There's a good chance that you should—and could—be using return on investment (ROI) calculations more than you currently do, or even more than you realize you could be. ROI is the way to measure value and objectively determine whether what you want to do will pay off, such as choosing among software options, or whether what you are actually doing is paying off (for instance, after you've implemented the chosen software).
Are You Missing the Real ROI?
Many organizations explicitly require formal ROI calculations for certain events, such as determining whether to go forward with a proposed project or a major purchase, especially when choosing among competing vendors. Such formal ROI calculations are often presented within a written business case.
Regardless of whether the need for calculating ROI is explicitly required, or even recognized, smart managers understand that knowing ROI is a key to success in many situations, including making strategy and other major decisions, buying and selling complex products and services, and participating in projects both as a project manager and as a key stakeholder or contributor.
Measuring the Variables Affecting Success
In fact, it's often not the ROI calculations themselves or the communication in a business case that are so important. Rather, the real effectiveness advantage frequently comes from developing a sufficiently in-depth understanding of the key variables that affect success to quantify them with ROI, financially as well as operationally.
Having such a handle on costs and benefits provides an added powerful perspective that many managers miss. And though these managers may not have been aware of it, not knowing the dollars and cents may well have been their undoing.
Even at the best of times, proposed projects and other initiatives must compete for limited resources. As the availability of funds declines, proposals which don't clearly, credibly, and convincingly identify adequate benefits beyond costs will be rejected outright or will be passed over in favor of those that do. Organizations expect expenditures to produce a visible return, and recognize that identifying benefits is a prerequisite for assessing an investment's value. Many require a formal cost and benefit analysis prior to an investment's being made.
Managers are frequently attentive to the "manager's triangle" of triple constraints (a product's functionality and quality, as well as cost and schedule), which are like three of the legs of a chair. However, they may often be oblivious to the fourth leg: value, as measured by ROI. Three-legged chairs are a shaky basis for managing a business. You need to know your ROI too.
ROI and Why It Isn't Used
No doubt the biggest reason people don't use ROI as much as would be helpful is that ROI just doesn't occur to them as something that would indeed help them do whatever they're doing. For those who do consider ROI, preparing a business case may seem like more formality or effort than they want. There can be controversy about the effectiveness of ROI as it is commonly calculated, and probably the calculations just scare a lot of people.
A business case is a written description of the rationale for proposed approaches. Supporting the rationale are calculations showing the financial return, or benefit, relative to the investment cost of achieving the return—adding up to ROI. An approach's return is typically portrayed by contrasting the approach's cost and revenue cash flows with those that could be expected if there were no change (in other words, business as usual). A business case is not necessary in order to use ROI.
Risk, Reward, and Payback
Typically, ROI users calculate two basic measures. The simpler measure is the payback period, or the length of time it takes for the cumulative return to equal the cumulative investment cost. Ordinarily, investment spending must occur before the investment starts producing benefits. The longer an investment's payback period, the riskier and less attractive the investment is. Similarly, the larger the initial investment, the riskier and less attractive it is; and not surprisingly, larger investments usually take longer to payback. These days, organizations want very short payback periods, preferably "yesterday."
The more complicated measure, which is most commonly to what "ROI" refers, can include additional, intimidating calculation variations. It depicts ROI as an annualized percentage, which then can be compared to the annual percentage return from competing proposed alternative investments. For example, an essentially risk-free bank certificate of deposit might pay interest at a rate of 3 percent per year. A proposed alternative investment would need to promise a somewhat greater annual return in order to compensate for the increased risk, such as the possibility that the proposed approach won't provide the expected benefits, or won't be completed within the expected time period or for the expected cost.
Many question the suitability of calculating ROI at all, especially those who can't find the financial return for an investment they favor. They may say the return is so obvious that ROI calculation is unnecessary. The fact is, to borrow Samuel Goldwyn's famous depiction of verbal contracts, many ROI analyses (as commonly performed) "are not worth the paper they're written on." The issues usually raised with ROI often reflect inappropriate understanding or usage, which of course are real issues but are not inherent to ROI.
In our experience, the ROI issues most people express are like the iceberg's tip. The far larger source of ROI difficulties is like the 90 percent of the iceberg below the surface. We've identified 10 common pitfalls that people frequently aren't aware they encounter when determining ROI—which means that very often the ROI people rely on is not right.
Identify the Right Requirements for Real ROI
For example, the most important of these seldom-recognized ROI shortcomings is the failure to adequately link the ROI calculations to what really provides value, usually because the real business requirements that provide value (when met) have not been adequately identified. A related reason is focusing too much on the arithmetic calculations and too little on getting the right numbers for the right things for those calculations. Among the right numbers that typical ROI almost always misses are quantified intangibles.
Thus, not only do people tend not to realize many of the instances when they could benefit from using ROI, but also the ROIs they do calculate are often less reliable than recognized.
The remainder of this article describes some of the often-unrecognized types of roles and situations where professionals could and should know the ROI. When determining ROI, it's also important to use techniques which avoid or overcome the common ROI pitfalls. If this advice is followed, the ROI determined should be more accurate and more reliable—and consequently more helpful.
Decision making is the day-in-day-out activity of all levels of management, not just senior executives. Dozens of decisions are made every day, often without the decision maker being consciously aware of making a decision. Decisions can involve choosing strategies, tactics, methodologies, markets, product and service lines, staffing, and technology—all the way down to choosing paper or plastic.
"Strategy" often seems to be used as a buzzword more than as an actual management practice. An organization's strategy identifies how it intends to go about meeting its mission. Strategy determines the types of products, services, and markets an organization will pursue, and the ways it will pursue them.
Do You Close Shop When Wal-Mart Moves In?
For example, Wal-Mart has become the world's largest retailer by assiduously following a strategy of offering the lowest prices on a wide range of average-to-low-quality consumer products. Wal-Mart's arrival in a locale often drives smaller, directly competing local merchants out of business. However, some small boutique and specialty stores still prosper despite the giant's presence by taking different strategies, such as offering a limited selection of unusual or very high quality merchandise and services, for which they may even be able to charge premium prices. Appropriate ROI analysis could be critical in determining whether or not opening or keeping open a retail store that competes with a nearby Wal-Mart will be fruitful or an enormously expensive strategic mistake.
When the economy worsens, organizations commonly adopt a strategy of cutting training, quality assurance (QA), and marketing expenses. In many instances, such almost knee-jerk decisions may create results directly opposite to those intended, cutting capability and quickly spiraling the organization downward into almost certain demise. Thorough ROI analysis that takes all key relevant variables into account, especially quantifying intangibles, could very well reveal the value of an alternative strategy. For instance, it might show that holding steady or even increasing these commonly cut activities would in fact increase chances of survival.
Ultimately, every decision should be based on net financial benefit. Yet, many decisions aren't, partly because most decisions are made informally and partly because the benefits may seem intuitively obvious. Ironically, higher-ups dealing with bigger and more far-reaching issues often are the worst offenders.
Why Some Formal ROI Processes Fail to Solve Problems
A recent experience with a large financial services client is probably too typical. Prompted by a recurring problem with projects running over budget and deadline while still failing to deliver adequate value, the client requested extensive assistance in training business analysts how to improve their requirements discovery on projects that had been initiated through a formal project approval process that included ROI.
The analysts learned valuable skills, but were limited in their ability to apply them. Our own analysis revealed that the analysts were repeatedly put into projects that inadvertently constricted the analysts' ability to define solutions that provided sufficient value. Long before analysts became involved, projects were already being destined to difficulty by a formal but flawed project initiation process based only on the well-intentioned intuitions of the senior executive group.
The executives needed the analysts' assistance during project initiation to provide sufficient understanding of the real business requirements and the quantified financial value these requirements achieve when met—essential for the meaningful ROI analysis that effective project initiation decisions are based on.
Some management gurus suggest that intuitiveness is a key top executive decision differentiator. While "gut feel" surely does turn out right sometimes, intuitive decisions are likely to be ill-advised far more often than realized. Moreover, political dynamics probably make it exceedingly unlikely that a high-level decision's weaknesses will be apprehended. Often the person making a questionable decision is the one charged with judging the decision's worthiness. This person will no doubt dismiss or even punish any challenges; and an "emperor's new clothes" effect can arise—though everyone can see the flaws in the decision, nobody dares question the decision maker's wisdom.
Looking for Justification Is a Pitfall
Even when ROI is calculated for decision making, it's often characterized as "justification." This term is a tip-off to one of the 10 common ROI pitfalls: that a decision is expected to be made based only on information supporting a pre-defined answer, rather than assisting objective decision analysis. Not surprisingly, decisions which are "justified" have a way of being unreliable. The positional level of the proponent not only doesn't reduce this risk, but probably increases it, since "justifications" favored by politically influential folks are less likely to be questioned—especially when the proponent is also the decision maker.
Failing to quantify intangibles, again typically unwittingly, is also related to justifying taking a favored approach while appearing to subject the decision to hard scrutiny. The common technique of financially quantifying tangibles but merely separately listing intangibles without quantification actually provides an "out"—a way of justifying a desired approach even when well-reasoned, tangible ROI has been calculated and doesn't support the favored action.
Getting Right, Reliable, and Responsible Decisions
Decision makers need to know the right, reliable, and responsible ROI so they can make their many large and small decisions pay off more effectively. They need to know the ROI before undertaking courses of action; and they need to periodically revisit the numbers to make sure that the chosen course of action continues to produce the desired value for a reasonable investment cost.
"Gut feel" decisions, which are inevitably based on inadequate requirements and often merely justify ill-conceived predefined solutions, can give the illusion of sound management while actually leading the organization to waste scarce time and resources on actions that don't pay off sufficiently. Moreover, people are less likely to commit to carrying out decisions successfully when they feel the financial benefits don't seem to add up.
On the other hand, when informed ROI financial analysis is integral to the decision-making process, strategy and similar decisions are far more likely to lead to success, in part because of greater buy-in to the strategy's implementation.
Financial ROI analysis probably is used most commonly by organizations when they must choose among competing vendors or offerings when considering the purchase of a product, system, software, tool, or services. Organizations typically follow very time-consuming and expensive purchasing procedures, including involving the legal department for assistance with structuring contracts with the selected vendors.
Buying represents a special form of decision making. Especially in a tight economy, buying as opposed to building a solution can often be a way of saving a significant amount of time and money. In fact, where both buying and building are options, the decision should be based first on the two approaches' respective ROIs before proceeding to select and engage a specific vendor or product.
It's usually cheaper to buy something that already exists than to build it. Implementation time is more immediate because there's no delay in waiting for it to be built. Ordinarily, risks are lower because an existing product or system can be evaluated; and generally, its costs can be identified more precisely, whereas there's no way to be sure what the result, duration, or cost of a development project will actually be.
Selecting a Vendor
The reliable way of selecting a vendor or product is to prepare an ROI calculation for each competing vendor or product solution, and pick the one that provides the most advantageous ROI over the expected useful life of the solution. It's essential that the calculations for all competing choices are based on providing equivalent results. Thus, an appropriate request for proposal (RFP) should charge the vendor with proposing a solution that will meet the buyer's real business requirements and thereby provide value. An RFP does not have to be overly formal, but it must inform vendors what their solution must achieve.
If a proposed vendor or product cannot meet certain requirements, the scenario and costs/benefits describing the vendor's solution must be adjusted to reflect what is necessary to enable that solution to meet the requirements. For example, the scenario may also need to include customization or supplementary products and services, such as additional support.
However, although buyers may apply all sorts of seemingly good procedures to protect themselves by assuring they purchase the vendor's product in a responsible manner— including conventionally calculating ROI—many purchases still go awry. For far too many (some might say for most) complex purchases, especially of software, the expected ROI never materializes. Such purchases frequently fail to deliver desired results, take too long, and/or cost too much.
Are You Buying Based on Product Design or Requirements?
Buyers often buy the wrong products because they don't understand important acquisition concepts that make purchasing complex products much different from buying something at the mall. Most buyers describe what they want to purchase in terms of a presumed product or system design, rather than in terms of their real business requirements that the product or system must satisfy in order to provide value. This mistake is aggravated when buyers focus on what the vendor is selling rather than what they, the buyers, actually need.
ROI calculations are inadequate when they are based only on price, without taking into account the total cost of ownership (TCO) and the other half of the ROI equation: the value received. TCO must include the costs of installing, operating, supporting, and possibly retiring the product or system over its life. The impact of revenue as well as expense on all affected parties must be reflected. Factors such as risk must be addressed, and both tangibles and intangibles must be quantified financially.
Effective sales people help their prospective customers become effective buyers—purchasing products or services that provide the most advantageous ROI by meeting the buyer's real business requirements, which provide real value from the buyer's perspective.
Typically, to save themselves the effort of calculating vendor ROIs for their internal buying process, buyers often request sellers to provide ROI figures for their products or services. Even when not requested, many sales people quote ROI as a way to make their product or service look more attractive; and many vendors have ROI calculators that justify buying their product.
What Are Vendor-supplied ROI Calculations Worth?
Unfortunately, such vendor-calculated ROIs frequently are neither convincing nor correct. Many sales people mainly pay lip service to customer needs while largely focusing on their product's differentiating features, presuming that whatever their product does must indeed provide value. Despite saying it's important to listen to customers, many prominent sales training methodologies essentially encourage product-based sales pitches and claimed product ROIs. It should be pretty obvious why they tend not to be believed—or bought.
On the other hand, sales efforts can receive a much different, positive response when they believably show right, reliable, and responsible ROI based on understanding and explicitly linking the vendor's product to satisfying the buyer's real business requirements. Of course, this involves actually listening to the prospective customer and learning how to discover what they really need and value; but that's what truly effective sales people know is their highest-payback activity.
Become a Valued Partner
Sales people who take this approach can become valued partners in their prospective customer's buying process. Moreover, both the seller's sales process and the buyer's buying process can be made quicker, cheaper, and easier. Sellers who have earned trust by understanding how their product delivers what the customer really values dramatically reduce the effort needed to make a sale.
In turn, the buyer doesn't need to spend so much time on the typical defensive acquisition procedures occasioned by vendors who are not believed; and the buyer can even save effort by being able to rely, without significant recalculation, on the vendor's credible calculation of ROI for their proposed solution.
Project Managers and Other Stakeholders
Money is the language of business and is usually important to many more of a project's stakeholders than just senior management. While task completion and deliverables are key measures of project progress, ultimately project success is measured in money—whether the return value received adequately exceeds the investment cost, including the quantified costs of time, risk, and other intangibles.
Therefore, even though calculating and reporting ROI generally is typically not the explicit responsibility of the project manager in most organizations, project managers and other stakeholders would be well advised to understand their project's ROI finances so they can continually monitor and communicate ongoing ROI status during a project and upon its completion to be sure expected real value is delivered.
Real Professionals Look at Real ROI
Any discrepancies should be analyzed and adjustments should accordingly be made to both the present project as well as to the estimating process so future projects will benefit from improvements.
Project managers who know their project's financial ROI value and take it into consideration when reporting project status will usually be perceived as more professional and capable than those who pay attention only to budgets and schedules; and they have a greater chance of a successful project that truly delivers the expected value. Similarly, stakeholders with an interest in receiving value will be more likely to get it when they measure and monitor ROI value returned relative to the investment cost.
Anthony Sarno is chief executive officer (CEO) of ProveIT (www.ProveIT.net), which provides REAL ROI™ and ROI Value tools, training, and advisory assistance for decision makers, buyers, sellers, project managers, and other stakeholders. He can be reached at firstname.lastname@example.org or +1 973-462-9965.
Robin F. Goldsmith, JD is president of Go Pro Management, Inc. (www.gopromanagement.com), and partners with ProveIT on REAL ROI™, ROI Value Modeling™, and the powerful Problem Pyramid™ featured in his recent Artech House book, Discovering REAL Business Requirements for Software Project Success. He can be reached at email@example.com or +1 781-444-5753.