ROI Calculations: Taming the Mythical Beast

November 08, 2016

Does this scene sound familiar? A product gets the green light, management pins high hopes on it, the CEO talks to the media and sales starts taking orders. Then suddenly, your boss wakes up and realizes that the ROI calculation hasn’t been updated—or worse, it is non-existent.

Enter the mythical, do-good, no-harm, never-say-no, jack-of-all-trades, objective-yet-subjective, quantitative-yet-qualitative, strategic-but-pragmatic product management professional. The product pro calls a few colleagues in engineering and sales for clarifications, dusts off the ROI template and works into the wee hours to complete the calculations. At last, the final stumbling blocks to an otherwise exciting business opportunity are banished to the netherworld. At least until the mythical beast decides to rear its ugly head again.

                                                      

As a product management pro, I have heard organizations and product practitioners ridicule the ROI exercise for its lack of real-world application. Few organizations give ROI calculation the rigor and scrutiny it deserves as an operations and risk-analysis tool. Too many companies use it within too narrow a scope.


Use Dynamic Models

Some companies use the ROI exercise to satisfy the needs of their finance team, or as a checklist item to satisfy the quality department. But even in organizations where ROI calculations are used extensively, the focus is often on a single metric, such as the internal rate of return (IRR) or net present value (NPV).

However, when organizations focus on a single metric like IRR or NPV, it can result in a static model. Because of their narrow scope, these models often fail as effective tools for answering rapid-fire questions from finance or the C-suite during the business plan review. Using a dynamic model to succinctly and instantly address stakeholders not only showcases the preparedness of the product management team, it strengthens stakeholder confidence in the project. Incorporating an effective dynamic model is akin to simulator training: It can be an effective crisis-preparation tool to anticipate things like changes in the sales forecast or increased costs.

Dynamic models have three distinct characteristics. First, a well-designed business model resembles a mathematical equation with defined variables and constants. Variables are typically the variable costs tied to sales volume or to another suitable metric. Constants are typically tied to fixed costs, such as rent.

Second, a dynamic model takes on a scope wider than the product or project under discussion; it closely resembles the P&L statement for the entire business unit. Such a model enables product teams to incorporate strategic and financial insights to the ongoing business such as new markets, sales cannibalization or changes in head count. Without a holistic view of the entire business, ROI calculations fail to address the nuances in strategy and tactics that differ between a new product, replacement product or enhancements to an existing product.

Finally, a dynamic model should have a front-end user interface that can analyze what-if scenarios and simulations. PC-based tools like Excel provide ample utilities to create a powerful front end for your business model that makes the data easier to understand and leverage. For example, color coding the input fields is a simple yet effective best practice. Graphs and tables can add further utility to the business model. Similarly, isolating the model’s variables and constants on a separate sheet enhances the ability to conduct what-if analysis on the fly. Incorporating a Monte Carlo simulation, designed to account for risk in quantitative analysis and decision-making to various verticals, is another way to integrate a simulation tool for sales forecasts.


Align with the Business Plan

ROI calculations are not independent artifacts. They need to mirror the business plan. Think of the business plan as the qualitative assessment while the ROI calculation is its quantitative manifestation. Yet business plans often ignore ROI calculations and vice-versa.

Each paragraph in a business plan should ask three essential questions: How much does it cost? How much does it make? Where is it in the ROI calculation? The reverse is also important. Each line item in an ROI calculation should beg three questions: What’s the source for this number? Why should I trust this number? What level of risk is associated with this number? In short, each line in a business plan is either a cost or a revenue item that must be accounted for.


Integrate with the Business Process

Organizations might forget about the existence of an ROI calculation if not for the product development or business process that requires it. But integrating ROI calculations into the business process is not enough. It is essential to ensure that ROI calculations are consistently applied across projects and then sufficiently reviewed and critiqued by the relevant stakeholders at the appropriate milestones. A formal review process that requires stakeholders to sign off on the ROI calculation is generally enough to attract sufficient review and critique.

The evolutionary nature of ROI calculations should not be forgotten. All product ideas start as a seed. The colorful details come later. Therefore, your process should provide the flexibility to progressively build an ROI calculation through successive project milestones. Integrate the business plan with the product development process to reap the full benefits.


Monitor and Tweak

No ROI calculations were built in a day. Neither should they remain static for years. Each is a work in progress, a living document for organizations of all sizes and shapes. ROI calculations that haven’t changed in years need serious attention. They often hide variables or formula errors that are waiting to be discovered by new, unsuspecting employees.

Monitoring and tweaking ROI calculations happens on two levels. First, the project calculations themselves should be reviewed and updated at milestones within the project lifecycle. Second, the ROI template should be reviewed and updated at frequent intervals.

Assemble the product management and finance teams annually to review the template. Then dust off the old calculations and compare them with the actuals. It won’t take long for patterns to emerge. Were the revenue numbers or costs off? Often, both figures are way off. Unless you learn from your experience and recalibrate your business plan with the ROI calculation, it will happen again.

ROI calculations can be a robust operations and risk-analysis tool. Treat them with the respect they deserve and you’ll be rewarded. Once you create dynamic, living documents with built-in check-ins at appropriate milestones, you will have all the tools you need to keep the dreaded beast at bay.

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