Drill

By Peter Edmonston  |  Posted 2002-07-10 Email Print this article Print
 
 
 
 
 
 
 

Financial math trips up many a technology manager. Luckily, it's not all your fault. Read on to discover a variety of means for determining return on investment (ROI) for your projects.

: Will the Real ROI Please Stand Up?">

Drill: Will the Real ROI Please Stand Up?

A company is considering a new call center package that will cost about $100,000 to set up. XLS DownloadOnce installed, estimates the company, it will cost about $25,000 a year to maintain but yield $75,000 in annual benefits. The result is a net benefit of about $50,000 a year. So what's the expected return on investment over three years? It depends on who's crunching the numbers, it seems. Here are three ways to find this project's ROI, and what each number really means. (Click on the icon at left to download a spreadsheet that demonstrates these ROI methods.)

Cumulative ROI: 150%
  • Total net benefits/ Initial costs = $150,000/ $100,000

    This formula sums the project's net benefits over three years and divides by the initial cost. Often called cumulative ROI (CROI), this calculation often yields the highest number, making it a favorite of marketing departments. But CROIs are misleading. They lump together several years of returns instead of considering them annually—sort of like a savings bank advertising 9% interest rates, when what it really offers is 3% for three years.

    This method also ignores the time-value of money, giving equal weight to payoffs no matter when they occur. But a dollar today is worth more than a dollar tomorrow. For a project whose benefits are back-loaded, CROI can dramatically overstate the time-adjusted return.

    Discounted ROI: 124%
  • Present value of net benefits/ Initial costs = $124,343/ $100,000
    To calculate a discounted ROI, which reflects the time-value of money, you first choose a discount factor—a number that reflects the annual penalty for tying up your company's cash. Typically, a discount factor approximates your opportunity cost, or the return sacrificed by devoting funds to this project rather than to other investments. Our discount factor of 10% yields total benefits of $124,343.

    If you were to subtract startup costs from that sum, you'd get a commonly used financial measure called net present value (NPV)—in this example, $124,343 - $100,000 = $24,343. If NPV is less than zero, it usually means that the project doesn't offer enough payback to justify the investment.

    Traditional ROI: 50%

  • Average annual net benefit/ Initial costs = $50,000/ $100,000

    By averaging the yearly benefits, this ROI comes closest to the textbook definition of an accounting rate of return. It is also the most conservative number. But like other versions of ROI, it says little about the payback period—how long before the project recoups its startup costs. Here, the payback period is two years.

    Some financial executives prefer the internal rate of return (IRR). The IRR is the discount factor that makes the present value of all benefits equal the initial costs exactly. Essentially, it represents the project's benefits as an interest rate. They can look good on paper, but lofty IRRs are often impossible to achieve because they assume you can reinvest all the benefits at the same high rate.



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