How to Calcuate ROI

ROI (return on investment) is essential to long-term profitability for any company, large or small. It is a measure that should be employed against each project and/or product line. The challenge is the calculation and buy-in. An excellent metric for finance professionals, ROI calculations bring objectivity into the accept/reject decision. However, when an ROI leads to rejecting a project, there will be pressure to change the variables or even the calculation.

Instructions

Calculating ROI

1. Understand the formula. The formula for ROI is the "final value of a project" (Vf) minus the "total cost of ownership" (TCO) divided by the "total cost of ownership" (TCO) and multiplied by 100. That is, ROI is equal to [(Vf - TCO) / TCO]*100.

2. Calculate the initial investment. Estimate the value of cash outflows for each month or year of the project. Is there more than one outflow stream? What is the cost of labor, operations, inventory and marketing, for instance.

3. Calculate the final value of the project. How much will the project make over a certain period of time? It is important to account for all the ways a particular project could make or save money, from direct sales to cost saves. Will it increase revenues by 5 percent and/or reduce costs by 5 percent? What are your projections or assumptions based on?

4. Work through an example. If you expect to make $50,000 from a project (Vf) with an initial investment of $10,000 (TCO), the calculation would be [(50,000-10,000)/10,000]*100 or 400 percent. In general, if the ROI is over 0 percent, you should accept the project.

5. Compare and contrast. Does a 400 percent ROI make sense? Compare the ROI calculation with other projects. Review your assumptions for accuracy midproject. Adjust the project ROI if needed. At the end of the project, conduct another review.

Tips & Warnings

• When evaluating any ROI calculation, the most important step is understanding the inputs and assumptions. ROIs are extremely flexible. Calculating TCO can be manipulated to the needs of the project calculation by changing assumptions. In other words, it is possible to create a positive ROI. This is why it is important to keep finance and operations as separate functions.

References

• Conservatism, Growth, and Return on Investment
• TDWI: The Business Intelligence ROI Challenge, Putting It All Together

Resources

• Read this Article in Spanish
• Free Excel ROI Spreadsheet