Part 4 of a 5 Part Series on Budgeting and Finance for the Non-Financial Manager
ROI calculations have extensive application in the financial world. If you’ve been involved in capital expenditure (CapX) budgeting, such as large equipment purchases, acquisitions or the development of new products, you’ve probably done ROI calculations before committing to the expense.
These calculations are typically quite extensive, as they involve a concept called the time value of money. In its simplest definition, it means a dollar today is worth more than a dollar collected tomorrow, which is worth a WHOLE LOT more than a dollar collected in ten years. The challenge with future money is that there are risks associated with actually collecting it.
If you’re involved in CapX budgeting, I’m guessing you have financial tools to calculate ROI which take into consideration the time value of money. A pretty comprehensive spreadsheet is offered for a small fee from Engineering Solutions On-line if you’re in need.
Next, let’s look at ROI calculations (also called cost/benefit analysis) for smaller projects that may be included in your Operating Expense budget. The calculations are basically the same; however, the payback period is within the same year, thus the time value of money is not in play.
The top chart illustrates the calculation for outsourcing benefits administration. ROI calculations start by determining the total costs and benefits for the initiative. In this example, the costs would be $900k with $1.2 million in savings. The Net Yearly Benefit is $300k, which equates to $33,333/month in savings to the company. However, it cost the company $100,000 to transition to an outsourced model, thus the ROI is $100,000/$33,333, or three months. This means that the breakeven point (or payback period) is three months. This means the company does not see a financial benefit until month four, because it took three months to recoup the $100k investment.
The second example here details the ROI for offering a presentation skills class to junior sales associates designed to increase their selling abilities. Take a look, and let me know if you have any questions. These charts are easily duplicated (and expanded) in Excel depending on your needs.
ROI calculations are a powerful resource when making decisions between competing projects, and should be used whenever possible.
Tune in next week for the final blog on Budgeting, which will detail fundamental elements of the three key financial statements.