ROI. Finance for fools? “Guidance” for the gullible? It’s hard to say, but it’s chic to pay homage to its numerology. Today I read an article that stated “In Social Media the Return on Investment (ROI) is based largely on the influence you have upon your group of friends.” Clear as mud.
Have salespeople and marketers corrupted a useful financial equation—and made it so generic that it lacks meaning? To find out, I dusted off my lightly-used college textbook, Techniques of Financial Analysis, by Erich Helfert. Here’s his definition, followed by an example:
“ROI = Average annual operating cash flow divided by net investment. = $25,000 divided by $100,000 = 25%.”
Then he wrote, “With no reference to economic life . . . all the measure indicates is that $25,000 happens to be 25 percent of $100,000. Note that the same answer would be obtained if the economic life were 1 year, 10 years, or 100 years. In fact, the return shown would be true in an economic sense only if the investment provided $25,000 per year in perpetuity; only then could we speak of a true return of 25 percent.” (If you sell a B2B solution and are willing to commit to that interpretation, please share your contact information below.)
Ignoring this not-so-trivial caveat, thousands of blogs, Tweets, conversations and sales proposals unabashedly pontificate ROI, a metric that ignores time and risk—two key business decision-making variables. How helpful is that? For insight, I contacted a person who understands the in’s and out’s of investment strategy, accounting professor Robert Kemp at the University of Virginia’s McIntire School of Commerce.
He prefaced his comments by sharing that the overarching objective of an organization is to create value, and that organizations favor transactions in which value received is greater than value given up. That makes sense. And ROI enables decision-makers to uncover the answer?
Not exactly, he explained. “There are three questions about value that decision makers must answer: What do I get, when do I get it, and how certain are the answers to the first two questions?” He said that ROI can answer the first question, but not the second or third. Further complicating the sometimes-assumed precision of ROI is that financial executives don’t regard the variables of cash flow benefits and investments consistently, because both are “subject to SWAG‘s in accrual accounting,” according to Kemp. ROI’s usefulness clearly has limits. Just ask anyone who invested with Bernie Madoff.
More robust calculations such as Net Present Value (NPV), which offsets the present value of cash outflows against the present value of cash inflows, consider time and risk. According to Robert Higgins, author of Analysis for Financial Management, “a crowning achievement of finance has been to transform value creation from a catchy management slogan into a practical decision-making tool that not only indicates which activities create value but also estimates the amount of value created.” With that nifty endorsement, you’d expect business developers around to world to flavor conversations with NPV instead of ROI, but it hasn’t happened.
Whether a business decision involves IT, Marketing, or Operations, Kemp believes that a key question to answer is “what is the value to the total organization if I approve a given initiative, versus what is the value if I do nothing? That requires comparing marginal benefit to marginal cost.” He cautions that decision makers face a dangerous trap by exploring that question without looking into the future.
He illustrated the conundrum using Netflix and once-archrival Blockbuster, which used vastly different value-producing strategies. Thriving Netflix adopted a long-term view of the business value of web-enablement, and invested accordingly. Failed Blockbuster, bloated on their doomed late-fee cash cow, focused on maximizing current period earnings. Happily, Netflix executives didn’t limit their investment analysis to performing a simple ROI calculation. If they did, they’d be sitting at the bar with ex-Blockbuster executives, talking about the good old days when decision makers could be fat, dumb and happy.
ROI hype creates numerical misalignment—with marketers and salespeople on one side, and CFO’s and financial decision makers on the other. Ironically, when salespeople tout time- and risk-agnostic ROI, they reinforce the same dysfunctional short-term, Blockbuster-like thinking they’re often trying to overcome.
But if ROI’s calculus has flaws, why do vendors persist in using it when “proving the business case?” It’s how we’ve been brought up. As marketers and salespeople, we aren’t rewarded for casting doubt on what we sell. We’re certain. We’re confident. We succeed because we create concrete visions. In sales meetings, acknowledging risk and waffling about Time to Value grate like discordant musical notes. Little wonder that we resist embedding those variables in the calculations we offer to decision makers.
Kemp put it this way, “change creates enormous amounts of risk.” But by hyping ROI, we conveniently sidestep that fact. We pretend it just doesn’t exist. But our customers and prospects aren’t stupid. They’ll figure out what increases value—and what threatens it.
In sales, when we lose an opportunity, we sometimes say “the customer didn’t buy the math.” Maybe they don’t buy the equation, either.
Great article and perspective on the hype of ROI. Another important consideration is opportunity cost. In other words, if I invest in A, then I can’t invest in B. And what if B would deliver an even greater ROI than A. Even is A delivers a good ROI, if something else has the potential to deliver an even greater return then A is toast.
Susan: thanks for your comment. Those who sell technology products and services that have short life cycles (is there a technology product that doesn’t?) experience this often.
Prospects have told me “I don’t want to buy right now because in six months your product will be obsolete.” or “If we wait, we can get something better. We just don’t know what that will be.” One thing is certain: someone will “work the numbers.” That doesn’t mean the reasoning behind investment decisions can’t be short-sighted.
While it’s logical to table a decision because the marginal benefits don’t outweigh the marginal costs, it’s borderline paranoid to reject an initiative because “something better might come along.”
If that reasoning were widely followed, the first computer never could have been sold.
Andrew,
This is a good blog post, in the sense that it does provoke thought and reaction. However, I think your criticism of the use of ROI is wrong. We live by ROI models because in a world of no discretionary spend, IT purchasing decisions have got to yield what we call a More for Same (Growth Mode) or Same for Less (Consolidation Mode) outcome. Of course, the devil is in the detail and not all our ROI models are perfect, for sure.
You should look at one of our simple on-page ROI Calculators, which is for a Cloud CRM (e.g. Salesforce CRM) purchasing decision.
See: http://www.xceliant.net/crmroi1.aspx
Firstly, this has two journeys – More for Same and Same for Less. Secondly, this ROI model has time at the centre of its outcome – the Cost of Delay, which is a guiding principle we apply to most situations, where we are designing Interactive Decisioning Tools for a particilar IT value proposition.
When we build ROI Calculators, we always add a good dose of ‘what-if’ tools – e.g. Sliders – that enables the buyer and seller to apply thinking – not dogma – to what is always a less-than-perfect or absolute calculation for investment. ROI Calculators are a way to get a real conversation going between a buyer and seller that supports a solid argument for timely purchasing decisions.
We also use ROI Calculators to support more than a point purchase, which means using Interactive Decisioning Tools to support decisions about strategy and direction for, say an ISV or IT services firm. An example of a P&L decisioning process between a More for Same or Same for Less approach is at:
http://www.xceliant.net/profitandlossroi.aspx
This compares Current State with Scenario A and Scenario B, enabling a choice between Growth Mode and Consolidation Mode.
Frank feedback and comments on all of the above is always welcome.
Ian,
If you believe CRM is software, then maybe you are right. Personally, that doesn’t work for me.
Mike Boysen
Effective CRM
Andrew,
Good article and directly on point. Looking solely at ROI to determine economic value is shortsighted because it provides a limited view of the economic value of any corporate initiative.
Most companies are opportunity rich but resource limited. Thus, economic analysis of the field of opportunity for corporate initiatives is a must. The analysis gives execs the insight they need to select the best initiatives to invest in…those that are forecast to provide the highest value.
True economic analysis is built on 3 planks – Cash flow analysis, Net Present Value, and ROI.
Cash flow gives execs insight into expected out of pocket gains and costs. It tells them whether they can afford to foot the bill for an initiative. It’s a difficult way to compare a field of investments though, and doesn’t take into account risk. That’s where NPV comes into play. It brings all cash flows of all investments back to a single point by applying a risk factor. Then ROI provides the final insight into valuation by providing a percentage return.
One of the biggest arenas right now misunderstanding ROI is the social media world. Too many folks are still confusing metrics with ROI and trying to sell social initiatives based on the benefits (metrics) rather than potential value (cash flow, NPV, ROI). Social media initiatives will move forward at a much more rapid pace when an economic value is placed on them.
But that leads to a soap box so I’ll stop here! 🙂
Kathy Herrmann
Pathlight Solutions
Andrew,
The source of NBC’s current problem is a combination of lousy programming strategy coupled with poor product ideation and design. Valuation is secondary to their problems.
I agree too many business favor short-term results when they should have a better eye on long-term value. And that’s exactly why economic valuation of corporate initiatives is so beneficial.
Valuation starts with a set of reasonable and defendable assumptions to feed into the economic forecast. If you do that well, then the value will fall out of the analysis (or the lack thereof) regardless of the timeframe when a payout is required or expected.
However the result falls out, though, execs can make decisions with their eyes open by looking at cash flow, NPV, and ROI. After all, even if long-term potential value is there, a company still has to pay the short-term bills.
Of course, if a company is going to create lousy products, like NBC has done in the last few years, then they have don’t have anything to build on to generate long-term value.
Hi Ian: thanks for taking the time to post a comment. I think you and Professor Kemp are describing two sides of the same coin when you speak of a “cost of delay.” He describes it as understanding the value to the organization for approving an initiative (or project) versus the value of doing nothing.
I like that the calculator you developed enables the mathematical expression of uncertainty, but your comment has me wondering whether supporting a “solid argument for timely purchasing decisions” is objective insofar as enabling an unbiased decision to refrain from investing. Of course, there is a “cost of delay”–to us as vendors–but we should recognize that a prospect CFO’s financial analysis might yield not a cost, but in fact a value to maintaining the status quo.–depends on how you look at it.
A related article column by Steven Pearlstein, published today in The Washington Post, NBC’s prime-time tragedy: Its business model, describes NBC’s strategic mis-steps in calculating business value. “NBC’s late-night farce is emblematic of just about everything that is wrong with American business these days. It starts with the mind-set that puts short-term profit over long-term value creation . . . Unable to come up with something new and fresh, NBC’s fallback–like so much of American business–was simply to do more of what worked, until it didn’t.”
For those who don’t sell for a living, welcome to the world of how many of our prospects think! The question is, would ROI sell NBC on a better strategy–or something else?
Who would have thought that stodgy old corporate finance would foster such spirited discussion?
Kathy–I agree that shrouding CRM/social media/other IT-de jour in an ROI wrapper isn’t serving decision makers, and it possibly sends otherwise-productive people scurrying down weird pathways in pursuit of a financial return mirage. A related problem is that when technologies are developed, there is a tendency to examine them on the “molecular” level, rather than as technologies embedded in larger systems designed to achieve specific goals and outcomes. As such, Social Media (the noun) does nothing–it’s the systems that combine social media to address specific business challenges that should be the focus of value analytics.
The analysis you recommend is much needed. Misconceptions about what ROI can prove are rampant. But salespeople have the opportunity to differentiate themselves by putting proposals through the same rigor as CFO’s. There’s no excuse for scratching our heads anymore and saying “I don’t know why our proposal wasn’t chosen–the ROI numbers were so good!”
I agree with Susan! Great post, but, as she said, another important consideration is opportunity cost. Thaks. Enjoyable time to read your posts.
From all the comments, I agree with you:
I do believe that the first computer never could have been sold.
…While it’s logical to table a decision because the marginal benefits don’t outweigh the marginal costs, it’s borderline paranoid to reject an initiative because “something better might come along.”…..