The Process of
Developing an ROI Model
By:
For
an example ROI model, please contact me at 703-486-8497 or send an email to mike@mikeatherton.com.
This
paper was first presented to the Digital Equipment Corporation's User Group (DECUS).
Overview
Many managers, when faced with the task of preparing a Return On Investment
(ROI) analysis, focus on the technical aspects of the exercise. They dust off
old text books and review concepts like Internal Rate of Return, Payback Period,
Net Present Value and Cash Flow analysis. These accounting principles are
certainly critical to preparing an ROI analysis, but there is another step of
equal importance that is often neglected. This step is the process of
determining what a project's functional criteria are as they relate to overall
corporate strategy, objectives of related functions (i.e. Manufacturing,
Marketing, Distribution, Finance, Information Systems).
This paper will discuss both the process of developing an ROI model with a top
down approach based on strategic objectives and technical aspects of ROI
modeling. A sample model, based on criteria often considered when comparing
physical distribution control systems, is included and referred to throughout
the paper.
The specific criteria used in various models will be different depending on the
functional area where investment options are being analyzed. The functional
objectives of investing in robotic welders, opening a plant somewhere in the
southwest, supplying field representatives with notebook computers for remote
order entry, or implementing a distribution control system are without a doubt
different. However, the process of developing project objectives and then
incorporating them into a model that utilizes sound ROI techniques is the same.
ROI Modeling - First Things First
Why do we go to the trouble of doing ROI analysis? It seems they are often
conducted by one level of management to persuade another level of management to
spend money. For this reason ROI analysis is often fundamentally sound - the
methods and formulas are correct - but the underlying elements are flawed. The
most important component of ROI analysis is incorporating the objectives for the
organization initially into the ROI model and ultimately into the project's
management. This is done not through the model itself, but through the process
by which it is developed. By incorporating organizational objectives, the model
becomes an accurate reflection of the expected functional outcomes of the
project and therefore the expected financial outcomes.
It is important to understand the limitations of ROI analysis. Text books
provide elaborate descriptions of the various financial ROI techniques - they
will be summarized later. But what does a model really tell you? In the end ROI
analysis can help you determine:
- whether to make an investment
- which investment option to
take
- expected financial outcomes
These outcomes are only valid
given four conditions:
- the expected functional
benefits are attainable
- the model itself is
technically sound
- the investment costs are
accurate
- the options analyzed are
compatible with corporate and functional trategic plans
Managers often
use ROI analysis like a divining rod. They use it as a nice black and white
decision tool to decide where to dig. Unfortunately they often find water when
they really needed oil. You have to know what it is you're looking for, what it
will do for you, and how it relates to the rest of your organization before you
can assess which of several options will best enable you to get it.
A model can be technically sound. Its assumptions and functional benefits can be
perfectly accurate. The cost, savings, and revenue estimates can be correct.
But, if the motivations for making the investment are not thoroughly understood
and if the means for achieving the functional benefits are not compatible with
the organization's strategic direction, the model is effectively worthless.
Why Are We Doing This?
Strategic issues from the top down must be considered in defining the motivation
for an investment. The starting point for any major project should be to define
the objectives that are to be achieved by the project at the corporate,
divisional, and functional levels. It is amazing how often projects are
undertaken for truly arbitrary reasons - like saving money.
Figure 1 - This chart depicts the top down process of determining ROI model
functional criteria from the corporate strategy through functional objectives
and finally project objectives.
When the project's strategic objectives have not been clearly defined as part of
the project team's task, the project team must do this ground work themselves,
before developing their ROI model. The effort will not be in vane as it
contributes significantly to identifying objectives up front. Early
identification of objectives is truly valuable in that it serves to focus the
project team early on and provides direction for the development and
implementation stages of the project life cycle.
It is important to keep in mind that an ROI model does not answer the question
why. If you do not know why you are initiating an effort in the first place, ROI
analysis will be of no value.
ROI Functional Criteria
Functional benefits are the means by which a project will achieve its intended
objectives. Figure 1 shows how a project's ROI functional criteria are
determined from the top (corporate strategy) down (functional and related
functional objectives to project objectives). For each functional criteria, one
or more quantifiable measures are determined and incorporated in the ROI model.
Some of these measures, especially those that directly reduce costs, are easily
quantifiable. Others, like the nebulous "improved customer service" or
"improved quality" are more difficult to quantify but are often the
most strategic in nature. A difficult criteria like "improved customer
service" may be quantified in terms of measures like improved sales through
better customer loyalty, greater market share, and improved customer retention.
The ROI model provided in Appendix A is for a business application system that
addresses physical distribution. Each item in the Functional Data section
requires an entry for an area related to operations that may be improved by
implementing a distribution control system. Each of the items listed in this
section addresses an opportunity for improvement related to physical
distribution.
Related Functional Objectives
Investments are not made in a vacuum. Managers often focus only on the
relationship of a project's functional benefits as they relate to the customer
and costs. They concentrate on what they are trying to achieve without giving
enough consideration to how the objectives will be achieved and how they relate
to the parts of the organization that may be required to support it. By
examining the status and direction of related functions, a manager can avoid
even considering an investment alternative that is not compatible with the
expertise or direction of a support or related function.
Consider a simple example of the lead administrator who was tasked to select a
new suite of office management software on which the company's administrative
function would standardize. The administrative function was using a word
processor based on the Macintosh PC so the administrator narrowed the choices to
Macintosh based offerings and ultimately selected the one with the functional
benefits that would enable the staff to be most effective given their type of
work. Imagine the shock of the lead administrator when on the day the new
software was delivered, the MIS department announced that after a careful review
that had lasted several months they had decided to standardize the company on
the Intel based PC. A multi-million dollar contract with a PC manufacturer had
been consummated and each person in the company would receive their own PC
within a year.
Parts of an ROI Model
Once we have an understanding of what we are trying to accomplish through the
project and how it fits into overall corporate and functional strategies, we can
begin to assemble the ROI model. The most convenient tool with which to build
the model is the computer spreadsheet. It enables the development of a standard
model that can then be adapted for specific projects and project options. The
spreadsheet also enables quick what-if analysis in which one or more variables
can be changed and their impact on the model seen immediately.
The model provided in appendix A (please call me at (703-486-8497 to get a copy
of this model. Currently it is not available on the World Wide Web) is divided
into the following sections:
Required Data
In this section general information about the business that will be used
throughout the model in various calculations will be entered. Examples include
annual sales, transportation costs, wage rates for specific functions, cost of
capital, estimated inflation rates.
Functional Data
In this section information pertaining to a specific functional benefit is
entered. The information is entered based on either the current situation
(example: Lost Sales Due to Poor Order Fill) or a planned improvement (example:
Inventory Reductions Resulting from Improved Inventory Accuracy).
Summary of Annual Cost Reductions
The Required Data along with the Functional Data is used in formulas in this
section to determine actual annual savings. Each line of this section
corresponds to the same letter in the Functional Data Section.
Analysis of Cash Flows and Returns on Investment
This section takes the system costs, income (savings), depreciation, taxes and
determines a net and cumulative cash flow. The net cash flow line is used to
determine the internal rate of return and the cumulative cash flow line is used
to determine the payback period.
The Functional Data section provides the biggest challenge in the formulation of
any model. This is the heart of the model because it requires the modeler to
specify the objectives of the project in a quantifiable manner. If you do not
have a handle on why you are considering making an investment and how it will
fit into to your overall strategic mix, you will find it exceedingly difficult
to develop a meaningful Functional Data section.
ROI Techniques
There are several common approaches to the financial aspects of Return on
Investment analysis. Several of the the more common techniques are described
below.
Internal Rate of Return (IRR)
The internal rate of return is the interest rate that equates the present value
of an income stream (the Net Cash Flow line for years 1 through 5 in the example
model) with the cost of the investment (the Net Cash Flow line for year 0 in the
example model). There is no specific formula that can be used to calculate the
IRR. It must be found by interpolation. However, most spreadsheets provide an
IRR function and will do it for you.
The advantage to IRR analysis is that it enables the comparison of rates of
return on alternative investment options. Given two investment alternatives and
assuming that both fit the strategic objectives of the organization, the
investment with the higher internal rate of return should be selected.
Conceptually it is the easiest method to understand.
Net Present Value (NPV)
The net present value returns a nominal amount. It is the amount in today's
dollars (present value) by which the projected income (the Net Cash Flow line
for years 1 through 5 in the example model) of an investment exceeds its cost
(the Net Cash Flow line for year 0 in the example model). The calculation is
based on the cost of capital which in the model is entered in the Required Data
section.
Given two investment alternatives and assuming that both fit the strategic
objectives of the organization, the investment with the higher net present value
should be selected. Again, most spreadsheets provide a Net Present Value (NPV)
function to make this calculation.
Payback Period
The payback period is the amount of time it takes for the cumulative cash flows
to equal the initial investment. The example model provides an approximation of
the payback period on the Cumulative Cash Flow line. The investment will have
paid for itself in the year where the cumulative cash flow is positive. Within
the payback year a larger number indicates the the payback occurs towards the
beginning of the year.
Other Considerations
The savings (income) produced by an investment is only a part of the actual
economic impact. The actual cash flow must also be adjusted for depreciation,
taxes, and business growth. These topics are discussed in the following
paragraphs.
Taxes
Because we pay taxes on our earnings, the savings derived from an investment is
equivalent to income on which we have to pay taxes. It is important to reduce
the expected cash flows with the correct real tax rate for that firm. If a firm
has been consistently profitable, it is likely it will have a standard corporate
tax rate. This rate is typically between 30 and 45 percent and is entered in the
in Required Data Section of the example model. If, however, the firm has
recently had a large loss or write downs due to an extraordinary item, the firm
may have a tax loss carry forward. In this case its actual tax rate may be
significantly lower than the norm.
Depreciation
Depreciation is a non-cash expense item. Therefore, cash flows in the model need
to reflect this. If our investment includes acquisition of depreciable items
such as machines, computer equipment, software, patents, trademarks, plant
expansion, or other similar items, we must configure our model to account for
them. The initial capital expense of the items will represent the cash outflow.
However, we do not write checks for depreciation even though we account for it
as an expense on the income statement. For this reason we should add back into
the cash flow stream the amount of depreciation for depreciable items acquire as
part of the investment. The example model uses the accelerated method called sum
of the years digits (SYD).
Growth Rates and Inflation
It is important to incorporate expected growth rates into an ROI model. As an
example, if you expect to save on labor costs, and you expect labor costs to
grow as a function of inflation over the period of cash flow analysis covered by
your model, the savings attributed to the investment should be adjusted
accordingly.
Likewise, if you expect to save a specific amount per transaction as a result of
an investment, and you expect the number of transactions to grow as a function
of normal business growth, you should increase savings accordingly over the
model's time horizon.
Conclusion
Return on Investment Analysis is a numerical technique for predicting the
expected financial outcomes of an investment. A model may be developed which
enables the comparison of several options based on the same criteria. The
process of developing the model is perhaps more important than the actual model
which is generally a combination of various standard formulae employed to
analyze anticipated costs and savings over time.
The process has the following steps:
- Review the overall corporate
strategy
- Review specific functional
strategy and objectives in the area where the investment is to be made.
- Review objectives and
directions of functions related to the area where the investment is to be
made.
- Identify project goals based
on strategy and objective reviews
- Develop one or more
quantifiable measure for each project goal.
- Incorporate quantifiable
measures into an ROI model
It is the up
front work related to strategy, objectives, and relationships to other business
functions that will enable you to make the investment decision based on more
than just the internal rate of return, net present value, or payback period. The
process of developing the ROI model will help to ensure that the functional
benefits you attain through the investment and project implementation are
consistent with the direction of your firm.
Appendix A
An example of an ROI model (This model is not yet available on the World
Wide Web. If you would like a copy please call me at (703) 486-8497
The following are the descriptions of each of the Summary of Annual Cost
Reductions section line items. They are examples of objectives associated with
the implementation of a distribution control system. The heart of any ROI model
is its objectives.
When a functional improvement is being accomplished through technology, it is
equally important to ensure that the approach taken is consistent with other
supporting functions. In the example of a business application, the
functionality is how the investment will achieve the paybacks. However, a
platform or language that is not familiar to the information systems staff or is
not consistent with their strategic direction may add additional support costs
and internal resistance.
A) Profit Gains
In a distribution environment sales are adversely impacted by problems such as
shipping the wrong product, shipping the product late, and invoice errors. Often
an objective for implementing a distribution control system is the reduction and
elimination of problems that result in lost sales and therefore profits due to
poor order fulfillment. The system provides a competitive advantage that can
reduce lost sales and in many cases increase sales through customer loyalty and
a larger share of a customer's business. Customers want to do business with
reliable suppliers.
Objective:
reduce lost sales by .5% to 5% (typical range) of total sales.
B) Floor Line-Offs/Backorders
Floor line-offs occur when stock cannot be found or is not shippable because its
inventory status is not known. Additional order administrative costs are
incurred when an order cannot be shipped complete.
Objective:
reduce number of orders with line-offs due to inventory accuracy problems
thereby reducing unnecessary additional administrative ordering processing
costs..
C) Normal Transportation Costs
When product must be shipped separately due to a line-off additional
transportation costs are incurred.
Objective:
reduce the number of line-offs due to inventory inaccuracy and thereby reduce
unnecessary transportation costs.
D) Air Freight Costs
Often line-offs and short shipments due to inventory inaccuracies at the
location level result in emergency shipments via air freight.
Objective:
reduce the number of emergency shipments and their related costs due to
inventory inaccuracies.
E) Accounts Receivable
Days outstanding on accounts receivable can be reduced by reducing the number of
disputed invoices related to order fulfillment inaccuracies.
Objective:
improve customer service in the area of order fulfillment accuracy thereby
reducing the number of disputed invoices and the amount of capital tied up in
accounts receivables.
F) Trailer Loading
Various functions of distribution control systems such as cross docking, system
controlled dock floor areas, and reverse sequenced order staging reduce the
amount of time it takes to load a trailer
Objective:
reduce the labor costs associated with loading trailers.
G) Overtime Hours
Overtime in a distribution environment is often caused by manual problems
related to receiving, putaway, replenishment, picking, packing, and shipping.
Directing these functions through the discipline associated with a distribution
control system reduces overtime requirements
Objective:
reduce overtime hours by streamlining operations through system directed
disciplines.
H) Searching
Distribution environments that do not employ system controlled directed putaway
and picking inherently have some degree of searching for product at location.
Objective:
reduce the level of searching and optimize location travel sequence through
system directed putaway and picking.
I) Annual Physical Inventory
Distribution control systems enable cycle counting for verifying accuracy and
identifying procedural problems. As a result the annual full physical and
related costs can be eliminated.
Objective:
Eliminate the full physical inventory count and related costs.
J) Shipping Errors
Shipping errors such as wrong quantity or product shipped effect customer
service levels and also have associated with them additional transaction
processing costs.
Objective:
improve shipping accuracy thereby reducing administrative processing costs
associated with order corrections.
K) Inventory
The implementation of a distribution control system and the resulting
improvements in inventory accuracy enables the reduction of inventory levels
with improved customer service levels. Reduces inventory levels translate into
lower levels of capital invested in inventory.
Objective:
improve inventory accuracy in order to reduce inventory levels and therefore the
amount of capital invested.
L) Safety Stock
Safety stock is used to hide inventory inaccuracies and support unexpected
surges in demand. Distribution control systems enable firms to achieve very high
inventory accuracy levels and, through cross docking respond quickly to
receipts, passing them through the facility from receiving dock to shipping
dock.
Objective:
Reduce or eliminate safety stock levels and the investment in them through
improvements in inventory accuracy and the ability to quickly receive material
and direct it immediately to the shipping dock.
Other
Other objectives not included in this model might include:
- Reduce costs of maintaining a
legacy system or outdated equipment
- Eliminate penalty costs of not
being in compliance with a legal, industry or key customer requirement.
Common examples here include hazardous material reporting requirements and
Advance Shipment
- Notification (ASN) labeling
and EDI requirements.
- Delay a capital expense for
expanding a facility by improving cube utilization and throughput of
existing facility.
- Reduce inventory writeoffs.
Lower inventory levels translate into lower writeoffs due to obsolescence.
This is especially important in an environment where the product life-cycle
is very short.
Appendix B
Strategic Modeling
John Martin of IBM recently published an article in the December 1993 issue of
APICS - The Performance Advantage titled "Use Strategic Modeling to
Evaluate Warehouse Automation." This article describes financial modeling
at a strategic level. That is, the evaluations of various options (in this case
the examples are warehouse automation solutions) take into account the firms's
overall financial position. Outcomes of various options are analyzed based on
their impact on the balance sheet and income statement and related ratios.
The premise of "The Process of Developing a Model for ROI Analysis" is
that strategic objectives must be incorporated into ROI models as they relate to
desired functional outcomes of investment options. The model will then be valid
and be a useful tool for comparing investment options. John Martins article
provides additional insight into how investment options can be analyzed for
their overall impact on an organization's financial performance.
The distinction between the two is that the first incorporates strategic
objectives into a model used for tactical analysis. The latter provides tools
for analyzing tactical outcomes on strategic performance.
Suggested Readings
Blomquist, J.A. and T.W. Speh, "The Financial Evaluation of Warehousing
Options: An Examination and Appraisal of Contemporary Practices," Miami
University, Oxford Ohio: The Warehousing Research Center and Affiliate of the
Warehousing Education Research Council, May 1988.
Burr-Brown Corporation, Economic Justification Workbook, (Tucson: 1991).
Chase, R.B. and Aquilano, N.J., Production and Operations Management, A Life
Cycle Approach, (Homewood, Illinois: Richard D. Irwin, Inc., 1981), pp. 117-124.
Dadzie, K.Q., and Johnston, W. J., "Innovative Automation Technology in
Corporate Warehousing Logistics," Journal of Business Logistics, Volume 12,
Number 1, 1991, pp. 63-82.
Martin, John, E. "Use Strategic Modeling to Evaluate Warehouse
Automation," APICS - The Performance Advantage, December, 1993, pp. 19-22.
Mentzer, J.T. and B.P. Konrad, "An Efficiency/Effectiveness Approach to
Logistics Performance Analysis," Journal of Business Logistics, Volume 12,
Number 1, 1991.
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