Understanding how to calculate the potential return on investment (ROI) of a project is an essential financial skill for all professionals to develop.
If you’re an employee, knowing how to calculate ROI can help you make the case for a project you’re interested in pursuing and have taken the lead on proposing. If you’re a manager, understanding ROI can give you greater insight into your team's performance. If you’re an executive, working knowledge of ROI can make it easier for you to identify which projects should be greenlit and which should be passed over. Once ROI is proven, it may be possible to replicate success by applying lessons learned from the first project to other segments of the business.
If you’re unfamiliar with accounting and finance, the prospect of determining the ROI of a project may seem beyond your abilities. However, it’s not an overly complicated process. By understanding the basics of financial valuation, which can enable you to put a monetary value on companies, projects, or anything that produces cash flows, anyone can learn to calculate the ROI of a project.
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DOWNLOAD NOWWhat Is Return on Investment?
Return on investment (ROI) is a metric used to denote how much profit has been generated from an investment that’s been made. In the case of a business, return on investment comes in two primary forms, depending on when it’s calculated: anticipated ROI and actual ROI.
Anticipated vs. Actual ROI
Anticipated ROI, or expected ROI, is calculated before a project kicks off, and is often used to determine if that project makes sense to pursue. Anticipated ROI uses estimated costs, revenues, and other assumptions to determine how much profit a project is likely to generate.
Often, this figure will be run under a number of different scenarios to determine the range of possible outcomes. These numbers are then used to understand risk and, ultimately, decide whether an initiative should move forward.
Actual ROI is the true return on investment generated from a project. This number is typically calculated after a project has concluded, and uses final costs and revenues to determine how much profit a project produced compared to what was estimated.
Positive vs. Negative ROI
When a project yields a positive return on investment, it can be considered profitable, because it yielded more in revenue than it cost to pursue. If, on the other hand, the project yields a negative return on investment, it means the project cost more to pursue than it generated in revenue. If the project breaks even, then it means the total revenue generated by the project matched the expenses.
Return on Investment Formula
Return on investment is typically calculated by taking the actual or estimated income from a project and subtracting the actual or estimated costs. That number is the total profit that a project has generated, or is expected to generate. That number is then divided by the costs.
The formula for ROI is typically written as:
ROI = (Net Profit / Cost of Investment) x 100
In project management, the formula is written similarly, but with slightly different terms:
ROI = [(Financial Value - Project Cost) / Project Cost] x 100
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Calculating the ROI of a Project: An Example
Imagine that you have the opportunity to purchase 1,000 bars of chocolate for $2 apiece. You would then sell the chocolate to a grocery store for $3 per piece. In addition to the cost of purchasing the chocolate, you need to pay $100 in transportation costs.
To decide whether this would be profitable, you would first tally your total expenses and your total expected revenues.
Expected Revenues = 1,000 x $3 = $3,000
Total Expenses = (1,000 x $2) + $100 = $2,100
You would then subtract the expenses from your expected revenue to determine the net profit.
Net Profit = $3,000 - $2,100 = $900
To calculate the expected return on investment, you would divide the net profit by the cost of the investment, and multiply that number by 100.
ROI = ($900 / $2,100) x 100 = 42.9%
By running this calculation, you can see the project will yield a positive return on investment, so long as factors remain as predicted. Therefore, it’s a sound financial decision. If the endeavor yielded a negative ROI, or an ROI that was so low it didn’t justify the amount of work involved, you would know to avoid it moving forward.
It’s important to note that this example calculates an anticipated ROI for your project. If any of the factors affecting expenses or revenue were to change during implementation, your actual ROI could be different.
For example, imagine that you have already purchased your chocolate bars for the agreed-upon $2 apiece and paid $100 to transport them. If the most that the store will pay you is $2.25 per chocolate bar, then your actual revenues drop substantially compared to your projected revenues. The result is a reduced net profit and a reduced actual ROI.
Actual Revenues = 1,000 x $2.25 = $2,250
Total Expenses = (1,000 x $2) + $100 = $2,100
Net Profit = $2,250 - $2,100 = $150
ROI = ($150 / $2,100) x 100 = 7.14%
Circ*mstances are rarely as straightforward as this example. There are typically additional costs that should be accounted for, such as overhead and taxes. In addition, there’s always the possibility that an anticipated ROI will not be met due to unforeseen circ*mstances, but the same general principles hold true.
How to Use Finance to Pitch Your Project
Have you ever pitched a project to senior management, only to have the idea shot down under the guise of “not making financial sense?" It happens more often than you might think. By learning how to calculate ROI for projects you’re interested in pursuing, you can self-evaluate them before they're raised up to decision-makers within your organization and defend them as they’re being considered.
Similarly, by understanding how to calculate ROI after a project you’ve spearhead is done, you can better speak to the contributions that you and your team have made toward shared company goals.
High-performing businesses are successful because they make smart decisions about when and where they allocate available resources. Calculating the ROI of a project before it moves forward can help ensure that you’re making the best possible use of the resources you have available.
To learn more ways that you can use financial concepts to improve your efficacy and advance your career, explore our online finance and accounting courses. Download your free flowchart to determine which is right for you.
