Return on Investment (ROI)

February 29, 2012

Most discussion around return on investment, or ROI , center around measuring an opportunity or investment to get a sense of how profitable the endeavor could be to attempt. While there is no one easy formula for ROI, as the very idea of ‘return’ can be subjective, most basic measurements will include the profit potential minus the cost or expenses of the activity and some form of time.

For example, to measure the ROI of an investment, a financial planner may take the potential profit of an investment (interest) and measure it over time to get a rate of return. This gives the planner a method to measure different investment options the determine one that best suits his needs.

Or to illustrate the breadth of an ROI calculation, assume a homeowner wants to buy a larger lawnmower to reduce the amount of time it takes to mow the lawn. The homeowner will have to look at the costs of purchasing the mower, calculate the time it would take to mow the lawn today with his old mower, and the time the new mower will save. Then he could compare the reduction in time versus the costs of the new mower, to help justify the purchase.

In both examples though, each has a target, or result that is a key component of measuring ROI for each case. The investment banker is looking for total profit over time. The home owner is looking for time savings. Each has different calculations, but both share the same process of coming to a decision on an action by determining the return on investment.

Process improvement is both a driver of ROI calculation and a result of ROI efforts. The very thought today of improving a process is the acknowledgement that we have something to gain, time, profit, lowering costs, etc.. that we need to improve by taking some kind of action. To decide on that action to improve a process, we will calculate some kind of ROI to determine an optimal path to improvement. Lets look at one method to finding ROI in a publication “Calculating ROI for process improvement” by Collin O’neill,

O’Neill suggests there are three steps to arriving at an ROI target in process improvement;

  • Step 1: Identify opportunities where process improvement can be effectively measured and quantified.
  • Step 2: Devise coherent, plausible formulas for calculating a cost savings for each process improvement opportunity.
  • Step 3: Reduce those calculations to a number that becomes the bottom-line ROI for a process improvement effort over time.

So as you can easily gather from his steps, his understanding of arriving to ROI is to simply define the opportunity and measures of cost and profit and some form of time in there to calculate against. It can be as complicated as your situation needs it to be to make a decision or evaluate an opportunity.

Some things are difficult to quantify, or measure directly especially with a ROI that looks like a simple cost benefit analysis. How to you justify a new suit, carpeting the office, taking a client to a football game, or buying a puppy? Those activities don’t have an apparent measure of profit like previous examples, but they do have a cost and they do have benefits that make them worth doing. The very fact that they have benefits, which are difficult to measure, is sometimes an excuse as to why many time, ROI isn’t bothered with. But if you press the subject, you can devise some ways to justify about anything in some fashion with a well-crafted ROI, finding related measurements if you want to look deep enough.

This is the hidden danger with some ROI calculations. They are one sided, not always looking at the risk associated with an improvement, or an tertiary consequence that may unfold. ROI can easily be manipulated to arrive at desired outcomes, so it is important when using an ROI calculation to justify a project or endeavor, to pay attention to the measurement of assumed cost and potential profit and build into the model some factors for risk and risk avoidance.
SUBMITTED BY : JOEY BECK

“Calculating ROI for process improvement” by Collin O’neill, http://www.ibm.com/developerworks/rational/library/edge/09/mar09/oneill/index.html , 15 MAR 2009.

“Return on Investment” http://www.investopedia.com/terms/r/returnoninvestment.asp#axzz1no0wJDqL

“Calculating ROI to Realize Project Value” by Chris Schwieghardt, http://www.isixsigma.com/operations/finance/calculating-roi-realize-project-value/ 27 MAR 2010.

“How to Calculate ROI” http://www.marketingmo.com/how-to-articles/marketing-metrics/how-to-calculate-roi/ MAR 2009.

Advertisements

One Response to “Return on Investment (ROI)”

  1. simsjon said

    I think it is absurd that anyone in business would try to manipulate the numbers to justify buying something. While I feel sure it is sometime done, doing so will probably prove to be detrimental to the business.

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s

%d bloggers like this: