How to Calculate return on investment (ROI) for operation – definition | explanation | example
How to Calculate return on investment (ROI) for operation
Calculating the ROI will help you translate the operational benefits of a project into financial terms. Let’s use an example and say that you want to buy a piece of equipment that will cost $100,000 and take one year to set up. When it’s up and running at the end of the year, the new device will reduce your future costs by $45,000 a year. It has an expected life of four years. So when you factor in the setup time and the expected life of the equipment, this is really a five-year project. What do you think? Is it a good investment or not? Let’s find out by calculating the ROI.
You’re investing $100,000. Then you’ll generate a benefit of $45,000 a year for the next four years. So this investment will have a total return of $180,000. When you take the total return minus the investment of 100,000, you have a net return of $80,000. You’ll earn this net return over five years. So take 80,000 divided by five, which gives you an annual return. Divide the annual return by the total investment of $100,000 and that gives an ROI of .16, or 16%. In other words, you’ll be growing your investment of $100,000 at a rate of 16% per year. The higher the ROI the more attractive any investment is going to be. Is 16% a good ROI? Well, that depends on two things. First, it depends on your investment alternatives. You could be able to earn a better rate by investing your money somewhere else. Some companies even have a minimum ROI, called the Hurdle Rate. And unless your project’s ROI is above that Hurdle Rate, it probably won’t even get considered.
The second thing that your ROI depends on is inflation because money becomes less valuable over time. In four years $45,000 won’t buy you as much as it will today. You can account for that annual loss in value by factoring in a discount rate. Understanding how ROI is calculated can help you make adjustments to your projects, too. For example, you can increase the ROI in two ways, either by making the investment smaller or by making the returns bigger.
Making Investment Decisions. Operations and supply chain professionals understand that the future is full of uncertainty, but part of your job as a manager is to make educated guesses and plan ahead for your business.
If you can make reasonable assumptions and calculate a return on investment, you’ll find it much easier to justify the importance of your projects and get the resources you need so that you can manage your operations successfully.