Calculating the true value of any project has always been a challenge. This is mainly due to the ambiguity of the change from a paper project to an economic value.
Let us show you some examples, just to be clearer. It is evident, for example, that the training of employees will improve the experience and productivity of our Project Team. But how does this benefit translate into cost savings and/or increased profits?
Spending thousands of euros on automated systems and software is likely to improve work efficiency, but what is the value of this improvement in euros?
Organizations are on the market to make a profit of course, and the return on investment – ROI – is a key figure for understanding what the profit margins of a project are. Calculating the ROI of a project will also answer the questions raised above, as well as showing the value of the project and its impact on the margin.
ROI is an indicator used to measure the profit/loss, or financial “value”, of a project in relation to its cost.
Typically, it is used to determine whether a project will generate a profit and therefore will be a benefit to the company.
Why is ROI important?
The ROI quantifies the value of the project and is capable of showing project managers, corporate executives and all stakeholders the value of a project in numbers that anyone can understand.
ROI converts the subjective into objective, which can often turn uncertainty into support.
Here’s why ROI is important:
- It can create support when it comes to stakeholders: binding a euro value to a project can help with a “go/no-go” decision. Often, stakeholders want to see what the actual euro value to decide whether or not to support a particular project.
- It may discover additional benefits: The ROI calculation process forces project managers to study benefits that may not seem obvious at the outset of a project.
- It can lead to the definition of project priorities: once it is decided to start a project, the ROI helps to determine the priorities of the various projects. Usually, projects with a higher ROI are ranked higher and get faster support from project resources.
How to calculate ROI
The formula for determining the ROI is:
ROI = [(Financial value – Project cost) / Project cost] x 100
Considering the formula, there are two components that need to be determined: the financial value and the cost of the project. Let’s see how to do it.
How to calculate the Financial Value
The financial value is simply the reimbursement of the project.
The estimation of the value can sometimes be complicated due to the uncertainty of assigning an actual value expressed in dollars (or any other currency) to a suggested result.
The trick is to break down the value into currently known components and then define them.
When trying to quantify the value of the ROI formula, always remember the acronym TVD – time, volume, dollars.
If you can define the time, volume and dollars/euro needed to complete the process, the value of the project can be determined.
This acronym corresponds to a formula that calculates the potential value of the project from a different perspective:
TVD(current) – TVD(project)
- T = time required for the process
- V = Volume or quantity of units, transactions, people, etc. required
- D = Dollars or cost required
- Current = current value
- Project = value that a project will have in case of success
To better understand this formula, let’s have a look at some examples.
The first is a project that will reduce the process cycle time of a given product by 10 percent.
In this example, the team calculated a single unit cost of € 2,455, based on current values for the time required (13 hours), volume (1 unit) and euros (salary of € 85/hour and total cost of materials amounting to € 1,350). It has also been calculated that, based on the production of 480 units per year, this cost will be equal to 1.178 million euros per year for this product line.
The team then calculated the project values, reducing the cycle time by 10 percent, from 13 hours to 11.7 hours; all other variables were left unchanged. The new costs are therefore €2,344.50 per unit and €1.125 million per year for the product line.
Therefore, the value of the project is: 1,178,400 € – 1,125,360 € = 53,040 € of savings per year.
How to calculate Project Cost
The second unknown component of the ROI formula is the cost of the project.
To calculate this value, it is necessary to obtain revenue information and make a detailed cost analysis with a breakdown by different categories.
The breakdown by category can be useful if you want to evaluate different costs to build cost reduction strategies for a higher ROI on future projects.
Typical costs generally include the provision of materials, overheads for labor and employees, fuel, equipment, and work-related services.
Clearly, these factors vary according to the activity and type of project.
The cost assessment for a simple ROI analysis on a single project will not take into account annual expenses such as the lease for the construction of space and/or capital investments.
The formula is isolated for a single project and includes only costs associated with that single event.
You can forecast costs and returns based on past events before the start of a project.
Although it is not possible to obtain a perfect estimate, keeping project records allows you to know an approximate ROI interval based on available data.
How to calculate the ROI of a project: bottom line
Ultimately, understanding how to calculate the ROI for a project is the first step without which it is not possible to get a definite picture of the objectives and benefits of the project itself.
In many cases, moreover, without ROI, it can be very difficult for company executives to approve the budget required for a given project.
ROI evaluation, whatever the type of project, will help the project manager and stakeholders to better visualize and manage the project from a financial perspective.
Project managers should therefore fully understand all the elements underlying an ROI calculation in order to obtain an accurate view of the means and resources required, as well as all the benefits that the organization will derive from it.