So you want to spend money, but it is difficult to figure out if its worth it. ` Or you’ve been tasked with calculating the Return on Investment (ROI) for a piece of equipment or undertaking a new initiative. Where to start?
One of the challenges with ROI is the calculations - you need someone well-versed in the Generally Accepted Accounting Principles (GAAP) to calculate all the allocations and net present value and a raft of other items that aren’t part of your knowledge base. So frustrating.
At least that is what it seems like. Maybe we don’t need a full accounting analysis to do some quick checks. I like to take a step back and ask what is it that I’m trying to figure out. Will this activity create a change that is worth the time and money required to make it come to life? So it is about a change. There are three key elements of the change:
How will it affect what we sell? Can I sell more? More specifically, how much additional sales dollars will we have (less the raw material costs for what we sell - totally variable costs)? (In Theory of Constraints, this is known as Throughput, Sales less Totally Variable Costs. T = S - TVC.*)
How much do we need to spend as the investment? This is new money that I would spend to acquire a piece of equipment, hardware, software, real estate, etc.
How much will our ongoing expenses change? Do we need to pay more/less for utilities, salaries, maintenance, ongoing license fees, etc?
The basic ROI calculation checks if our NEW income less NEW operating expenses is worth it compared to the NEW investment. Or
ROI = [△(Sales-TVC) - △Operating Expenses] / △Investment (△ is delta or “change in”)
This calculation we can do on the back of an envelope or even in our heads. This is a quick way to judge if an investment might be worth it. And it provides a means for comparing options. It’s also a nice way to start having conversations about assumptions. What really is this option going to change from the system’s perspective, not from the perspective of a department? I like to be conservative in the △Sales number and liberal in the △Operating Expense number, just to be sure I’m not looking through rose-colored glasses.
Don’t forget that there is a time element in these calculations - specifically in the Sales, TVC and Operating Expense numbers. In general, the shorter the time between the decision to invest and the realization of the value, the better. If I have an option to invest $12 to make $24 with no change in expenses, that looks like a nice option (a six month payback). But what if we learn that it takes 2 years for that to come to fruition? What if we compare that to making 12 different investments of $1 each that make $2, and each takes two months? Over the two years, the result appears to be the same (invest $12 to make $24), but the faster investments are giving us a return much sooner and the cumulative value is much higher. [I didn’t want to do a lot of math here, but go ahead and check me.]
This specific formulation of Throughput, Investment and Operating Expense comes from Theory of Constraints and Throughput Accounting. I believe “lean accounting” has a similar way of making these calculation. There are many fun examples out there where “traditional” accounting calculations guide businesses to the wrong decision due to the freighting of cost allocations into the decision.
* The term “Throughput” is often thought of a count of items produced, rather than the sales of those items. If you produce it and it never sells, it doesn’t help - it is cash tied up in a warehouse, or lost opportunity to spend that cash in a way to create a sale.