Capital is tight for many companies these days. Even so, business owners must still invest in their businesses in order to grow – or simply survive. Especially, invest in a way that has the potential to positively impact your return on investment (ROI).
As a business owner, you are regularly presented with operational strategy and opportunities. Your task is to determine which one or ones will result in the best return on investment (ROI).
You may be considering putting your capital toward a major marketing technology. Or, perhaps a new technology that promises to increase revenue or productivity and, therefore, improve your bottom-line. And because you are (no doubt) pretty darn smart in shepherding your business toward success, every opportunity that you put on your own table will likely look like a possible step in the right direction.
So, how do you decide where to put your valuable and scarce capital?
The answer is obvious: Simply be very judicious about where you invest funds that will benefit the future of your company.
Of course, as any savvy business owners know, these types of decisions are simply not that simple. Especially, when every dollar counts.
Do you go with your very experienced gut? Do you choose based on what your competition is doing? Do you consult with your management team?
In reality, small and mid-size business owners make capital decisions in all those ways — and often to great success. But what we want to suggest is that by employing a more scientific, strategic and tested model, your decision making will become easier and you’ll also have a far better chance of producing your desired result.
Applying BIG Thinking
Many large companies use formulas for deciding among a number of alternative opportunities — and we want you to do the same. In short, we want you to think big.
If you are already doing this, Bravo! Hopefully, the information below can help you do it better. If you’re not doing this currently, you’re not alone – and welcome to a whole new way to get a good night’s sleep in the midst of critical strategic decision making.
Following are two formulas any small- to mid-size business can use to make smarter capital investment decisions:
FORMULA #1: ROI Analysis
A relatively simple formula for determining where to invest capital involves analyzing ROI. ROI analysis measures the present value of the expected net benefits over the present value of expected costs.
ROI analysis should always be performed prior to making a “go, no-go” decision on any large-scale project or acquisition. Here are some advantages of using an ROI methodology for these types of decisions:
• ROI analysis helps you determine which of a number of alternative investment opportunities should garner the best results.
• ROI analysis brings a discipline to both internal decision makers, as well as to external vendors.
• ROI analysis brings objectivity to the decision-making process.
• ROI analysis engenders an understanding of the financial expectations for each potential project, and developing these expectations is an inherent part of developing the overall business case for each project.
• ROI analysis facilitates investment prioritization among a number of alternatives.
• ROI analysis enforces accountability for the management sponsoring the capital investment initiative(s).
We said that ROI analysis is relatively simple. We frame it that way because it is, indeed, a simple concept. But the assumptions that need to be included in the analysis are both objective and subjective – and this fact adds a great deal of complexity to the process.
The following case study illustrates how the assumptions required for proper ROI analysis complicate the picture:
Assumptions in ROI Analysis
A BottomLine Growth Strategies’ client reported erosion in sales for one of their business lines over the past few years. The client argued that this is a business trend in their industry, but they also recognize that their marketing department is doing a poor job of following up on potentially hundreds of leads. Therefore, the client is exploring outsourcing lead follow-up. As with most capital investments, outsourcing comes with a high price tag. So, the challenge is to figure out if embarking on this path is a good investment for this particular client.
Below are the cost and benefit assumptions that could be considered in the ROI analysis, as well as the pitfalls often encountered in making the decision to outsource.
Vendor upfront costs. The cost to set-up the outsourcing arrangement (typically paid up front to the vendor). This cost assumption is fairly objective because it will come from the vendor based on volumes or another assumption.
Internal IT costs or other key internal resource costs. This is an opportunity cost: If IT staff or other internal resources were working on this project, they may not be working on another mission-critical project. The IT team might argue that this is not an incremental cost. However, if they are working on this new project, by definition they are not working on another project critical to the organization’s mission. And if they aren’t, do we really need them? Subjective? Objective? We’ll explore this again later.
Cost of any equipment that would need to be purchased. The cost of making the outsourcing opportunity work. For example, the purchase of new servers. This cost assumption is often pretty straight forward and objective.
It’s difficult to measure the benefits associated with some projects. Especially, if the benefits are nonfinancial, such as a competitive advantage or product differentiation. This is where ROI analysis gets a bit controversial, and oh so “fun.”
Basically, decision makers need to include all related expense reductions (staff savings is a typical example) and all upside opportunities in examining benefits.
For our case study client, we might find the following:
Savings in staffing. Letting go of the people who are currently doing a poor job following up on leads. This is where we, as advisors, see push back. We would argue that if lead follow-up was the function handled by this set of employees, and now, someone else will be doing the job, then the associated positions should be eliminated. Our general rule of thumb is that if the costs are included as a savings, they should be eliminated. Otherwise, the formula does not make sense. Simply giving the lead follow-up staff “other work to do” does not qualify as an expense savings unless new business is associated with the “other work!” So, savings in staffing becomes an objective benefit – staff must go, therefore, savings. But you can see how this choice might “feel” subjective to the people doing the firing.
Additional upside revenue opportunity. The quantifiable additional revenue the client should see from leads actually pursued (the vendor can sometimes provide this information, but remember that it is in their vested interest for the number to be high- so beware!). To determine the revenue increase, we start by looking at the “as is” scenario and quantify how many leads the company currently receives and the current closing ratio. It’s important to note that quantifying additional upside revenue during an ROI analysis can be very subjective. Also, make sure to look at the revenue benefit NET of related direct costs.
You can now see why ROI analysis tends to live in the world of the larger company. It’s simple relative only to the more complex ways to analyze return. But performed by experienced analysts, or by a small business owners who have learned the process, it truly is one of the best tools in your decision-making arsenal.
FORMULA #2: Payback Period
Another formula you can use to decide whether or not a potential opportunity is worth the capital investment – or to prioritize among multiple vetted opportunities – involves determining the Payback Period for each project. In other words, figure out how quickly your upfront investment will be recovered in each scenario you are considering.
So, while ROI analysis shows you what you might expect in return for your investment, Payback Period analysis shows you have fast you can expect it.
As a rule of thumb: The faster the Payback Period, the more attractive the project.
The Formulas are Not the Point
Now that we’ve explored two basic formulas any small to mid-size business owner can use to analyze the wisdom of a capital investment decision, we want to leave you with the most sage advice we’ve ever heard: Measure twice, cut once.
Of course, we are not telling you to analyze twice and then make a decision. We’re simply saying: 1) the emphasis needs to be on measuring; and 2) every company needs to have a capital investment decision-making process in place – in good times and bad.
Just as “measure twice, cut once” is a guiding philosophy in making beautiful furniture with the least amount of mistakes, companies need a guiding philosophy in making beautiful profits with the least amount of mistakes.
“Analysis Before Action,” is how we express it.