ROI on a New Strategic Program or Service

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Please see response attached for completed response (some of which is presented below). I hope this helps and take care.

RESPONSE:

1. What ROI would you expect on a new strategic program or service?

It depends, at least in part, on type of service, how much return on your investment you expect; amount of cash flow available, etc. This will vary across individual and type of service. In fact, before a company invests in a complex business critical information system, for example, it should have a clear idea of the project's expected ROI for initiative prioritization. For example, return on investment (ROI) is kinky. Everybody loves ROI, but many like it done differently. ROI philosophy varies dramatically from company to company. It varies by which ROI model(s) to use (e.g., DCF, IRR, P2P, ROO, etc.), by what constitutes acceptable figures (e.g., hard vs. soft dollar benefits and weightings for risk levels), and it varies by what initial and long-term costs (e.g., Gartner's total cost of ownership [TCO] figures) are considered (http://www.risnews.com/ris_red_nov/red_nov02_identifying_pos_paybacks.htm).

Let's look at three examples below to see the considerations for different types of services.

ROI is the most used metric when you need to compare the attractiveness of a particular investment to another. The results of an ROI calculation are expressed in percentage terms and qualified by a time period. The time period can be a three-year time period or five-year period. However, a three-year period is the standard in software purchasing, since technology becomes effectively obsolete in that time period. Simply speaking, a three-year ROI of 200 percent means that the benefits you accrue over three years are two times greater than the cost necessary to implement the purchase. While ROI tells you what percentage return you will get over a specified period of time, it does not tell you anything about the magnitude of the project. That is why you will often want to know the Net Present Value.

The equation for a three-year ROI is:

[net benefit year 1 /(1+discount rate) + net benefit year 2 /(1+discount rate)^2 + net benefit year 3 / (1+discount rate)^3] / initial cost

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Example1: If the initial cost for your manufacturing company's small new software roll-out was $10,000, your annual benefits minus annual costs are constant at $5,000 for the next three years, and the discount rate is 10 percent, your three-year ROI would be:

[$5,000 / (1 +.1) + $5,000 / (1 + .1)^2 + $5,000 / (1 +.1)^3 ] /$10,000
= $12,434.26 / $10000
= 124%

While ROI tells you what percentage return you will get over a specified period of time, it does not tell you anything about the magnitude of the project. So while a 124 percent return may seem initially attractive would you rather have a 124 percent return on a $10,000 project or a 60 percent return on a $300,000 investment? That is why some companies will often want to know the Net Present Value.

Net Present Value
The Net Present Value (NPV) gives you a dollar value of your expected return and is useful to determine the magnitude of your results. It is ...