Calculating ROI

Hi, I'm Carmen Barrett from TechRepublic Press and I'm here to talk to you today about calculating ROI. ROI is used widely to evaluate IT projects, but really very few people understand what it is or how to use it. So today we're going to go to the fundamentals of ROI. We're going to talk about what it is, when to use it, and most importantly how to calculate it.

So what is ROI? ROI is an analysis tool that lets you look at a project's expected benefits in light of its costs. So in other words for every dollar that your company invests, it's expecting to get many dollars in return. An ROI helps you figure out if you're getting those dollars. When do you use ROI? Well, for one thing, ROI is really popular when comparing seemingly different projects. It lets you put all the projects, evaluate them all on the same metric, so it's easy to look at projects all across your company.

The one thing to remember though when using ROI is you have to have a fair degree of certainty in your cost and your expected benefits. The basic formula for ROI is your return, which is the net financial gain that you expect from that project over the investment. The investment is the initial cash outlay for that project, seemingly simple calculation. Let's go do an example. Let's say your company wants to invest in some sales force automation software. Well, you have the cost of the software, you may have some additional hardware, and of course there's always consulting fees. All these things together, for example, let's just say there are $200,000, that's your investment, that's money that's going out the door. So this sales force automation software though is really great and it can increase the productivity of your sales force and your revenue will go up by $80,000 a year for three years. So $80,000 every year for three years, that's $240,000. That seems like a pretty good deal. Spend $200 get $240 back, I would do that.

The thing to remember though is a dollar today is worth more than a dollar tomorrow, so this $240,000 over three years isn't really $240,000. It needs to be discounted back to today's dollars using your company's cost of capital. It's really the rate at which your company earns money on other investments. It's specific to each company so you have to talk to your finance department about what your company's cost of capital is. For this example, we're going to use 12%. So if we discount the $240,000 back using 12% that gives us $215,000 so the $240,000 dollars over three years is worth $215,000 today. This is our return that goes in the numerator of our formula. Now in the denominator is your investment. Remember we've spent $200,000 on software, hardware, and consulting. We do the math and your ROI is 8%.

So remember when doing an ROI, you need to have a good idea of what your investment is, what your return is and your cost of capital. Those three things together will give you an ROI.