Return On Investment
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Introduction
What actually is a return on investment? It is the net income after income tax divided by average owner’s equity for the period (Coltman & Jagels, 2001).
Return on investment is known as a profitability ratio, because it provides information about managements performance in using the resources of a small business to generate income. Return on investment and other financial ratios can provide small business owners and managers with a valuable tool to measure their progress against predetermined internal goals, a certain competitor, or the overall industry. Return on investment is also used by bankers, investors, and business analysts to assess a companys use of resources and financial strength (ROI, n.d.).
The use of return on investment (ROI) is exploding. ROI has become one of the most challenging and intriguing issues. Several books have been developed on the topic, and consulting firms have been developed to tackle this critical and important issue. Several issues are driving the increased interest in ROI. Pressure from clients and senior managers to show the return on their investment is probably the most influential driver (Phillips, 2003).
Although owners frequently appear tight-fisted, often rejecting property-level management’s requests for investment, this is typically because ownership is not convinced the expenditures will add value. In fact, many hotels are acquired because they represent opportunities to achieve a return on investment by investing, often significant sums, to realize marketing or operational advantages. For example, purchasing a hotel that has too little meeting space for its room count and adding meeting rooms can often prove a very profitable investment. Similarly, cost reductions achieved by the installation of more efficient equipment can provide substantial returns on investment. Measuring the asset manger’s acumen in selecting such opportunities is usually a relatively straightforward process of comparing the costs to the present value of future benefits. It should be noted, however, that asset managers and ownership regularly perform such analyses ex ante, but not all firms rigorously perform the same analyses ex post (Harris & Mongiello, 2006).
As James O. Gill noted in his book Financial Basics of Small Business Success, most entrepreneurs decide to start their own businesses in order to earn a better return on their money than would be available through a bank or other low-risk investments. If the ROI and other profitability ratios demonstrate that this is not occurring—particularly once a small business has moved beyond the start-up phase—then the entrepreneur should consider selling the business and reinvesting his or her money elsewhere. However, it is important to note that many factors can influence ROI, including changes in price, volume, or expenses, as well as the purchase of assets or the borrowing of money. In addition, ROI is limited by the fact that it focuses on one period of time and thus should be considered a short-term performance measure. Ignoring the long-term effects of investments can cause poor decision-making, so it is advisable to combine ROI with other measures of profitability and performance (ROI, n.d.).
Why ROI?
There are good reasons why return on investment has gained acceptance. Although the viewpoints and explanations may vary, some things are very clear. The key issues are that the ROI methodology has been refined over a 25-year period; the ROI methodology has been adopted by hundreds of organizations in manufacturing, service, non-profit, and government settings, thousands of studies are developed each year using the ROI methodology; a hundred case studies are published on the ROI methodology; and two thousands individuals have been certified to implement the ROI methodology in their organizations (Phillips, 2003).
Return on investment is a very popular metric because of its versatility and simplicity. That is, if an investment does not have a positive ROI, or if there are other opportunities with a higher ROI, then the investment should be not be undertaken (ROI, n.d.).
How to measure the return on investment? Measuring ROI is a topic of much debate. It is rare for any topic to stir up emotions to the degree the ROI issue does. Return on investment is characterized as flawed and inappropriate by some, while others describe it as the only answer to their accountability concerns. The truth probably lies somewhere in between. Understanding the drivers for the ROI process and the inherent weaknesses and advantages of ROI makes it possible to take a rational approach to the issue and implement an appropriate mix of evaluation strategies that includes ROI (Phillips, 2003).
Although much progress has been made, the ROI process is not without its share of problems and concerns. The mere presence of the process creates a dilemma for many organizations. When an organization embraces the concept and implements the process, the management team is usually anxiously waiting for results, only to be disappointed when they are not readily available. For an ROI process to be useful, it must balance many issues such as feasibility, simplicity, credibility, and soundness. More specifically, three major audiences must be pleased with the ROI process to accept and use it. The first are the practitioners, who design, develop and deliver programs. Next are the senior managers, sponsors, and clients who initiate and support programs (Phillips, 2003).
According to Phillips (2003) there are some barriers to ROI implementation. Although progress has been made in the implementation of ROI, significant barriers inhibit the implementation of the concept. Some of these barriers are realistic, while others are actually myths based on false perception. The first barrier would be the costs and time. The ROI process will add some additional costs and time to the evaluation process of programs, although the added amount will not be excessive. The next barrier is the lack of skills. Many staff members do not understand ROI nor do they have the basic skills necessary to apply the process within their scope of responsibilities. Another barrier would be the discipline and planning. A successful ROI implementation requires much planning and a disciplined approach to keep the process on track.
When using the ROI methodology, there are also many benefits occurring. Although the benefits of adopting the ROI process may appear to be obvious, several distinct and important benefits can be derived from the implementation of ROI in an organization. The first benefit is that ROI measures contribution. The ROI will determine if the benefits of the program have outweighed