Hi, I'm Carmen Barrett from TechRepublic Press and I'm hereto talk to you today about calculating ROI. ROI is used widely to evaluate ITprojects, but really very few people understand what it is or how to use it. Sotoday we're going to go to the fundamentals of ROI. We're going to talk aboutwhat it is, when to use it, and most importantly how to calculate it.
So what is ROI? ROI is an analysis tool that lets you lookat a project's expected benefits in light of its costs. So in other words forevery dollar that your company invests, it's expecting to get many dollars inreturn. An ROI helps you figure out if you're getting those dollars. When doyou use ROI? Well, for one thing, ROI is really popular when comparingseemingly different projects. It lets you put all the projects, evaluate themall on the same metric, so it's easy to look at projects all across yourcompany.
The one thing to remember though when using ROI is you haveto have a fair degree of certainty in your cost and your expected benefits. Thebasic formula for ROI is your return, which is the net financial gain that youexpect from that project over the investment. The investment is the initialcash outlay for that project, seemingly simple calculation. Let's go do anexample. Let's say your company wants to invest in some sales force automationsoftware. Well, you have the cost of the software, you may have some additionalhardware, and of course there's always consulting fees. All these thingstogether, for example, let's just say there are $200,000, that's yourinvestment, that's money that's going out the door. So this sales forceautomation software though is really great and it can increase the productivityof your sales force and your revenue will go up by $80,000 a year for threeyears. So $80,000 every year for three years, that's $240,000. That seems likea pretty good deal. Spend $200 get $240 back, I would do that.
The thing to remember though is a dollar today is worth morethan a dollar tomorrow, so this $240,000 over three years isn't really $240,000.It needs to be discounted back to today's dollars using your company's cost ofcapital. It's really the rate at which your company earns money on otherinvestments. It's specific to each company so you have to talk to your financedepartment about what your company's cost of capital is. For this example,we're going to use 12%. So if we discount the $240,000 back using 12% thatgives us $215,000 so the $240,000 dollars over three years is worth $215,000today. This is our return that goes in the numerator of our formula. Now in thedenominator is your investment. Remember we've spent $200,000 on software,hardware, and consulting. We do the math and your ROI is 8%.
So remember when doing an ROI, you need to have a good ideaof what your investment is, what your return is and your cost of capital. Thosethree things together will give you an ROI.
