Return on Investment: The Ultimate Guide
TransparentChoice delivers software that helps organizations make decisions about which projects and initiatives they should implement (what is aligned to strategy, what is not, what should be in, what out, what should have high or low priority). In most cases, Return on Investment (or ROI) is one of the most important factors for these decisions and we see people struggle with it all the time.
Using ROI in decision-making is often difficult and there are traps that sometimes mean it’s not even the right tool to use (even though many people use it anyway)... or at least, that it’s an incomplete tool for good quality decision making.
ROI is a tool. It can be used properly or it can be used incorrectly. It’s not a solution for every problem. There’s an old saying: “If your only tool is a hammer then every problem looks like a nail.” – If your only tool is ROI then every project looks like a financial investment.
And most decisions are not that simple.
This is why we created this guide. We want to help people use ROI correctly. We will share our knowledge and observations. We’ve also looked at best practice from around the world to make this, the Ultimate Guide to ROI. We hope this guide will, therefore, help anyone who really wants to understand RoI and to use it to make good decisions.
In this guide you will find links to valuable content about ROI from around the ‘web. (If you spot other good content on ROI that would add value to this guide, please let us know and we will consider adding this to this guide).
We’re going to dig deep into ROI, but feel free to jump to any section that interests you:
- How to calculate the Return on Investment
- Common ROI mistakes
- How can I use ROI?
Return on Investment (or ROI) is a FINANCIAL metric to evaluate the profitability of an investment. It tells you how much net income (“new money” from savings or from the realization of some benefit) you can generate from an investment (typically in a project to implement a new process, some new infrastructure, a new piece of software, etc.).
You calculate return on investment as a ratio of net income to invested amount and turn it into percentage. Note: sometimes it is expressed as “We get $1.50 back for every dollar investment”.
Why is ROI important?
ROI is an easy way to evaluate and compare various investments in the context of their possibility to “generate income”. And because we live in the world where “generating money” is very important, ROI has become one of the main evaluation factors when people or organizations spend money.
- Do you want to launch a new project? Be prepared to explain its ROI
- Are you selling something? Be ready to prove how your product or service will deliver ROI
- Are you leading an initiative? Be ready to defend its ROI
In today’s world, almost every process, department, company, product, service… must have an ROI assigned to it. And your success may depend on how good you are in recognizing and defending the ROI of various investments.
Why is return on investment so popular?
ROI is something that many people use. It has become a “standard” part of the business world because it has some really attractive benefits.
Simplified communication: ROI has become part of the common language of business - it’s no longer just a financial measure. Many people are familiar with the concept which makes it easier to communicate with multiple stakeholders in a “common language”.
Flexibility. ROI can be used to evaluate and compare any form of investment. Anything from buying stocks to implementing new cloud-based ERP software can generate an ROI. You can calculate an ROI for anything that has a cost and that can generate either a saving or extra income. This metric gives you a way to compare those diverse investments.
Easy interpretation. Most people think of ROI as being easy to interpret. A negative ROI means you’re losing money, a positive one is a gain. The more positive an ROI is, the more attractive the investment is. The world is, in fact, a little more complicated than this, but at first glance, ROI is simple.
Benchmark. There are benchmarks out there for all kinds of things, including ROI. You can use these to measure how well you are performing. For example, you could see if your return on marketing investment is higher or lower than the industry norm. This can be very useful in identifying areas in which your business needs to improve.
Decision making. In many companies there is a minimum ROI threshold for new investments. This is sometimes called a “hurdle rate.” Some organizations even have different hurdle rates for different kind of projects, or for investments with different risk profiles. So ROI becomes a quick way for screening potential investments.
How to calculate the Return on Investment
The general formula for calculating ROI is simple:
ROI = 100% * net income / cost of investment
Sometimes, this is easier to write it as:
ROI = 100% * (gain of investment – cost of investment) / cost of investment
This seems pretty simple, but actually doing the calculation can be quite involved. There are often a number of factors that contribute both to the income/gain and to the cost. It’s very rare, therefore, that an ROI calculation is as simple as those above - instead you usually end up with an ROI model.
An ROI model is simply a list of all the inputs (benefits and costs) and the maths needed to turn those benefits and costs into dollars.
For example, if deploying new software is expected to reduce the number of calls into your call-center, you will need to work out how many calls you will save and how much each call costs in order to work out the “saving” from deploying the software.
Sometimes the path between “initial benefit” (reduced number of calls to the call center) and the “financial benefit” is quite long and difficult to track. It comprises a mix of data (current call volume) and assumptions (by how much will we reduce call volume).
This raises a really important point. Your ROI model is just that - a MODEL. It is, by definition, incomplete. As such, when you present your model, you should also list the important assumptions and inputs of that model.
To give you an idea of how to build your own ROI model, and of some of the variables that lead into the financial benefit, we’ve assembled some examples for you to look through.
ROI Model Examples
Accounting software. This blog looks at the ROI of accounting software. This is a pretty simple calculation based on taking a process and reducing the amount of time spent on that process - in this case, doing the accounting for your business.
Training. This article shows how you need to make assumptions in order to calculate the ROI of your investment in training.
Projects. This article looks at how to calculate an ROI for a project. If you’re not comfortable with maths, you might find this a little difficult to get your head around, but if you are comfortable with maths, this is a great read.
Risk reduction. This blog shows how the avoidance of risk can be quantified and built into your ROI model.
ROI in Excel
If your ROI model is simple, you can probably just work it out. For example,
- if I spend $1000 per year on heating my house, and
- putting insulation will save me 20% on my heating bill, and
- Iit will cost $100 to put in the insulation
- I see my saving is $200, cost is $100 so ROI is 100%
No spreadsheet needed.
But imagine I now have 6 variables that drive my savings and 5 that drive my costs…. well, now a spreadsheet is starting to make sense. This is especially true when I need to do a few calculations before working out the final ROI. For example, there might be several separate components of “savings” from an investment, each of which must be calculated from different inputs.
Using a spreadsheet can let you make your assumptions visible. The process of putting a spreadsheet together can be really helpful because it forces you to think through each step in the value-cost chain. A spreadsheet can be easily shared with colleagues allowing you to gather their input on anything you’ve missed. This all helps make your ROI more robust and more credible.
So, a spreadsheet-built ROI model is more than a calculating tool, it’s a brainstorming and collaboration tool.
Range of ROI and Tornado Diagrams
As we mentioned earlier, your ROI model will usually involve some assumptions. As such, it’s usually a good idea to show sensitivity to changes in your assumption. This will take you some effort to do in Excel, but is well worth it. Here’s how:
For each of your key variables, create three values:
- The most likely value
- An optimistic-but-realistic value
- A pessimistic-but-realistic value
- Calculate your ROI using the most likely values for all of your inputs.
- Now, one-by-one flex the variables while keeping each of the others at their “most likely value” and make a note of the ROI.
- You can now work out the difference, for each variable, between the optimistic ROI and the Pessimistic ROI - this is the RANGE of the ROI.
- You can, if you like, plot this on a chart where the variable with the widest range is at the top and the one with lowest is at the bottom. This is called a Tornado Diagram and is a great way to communicate to your stakeholders what the “expected ROI” is, but also where the risks are in your model.
- Finally, come up with scenarios that are “absolute disaster” and “total dream” scenarios and calculate the ROI for each.
You now have a really robust picture of the ROI ready to present to your stakeholders, one that will inspire confidence that you have “done your homework”.
Online ROI calculators
Vendors will often provide you with online ROI calculators for their product. They are useful but you should be careful; they are often sales tools built to sell you the process or solution. Often, this is a black box where you put numbers and get a result.
As such, it can be a good idea to use online ROI calculators as a quick check, but then build your own model based on the benefits and costs you are likely to realize within your organization. Once again, this will allow you to present the ROI in a way that builds confidence and that shows you know what you’re talking about.
This blog gives some good tips for anyone planning to build an online ROI calculator. It might give you some inspiration… or it might just help you better understand the limitations of these tools.
Here are some examples of ROI calculators that organizations have published online. While some are “black boxes” (you can’t see the calculation), you can see in the inputs - that is good inspiration for your own models.
Sample ROI Calculators
- Integrating social services with medical care
- Promotional products
- Social ROI calculator
- Facebook Ads
- Implementing D-Tools SI software
- Implementing Easy Projects
- Implementing HubSpot
Common ROI mistakes
There are many common mistakes when using ROI - we’ll try to capture the most important ones here. They fall into two main categories; a problem with the ROI calculations or using ROI when you should use something else.
When not to use ROI
If you search the web for the mistakes people make with ROI, you’ll find many articles that start talking about the time-value of money and the difference between profit and cash. They typically then go on to talk about mapping out cash flows and using discount rates to account for the time-value of money to calculate your ROI.
Actually, these articles are plain wrong. They are describing various (really good) methods of doing financial analysis for decision-making, but these are NOT called “return on investment”. Net Present Value (NPV) or Internal Rate of Return (IRR) are just such methods and they can be very effective, but they are not the same as ROI.
The people writing these articles are not stupid - quite the opposite. They are wrestling with two conflicting forces. On one hand, managers like a good ROI. They feel like they know what to do with it. On the other hand, ROI is often the wrong tool. So, as a clever consultant or accountant, what you do is try to dress something like NPV up as ROI so that it’s not scary.
SO, the message here is use ROI when it’s appropriate to use ROI. Use NPV (or IRR, etc.) when it’s appropriate to use those tools. You should avoid ROI when
- There is a long delay between investment and payback. For example, imagine a project that costs $1m and pays nothing back for 5 years... and even then, the payback comes over time. In this case, NPV or IRR
Your benefits are non-financial. For example, if you are a government department and an investment will reduce homelessness by 30%... how do you measure ROI? Well, the ROI calculation will come down to “does it cost more to get people off the street or leave them where they are?” and it is probably cheaper to leave them where they are.
ROI is giving the “wrong” answer because it’s measuring the wrong thing; it’s measuring money when money is not what the initiative is about. In this case, techniques such as the analytic hierarchy process are far more appropriate (and you can include ROI as one of the criteria).
You are comparing projects or initiatives that have very different time- or risk-profiles. For example, if you’re investing in making an existing process more efficient your risks are quite small.
If, on the other hand, you’re launching a new product, you have way more risk (Will customers buy it? Will there be any supply-chain issues?) If you compare the ROI of these two investments, it will be a totally unfair comparison and you may end up with a portfolio of very risky investments.
This essentially comes down to the fact that ROI is incomplete as a way of making decisions. It’s intended to be used in simple situations where your decision is really driven by financial considerations and where the time-frame and risk-profile of your investments is similar.
Common errors in ROI calculation
So let’s assume ROI is the right metric to use. What are the common mistakes in the way ROI is used?
Overestimate costs or benefits
I cannot count how often I’ve heard a manager say, “Right, I need to build an ROI to get this approved.” The ROI is often seen as a tool to prove that “My investment is a good one!” whereas it SHOULD be a tool you use to determine whether or not your investment is good.
This introduces something called “Overconfidence bias”, both subconscious and deliberate, into the process. This is where you overestimate the benefits and underestimate the cost. The best way to avoid it? Have someone who is impartial build or evaluate the ROI model and its assumptions. Is the model complete? Are the assumptions reasonable?
Forget about dependencies
Imagine you have a project that involves upgrading to the latest version of your company’s preferred database. The upgrade and migration costs should, naturally, be part of your ROI model but - and it’s a big but - what if the IT team is planning to do a corporate-wide upgrade in a couple of months’ time anyway?
Well, in that case, including the database upgrade cost in your project will unfairly reduce your ROI. Other projects that are going on around you can increase or decrease your ROI... ignore them at your peril!
Treat ROI as a one-off vs. process
Your ROI is a number, derived from a model that was created at a particular point it time. The environment you’re operating in, however, is not static.
Once you have picked your portfolio of projects and investments, it’s worth double-checking the ROI from time-to-time to ensure you’re still working on the right things.
Ignore cost avoidance
Sometimes, investing in something may mean you don’t need to spend money on something else.
For example, investing in software to more efficiently schedule trains may mean you don’t need to upgrade your tracks. This cost avoidance should be part of your ROI.
Ignore opportunity cost
If I’m planning to run a project that will consume resources that might otherwise be used for something else, I need to think about the “cost” of consuming that resource.
For example, if I take over a warehouse that was sub-let for $50k per year, I have to take account of that $50k as a cost to my project.
Ignore hidden costs
Every project has hidden costs. The most obvious is time.
If you are, for example, implementing a new CRM system, you obviously cost out the software, you will get a quote for the consultant who’s going to deploy it… but will you account for your team’s time for providing requirements, testing, training and oversight?
If not, you have underestimated the cost of your project. Increases in working capital, upgrades to enabling infrastructure and compliance costs are all examples of potential hidden costs.
Lack of collaboration
Most of us operate in complex organizations. As you pull your ROI model together, it’s always worth reaching out to people around you for their opinion.
People from other teams will think of benefits and costs that you miss. They may spot errors in your calculation. In short, collaboration makes your model stronger.
We touched on this with the tornado charts earlier - every model has its assumptions and there is usually some uncertainty in those assumptions.
For example, you might expect productivity to increase, as a result of our project, by 15% - 20%.
That’s a pretty wide range… so present your decision makers with scenarios and sensitivity analysis. If you’re feeling really fancy, you might try using something like Monte Carlo analysis in your model (tho’ this can come with its own costs and risks).
How can I use ROI?
Up to now, we’ve mostly focused on how to calculate ROI - how to get a VALUE. Now let’s look at what ROI is for. How do you actually use ROI to make decisions and win support?
Building a business case to get the green light
This is probably the most common use-case for ROI. You want to get something approved and to do so, you have to show a “solid business case, one that has a strong ROI!”
This is about 2 things. First, it’s about having a model that can be defended. Second, it’s about presenting that model in an effective way.
We’ve talked a lot about how to build the model, how to make sure it’s complete and credible (e.g. through collaboration). Other ways might be to use market data or case studies to inform your assumptions (e.g. “Here are three case studies where the improvement in productivity was 20% - 30%, so we have used 20%”).
Let’s turn to how you present ROI.
Think about diamonds. They’re just little lumps of squashed coal, right? But put a well-cut diamond into the right setting and it becomes a thing of true beauty.
If you’ve built your model well, it is a well-cut diamond - all you need is the setting to make it really shine. The document, or presentation, you wrap around your ROI will help you push your project through to approval.
Here are some ideas of what you could include:
A summary of the key business benefits of your project. If possible, tie those benefits to your organization's strategic goals or KPIs. For example, you might say something like, “This new call-handling software will reduce call queues by 20%. This will contribute $2m to our strategic goal of reducing cost and will help us achieve our strategic goal of improving our customer satisfaction score by addressing one of our customers’ biggest complaints, call wait times.”
A list of benefits for different stakeholders - especially if some of those stakeholders are sitting at the table! You might say, “This new gadget will help sales people close 5% more deals (the sales VP just woke up!) while simultaneously ensuring we have stock, thereby reducing the number of manual back-orders (the VP of Operations is now engaged) and shortening out order-to-cash cycle (...and now we have the CFO on board!)”
Your ROI model possibly including;
Your key assumptions and their justification
The ROI you expect. While ROI is a percentage, I usually also like to make the numbers clear - “We will save $2m and we only need to invest $1.3m to do so leading to a net return of $700k. That is an ROI of 53%.”
Present some kind of sensitivity / risk analysis. This might take the form of a tornado chart (see above) and might include steps you could take to reduce the risks.
Now people are excited, it’s time to make sure you ask for the resources you need. Do you need people, budget, some executive time?
I would usually also include next steps… the first of which is explicit agreement and support for your project.
ROI to win support for your project
Imagine you are responsible for delivering a major project within your organization. How do you win support from stakeholders, from resource managers and from people who will be affected by your project? This support will be essential if your project is to succeed.
Well, not surprisingly, the answer is a little bit like what you did to sell the project in the first place (see above). You can use ROI as part of your “pitch” to help everyone understand “What is in it for the organization” as well as what the key benefits and risks are. This will help them understand why your initiative is important, how it might affect them and what they can do to minimize risk.
ROI in Project Prioritization and Selection
Project prioritization is one of the most important strategic decisions made by any organization. Some organizations use ROI to prioritize their project investments across the organization.
Picking projects is all about finding investments that support your overall business goals and drivers and ROI may well be one of the financial factors you use to work out whether or not a project is worth pursuing.
Other objectives might be important in their own right, even without a strong ROI. For example, improving customer support or reducing order-to-cash time might not deliver a very strong direct ROI, but they could be important for other reasons.
There has been a lot of research into project prioritization methods and the winner is something called the Analytic Hierarchy Process. This is, basically, a way of scoring projects against a set of strategic criteria --- and ROI fits really well as one of those criteria.
ROI as a sales tool
If you are selling a product or service, having an ROI template can be really valuable. This is a good way, along with reports, case studies and market data, to show the value your clients can expect to get from your product or service.
Building an ROI sales tool is a balancing act. You want something detailed enough to be realistic, but not so detailed that completing it turns into a project all of its own! You also don’t usually want to convey the impression that your offering is so complex.
Again, presentation is important. If you can provide your customers with examples, market data, case studies while they are completing the ROI, it will really help them understand the sources of value for them and will help them present that value to their managers.
ROI in Marketing
We normally think of using ROI to “sell” our investment. It’s very difficult to build an ROI in advance of a marketing campaign, however, because of the uncertainty in your assumption.
Will people see my ad? Will they like it? Will they remember it? How often will they need to see it before they take action? Does this ad make it more likely someone will buy from us at some future time, even if they don’t buy now?
In addition, the path from campaign-to-cash is not always clear with multiple campaigns contributing to the sale. So which campaigns should you invest in?
This is not a new problem. Marketing pioneer, John Wanamaker (1838-1922), famously said, “Half the money I spend on advertising is wasted; the trouble is I don't know which half.”
A person could go mad thinking about this stuff.
Building an ROI for a marketing campaign in advance, therefore, is incredibly difficult. It is possible to do it in situations where you have good data. For example, if you have 20 years’ data on “sales uplift following our Superbowl ad”, then you will have a good idea that, if you place your add, you will get uplift “within this range”. But in many cases, you simply don’t have that kind of data.
Interestingly, there is a whole raft of companies that are trying to use technology to reduce the uncertainty. For example RealEyes does research using large panels of people linked to artificial intelligence to predict “engagement and response” to online ads. That way, you can create 2 or 3 versions of an ad, test them and choose the one that is likely to perform best and do all of that before you spend $10m on that Superbowl advertising slot!
We can turn the ROI model upside down and use it as a planning and validation tool in for a particular campaign or event. Imagine you are considering attending a trade show. You might build an ROI model something like this:
Yellow cells are the inputs to the model. You’ll see ROI is now an INPUT. We’re going to use that target ROI to help us test the assumptions we need to make to hit our target. The idea is that we can then decide whether or not those assumptions are realistic.
So…. if we believe (based on previous shows) that we can convert 10% of leads, and that 10% of people who come to our booth convert into leads, etc…. then to achieve our target ROI of 50% we’d need to get 1,650 people to our booth. Is that a credible number given the number of attendees, the time available, etc.?
In marketing, therefore, the role of ROI is often relegated to “proving you spent your money wisely” after the event or to being something you use to test your assumptions before committing to a campaign or event.
You can also, of course, try to measure the ROI of your entire marketing budget (or use an ROI model “in reverse” to work out how much budget you should spend given your growth targets), but it’s so difficult to untangle cause-and-effect (how much of our growth is down to marketing, how much is down to sales training?) that the numbers are often somewhat contentious.
Return on investment is a widely used decision-making tool. It helps decision-makers identify investments that they should and should not make. It is a powerful communication tool.
There are limitations to ROI, however, and there are times when it should not be used, or should be used alongside other techniques such as AHP. This is especially true when the nature of the benefits are largely non-financial.
In any case, the process of building an ROI will help you identify and test the assumptions you are making which is a valuable process in itself… so long as you can resist the urge to “play the numbers” to get the answer you want.
Used well, ROI is a very powerful tool. Used incorrectly, it can lead to bad investments and failed projects. Learning to use it well, however, is an investment that’s worth making.