Roi

Introduction: What is the ROI of a Toaster?

If I spend $29.95 on a toaster, what is my return on investment (ROI)? Most of us, of course, don’t analyze the ROI before we buy a toaster, but I suppose we could. More likely we simply do a little comparison shopping. We assume a toaster is a worthwhile thing to own; we just want to know we are getting value for our money.

Increasingly, however, buyers of all sorts of things, especially business buyers, are running an informal if not formal ROI analysis before making purchases. For some things–necessities–the ROI is assumed, but how many times has a prospective customer insisted on analyzing the ROI before buying your product or service?

Today managers are demanding that every purchase be justified in terms of ROI. And with the economy slowing, recession looming, and belt-tightening the order of the day, the ROI analysis becomes a central factor in just about every sale. Although there are some purchases that simply must be made regardless of the ROI, such as a base level of insurance or phone service, what manager today would make any significant purchase of hardware, software, equipment, tools, machinery, or even services without some sort of ROI analysis. It doesn’t have to be a formal ROI analysis, but the buyer needs to understand the value to be received from the expenditure.

This paper looks at the growing clamor for ROI analysis and examines the role it plays in communicating value. It will identify the critical pieces of an ROI and business payback analysis and explain how you can develop an ROI guide that effectively communicates value. In the process, it will provide you with model calculations that you are welcome to use in preparing your own ROI guide. Although an ROI guide can be developed for almost any purchase, the paper focuses primarily on business-to-business products and services.

And now the disclaimer: Although based on actual analyses, the models, calculations, and examples presented here have been simplified and generalized for use in this paper. Your accountant probably wouldn’t approve.

Not Your Accountant’s ROI

A formal ROI is really an accountant’s tool, something financial managers use to measure value. It goes beyond straight payback to examine the value received in relation to investment over time. As such it is only one of many measurements. Others include return on equity (ROE), economic value add (EVA), return on capital (ROC), and more. Each allows you to quantify and understand value in different way.

A solid ROI analysis represents a substantial undertaking, requiring weeks of work by accountants, consultants, and quantitative analysts. The cost of a formal ROI analysis can easily run into six figures.

But most managers aren’t accountants, and they aren’t really interested in ROI or ROE or any other accounting metric, except maybe profit and loss. All they really want is to identify and quantify the business value gained from an expenditure. Today, this desire to understand business value is couched in the lingo of ROI, but it not quite your accountant’s ROI. It is more like straight payback.

In the world of formal ROI, every dollar starts out equally. If I spend a dollar, I want to receive the most value I can from it. And, if I cannot get a return of at least 2-3% compounded over time, then I may as well leave that dollar in a financial instrument like a bank certificate of deposit where I will be guaranteed at least that much, sometimes more.

Similarly, when you ask prospects to spend money for your product or service, the prospects will try to determine what value they are getting in return and compare it to the value they would receive by spending or investing that money elsewhere. In short, they want a straight payback analysis. This would not seem difficult, but in practice even the process of a straight payback analysis can quickly get quite complicated.

If, for example, I spend $50,000 on CAD software, my product design team might become 20% more efficient. But if the same $50,000 invested in a new forklift for the warehouse would increase the efficiency of my warehouse operation by 40%, the decision gets more complicated. Now I have to think about how likely I am to actually achieve those gains and how fast. And worse yet, I will need to measure and weigh the relative contributions of the design team and the warehouse team as well as gauge which of the possible returns are more realistic before I can determine which delivers the best payback. This can get quite convoluted, and the corporate politics involved can be ferocious. Creating a formal ROI under these circumstances can cost hundreds of thousands of dollars and keep a small army of consultants and quantitative analysts busy for weeks and you still have to deal with the politics involved.

Fortunately, most business managers don’t actually want or need a formal ROI analysis although they may ask for one. They usually don’t have the time, budget, energy, skills, or data necessary to produce a thorough, formal ROI analysis. What they really want is a reasonably accurate sense of value received, of whether the 20% productivity gain achieved by the design team is realistic and what impact it might have on the budget or even profit and loss. Often the effort is couched in the language and style of a formal ROI, but the real goal is to communicate relative business value–payback–at some level.

For a marketer, therefore, the objective is not be play accountant but to guide the prospect through the process of identifying and understanding the value received in a quantifiable way and translating it into the bottom line business benefits. The ROI guide becomes the mechanism for doing this.

Developing the ROI Guide

Marketers expend considerable effort explaining what their product or service is and how it works. They are effective at elaborating on the features and the things that differentiate the product from the competition. They are even pretty good at communicating the business benefits in a general way. While all this is helpful, it does not provide much insight into ROI or business value.

To help prospective customers understand the business value generated by your product, you need to do four things:

  1. Understand the customer’s process and the form any payback will take–show where in the customer’s business process the product fits and how it will deliver payback and the form that value will take.
  2. Identify specific areas where the customer can capture the benefits that produce a payback–point out all the different ways the product can deliver a payback
  3. Quantify the benefits–using rules of thumb, industry benchmarks, common business metrics, and such, show how to calculate the value of a specific set of benefits.
  4. Tie the business value to the customer’s bottom line–many business processes and tasks are far removed from direct impact on the company’s business performance and overall strategic and financial objectives.

Developing an ROI guide is as much an educational effort as it is a sales effort, but it is an educational effort that directly drives sales. The prospective customer can’t know what the impact of using your product will be. Your ROI guide needs to show the customer where to look for the payback, what form it will take, and how to get the most from it. This requires knowledge of your product, familiarity with your customer’s business process and, especially, data, lots and lots of data.

Data: The Critical Hurdle

How much wood would a woodchuck chuck if a woodchuck could chuck wood? That’s the ROI data challenge in a nutshell. The problem, despite years of capturing data and evangelizing the gospel of information-based management, most managers don’t really know how much wood their woodchucks chuck.

Your business value analysis is only as credible as the data you use to quantify the payback. But few managers have more than the most rudimentary data on their business processes. They know how many people report to them, but they may not know how many people are involved in a given task or how long an individual spends on a task. They know what the payroll is but not what it costs to perform a particular function. When a business process crosses workgroups or departments, the data becomes even skimpier.

Few managers have the time and energy to start hunting around for detailed cost and business process data. So, you are going to have to help the customer develop the payback analysis using data that is readily at hand. This data may not be precise or complete, but it can give your prospective customer a good sense of the tangible value your product or service delivers.

To develop a payback analysis, you need some basic data:

How much it costs to do a task? How many people? How much time?

What are the alternatives and what do they cost?

How is the organization getting the job done now?

What is the cost or penalty to the organization of not doing this task?

What is the result of the task or activity and what is its value to the organization?

I typically start with whatever data the customer does have: how many people, how much time to do a given task. I’m not looking for exact numbers, although those would be nice to have. Instead, I look for estimates, guesstimates, approximations, ballpark figures–whatever you choose to call it. Often, it is easier to work in percentages or with a range (i.e. 15%, $50-$80 per hour) rather than in actual numbers. But with this kind of inexact data, you must be very conservative. The key to a good analysis is credibility; the more conservative your underlying data and assumptions, the more credible your results will be. Flights of fancy may lead to a more attractive payback, but it won’t be as believable.

After you have grabbed whatever data you can coax from the organization, you can start looking at outside sources for data:

Public or published industry benchmarks

Widely accepted rules-of-thumb data

Reasonable extrapolations from similar or related situations

Relevant anecdotal data

Third-party data (such as the cost of processing a transaction or the cost of a Java programmer)

Government data (such as labor and salary figures)

The goal is to come up with some credible data that can be used in calculations to illustrate the kind of value the prospective customer will receive from your product or service.

Quantifying the Business Value of Soft Benefits

The business benefits of your product define the business value you provide. More often than not, the business value your product or service delivers is based in part or even entirely on soft benefits–gains that do not easily translate into real, actual dollars. But soft benefits are valuable, and the ROI analysis must encompass soft benefits as well as hard benefits.

The hard benefits are pretty easy to quantify. These typically revolve around increased productivity and efficiency in the form of time saved or lower head counts or increased revenue. Increases in revenue usually take the form of more or bigger sales to new or existing customers. In short, hard benefits ultimately result in tangible savings of time, labor, and money or increased revenue. This is pretty measurable stuff.

The soft benefits are harder to pin down. Improved customer satisfaction is a frequently cited soft benefit. You can measure increases in customer satisfaction, but you cannot easily translate those gains into an actual dollar figure. How much additional revenue, for instance, does a five-point increase in some customer satisfaction rating translate into? $1000? $100,000? $1 million? Nothing? A company that has meticulously tracked the ups and downs of its customer satisfaction rating over the years may be able to correlate those results with rises and declines in revenue, after factoring for a host of other variables, but those companies are rare indeed.

Instead, we are left in our analysis with trying to quantify in actual dollars the value of such soft benefits as increased customer satisfaction, better decision-making, or improved collaboration among workers. There is no simple solution to this problem. I generally adopt one or a combination of the following approaches.

Translate the soft benefit into a hard benefit–for example, better quality work really means less rework or returns, which can be described in hard-dollar time, labor, and materials.

Use anecdotal evidence–you can estimate a value derived from customer stories, incidents, testimonials.

Relate to high-level business objectives–you can claim a share of the already recognized value of achieving some high-level business objective. The size of your share will depend on how closely your soft benefit is tied to achieving the business goal.

Draw on accepted industry figures–many industries recognize general values for certain soft benefits, such as customer satisfaction.

Use a range of values–rather than try to pin down a single specific value, work with a set of values.

Negotiate an acceptable value–work with the prospective customer to come up with a number that seems reasonable and feasible based on the other factors noted above.

Increased or improved security may present the ultimate soft benefit payback challenge. Like insurance, until you’ve suffered a loss, the payback on security expenditures is just about zero. In fact, companies have traditionally treated security as a cost center to be minimized. Absent a security event, the best case for business value derived from a security investment probably revolves around greater customer confidence. In the aftermath of a security event, the government, insurance companies, and the courts will want to know if you took reasonable steps to protect yourself and others. Only then will the business value of security become apparent.

To come up with a value gained from a security expenditure, you will need to look at a range of scenarios from minimal case to worst case and assess your exposure and risks in terms of liability. The tendency now and for the foreseeable future is to give greater credence to every security threat, which should boost the perceived payback from security expenditures.

In any case, soft benefits are real; they are just harder to quantify. The trick is to assign a value to them that is realistic and credible and helps make an attractive payback.

Business Value Calculations

Everything in the ROI guide is focused on answering the payback question: how much more will I get back from this product than I pay for it? The answer, it turns out, is not so straightforward. You may pay $1 million for a product and get back a 20% increase in customer satisfaction. That might be an incredibly great deal or a big rip-off. At this point, you can’t tell.

Since value can take many forms, the ROI guide must go through a variety of steps and calculations to clarify the answer. The following calculations will help you develop your own payback analysis. (Note: none of these calculations consider the cost of money over time, which is an underlying premise of a formal ROI analysis.)

What is this going to cost me?

Sometimes this is simply the cost of the product or service but not often. Time must also be considered. We have to consider not only the cost of the product but the cost of implementing it and the cost of maintaining it over time. Increasingly, companies must also consider the cost of getting rid of it when its useful life is done. Together, these costs represent the total cost of the product or total cost of ownership (TCO).

TCO=(cost of the product) + (cost of implementation) + (cost of maintenance and support over however many years) + (cost of disposal)

What does it cost me to do this task now?

Here you try to pin down the cost of doing the task without the product or service being evaluated. In short, you want to know what it costs today to get the job done. Sometimes you aren’t doing the task now. In that case, you need to figure out what it would cost if you tried to do it or the cost of alternative approaches or the cost of doing without, a lost opportunity cost.

Current cost=(cost of people) + (cost of any tools)

What is the net value to me?

This is the crux of the ROI guide. If I buy your product, what net business value or payback do I get for my money?

Net value=(value of expected results) – (the cost of getting those results)

Ideally, the exercise will show that your product or service will deliver a greater net value than whatever results your prospective customer is getting now. The customer might be spending less now but getting far less in return. Or the customer might be spending a lot more but getting only a little bit better return, hardly justifying the added cost. Whatever the results, however, with these three questions, you’ve got the basis for your ROI guide.

The next challenge comes from putting a value on the expected results. This is where the effort to quantify all the hard and soft benefits pays off. What is it worth to speed up a business process or reduce the number of people required to do it? What’s the lifetime value of a new customer? What’s the value of a 10-point gain in customer satisfaction? What’s the value of making better decisions or of improving collaboration? Once you’ve quantified it, you have a reasonable number that you can plug in as the value of expected results. Often this takes the form of a table or a quick calculator.

ROI Models

Here are some payback calculators I find helpful. You can use them as models
for your own efforts. They are quite simplified; feel welcome to elaborate as
needed. Value of New Customers

Revenue Factors Hypothetical Example Your Actuals
Average initial purchase $100
Average additional annual volume $800
Average age of customer relationship 3.5 years
Anticipated number of new customers this year 1000
Lifetime value of new customers $3.15 million ($900×3.5×1000)

(Note: this does not include a cost of acquiring the new customer.)            

Value of Improved Business Task Efficiency

Efficiency Factors Hypothetical Example Your Actuals
Average time spent on task 4 hrs.
Average number of workers performing task 6
Fully loaded cost of the worker $65/hr
Total cost of task $1560 (4x6x65)
New average time spent on task 2.75 hrs
New cost of task $715 (4×2.75.65)
Improved process savings $845

(Note: you may want to multiply both the cost of the task and process
savings by the number of times the task is performed in a given period of time
to arrive at a total cost and total savings figure.)        

Value of Improved Customer Satisfaction

Customer Satisfaction Factors Hypothetical Example Your Actuals
Previous customer satisfaction rating 87% favorable or very favorable
Industry benchmark Top tier players generate 90% or above favorable, very favorable rating
New customer satisfaction rating 92% favorable, very favorable
Benefits of improved customer satisfaction rating Recognition as top tier player
Increased revenue per customerIncreased market share
Value of customer satisfaction improvement 10%-15% increase in revenue from existing customers 3%-5% increase in new customers

(Note: again, this model does not consider the cost of acquiring the customer.)  

The ROI Guide: Data, Numbers, Context, and Interaction

Once you’ve gathered your data and crunched the numbers, you are ready to create your ROI guide. The ROI guide can be specific for a given customer or more likely something generic that reflects the experience of your typical customer. You can even run the calculations several times with different values reflecting different types of customers, say small, medium, and large.

The ROI guide actually consists of four major elements:

    1. Data
    2. Calculations and the resulting numbers
    3. Context/narrative
    4. Interaction

You assemble these four elements to make a compelling payback-based case for your product or service.

The payback numbers may be at the core of the ROI guide, but they aren’t what really communicate business value. The business value is communicated through the context or narrative. Without this narrative, the numbers are just that, numbers, without any real business meaning or impact. It is the narrative that ties the payback results to strategic business objectives and creates the business case for your product. This business case will include substantive discussion of the business benefits and the context for understanding how the business value will be captured. This narrative can include customer references, anecdotes, third-party industry research, and more.

Finally, an effective ROI guide offers more than a static analysis. It should engage the prospective customer by getting him (or her) to run his own numbers through your calculations. That is why I usually add a column alongside the numbers for the customer’s actual figures [see above model calculators]. Checklists and various other calculators and weighted decision trees provide other good ways to pull the prospective customer into the process.

It is very difficult to write an effective ROI guide in-house. Although your people have the product knowledge, they typically lack the all-important customer perspective. It is next to impossible for the in-house staff to look at the product the way the customer does. A good outside writer should provide the customer perspective that ensures the credibility of the ROI guide.

The last step is the production and distribution of your ROI guide. The production can be as simple or as elaborate as you like; the real power comes from credible numbers and a compelling narrative. To distribute the ROI guide, organizations not only deliver copies through the sales force as a leave-behind, but also use it as a fulfillment piece for advertising and direct mail. Increasingly, the ROI guide is posted on the Web and distributed electronically.

As a fulltime independent writer/researcher/analyst specializing in business and technology, I work with companies on a wide range of projects, from white papers to newsletters to ROI guides. You are welcome to visit my Web site, www.technologywriter.com, to see samples of my work, including an ROI guide. While you are there, you may also want to check out my report titled The White Paper White Paper–required reading for anybody trying to communicate about complex products and services. Or view these other Ultimate Guides:

The Ultimate Reviewer’s Guide–how to influence those who are evaluating or reviewing your product or service

The Ultimate Case Study Guide–how to create believable customer testimonials

The Ultimate Business Presentation–how to make a compelling business case

And watch for my upcoming reports:

The Ultimate Web Content Guide–how to create killer online content

The Ultimate Sales Guide–how to create a document that can actually drive sales

The Ultimate Newsletter–how to maintain regular meaningful contact with customers and prospects

The Ultimate Press Release–how to write press releases that go into print rather than into the editor’s trash