ROI illustrates the ratio of the net benefits of a project to the costs to show that the project has rewards that exceed the required investment. For example, a project with $3M in benefits and $1M in costs over a three-year period has an ROI of 200% calculated as ($3M-$1M) / $1M = 200%. This means that for every $1 invested in the project, the project returns the original $1, plus $2 additionally in incremental net benefits.
A project might have a high ROI if the ratio of benefits to costs is high, or a low ROI if it has little benefits but high costs. One of the weaknesses of the ROI formula is that although it shows the ratio of costs to benefits well, it has no indication of the overall value of the benefits to the company – ie. Are the benefits significant or not?
Using the example above, a project with a 200% ROI can have $3M in benefits and $1M in costs, or can have $300K in benefits, and $100K in costs, or $3 in benefits and $1 in costs – all with a 200% ROI value.
But using this same example, it is easy to see how the net present value (NPV) can be drastically different for these three examples even though the ROI is the same 200%.
This was first published in May 2007