ROI. Finance for fools? “Guidance" for the gullible? It’s hard to say, but it’s chic to pay homage to its numerology. Today I read an article that stated “In Social Media the Return on Investment (ROI) is based largely on the influence you have upon your group of friends.” [1] Clear as mud.
Have salespeople and marketers corrupted a useful financial equation—and made it so generic that it lacks meaning? To find out, I dusted off my lightly-used college textbook, Techniques of Financial Analysis, by Erich Helfert. Here’s his definition, followed by an example:
“ROI = Average annual operating cash flow divided by net investment. = $25,000 divided by $100,000 = 25%.”
Then he wrote, "With no reference to economic life . . . all the measure indicates is that $25,000 happens to be 25 percent of $100,000. Note that the same answer would be obtained if the economic life were 1 year, 10 years, or 100 years. In fact, the return shown would be true in an economic sense only if the investment provided $25,000 per year in perpetuity; only then could we speak of a true return of 25 percent." (If you sell a B2B solution and are willing to commit to that interpretation, please share your contact information below.)
Ignoring this not-so-trivial caveat, thousands of blogs, Tweets, conversations and sales proposals unabashedly pontificate ROI, a metric that ignores time and risk—two key business decision-making variables. How helpful is that? For insight, I contacted a person who understands the in's and out's of investment strategy, accounting professor Robert Kemp at the University of Virginia’s McIntire School of Commerce [2].
He prefaced his comments by sharing that the overarching objective of an organization is to create value, and that organizations favor transactions in which value received is greater than value given up. That makes sense. And ROI enables decision-makers to uncover the answer?
Not exactly, he explained. “There are three questions about value that decision makers must answer: What do I get, when do I get it, and how certain are the answers to the first two questions?” He said that ROI can answer the first question, but not the second or third. Further complicating the sometimes-assumed precision of ROI is that financial executives don’t regard the variables of cash flow benefits and investments consistently, because both are “subject to SWAG's in accrual accounting,” according to Kemp. ROI’s usefulness clearly has limits. Just ask anyone who invested with Bernie Madoff.
More robust calculations such as Net Present Value (NPV), which offsets the present value of cash outflows against the present value of cash inflows, consider time and risk. According to Robert Higgins, author of Analysis for Financial Management, “a crowning achievement of finance has been to transform value creation from a catchy management slogan into a practical decision-making tool that not only indicates which activities create value but also estimates the amount of value created.” With that nifty endorsement, you’d expect business developers around to world to flavor conversations with NPV instead of ROI, but it hasn’t happened.
Whether a business decision involves IT, Marketing, or Operations, Kemp believes that a key question to answer is “what is the value to the total organization if I approve a given initiative, versus what is the value if I do nothing? That requires comparing marginal benefit to marginal cost.” He cautions that decision makers face a dangerous trap by exploring that question without looking into the future.
He illustrated the conundrum using Netflix and once-archrival Blockbuster, which used vastly different value-producing strategies. Thriving Netflix adopted a long-term view of the business value of web-enablement, and invested accordingly. Failed Blockbuster, bloated on their doomed late-fee cash cow, focused on maximizing current period earnings. Happily, Netflix executives didn’t limit their investment analysis to performing a simple ROI calculation. If they did, they’d be sitting at the bar with ex-Blockbuster executives, talking about the good old days when decision makers could be fat, dumb and happy.
ROI hype creates numerical misalignment—with marketers and salespeople on one side, and CFO’s and financial decision makers on the other. Ironically, when salespeople tout time- and risk-agnostic ROI [3], they reinforce the same dysfunctional short-term, Blockbuster-like thinking they’re often trying to overcome.
But if ROI’s calculus has flaws, why do vendors persist in using it when “proving the business case?” It’s how we’ve been brought up. As marketers and salespeople, we aren’t rewarded for casting doubt on what we sell. We’re certain. We’re confident. We succeed because we create concrete visions. In sales meetings, acknowledging risk and waffling about Time to Value grate like discordant musical notes. Little wonder that we resist embedding those variables in the calculations we offer to decision makers.
Kemp put it this way, “change creates enormous amounts of risk.” But by hyping ROI, we conveniently sidestep that fact. We pretend it just doesn't exist. But our customers and prospects aren’t stupid. They’ll figure out what increases value—and what threatens it.
In sales, when we lose an opportunity, we sometimes say “the customer didn’t buy the math.” Maybe they don’t buy the equation, either.