The Process of
Developing an ROI Model
Michael D. Atherton
an example ROI model, please contact me at 703-486-8497 or send an
email to Mike Atherton.
paper was first presented to the Digital Equipment Corporation's User
Many managers, when faced with the task of preparing a Return On
(ROI) analysis, focus on the technical aspects of the exercise. They
old text books and review concepts like Internal Rate of Return,
Net Present Value and Cash Flow analysis. These accounting principles
certainly critical to preparing an ROI analysis, but there is another
equal importance that is often neglected. This step is the process of
determining what a project's functional criteria are as they relate to
corporate strategy, objectives of related functions (i.e.
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
modeling. A sample model, based on criteria often considered when
physical distribution control systems, is included and referred to
The specific criteria used in various models will be different
depending on the
functional area where investment options are being analyzed. The
objectives of investing in robotic welders, opening a plant somewhere
southwest, supplying field representatives with notebook computers for
order entry, or implementing a distribution control system are without
different. However, the process of developing project objectives and
incorporating them into a model that utilizes sound ROI techniques is
ROI Modeling - First Things First
Why do we go to the trouble of doing ROI analysis? It seems they are
conducted by one level of management to persuade another level of
spend money. For this reason ROI analysis is often fundamentally sound
methods and formulas are correct - but the underlying elements are
most important component of ROI analysis is incorporating the
objectives for the
organization initially into the ROI model and ultimately into the
management. This is done not through the model itself, but through the
by which it is developed. By incorporating organizational objectives,
becomes an accurate reflection of the expected functional outcomes of
project and therefore the expected financial outcomes.
It is important to understand the limitations of ROI analysis. Text
provide elaborate descriptions of the various financial ROI techniques
will be summarized later. But what does a model really tell you? In the
analysis can help you determine:
- whether to make an
- which investment
option to take
- expected financial
These outcomes are
given four conditions:
- the expected
functional benefits are attainable
- the model itself is
- the investment costs
- the options analyzed
are compatible with corporate and functional trategic plans
use ROI analysis like a divining rod. They use it as a nice black and
decision tool to decide where to dig. Unfortunately they often find
they really needed oil. You have to know what it is you're looking for,
will do for you, and how it relates to the rest of your organization
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
But, if the motivations for making the investment are not thoroughly
and if the means for achieving the functional benefits are not
the organization's strategic direction, the model is effectively
Why Are We Doing This?
from the top down must be considered in defining the motivation
for an investment. The starting point for any major project should be
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
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
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
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
analysis will be of no value.
ROI Functional Criteria
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
functional objectives to project objectives). For each functional
or more quantifiable measures are determined and incorporated in the
Some of these measures, especially those that directly reduce costs,
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
better customer loyalty, greater market share, and improved customer
The ROI model
provided in Appendix A is for a business application system that
addresses physical distribution. Each item in the Functional Data
requires an entry for an area related to operations that may be
implementing a distribution control system. Each of the items listed in
section addresses an opportunity for improvement related to physical
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
and costs. They concentrate on what they are trying to achieve without
enough consideration to how the objectives will be achieved and how
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
even considering an investment alternative that is not compatible with
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
function would standardize. The administrative function was using a
processor based on the Macintosh PC so the administrator narrowed the
Macintosh based offerings and ultimately selected the one with the
benefits that would enable the staff to be most effective given their
work. Imagine the shock of the lead administrator when on the day the
software was delivered, the MIS department announced that after a
that had lasted several months they had decided to standardize the
the Intel based PC. A multi-million dollar contract with a PC
been consummated and each person in the company would receive their own
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
the model is the computer spreadsheet. It enables the development of a
model that can then be adapted for specific projects and project
spreadsheet also enables quick what-if analysis in which one or more
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
into the following sections:
In this section
general information about the business that will be used
throughout the model in various calculations will be entered. Examples
annual sales, transportation costs, wage rates for specific functions,
capital, estimated inflation rates.
In this section
information pertaining to a specific functional benefit is
entered. The information is entered based on either the current
(example: Lost Sales Due to Poor Order Fill) or a planned improvement
Inventory Reductions Resulting from Improved Inventory Accuracy).
Summary of Annual Cost
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
determine the internal rate of return and the cumulative cash flow line
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
specify the objectives of the project in a quantifiable manner. If you
have a handle on why you are considering making an investment and how
fit into to your overall strategic mix, you will find it exceedingly
to develop a meaningful Functional Data section.
There are several
common approaches to the financial aspects of Return on
Investment analysis. Several of the the more common techniques are
Internal Rate of
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
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
IRR. It must be found by interpolation. However, most spreadsheets
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
assuming that both fit the strategic objectives of the organization,
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
for years 1 through 5 in the example model) of an investment exceeds
(the Net Cash Flow line for year 0 in the example model). The
based on the cost of capital which in the model is entered in the
investment alternatives and assuming that both fit the strategic
objectives of the organization, the investment with the higher net
should be selected. Again, most spreadsheets provide a Net Present
function to make this calculation.
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
the payback period on the Cumulative Cash Flow line. The investment
paid for itself in the year where the cumulative cash flow is positive.
the payback year a larger number indicates the the payback occurs
beginning of the year.
(income) produced by an investment is only a part of the actual
economic impact. The actual cash flow must also be adjusted for
taxes, and business growth. These topics are discussed in the following
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
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
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
recently had a large loss or write downs due to an extraordinary item,
may have a tax loss carry forward. In this case its actual tax rate may
significantly lower than the norm.
Depreciation is a
non-cash expense item. Therefore, cash flows in the model need
to reflect this. If our investment includes acquisition of depreciable
such as machines, computer equipment, software, patents, trademarks,
expansion, or other similar items, we must configure our model to
them. The initial capital expense of the items will represent the cash
However, we do not write checks for depreciation even though we account
as an expense on the income statement. For this reason we should add
the cash flow stream the amount of depreciation for depreciable items
part of the investment. The example model uses the accelerated method
of the years digits (SYD).
Growth Rates and
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
grow as a function of inflation over the period of cash flow analysis
your model, the savings attributed to the investment should be adjusted
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
of normal business growth, you should increase savings accordingly over
model's time horizon.
Investment Analysis is a numerical technique for predicting the
expected financial outcomes of an investment. A model may be developed
enables the comparison of several options based on the same criteria.
process of developing the model is perhaps more important than the
which is generally a combination of various standard formulae employed
analyze anticipated costs and savings over time.
The process has the
- Review the overall
- 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.
quantifiable measures into an ROI model
It is the up
front work related to strategy, objectives, and relationships to other
functions that will enable you to make the investment decision based on
than just the internal rate of return, net present value, or payback
process of developing the ROI model will help to ensure that the
benefits you attain through the investment and project implementation
consistent with the direction of your firm.
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
the implementation of a distribution control system. The heart of any
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
supporting functions. In the example of a business application, the
functionality is how the investment will achieve the paybacks. However,
platform or language that is not familiar to the information systems
staff or is
not consistent with their strategic direction may add additional
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
an objective for implementing a distribution control system is the
elimination of problems that result in lost sales and therefore profits
poor order fulfillment. The system provides a competitive advantage
reduce lost sales and in many cases increase sales through customer
a larger share of a customer's business. Customers want to do business
reduce lost sales
by .5% to 5% (typical range) of total sales.
occur when stock cannot be found or is not shippable because its
inventory status is not known. Additional order administrative costs
incurred when an order cannot be shipped complete.
reduce number of
orders with line-offs due to inventory accuracy problems
thereby reducing unnecessary additional administrative ordering
When product must
be shipped separately due to a line-off additional
transportation costs are incurred.
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.
reduce the number
of emergency shipments and their related costs due to
E) Accounts Receivable
Days outstanding on
accounts receivable can be reduced by reducing the number of
disputed invoices related to order fulfillment inaccuracies.
service in the area of order fulfillment accuracy thereby
reducing the number of disputed invoices and the amount of capital tied
F) Trailer Loading
of distribution control systems such as cross docking, system
controlled dock floor areas, and reverse sequenced order staging reduce
amount of time it takes to load a trailer
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
Directing these functions through the discipline associated with a
control system reduces overtime requirements
hours by streamlining operations through system directed
environments that do not employ system controlled directed putaway
and picking inherently have some degree of searching for product at
reduce the level of
searching and optimize location travel sequence through
system directed putaway and picking.
I) Annual Physical
control systems enable cycle counting for verifying accuracy and
identifying procedural problems. As a result the annual full physical
related costs can be eliminated.
Eliminate the full
physical inventory count and related costs.
J) Shipping Errors
such as wrong quantity or product shipped effect customer
service levels and also have associated with them additional
accuracy thereby reducing administrative processing costs
associated with order corrections.
of a distribution control system and the resulting
improvements in inventory accuracy enables the reduction of inventory
with improved customer service levels. Reduces inventory levels
lower levels of capital invested in 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
inventory accuracy levels and, through cross docking respond quickly to
receipts, passing them through the facility from receiving dock to
Reduce or eliminate
safety stock levels and the investment in them through
improvements in inventory accuracy and the ability to quickly receive
and direct it immediately to the shipping dock.
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.
John Martin of IBM recently published an article in the December 1993
APICS - The Performance Advantage titled "Use Strategic Modeling to
Evaluate Warehouse Automation." This article describes financial
at a strategic level. That is, the evaluations of various options (in
the examples are warehouse automation solutions) take into account the
overall financial position. Outcomes of various options are analyzed
their impact on the balance sheet and income statement and related
The premise of "The Process of Developing a Model for ROI Analysis" is
that strategic objectives must be incorporated into ROI models as they
desired functional outcomes of investment options. The model will then
and be a useful tool for comparing investment options. John Martins
provides additional insight into how investment options can be analyzed
their overall impact on an organization's financial performance.
The distinction between the two is that the first incorporates
objectives into a model used for tactical analysis. The latter provides
for analyzing tactical outcomes on strategic performance.
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
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
Cycle Approach, (Homewood, Illinois: Richard D. Irwin, Inc., 1981), pp.
Dadzie, K.Q., and Johnston, W. J., "Innovative Automation Technology in
Corporate Warehousing Logistics," Journal of Business Logistics, Volume
Number 1, 1991, pp. 63-82.
Martin, John, E. "Use Strategic Modeling to Evaluate Warehouse
Automation," APICS - The Performance Advantage, December, 1993, pp.
Mentzer, J.T. and B.P. Konrad, "An Efficiency/Effectiveness Approach to
Logistics Performance Analysis," Journal of Business Logistics, Volume
Number 1, 1991.