One might think that calculating return on investment would be a common tool for businesses to use to make capital investment decisions. Who could make an intellectual argument against determining an estimated level of payback on an investment? Yet, businesses of all sizes and industries spend little effort determining any kind of ROI or Payback Analysis in the capital budgeting or decision-making process.
Why You Should Calculate ROI
Despite the fact that it is easy to do, few organizations routinely incorporate any formal analysis or process in their decisions to spend money. The most common drivers used to allocate capital funding are:
- The CEO simply wants it done.
- The squeaky wheel syndrome, where funds are allocated to the division head who squawks the most often or the loudest.
- Something is broken, and there is simply no choice but to address it.
- The customer demands it. (This is obviously not a bad reason to do something, but perhaps it should not always trump everything else.)
- Government regulation forces the issue.
Factors to Consider When Calculating ROI
These decision drivers should not be ignored or removed from the ultimate decision. All of them are part of our daily reality. However, there are several other factors that should be considered, and perhaps made part of a formal capital budgeting or decision process, such as:
- Will the investment manifest an increase in sales? This can be difficult to predict with certainty, but taking the time to develop 3 or 4 scenarios (sales increases of 5, 10, 15 percent, for example) might provide insight into the potential payback of an investment.
- Will the investment manifest tangible efficiency gains, such as a reduction in staff or more streamlined operations allowing for more work to be done or product/service to be delivered with the same resource level?
- Will the investment manifest the ability to enter into new product or service lines, thus increasing revenues? Again, developing multiple scenarios can help mitigate the uncertainty often associated with the answer to this question.
- If the organization has defined and regularly tracks formal KPIs (Key Performance Indicators), how will the requested investment of capital measurably move those indicators in a positive direction?
In addition to answering these questions, consider factoring them into a formal decision process where the business manager making the capital request actually builds the formal business case using the above or similar criteria to justify approval of the expenditure. Not only does such a process facilitate better decision making, but it also facilitates ranking and prioritizing projects and initiatives when there are more opportunities than resources to implement them. This helps to establish accountability and create a more efficient use of scarce resources.