Six Secrets of ROI You Need to Know

The planned IT infrastructure upgrade comes with a projected ROI of 120%!
We estimate an ROI of 80% for this proposal!
The proposed CRM (Customer Relationship Management) system should bring an ROI of more than 200%!

Participants in "Building the Business Case" seminars tell us that projected ROI (return on investment) figures like those are typical for proposals of all kinds. When was the last time you saw a proposal supported with a projected ROI under 10%?

Expected ROIs like these may seem stunning, especially when compared to other figures such as a company’s overall "return on assets" of perhaps 10%, or investments in bonds that yield 7%. Not to mention the whopping 2 to 4% annual interest that banks pay these days for cash on deposits.

Even a child can see that ROIs like these—80% or more—point the way to good investments. Choosing to fund these proposals should be a good business decision, shouldn’t it?

Many business people have learned the hard way that the answer is: "That depends." Using an ROI figure by itself as the basis for an important decision is dangerous because the stand alone ROI figure has some important "secrets" that are not always out in the open.

Whether the ROI estimate comes from a sales person, or from one of your own project, program, or product managers, here are the questions you need to ask

ROI Secret 1. Investment returns must result from investment costs.

When you purchase an investment bond and then collect the dividends, there’s no question that the "returns" were brought by the investment costs. But most investments in a business environment are more complex than that. Business investments may include enterprise resource planning software systems, employee training, marketing programs, or new product launches, for instance.

When benefits such as increased employee productivity, or increased sales appear over the next few years, they may be the result of several initiatives and actions. An ROI figure that factors in these benefits is making the claim, however, that the benefits in view were brought by the costs in view.

Whether the projected ROI figure comes from a vendor sales person or one of your own project managers, be sure that you understand the connection between investment costs and investment returns. The ROI figure validity depends on the answer to:

ROI question 1: Were the investment returns brought by—and only by— the investment costs?

ROI Secret 2. ROI can depend heavily on the time period covered.

When you purchase a bond and then collect dividends, the "yield" is usually calculated on an annualized basis. This makes it easy to compare the investment with alternative uses of the funds, investments in shares of stock, mutual funds, or cash deposits in the bank.

ROI figures, in common practice, are usually not quoted on an annualized basis. Instead, we often speak of a "3-year ROI" or a "5-year ROI," for instance. Remember that most investments in business bring many costs and returns over a long time period and the "ROI" can depend heavily on the time period in view.

Here, for instance are projected cost and benefit cash flows that could represent an investment in e-learning training for customer service people across five years (figures in $1,000).

	Year 1	Year 2	Year 3	Year 4	Year 5
Returns	50	70	100	100	100
Costs	80	40	30	30	30
ROI	-37.5%	0.0%	46.7%	77.8%	100.0%

The bottom row is the "Simple ROI" (Incremental gains over investment costs) through the end of each year. On a two-year basis, this investment has an ROI of 0. On a five year basis, the ROI for the same investment is 100%. When presented with an ROI figure, be sure to ask:

ROI question 2: What time period does the ROI cover? Is this the right time period for evaluating the investment?

ROI Secret 3. All the investment costs, hidden and obvious, must be included.

Investment costs are half the ROI story. Underestimate the costs and you over inflate the ROI. But finding all the investment costs can be a less than certain undertaking—if you do not use a good, comprehensive cost model to identify both the obvious costs and the less obvious costs.

Here, for instance, is a total cost of ownership model that works well for identifying cost categories and cost items for major IT acquisitions. The yellow cells show where the obvious costs lie (HW and SW acquisition and operation). The majority of IT costs, however, usually lie elsewhere, especially in the "Personnel" row and "Change" column. (See Newsletter No. 95 for more on TCO).

Without a good cost model like this, no one can be sure that the total cost of ownership or the ROI cost estimates cover all the costs. When someone presents you with an ROI figure, and where the investment may very well have "hidden" costs, ask:

ROI question 3: How do we know that all the costs are covered? Can we see a simple cost model that summarizes the "I" in this ROI?

ROI Secret 4: Actual ROI will almost certainly differ from the predicted value.

When a project proposal or investment proposal projects an expected ROI of, say 50%, everyone knows that the actual result will not be 50%, exactly. It will be something more or something less. Everyone who will evaluate the ROI figure needs to know how likely it is that the actual results will vary a little or a lot from the predicted value.

An ROI figure by itself means little unless accompanied by a risk assessment that shows the likelihood of other results. Ideally, the ROI estimate will also come with a confidence interval estimate that lets the ROI analyst say something like this: I'm 95% confident the actual ROI will be between 42% and 58%. For more on minimizing and measuring uncertainty in business case projections, see the whitepaper "Business Case Essentials" or the The Business Case Guide. When evaluating ROI figures, business people might take a lesson from the gambler who compares the pay out odds with the actual probability of winning before placing a bet. In other words, ask:

ROI question 5: How likely are other results besides the predicted ROI? How do the potential risks compare with the potential rewards?

ROI Secret 5: ROI estimates usually stand on contingencies and critical success factors.

The ROI figure may depend on many factors "going right" during the life of the investment: software is installed, tested, integrated, and running on time, employees are trained and up to proficiency by a certain date, and Purchasing negotiates prices of raw materials to a target level, for instance. These may be critical success factors for the ROI, meaning that if we do not manage these to target levels, the projected ROI will not come in.

The projected ROI should not be viewed simply as a prediction out of the crystal ball. It should be seen instead as an estimate of what will happen, if certain critical success factors and other contingencies are managed to expected levels. Before putting confidence in an ROI estimate, ask:

ROI question 5: Which contingencies and critical success factors have to be managed in order to bring in these results?

ROI Secret 6: The quality of the ROI may depend on its heritage

An ROI figure by itself says nothing about its heritage. That is, it does not indicate whether the costs, benefits, and return estimates come from methods that have been tested, validated, and improved through previous ROI and business case analysis in this environment, or whether the ROI developer is trying something completely new. Without a history of validation, there is no way to know how much confidence should be placed in the estimated costs and returns.

When presented with an ROI figure, remember that the ROI figure is no better than the cost and return figures that go into it, and ask:

ROI question 6: Have the cost and return estimating methods been validated in this environment?

Take action by learning more in a business case seminar or read The Business Case Guide.

Marty Schmidt
20 August 2006
mschmidt@solutionmatrix.com
www.solutionmatrix.com