Best Business Practices: Simplifying Return on Investment (ROI)

In order to increase your market share, and meet your growth objectives, you may decide that a capital expenditure on equipment is necessary and will therefore need to do an ROI (Return on Investment) analysis on a capital expenditure. Perhaps you’ve decided that to attain the goals you have set for you company, you need to increase your production capacity and drive down costs. You have your eye on a piece of equipment, and are relatively sure it will produce the desired results of lower costs, but aren’t sure how to go about justifying the purchase and analyzing the returns versus the investment. What do you do in this case?

Every company's growth and success relies upon the ability to capture new customers and increase market share. In this capacity, companies must sometimes increase their manufacturing capacity to increase their ability to win customers and deliver products sooner. When it comes to capital expenditures for new equipment, most companies do a return on investment analysis, commonly referred to as ROI. However, ROI is not the end all, be all, solution. It doesn’t make the decision for you. Along with ROI, you must make sure that you have the right information and input in order to provide the right answer. Don’t assume that ROI on its own will prove the decision to be the right one. You’ll have to gather proper data points and enough information to make your ROI a successful analysis. However, even with the right information, it’s no guarantee of success.  The purpose of the ROI analysis is to provide the best working scenario, and to come as close to that guarantee as you can. In doing this, there are several criteria that must be included in your analysis. We’ll cover these in this document as well as look at the calculation that goes into your ROI analysis.  

1. Costs of Both the Equipment and Potential Cost Reduction

An essential aspect of your ROI analysis is to include all the necessary data. You must not only know what the total cost of the equipment will be, but also know what the potential cost reductions, or savings, will be from purchasing the equipment. What does this mean? Well, let’s assume that your company is interested in purchasing a piece of equipment that will reduce your production cycle times and improve your production total by 10% to 20%. So, if your company produces 100 units a day, with this piece of equipment, you’ll now have the ability to produce 110 or 120 units. The equipment will increase your production throughput, or production totals, by 10 to 20 additional units respectively. What does this reduction in cycle times, and subsequent increase in your production throughput, mean for your company in terms of savings, and how does it impact your decision to purchase the equipment? In this case, knowing the cost of the equipment is one part of the equation, but understanding what the additional production increase will mean in profit, is equally important. The saying “it’ll end up paying for itself” is very applicable to this situation. It’s what companies want to see when they decide to move forward with a capital expenditure. 

2. Timing & Frequency of Use

Another essential aspect of ROI analysis is to understand the impact of time, and frequency of use. Time is everything in terms of ROI analysis. How long will it take to pay for the investment? Are we guaranteed to use this piece of equipment in our production full time, and for how long? How can it help to improve production? When it comes to understanding the criteria behind the decision, it becomes far more involved than just going on a hunch. To give some perspective on the situation, does the time to pay for the machine improve when your company is able to produce more? Of course it does. Producing more will improve profit. How much additional profit will come from the additional 10 to 20 unit increase in production? The answer to this question is essential in terms of your analysis. 

3. Knowing The Market is Essential To Success

Perhaps the single most important aspect of a good ROI analysis, is to know your market and the application for the product your company makes. What is the five year and ten year forecast for your product’s application? Will customers in your market continue to need your products long after your company has purchased the equipment? Knowing your market, your customer’s future applications, and your company’s ability to continue to use this equipment well into the future, is an essential part of your analysis. Your future sales must support the decision to purchase the equipment. 

4. Resale Value & Reputation of Equipment 

While your objective is to remove any doubt about the decision, you must still be aware of the potential resale value of the equipment itself, should the decision prove to be the wrong one. Keep this information in mind. Deciding to move forward on a capital expenditure is much easier when the equipment has a reputation in the industry for high resale values.  

5. The Calculation Itself

The calculation itself is rather simple and straight forward. However, what’s more involved is the information that’s included in the analysis. The values you use for the analysis require more than simple assumptions. However, once you’ve gathered all relevant information, the calculation itself is relatively easy. 

ROI = (perceived value from purchase – actual cost of purchase)/(actual cost of purchase) 

6. Bringing it all Together 

Understanding all the criteria that goes into the analysis is just one half of what needs to be done. Now, you must use the information you know, and plug those values into the calculation. For instance, if the equipment will increase your production rate by 10% to 20%, and you know what additional revenue and profit that will generate, you now only need to place that data into the calculation. If your production will increase by 10% to 20% every day, then you can easily calculate your weekly, monthly and yearly increase in production, and additional revenue and profit generated. Take that value, and apply it to the portion of the calculation called “perceived value from purchase”. Now, you simply need to input the total cost of the capital expenditure. 

While this has been a relatively easy example, the basic principles and rules still apply. By no means are we implying that the calculation is an easy one. What we are stating is that there is a process to gather the information. Having the right information will make the calculation far more relevant and impactful. Taking the time to gather all relevant information, from multiple sources, is essential in putting together a solid business case to move forward.