The mysteries of ROI revealed
THE BUSINESS OF PROJECTS
BY GARY R. HEERKENS, MBA, CBM, PMP
In my May column, I discussed how and why companies should use ROI when deciding to approve individual project investments and in evaluating the relative attractiveness of competing projects. Now I'd like to expand on these thoughts by describing what ROI is and how it can be expressed.
As the term suggests, ROI is an evaluation of the incremental financial benefit a company expects to receive for a given amount of incremental expenditure. The term incremental has considerable significance here. ROI calculations are based entirely upon the economic change (both positive and negative) that would result from approving a particular project.
Incremental financial benefits can assume any number of forms:
- n A new revenue stream or increase in an existing one
- n Cost savings (lowering current cash outlays, such as spending less on maintenance)
- n Cost protection (reduction, elimination or deferral of a future expense)
- n Cost avoidance (elimination of an unfavorable future impact such as a fine or lawsuit)
Similarly, incremental expenditures can take on many different forms:
- n Costs associated with executing the project
- n Increases in “steady-state” costs (a jump in headcount or waste, for example)
- n New cost expenditures (such as a follow-on service or maintenance obligation)
- n Loss in existing revenue streams (as in the case of competing products)
Let the Calculations Begin
Once all of the financial impacts have been identified and charted, calculation of the ROI metrics can start. Among the more popular ones in use today are:
Net present value (NPV): Expressed in terms of a specific currency (dollars, euros, etc.), this is the amount of wealth a project is expected to deliver to the company. NPV calculates the extent to which a project's benefits exceed its costs (assuming the project is a good one). When this occurs, the project is referred to as financially justified.
»ROI calculations are based entirely upon the economic change (both positive and negative) that would result from approving a particular project.
Internal rate of return (IRR): Expressed as an annual percentage rate, this describes the speed at which wealth is returned to the company. For a project to be financially justified (i.e., to have a positive NPV), the IRR must exceed the cost of capital. Think of this as the “loan rate” on the money used to fund the project.
Payback period: This is the time, articulated in months or years, required for the cumulative financial returns to exactly equal the cumulative costs. In other words, this is the break-even point—when the project investment has paid for itself.
There are certainly many ways to evaluate the attractiveness of projects. But in cases where financial considerations are important, calculating key ROI metrics enables management decision-makers to make informed, appropriate decisions. After all, projects are financial investments! PM
Gary R. Heerkens, MBA, CBM, PMP, president of Management Solutions Group Inc., is a consultant, trainer, speaker and author with 25 years of project management experience. His latest book is The Business-Savvy Project Manager.
AUGUST 2010 PM NETWORK
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