The determination of the ROI allows managers to include
quantitative, readily interpretable results in their decision-making. While the formulation of an ROI associated
with investing money in a financial instrument is straightforward, the
calculation of an ROI associated with the generation of an increase in the customer
base, cost savings, or a future cost avoidance is less straightforward.
ROI is a common performance measure used to evaluate the efficiency of an investment or to compare the efficiency of a number of different investments. To calculate ROI, the benefit or gain associated with an investment is divided by the cost of the investment and the result is expressed as a percentage or a ratio:
An ROI of 0 represents a break-even situation--that is, the value you get back exactly equals the value you invested. If the ROI is > 0, then there is a gain; if the ROI is < 0, there is a loss. Equation (1) is relative to the no-investment case (e.g., burying the cash in the ground).
Cost Avoidance ROI
Cost avoidance is a reduction in costs that have to be paid in the future. Cost avoidance is commonly used as a metric by organizations that have to support and maintain systems to quantify the value of the services that they provide and the actions that they take. See my May 31, 2017 Blog post for more about cost avoidance.
Cost avoidance is a reduction in costs that have to be paid in the future. Cost avoidance is commonly used as a metric by organizations that have to support and maintain systems to quantify the value of the services that they provide and the actions that they take. See my May 31, 2017 Blog post for more about cost avoidance.
Cost avoidance ROIs are a bit more difficult to calculate than the financial ROIs. As an illustration, consider the determination of an ROI for the addition of some sort of improvement to a system. This improvement will result in a future cost avoidance (maybe it reduces the future maintenance costs). Is the investment in the improvement worth it?
To formulate the ROI for adding this improvement to a system, we first have to decide what we are measuring the ROI relative to. For our example, we could measure the ROI relative to maintaining the system without the improvement. The ROI from Equation (1) becomes, [1]:
where
Cwo = the life-cycle cost of
the system managed without the improvement
Cw = the life-cycle cost of the system managed with the improvement
Iw = the investment in the improvement
If Cwo is larger than Cw then there is a positive ROI. The nice thing about Equation (2) is that the numerator is the difference of life-cycle costs, i.e., one only has to be able to determine the difference between the two cases (the actual values of Cwo and Cw, which are much harder to determine, are not needed) – see my November 2016 blog post on absolute vs. relative costs. Note that Cw is a life-cycle cost that therefore includes Iw within it.
Another challenge with this ROI calculation is determining the investment cost (the denominator of Equation (2)). For cost avoidance cases it is not always clear what costs are the investment and what costs are the result of an investment. For example, if my improvement converts corrective maintenance actions (due to system failures) to preventative maintenance actions (taken before failure), the improvement could result in more (but less expensive) maintenance actions and the need for more spare parts. Is the cost of the extra spare parts accounted for in the investment (Iw)? The extra spare part cost in this case would not be included in the investment cost because the extra spare parts are the result of the improvement (i.e., the result of the investment) and are reflected in the life-cycle cost Cw.
General Comments about Calculating ROIs
- Constructing a business case for an activity does not necessarily require that the ROI be greater than zero; in many cases, value is not fully quantifiable in monetary terms, or the activity is necessary in order to meet a system requirement that could not otherwise be attained, such as satisfying a system availability requirement.
- The calculation of ROI can be modified to suit the situation depending on what you include as returns and investments. This means that ROIs are easy to calculate but can be deceivingly difficult to get right. Financial investment ROIs are straightforward, but when evaluating the ROI of a cost savings, market share increase, or cost avoidance, the difference between costs that are investments and those that are returns is blurred.
- ROIs have to be relative to some clearly defined situation. Most often ROI for cost avoidance is measured relative to “business as usual”, i.e., the management of the system if no investment was made.
- ROI is not independent of the cost of money (discount rate). The discount rate will impact the life-cycle costs in Equation (2).
- ROI can fool you, be careful. The largest ROI solution may not represent the best option for an organization – see my February 6, 2020 Blog post.
[1] Feldman, K., Jazouli, T. and Sandborn, P. (2009). A methodology
for determining the return on investment associated with prognostics and health
management, IEEE Transactions on Reliability, 58(2), pp. 305-316.
