We make business decisions every day. We evaluate whether to replace aging warehouse equipment or delivery vehicles, whether to add personnel to the sales team, or increase spending on marketing. A simple Return on Investment analysis can help us make better decisions.
Do you calculate a return on investment for every financially important business decision in your company? I believe that most beer distributors don’t, and it could be costing them dearly. In business, if you are going to spend money it should be for one reason and one reason alone – to achieve a financial return on investment.
In this article, I will teach you how to conduct a simple return on investment analysis (ROI) so that you can improve the quality of your business decisions, and the outcome on your financial statements.
Return on investment is a performance measure used to evaluate the efficiency of an investment. In other words, if you choose to spend money on something, what kind of financial result do you get for it?
ROI = Return on Investment divided by Cost of Investment
For example, if a $100,000 purchase of a new delivery truck saves $10,000 in total cost of ownership compared to the truck being replaced, you have a 10% ROI. The math works like this: $10,000 return, divided by $100,000 investment = 10%.
The ROI analysis can be applied to most any decision you make in your business: whether to add new employees, change a compensation plan, or purchase new cars, trucks, or equipment. Below is a process you can use to keep the ROI analysis simple and useful.
KISS ROI
An ROI analysis can be as complicated or as simple as you like, but I vote for simple. Below is a simple three-step process that we use in our company:
- Outline the cost and need for the investment
- Present the expected financial return
- Track and measure the results
Outline the cost and need for the investment. Indicate the amount of the expenditure, what it will be used for, and how it will benefit the company. For example, we need to replace two older delivery trucks with new ones. The older vehicles are breaking down frequently, costing us time and money to repair. The total of the two new trucks is $200,000.
Present the expected financial return. This is the meat of the ROI analysis – bringing together the cost of the investment with the expected financial return. Continuing the example above, the cost of the investment is $200,000 and the expected financial return is an annual savings of $15,000 to $20,000. The annual cost savings is based on reductions in maintenance and repair of the vehicles, as well as lost time for drivers during truck break-downs.
The cost savings should be presented on a spreadsheet to support the validity of the numbers. This allows for the numbers to be scrutinized and challenged to determine the likelihood that the savings will be realized.
Track and measure the results. Make a commitment to looking back on the investment and determining if the expected financial return was achieved. In the example above, after the first year did the company achieve a savings of the expected $15,000 to $20,000? If not, what went wrong? What created the variance from the expected result?
Creating these feedback loops will help make managers make better decisions in the future. They will see each step of the process – the request for the investment, the expected return, and the actual return and factors that influenced whether the return was achieved. The repetition of this process teaches managers how to improve on their ability to predict the financial result of their investment decisions.
In my experience, most financial decisions are made based on steps 1 and 2 above. The actual result of the decision – tracking and measuring the return after the investment – happens intermittently. However, this is perhaps the most important step as it demonstrates whether the financial result was achieved.
The real power of the ROI analysis is not just in the mathematical result, but in the process of conducting the analysis. Asking questions, challenging assumptions, looking for alternative solutions are integral components of a well-done ROI analysis.
Teach Them ROI
In the early days of my career, our managers would come to budget meetings with a list of needs but few numbers to justify the requested spends. We would hear a lot of comments like: “we need to add another salesperson,” or “we are wasting a lot of money keeping that old delivery truck running, we need to replace it.” These were seemingly reasonable requests, but there were few numbers to support the request, and certainly no ROI analysis.
One of the first things we did was to teach our employees how to prepare a simple ROI analysis. We showed them the three-step process above: outline the cost and need for the investment, present the expected financial return, and demonstrate how the return will be tracked and measured. Next, we required a simple ROI analysis to justify any requested spends they wanted to make.
The process of creating an ROI analysis improved the quality of our business decisions, and the outcome on our financial statements. It also engaged our employees and helped them feel a greater part of the decision-making process.
An added benefit of this training was that employees would run the ROI analysis and frequently come to the conclusion that an investment didn’t make financial sense. Rather than wasting time and energy debating the spend in a budget meeting, they would simply conclude it was not a spend worth making, and would look for alternative solutions to the problem.
ROI Wrap Up
The power of a good ROI analysis is in asking questions, challenging assumptions, looking for alternatives and doing the financial analysis. Teaching your ownership group, managers and key staff how to conduct a simple ROI analysis will greatly improve the quality of your business decisions and improve results on your financial statements.
Use the 3-step KISS ROI
- Outline the cost and need for the investment
- Present the expected financial return
- Track and measure the results
Teach them well and ask questions: What do you want to spend and why? How will it benefit the company? What is the ROI? Show it in numbers, and in dollars, not in “we need its”. Teach the process, educate your team, and enjoy the improved financial results in your business.