Return on Investment (ROI)

Return on investment, or ROI, is one of the most familiar measures in business. It answers a simple question: for every dollar spent, how much was gained? ROI is calculated by subtracting the cost of an investment from the benefits it produces, then dividing the result by the cost. An investment that costs $100,000 and produces $150,000 of benefits has an ROI of 50 percent, meaning it returned 50 cents of net gain for every dollar spent.

ROI is popular because it is easy to calculate and easy to understand, which makes it a common way to present technology investments to executives. It also has limitations: it ignores the timing of benefits and depends heavily on how costs and benefits are defined. For IT financial management, ROI is a useful headline measure, best used alongside more rigorous measures such as net present value.

Definition of Return on Investment (ROI)

Return on investment is the ratio of the net benefit of an investment to its cost. The basic formula is ROI equals total benefits minus total costs, divided by total costs, multiplied by 100 to give a percentage.

Benefits might include cost savings, avoided costs, additional revenue or productivity gains converted to money. Costs include purchase, implementation, training, ongoing running costs and any other expenses resulting from the investment.

Simple and Annualized ROI

Simple ROI compares total benefits and costs over the full life of an investment, regardless of how long that is. An ROI of 60 percent over five years is very different from an ROI of 60 percent over one year, but simple ROI does not distinguish them.

Annualized ROI adjusts for time, expressing the return as an average annual rate. This makes it easier to compare investments of different durations, although it still does not fully account for when benefits occur.

Business cases should always state the period over which ROI is calculated, so that readers can interpret it correctly.

ROI Compared With NPV and IRR

Unlike net present value (NPV), simple ROI does not discount future cash flows, so $1 of savings in year five counts the same as $1 in year one. Unlike internal rate of return (IRR), it does not produce a rate that can be compared directly with the cost of capital.

For short, simple investments, these differences matter little. For larger, multi-year technology investments, NPV and IRR give a more accurate picture, while ROI provides an easily communicated summary.

Many organizations report all three, using ROI as the headline figure and NPV and IRR to support the decision.

Importance of ROI in IT Financial Management

ROI is often the first measure executives ask about when evaluating technology proposals. Presenting it clearly and credibly helps IT leaders secure funding.

It is also widely used to report on the results of past investments.

Because ROI is so widely understood, it is a useful bridge between technology teams and business leaders who may not be familiar with discounted cash flow methods.

Communicating Investment Value

A clear ROI figure translates the benefits of a technology investment into terms business leaders understand. An automation program with an ROI of 180 percent over three years is an easy story to tell, provided the calculation is sound.

ROI is also useful for comparing smaller investments, such as tools and process improvements, where a full discounted cash flow analysis would be more effort than the decision warrants.

For larger investments, ROI works best as a summary of a more detailed analysis, rather than the analysis itself.

Pitfalls to Avoid

ROI figures can be inflated by counting soft benefits, such as time saved that is not redeployed, as if they were cash, or by leaving out costs such as training, integration and ongoing support. Inflated ROI damages credibility when results are reviewed later.

Distinguishing hard financial benefits from softer benefits, and stating assumptions clearly, keeps ROI credible. The distinction between hard savings and avoided costs is described under cost savings.

Comparing ROI figures calculated over different periods or with different definitions can also mislead, so organizations benefit from a standard method for all technology business cases.