the value of software from multiple vendors, each of whom may have used a different methodology to arrive at the ROI for their particular software. Managers selecting a software vendor have the task of untangling the true ROI from each vendor, and creating a normalized, single view for comparison purposes.

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