Return on Investment (ROI) examples like the one used in last week’s post reveal one of several limitations when using ROI, particularly when comparing investments or the value of projects. While the ROI of the second project was much lower than that of the first investment, the time to realize the benefits of the second project was much less. The ROI for the first investment was 29:1 in one year and the ROI for the second project was 15.7:1 in only six months. At first glance, the first project was more financially beneficial; however, when the time to achieve the benefit is considered, the second project yielded its benefits in only half the time of the first project. To properly compare the value or potential value of both projects, they must use the same time factor. By annualizing the second project, the calculations would be as follows: $250,000 X 2 = $500,000 – $15,000 divided by $15,000 = 32.3:1.
If one considers that the duration of the second investment was half as long as that of the first, it becomes apparent that we should have questioned our initial conclusion that the second investment was the less financially viable one. When comparing these two projects on an annual basis, we needed to adjust the ROI calculation accordingly. While the first project returned more total financial benefits than did the second, the second investment was the more beneficial choice since its annualized ROI was higher. Therefore, ets recommends annualizing the project’s time to calculate benefits when determining simple ROI. If other adjustments are incorporated into the ROI calculation, inform your audience and provide the calculations in the appendix of your project story or presentation. Examples like this indicate how a cursory comparison of investments using ROI can lead one to make incorrect conclusions about their value or profitability. Given that simple ROI does not inherently account for time during which the investment in question is taking place, this metric can often be used in conjunction with Rate of Return, which necessarily pertains to a specified period of time, unlike simple ROI. One may also incorporate Net Present Value (NPV), which accounts for differences in the value of money over time due to inflation, for even more precise ROI calculations. The application of NPV when calculating rate of return is often called the Real Rate of Return.
A return on investment ratio alone can paint a picture that looks quite different from what one might call an “accurate” ROI calculation—one incorporating every relevant expense that has gone into the development and maintenance of an investment over the period in question—and funders should always be sure to consider the bigger picture. Many organizations factor “life cycle” or “cradle to grave” costs into the ROI calculation to present a more comprehensive and realistic picture of the investment under consideration. This variability of ROI calculations, then, reveals another key limitation of using ROI. ROI calculations can be easily manipulated to suit the user’s purposes, and the results can be expressed in many ways. As such, when using this metric, the savvy funder would do well to make sure he or she understands which inputs are being used.
And that’s the bottom line.
Next week we will discuss the application of ROI in Lean Six Sigma projects, and when it is used in the DMAIC methodology.