The Formula for ROI, Just a Little too Simple

Recently, I reviewed a book on calculating ROI, but today I’d like to call into question this iconic phrase.

The formula for calculating Return on Investment (ROI) could hardly be simpler. Just subtract the cost from the gain and divide the difference by the cost. Then multiply by a hundred to convert the ratio into percentage form.

ROI(%)=((Gain-Cost)/Cost )*100

Despite its popularity and perhaps because of its simplicity, there is much that the standard ROI formula fails to capture.

Unlike formulas for Net Present Value and Internal Rate of Return, the ROI formula does not capture the timing of costs or gains. So an investment that took twenty years to provide its return would look just as good as an investment that reaped its benefits in twenty days. Unless the time frame is specified in accompanying notes, it would be hard to use ROI to compare one investment to another.

And since it does not capture time, the standard ROI formula does not adjust (at least not in a standard, generally accepted way) for the present value of outlays and returns. These calculations, if used, must be baked into the inputs—the gains and costs—prior to the calculation and explained in notes accompanying the calculation.

Nor does the ROI formula provide any indication of risk, which might make a roulette wheel in Las Vegas look like a sounder investment than US treasury bonds. Again, risk, like time, could and should be handled outside of the formula when comparing investments.

Another factor that needs to be specified outside of the ROI formula are taxes, the impact of which might make one investment with higher ROI preferable to another with a lower return. The tax impact could be described outside of the calculation or baked into the inputs. In either case, a business case including an ROI calculation needs to include explanatory notes on tax impact.

And, of course, ROI calculations, especially those based on expected future gains, are only as good as the inputs. Does the cost include all expenses, direct and indirect? Upon what assumptions do the future returns depend? As in all such calculations, it’s garbage in, garbage out. So, despite its popularity, use ROI with care.

What cautions are used when computing ROI in your organizations?

Other posts in series: MIRR, IRR, Break-Even Analysis, NPV, ROI

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I’m a solution engineer for Shape Security, an awesome web security startup in Mountain View that defends some of the worlds largest web sites from bot attacks. I see this blog as a learning tool. It gives me a chance to collect my thoughts on topics of interest and to share with others. If you see a mistake or think I’m on the wrong track, please let me know. I appreciate comments. See my LinkedIn profile at http://www.linkedin.com/in/jamesdowney and follow me on Twitter at http://twitter.com/james_downey.

Posted in Business Case Analysis, Project Selection, ROI

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