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Calculating Your Return on Investment

By George Keller

Here is a short lesson on methods of calculating your return on investment (ROI). Return on investment (ROI), or more precisely rate of return on investment, is the ratio of the composite benefits accrued as a result of making an investment to the amount of that investment.

For example, if a $2,000 investment will yield a benefit of $5,000, the ROI is 2.5—in other words $2.50 for each $1.00 invested. This is particularly valid if the benefits (or savings) are accrued in the same period (normally a year) in which the investment was made. However, since most benefits are realized over a period of years, the time value of money must be considered and the actual value discounted over the periods of benefits.

Usually we evaluate future benefits in terms of their worth at the time the investment is made and we term this the present value of future benefits. The sum of the present value of all future benefits is called net present value or NPV.

So in the above example, if the benefits were accrued at the rate of $1,000 per year for five years, the NPV would be $4,100 (using the OMB [Office of Management and Budget]-recommended discount rate) and the ROI would be 2.05 rather than 2.5.

Discount rates, such as those recommended by the OMB, reflect the nominal rate at which you could earn interest on a reasonable investment of your money. If the above example represented an opportunity to buy a piece of equipment to perform a job at a savings of $1,000 per year over the present method, your alternatives are to invest your $2,000 in that equipment or to invest them in, say, a certificate of deposit that returns 7% annually. If you invest in the equipment, you forego compounded profit of over $800, so you must account for this "loss" by discounting the future year savings at the rate at which you could otherwise invest your money.

Use the above worksheet to calculate return on investment. Click on image above to download and print.

The Return on Investment Calculation spreadsheet provides a simple method for computing ROI based on the net present value of expected benefits. It computes NPV using the discount rates suggested in Appendix B of OMB Circular A94. (For detailed guidance on benefit-cost analyses and discount rates, refer to the circular which can be downloaded from the OMB Web site at www.whitehouse.gov/omb/circulars/index.html.)

The spreadsheet requires entries in the investment block at the top of the sheet, and entries in at least one of the four data entry columns (B through E). No sunk costs should be entered—money already spent has no bearing on the analysis although such expenditures can be used to estimate future costs or benefits.

The amount of investment in the system being considered should be the sum of all up-front costs associated with that alternative system. This includes design, manufacturing, testing, and transition to use. You can assume that all investment is made at one time. However, if you plan to invest in the project over several years, you can compute the net present value of investments using the same scheme as for discounting costs. Just enter the value of each annual investment in column E of a separate spreadsheet, and the present value will be shown in the Net Present Value of Costs and Benefits/Savings box above column H. Since the net present value of a series of annual investments will be less than the sum of all investments, the total savings and ROI will be higher than if you assume all investments are made before the project begins.

The analysis of costs and benefits or savings should cover the useful life of the alternative system being considered. The spreadsheet will accommodate up to thirty years—most systems or equipment has shorter useful life, and for those that do exceed thirty years, the present value of costs and benefits rapidly approach 10% or lower.

The first two data entry columns reflect costs and benefits associated with the baseline method or equipment. This assumes that the alternative under consideration is a replacement for the baseline. Entries in the column B should include all annual operating and support costs as well as replacement costs, such as buying new systems, which would be required if the alternative is not selected. Entries in column C should include the value of any benefits from retaining the baseline system, such as salvage value when the baseline system is retired. Both columns should reflect projected costs and benefits for the period equal to the useful life of the alternative system. Incidentally, many baseline costs and benefits can be projected from past history.

The third and fourth data entry columns of the spreadsheet reflect costs and benefits associated with the alternative system under consideration. All the annual projected operating and support costs should be included in column D. This might include overhauls, modifications, or other periodic activities to retain system capability. Column E should include any benefits or savings that result from replacing the baseline system with the alternative. This does not include any cost savings from column B, since those are already computed in the spreadsheet. It does include any savings in increased readiness or operating and support cost savings due to the reduction in the number of systems required, and the value of improved performance.

The spreadsheet is quite flexible in that you need only fill in one column and only those rows in which annual data is appropriate.

The spreadsheet is quite flexible in that you need only fill in one column and only those rows in which annual data is appropriate. If you have no baseline system, then you need to fill in columns D and E. Column D still reflects operating and support costs. But in this case, column E should reflect operational benefits and could reflect savings in the use of the system being evaluated compared to not having the system. If there are no operating or support costs after an initial investment, you need only make column E entries that reflect benefits or savings.

It might be easier to compare the alternative system to the baseline system by determining the incremental annual operating and support cost differences between these systems, and only filling in columns D and E. In this case, the cost differential between the alternative and baseline systems would be entered in column D if the alternative system costs are greater than the baseline system costs, or in column E if the alternative system costs are less than the baseline system costs. Be sure that reinvestment costs associated with the baseline system are reflected as benefits for the alternative system. The same principle applies to benefits. Any benefits associated with the baseline system should be entered as a cost of the alternative system in column D.

The spreadsheet automatically computes the present values of costs and benefits in columns F, G, and H and accrues the net present value. It also computes ROI as a percent and a ratio. Note that present value factors for a 7% discount rate are available to the right of the computation matrix. These can be changed by unprotecting the spreadsheet and entering appropriate percent discount values from available tables. Also note that the total present value of cost (column F) is the sum of columns C and D and the total present value of benefits (column G) is the sum of columns B and E, since a baseline cost is an alternative system benefit and a baseline benefit is an alternative system cost.

Here is an example that illustrates how to use the spreadsheet (all numbers are in $K). An existing system with a 20-year life needs to be replaced at years 8 and 28 for $5M each. The scrap value of each baseline system is $.5M—shown in column C at years 7 and 27. Annual operating and support costs for each system are entered in column B along with replacement costs. The alternative system costs $7M each. However, operating and support costs are significantly lower for each unit.

In addition, vastly improved readiness means only half as many systems are needed, so an equal operating and support cost avoidance for each system not needed is reflected in the benefits column (E) along with performance improvements valued at $40K per year. Refurbishment every 15 years costs $.5M—shown as a cost in column D and as cost avoidance in column E. The ROI based on the net present value is 216%. Note that the ROI would be 529% if the net present value was not computed (see supplemental calculation at the bottom of the spreadsheet).