Definition of ROI – Return on Investment
We talk about ROI all the time – what is it, in layman’s terms?
ROI is the acronym for return on investment. Another way to think of it is “How much profit will we make if we invest in this project?” Profit is revenue minus costs. Technically, the question should be “How much profit will we make, relative to our investment, if we invest in this project?” We’ll look at both definitions, and see the differences below.
Note – we also have posts explaining expected value and net present value (NPV). Both of these should be incorporated into any real-world ROI calculations, but the examples in this post do not include them, for the purpose of making ROI easier to understand.
A very simple example
We will imagine a software project to build a website for our company. The website takes 4 months to develop, plus we will need some developers to fix bugs for the first month after the site goes live. So, we will be spending money for 5 months. We’ll also assume that we already have the server and network access, so there are no extra costs associated with running this project (other than the developer salaries). We have a plan to get the software delivered as quickly as possible, so once we get the project running, we will double the size of our staff (in the third month of development). In the last month of development, we will increase our costs by another 50% because we have a real-world project, and we discover that we’re going to miss our deadline if we don’t increase staff (or pay for some overtime).
Here’s what our costs per month look like.
[Ed: 86% of you can assume the costs are measured in thousands of USD. 10% of you should assume your local dollars, 3% should use british pounds, the rest of you can use euros, yen, krona (Swedish and Icelandic), rupee, shekels, dirham, won, rubles, baht or pesos. That covers the top 20 currencies for our readers as of this writing.]
We also see that the total cost of the project is projected to be 80. So our investment is 80.
Cost is only half of it – what about revenue?
In our setup, we identified that the website will go live after four months, and will start generating revenue in month 5. Also, since we measure things in internet time, we will assume that we are only projecting revenue for the next twelve months. Twelve months from now, we have no idea if someone will compete with us with a better, free, open-source solution, or if we’ll keep making money. So we’ve decided to only look at revenue that happens between now and twelve months from now. If we add that projected revenue to our cost data, we get this:
It’s now very clear that we will spend 80 units to get 230 units back. Our profit is 230-80=150. So we get almost twice what we invest back. The answer to our first question (How much will we make if we invest in this project?) is 150.
ROI – Return on investment
The ROI, or return on the investment is 150. To determine the relative earnings, we simply need to divide net revenue by the amount that we invested. 150/80 = 1.875, or 187.5% This answers our second question (How much will we make, relative to our investment, if we invest in this project?) is 187.5%.
The ROI for this project is 187.5%. Sounds like a really good project.
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February 1st, 2006 at 9:44 pm
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February 1st, 2006 at 9:45 pm
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February 1st, 2006 at 9:48 pm
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February 1st, 2006 at 10:54 pm
[...] Our customers buy our software because it increases their profits. It’s an investment for them. The payback can be in cost-savings (bottom-line growth) or increased sales (top-line growth), or anywhere in between. We could be cutting overhead (and therefore cost of goods sold) by reducing their cost-to-quote. We could be optimizing their supply chain (reducing the dollars invested in work-in-process inventory), or we could be opening up a new sales channel (a portal website for resellers to directly submit orders to the factory). The bottom line is that it all comes down to ROI. In a comment on a recent thread, Marcus asked how we would trace requirements to corporate strategy. One example he used is the tactic of becoming the low-cost provider in a market. We have to abstract that back up to get to the dollars. Follow the money. A low-cost provider can increase market share, and potentially lower costs through automation. The strategy was presumably accepted (by the business) based upon a projected impact on company profits. We need to understand that impact-projection, and use the resultant profitability forecast to value our requirements. [...]
February 1st, 2006 at 10:55 pm
[...] Make a list of the first cut requirements. We’re not done, however. There is usually at least one really good idea that didn’t fall in the top cluster because the “group” didn’t all agree that it was important. Give everyone in the room a chance to nominate one of the leftover requirements into the first cut group. Let them make a case for it. If we see something that we suspect is valuable, ask questions about it. Pull these ideas into the list. We don’t have a spec. Yet.Brainstorming isn’t the key to writing a requirements document. There’s a reason that design by committee and group think make us cringe – because nothing great comes (solely) of it. A brainstorming session gets us a starting point when we are faced with customers who “don’t know what they want.” Even people who don’t know what they want generally have a good idea about what they don’t want. It’s easy to be a critic. Use this first cut list of requirements as a starting point. Review the list in individual interviews. Understand the ROI of these ideas, validate their strategic alignment with the stakeholders. Having a concrete set of requirements is the easiest way to get someone to say “We don’t need that, what we need is this!”Use the results of the brainstorming session to seed the cloud of ideas in one-on-one interviews. Don’t just spell-check them and hand them over to the dev team for implementation. [...]
February 1st, 2006 at 10:57 pm
[...] Budgeting and planning (winner: waterfall process) With a waterfall process, we decide at the start exactly what we intend to accomplish. We can therefore scope and schedule the project. We can also determine staffing and costs. Budget decisions are easy – IRR and ROI can be calculated – we can calculate expected values for both costs and (forecasted) benefits. With an iterative process, we’re saying “I reserve the right to change my mind later.” We fully expect to change the scope of delivery mid-project. We know we will learn more about how to forecast the benefits after each incremental release. Because we know about, and even desire future changes, we can’t reasonably estimate ROI. We can “fix” the budget (aka timebox the project), but we can’t predict the value we will achive within the time allotted. [...]
February 1st, 2006 at 11:06 pm
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February 1st, 2006 at 11:07 pm
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February 1st, 2006 at 11:09 pm
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February 1st, 2006 at 11:10 pm
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February 1st, 2006 at 11:23 pm
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February 2nd, 2006 at 12:19 am
Great post!
Comparing ROI between projects (or potential releases items) is an excellent way to prioritize development activities. One thing that you must be careful with is the timing of the cashflows. The more distant they are, the less they will be worth in terms of today’s dollars (e.g., I’ll give you $100 3 years from now if you give me $100 today. Somehow I don’t think anyone will accept.) In your example, this is not an issue because everything occurs within the same year.
If you do not use Net Present Value (NPV) you may choose a project that has a higher absolute dollar return but is actually worth less in terms of current dollars. Generally, some discount factor is applied to future cashflows which accounts for inflation, the cost of borrowing and some additional percentage points (opportunity cost). The NPV formula will account for the compounding affect. You can read up on NPV @ http://en.wikipedia.org/wiki/Net_present_value
February 2nd, 2006 at 7:28 am
Thanks Marcus!
Yes, I absolutely want to get into NPV, IRR and hurdle rates, payback period and other measures. There’s a bunch of this stuff to cover, just starting with the basics for now. Thanks for the wikipedia link too.
February 4th, 2006 at 11:05 am
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February 4th, 2006 at 9:14 pm
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February 9th, 2006 at 12:24 am
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February 11th, 2006 at 1:42 pm
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