Projects should add financial value to an organisation. This Project Return on Investment blog is part of a set of four blogs looking at the financial methods of assessing projects
I wrote about project selection in an earlier blog, however that blog over-viewed both financial and non-financial methods for project selection. This blog will look at the advantages and problems with these financial methods.
Project Return on Investment Methods
There are many different names and a variety of calculation methods for this, however all basically calculate a ratio of the profit to the investment outlay:
- Return on Capital Employed
- Accounting Rate of Return
- Return on Investment
- Return on Initial Investment
This blog will describe the Accounting Rate of Return (ROI) method.
Project Return on Investment
The Return on Investment (ROI) is calculated as the average annual profit as a percentage of the initial investment.
Note that to calculate the ROI we need the total profit, and the number of years to calculate the average annual profit.
Project Return on Investment Example
The following example describes a project which costs £300,000 and generates £90,000 profit over 3 years.
The average annual profit will be £30,000.
This gives a Return on Investment of 10%.
Using the Return on Investment Method
The ROI method is widely used in projects. The method can be used to compare two projects of similar value to discover which project has the larger ROI. If the ROI is very small, then it may be better leaving the money in the bank, which should be 100% safe. Risky projects will need a large ROI to justify the high risks involved. An organisation may set a target for ROI that must be achieved for all projects.
Problems Using the Project Return on Investment Method
The ROI method has some disadvantages:
- When comparing two projects, account must be taken of the relative risks for each project
- All future incomes and savings are estimated – and may be wrong!
- The value of money in the future is less due to inflation, and investment opportunities
- The method uses the average annual profit, where cash-flow may be more important, the following example describes this:
In the case of both Project A and Project B, the total profit is £90,000, and the average annual profit is £30,000. However, Project A delivers cash much earlier in the project life, and is probably a better choice. This is not discovered by an ROI calculation.
As with all projects, there are other factors that should be considered when making a judgement.
All of these project finance techniques are shown in this video playlist:
Project Return on Investment has many different names and calculation methods. It can be easily understood by management as it provides a single figure for judgment and comparison, however it has some flaws that should be considered.