Return on Investment, or “ROI”, is a performance measure used to evaluate the value of a potential investment, to compare the efficiency of several different investments, or to determine the value of a completed project. ROI measures the amount of return on an investment relative to the investment’s cost. The ROI concept is used in all fields, and there are many variations of the ROI formula.
To calculate simple ROI, the benefit (or return) of an investment is divided by the cost of the investment, and the result is expressed as a ratio (e.g. 5:1), or a percentage (%).
The simple Return on Investment formula:
ROI = Net Benefit of Project Investment / Cost of the Project
In the above formula, “Net Benefit from Investment” refers to the expected savings obtained from the implementation of the project less the costs. Because ROI is measured as a ratio, it can be easily compared with ratios (returns or benefits) from alternative investments or projects, allowing one to measure value of a variety of types of projects against one another.
Return on Investment is a very popular metric because of its versatility and simplicity. Essentially, Return on Investment can be used as a rudimentary gauge of an investment’s benefits. ROI is easy to calculate and to interpret and can apply to a wide variety of investments. That is, if an investment does not have a positive ROI, or if an investor has other opportunities available with a higher ROI, then these ROI values can inform as to which investments are preferable to others.For example, suppose an agency invested $10,000 in a project in August and realized $300,000 in financial benefits 12 months later. To calculate the ROI, we would divide the net benefits ($300,000 – $10,000 = $290,000) by the project cost ($10,000), for a ROI of $290,000/$10,000, or a ratio of 29:1.
With this information, we could compare the value of this project with that of other projects. Suppose the agency also invested $15,000 in another project in August and realized benefits of $250,000 six months later. The “simple” ROI on the second project would be $250,000 – $15,000 = $235,000 divided by $15,000 = 15.7:1. If a choice had to be made between the two projects, we would normally select the one with the higher ratio, or the first one, in this case. But this example introduces a key limitation of simple ROI calculations which can lead to poor resource allocation decisions.
And that’s the bottom line for this post.
During the next few weeks, we will discuss the limitations of ROI, how to address them, and factors to consider when making ROI calculations. We will also cover how ROI can be used in the application of Lean Six Sigma to quantify potential and actual benefits of process improvement projects.