THE ROI CALCULATION

The term return on investment for projects and programs is occasionally

misused, sometimes intentionally. In this misuse, a very broad definition
for ROI is given that includes any benefit from the project.
ROI becomes a vague concept in which even subjective data linked to a program
are included. In this book, the return on investment is defined more
precisely and represents an actual value determined by comparing project
costs to benefits.
The two most common measures are the benefits/costs
ratio (BCR) and the ROI formula. Both are presented along with other
approaches to calculate the return or payback.
The formulas presented in this chapter use annualized values so that
the first-year impact of the investment can be calculated for short-term
projects. Using annualized values is becoming an accepted practice for
developing the ROI in many organizations. This approach is a conservative
way to develop the ROI, since many short-term projects have added
value in the second or third year. For long-term projects, longer time
frames should be used. For example, in an ROI analysis of a project
involving major software purchases, a five-year time frame was used.
However, for short-term projects that take only a few weeks to implement
(such as a leadership development program), first-year values are
appropriate.
In selecting the approach to measure ROI, the formula used and
the assumptions made in arriving at the decision to use this formula
should be communicated to the target audience. This helps prevent
misunderstandings and confusion surrounding how the ROI value was
developed. Although several approaches are described in this chapter,
two stand out as preferred methods: the benefits/costs ratio and the basic
ROI formula. These two approaches are described next.

Benefits/Costs Ratio
One of the original methods for evaluating projects was the benefits/costs
ratio. This method compares the benefits of the project with the costs,
using a simple ratio. In formula form,
BCR = Project Benefits:Project Costs
In simple terms, the BCR compares the economic benefits of the project
with the costs of the project. A BCR of 1 means that the benefits equal the
costs. A BCR of 2, usually written as 2:1, indicates that for each dollar
spent on the project, two dollars were returned in benefits.
The following example illustrates the use of the BCR. A behavior modification
project designed for managers and supervisors was implemented
at an electric and gas utility. In a follow-up evaluation, action planning
and business performance monitoring were used to capture the benefits.
The first-year payoff for the program was $1,077,750. The total, fully
loaded implementation costs were $215,500. Thus, the ratio was
BCR = $1,077,750:$215,500
=5:1
For every dollar invested in the project, $5 in benefits were returned.

ROI Formula
Perhaps the most appropriate formula for evaluating project investments
is net program benefits divided by costs. This is the traditional financial

ROI and is directly related to the BCR. The ROI ratio is usually expressed
as a percentage where the fractional values are multiplied by 100. In
formula form,
ROI(%) = Net project benefits:Project costs
~ 100
Net project benefits are project benefits minus costs. Subtract 1 from
the BCR and multiply by 100 to get the ROI percentage. For example, a
The ROI Calculation 211
BCR of 2.45 is the same as an ROI value of 145 percent (1.45 ~ 100%).
This formula is essentially the same as the ROI for capital investments.
For example, when a firm builds a new plant, the ROI is developed
by dividing annual earnings by the investment. The annual earnings
are comparable to net benefits (annual benefits minus the cost). The
investment is comparable to the fully loaded project costs.
An ROI of 50 percent means that the costs were recovered and an
additional 50 percent of the costs were returned. A project ROI of 150
percent indicates that the costs have been recovered and an additional
1.5 times the costs are returned.
An example illustrates the ROI calculation. Public- and private-sector
groups concerned about literacy have developed a variety of projects to
address the issue. Magnavox Electronics Systems Company was involved
in a literacy project that focused on language and math skills for entrylevel
electrical and mechanical assemblers. The results of the project
were impressive. Productivity and quality alone yielded an annual value
of $321,600. The total, fully loaded costs for the project were just $38,233.
Thus, the return on investment was
ROI = $321,600 $38,233
$38,233
~ 100 = 741%
For each dollar invested, Magnavox received $7.40 in return after the
costs of the consulting project were recovered.
Investments in plants, equipment, subsidiaries, or other major items
are not usually evaluated using the benefits/costs method. Using the ROI
formula to calculate the return on project investments essentially places
these investments on a level playing field with other investments whose
valuation uses the same formula and similar concepts. The ROI calculation
is easily understood by key management and financial executives
who regularly work with investments and their ROIs.

Basis for Monetary Benefits

Profits can be generated through increased sales or cost savings. In
practice, there are more opportunities for cost savings than for profits.
Cost savings can be realized when improvements in productivity, quality,
efficiency, cycle time, or actual cost reduction occur. In a review of almost
500 studies, the vast majority of them were based on cost savings.
Approximately 85 percent of the studies used a payoff based on cost
212 MONITORING PROJECT COSTS AND CALCULATING ROI
savings from output, quality, efficiency, time, or a variety of soft data
measures. The others used a payoff based on sales increases, where the
earnings were derived from the profit margin. Cost savings are important
for nonprofits and public sector organizations, where opportunities for
profit are often unavailable. Most projects or programs are connected
directly to cost savings; ROIs can still be developed in such settings.
The formula provided above should be used consistently throughout
an organization. Deviations from or misuse of the formula can create
confusion, not only among users but also among finance and accounting
staff. The chief financial officer (CFO) and the finance and accounting staff
should become partners in the implementation of the ROI methodology.
The staff must use the same financial terms as those used and expected
by the CFO. Without the support, involvement, and commitment of these
individuals, the wide-scale use of ROI will be unlikely.

Table 11.3 shows some financial terms that are misused in the literature.
Terms such as return on intelligence (or information), abbreviated as
ROI, do nothing but confuse the CFO, who assumes that ROI refers to the
return on investment described above. Sometimes return on expectations
(ROE), return on anticipation (ROA), and return on client expectations
(ROCE) are used, also confusing the CFO, who assumes the abbreviations
refer to return on equity, return on assets, and return on capital
employed, respectively. The use of these terms in the payback calculation
of a project will also confuse and perhaps lose the support of the finance
and accounting staff. Other terms such as return on people, return on
resources, return on training, and return on web are often used with
almost no consistency in terms of financial calculations. The bottom line:
Dont confuse the CFO. Consider this person an ally, and use the same
terminology, processes, and concepts when applying financial returns for
projects.