Return on investment (ROI) is "the most important measure of a firm's financial position," according to the SBA, because it reveals overall profitability. Though it's easy to calculate-divide net profit by total assets-it's also easy for entrepreneurs to misinterpret, misuse and be misled by ROI, especially when using it to justify investing in a new product or other business activity.
"You can make up any fantasy you want with an ROI analysis," says Sandra Winters, a partner with The International Business Strategy Group, a Seattle-based technology consulting firm that does ROI analyses to help clients make technology purchase decisions. Entrepreneurs doing ROIs are prone to fudging variables to make the ROI come out the way they want it to.
For a company deciding whether to invest in new product development, the ROI calculation may involve a few hundred line items, including the time to bring a product to market, the selling price and so on. If you plug in best guesses on these variables and ROI comes out too low, it's easy to go back and change one or more until the ROI reaches or exceeds the rate at which the investment fits the business plan. But it's critical to use the most accurate estimates, rather than the ones that give you the number you want.
You may also go astray by leaving out important variables and even by performing ROIs at all. "You need certain things to be competitive, so you can't do an ROI for them," says Winters. Such investments may include a website, which many firms consider a basic requirement, and investments with hard-to-quantify returns, such as customer service training programs.
To keep ROIs honest, get help from outside the company or from a team of insiders. Ideally, the person doing the ROI won't be affected by the decision to invest but is close enough to the situation to understand the background. "You want someone who can provide unbiased information and go beyond the numbers," says David Harper, owner of Savannah, Georgia, management consulting firm The Advisory Alliance LLC.
Instead of tinkering with inputs until you get the desired output, you can also assign weights to inputs, based on the probability of things turning out that way. You might figure ROI based on two months for product development as well as four months and six months. But if you use weighted variables, Harper warns against accepting the resulting average as justification for an investment. You should also consider how you'll fare if the most pessimistic scenario comes to pass. No matter how large the potential reward or how appealing the chances are, you may want to pass on an investment that could bankrupt your company if it fails.
Entrepreneurs can use specialized tools to generate realistic ROI figures. Using Excel is risky because you can make a spreadsheet generate any number you want, says Kel Hoffmann, president and CEO of Whitebirch Software, a Salem, Massachusetts, firm that produces financial analysis software. Specialized software can be pricey-Whitebirch's Projected Financials software costs $1,500 per single-user license-but may prevent costlier mistakes.
ROI may seem intimidating and risky, but it's important to try figuring it out. "At least you're looking at what can happen," Hoffmann says.
Finally, keep in mind President Dwight D. Eisenhower's advice: "Plans are worthless. Planning is everything." No matter what the ROI is, performing the analysis will alert you to the most sensitive variables. Use that information to make the investment perform better.
Mark Henricks writes on business and technology for leading publications and is author of Not Just a Living.