|Here is an example of a simple return on investment (ROI) calculation.
ABC Company wants to purchase a new office-automation product with an estimated life cycle of three years. Based on the estimated lifecycle, we will use a three-year time line with four dates: year 0 (start of project), year 1, year 2, and year 3.
The product costs $10,000. The installation fee is $2,000, and the cost of the annual maintenance contract is $500.
The new product will replace leased equipment that costs $2,000 a year, and it will save five hours a week of administrative time.
The total cost per hour (including overhead) for an administrative assistant at ABC Company is $30. At $30 per hour, the new product will save $7,800 per year (5 hrs./week x $30/hr. x 52 weeks/year).
ABC Company plans to purchase and install the new product when the next payment for the leased equipment is due.
The table below shows the cash flow statement for our proposed project (if the project is implemented on July 1, 2006).
Cash Flow Statement (three years)
When the project starts (year 0), $10,500 will flow out of ABC Company. The project will bring in $9,300 during year 1, $9,300 during year 2, and $7,800 during year 3. At the end of year 3, the new product should be replaced. For that reason, year 3 does not include:
- Paying the maintenance fee for year 4
- The savings from not leasing equipment
A project's return on investment (ROI) is its savings (quantified benefits) over a specified period divided by its costs over the same period. Multiple the result by 100 to obtain the ROI percentage.
ROI = (Savings/Costs) x 100
Here is an example of a simple ROI calculation for ABC Company's project.
Immediate (year 0): savings: $2,000; costs: $12,500.
Year 1: savings: $9,800; costs: $500.
Through end of first year: savings: $11,800; costs: $13,000.
To calculate the ROI after one year, divide $11,800 (savings) by $13,000 (costs). The result is 0.91. Multiply by 100. The ROI is 91%. A project that breaks even has an ROI of 100%. There is no return on investment after one year.
Year 2: savings: $9,800; costs: $500.
Through end of second year: savings: $21,600; costs: $13,500.
To calculate the ROI after two years, divide $21,600 by $13,500. Multiple by 100. The result is 160%. The project returns 160% of its investment after two years.
Year 3: savings: $7,800; costs: $0.
Through end of third year: savings: $29,400; costs: $13,500.
The ROI after three years is 218%.
This simple example does not take into account the net present value of the money used to purchase the office-automation product.
The Business Case Primer computes net present value (NPV), internal rate of return (IRR), and payback period for the ABC Company project. The sidebar "More Information about Financial Analysis" links to an excellent article.
The material on this page has been taken from the Business Case Primer.
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