Return on investment (ROI) is perhaps the most universally applied tool ever created in the history of finance. It is a standard measurement used to evaluate the financial return from an investment or project.
For all its power, though, ROI is a lot like the monster or bogeyman hiding under the bed that young children fear. It can seem big and scary, even at times all powerful, when we are young. But when we grow up and can see things with a broader perspective, we understand the reality and can put our youthful fears to rest. ROI today is used like a litmus test for HR—if HR cannot show a high enough ROI, then Finance will never approve what HR wants to do. And HR is like the young child fearing the ROI bogeyman under the bed: it doesn’t have the right perspective on the limitations of ROI and what should be done instead.
In my next post I will address why ROI doesn’t live up to the promise it’s supposed to have for evaluating HR. But first here I address why it’s lacking as a tool for making business decisions.
For the sake of this discussion, let’s divide the world of investment decisions into two parts: investing in something the organization has done successfully in the past versus investing in something the organization has never tried before (even if other companies have done so). For things you’ve done successfully in the past, ROI is a fine way to assign a value to the expected financial return. Your past experience with these types of investment ensures high levels of certainty and low risk regarding their success and the costs needed to get there. Examples include opening up a new office, factory, or retail outlet under conditions that are similar to what your company has experienced in the past, or rolling out new equipment and machinery using technology already tried and tested at pilot sites.
ROI also can be appropriate for evaluating activities that help maintain operations. This can apply to both capital expenditures and HR. If HR determines that the company needs to invest in employee compensation, training, or something else in order to maintain its current capability and operational performance, the ROI in terms of avoiding a hit to existing operations can often be demonstrated. For example, suppose that turnover among high-performing sales people increases because the market for their skills ramps up and competitors start poaching them. To keep them, the company may have to raise compensation, perhaps significantly more than the annual plan has room for. The financial return from increasing their compensation is expressed as the loss in sales that is avoided.
Avoiding lost sales is a clear financial benefit that can be included in ROI in this case. However, not all degradations in employee capability can be directly traced to lost sales. Consider another case, where the customer market shifts and accounts become more complex (more intricate contract terms, greater geographic coverage, tighter timelines, or some other situation), requiring greater cross-functional collaboration between sales, marketing, customer service, and IT. It may be next to impossible to establish a direct link between the need for better collaboration and an immediate impact on sales or customer retention. Nonetheless, the collaboration is essential to maintain competitive advantage.
This example helps demonstrate why ROI is not the preferred measure when the organization is doing something new. When an investment or changes in organizational capability have an uncertain and/or indirect, future-oriented impact on customer satisfaction and potential sales, something different than ROI is needed.
A more comprehensive analysis than traditional ROI requires building a detailed causal model. The model must include the key organizational processes that have to work properly for the investment to succeed, including the role that people’s capabilities, motivation, and job design will play in the investment’s success. The analysis would then assess the strength of the relationship between the causal factors and strategic and financial outcomes. It also should differentiate between financial benefits achieved through shorter-term cash flow improvements versus longer term capability building.
Increasing and maintaining competitive advantage are the ultimate objectives of strategy. If you have competitive advantage, revenue and cash flow are a direct result. But the causation does not go the other way around: increases in revenue and cash flow do not necessarily mean an increase in competitive advantage. Why? Because you can increase cash flow by cutting short-term investments in the very strategic capability you are trying to build over the longer term.
Consider spending on a new IT system that is due to launch in three years. If you want to boost short-term cash flow, you can defer some spending on the new IT system. And if you assume the short-term spending cuts won’t impact the ultimate project delivery (because you found ways to do the work more efficiently), then you can show a positive ROI from the spending cuts: the forecast for revenue stays the same while costs are lower, so profit has increased. Yet what proof do you have that making those budget cuts will not have a negative impact on the functionality and usefulness of the new IT system and thus on potential future revenue? Unless the proof is ironclad, you can’t assume that.
The easiest way to increase short-term cash flow (and thus ROI) is to cut spending on investment to improve capability, the organizational equivalent of cutting off your nose to spite your face—it can be done but it’s not very advisable. The tradeoff between the certainties of increased short-term cash flow from spending reductions versus the uncertain impact of investing in longer-term strategic capability is precisely why ROI alone is never sufficient to guide strategic investment decisions.
