Don't use ROI in investment decisions

I am a hard-bitten chief executive officer and my staff tell me that we must invest millions in a customer relationship...

I am a hard-bitten chief executive officer and my staff tell me that we must invest millions in a customer relationship management system or an e-commerce trading exchange or a system to link the components of the supply chain.

My reputation is that of being tough on appraising investments of time and money. However, people do not realise that projects eat up scarce senior management resource. I am told all is well with this investment, because it produces a superb return on investment (ROI).

There is one small problem - ROI is not useful in investment decisions. I know this, as I have sat on both sides of the fence. I spent years in an IT services company writing investment proposals, winning capital authorisations, all with beautiful ROIs, but knowing they were commercial nonsense.

You will probably be thinking, "Prove your case and what process is better?"
Capital investments are a mixed bag: required for health and safety, replacement of old systems, providing additional capacity, allowing new products or distribution channels, reducing costs.

Some of these are not directly "productive", for example a safety system required by law or a replacement system needed as the current one cannot be supported. Productive investments must therefore earn returns to cover the costs of non-productive investments.

When we then read the investment cases with high ROIs, what do we find? Areas of current business are at risk, so profits are safeguarded and not lost. New distribution channels are opened, so we have additional revenues and profits.

Here my experience or cynicism takes over. How many times have the same revenues and profits, old or new, been counted in different investment appraisals? What past or future costs are incurred to create the new profits and are not included? How many proposals are really part of a strategic initiative, but put forward separately to escape closer scrutiny?

I have only two tests to justify an investment: is it necessary to support my business strategy and is it fully integrated in all current plans including financial, marketing, operational, IT, human resource?

To gain my consent, company colleagues only need to show that all aspects of the project are included in the current and longer-term plans, not only financial, but operational. I want measures, such as improved customer service levels, access to new channels, higher conversion rates for customer prospects. All costs and benefits can then be measured and controlled.

Even if the investment under consideration is budgeted and accounted for, this does not mean automatic approval. The normal commercial questioning must take place - can we do this cheaper, what are the implications of choosing a particular technology, why are we sure that service levels will improve, etc.

Oh dear, the proposed expenditure is not budgeted, but there are real benefits to be had! What do we do?

We used to say no to projects not in the annual plan, as we would lose control. However, today the world is moving too fast and we must constantly make decisions to change - now. This is a test on how well we can now control the business, in a very different environment. I have two tests:

 

  • Can we afford it? If our cash flows and debt positions are not strong, then either we say no or other investments must be sacrificed


  • I subject the project to the normal commercial questioning, but then recast all plans and establish whether the revised strategic, financial, marketing and operational picture is acceptable. If it is, then the revised plans become those to be controlled and form the base for the next annual planning round. If not, then I say no.



ROI is an artificial and wrong measure, but developments that are integrated in company plans mean success.

Stuart Ruben is a partner at management consultancy KLR & Company

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