- Introduction
Return on investments (ROI) is one of the most crucial calculations that organizations’ management need to make as a way of ensuring that their businesses have a long-term viability. Thus, it is becoming crucial for businesses not only to identify their operations profitability but also to measure the efficiency of their investments in providing a return. However, the metric’s application varies with different business types, and that forms the objective of this study in establishing the various ROI standards that are applied by companies with a focus on the service oriented businesses. (Vinci, 2010) In that respect, the analysis has two objectives including:
- Identifying the various ROI standards that are applied in the market place.
- Identifying the most effective and efficient ROI standard in the marketplace.
- Literature review
ROI Overview
Return on Investment (ROI) is a financial tool for measuring the economic return on investment. The metric is an effective measure of how many times an investments’ benefits covers its costs hence its rising popularity as an evaluation tool for various investment projects and operations. With that, those operations with low ROI presents a risk of failure and may not be attractive to pursue while those with high ROI are a reflection of suitable returns that enhances business sustainability. Thus, ROI measures have become important tools in resources’ allocation with a growing need for efficient allocation that delivers a suitable return. (Phillips & Philips, 2006)
In respect to the ratio’s calculation, the standard ROI formula is as shown.
ROI = [Payback – Investments] / Investments.
Where Payback refers to the earnings received from the investment while investments refer to the cost of the resources allocated to the operation/project. (Phillips, 2012)
In that view, the most crucial aspects of the measure are benefits, costs and investments as summarized.
- Benefits
Investments’ benefits are the difference between the revenue generated and the costs incurred in generating that revenue. The benefits can be established either before or after taxation and depreciation. However, using the benefits after depreciation and tax presents a more accurate measure but would not present a suitable measure for comparison as it depends on tax rate, as well as the depreciation schedule. On the other hand, there are other variations with the use of weighted average benefits or the discounted cash flow adjusted benefits. (Kent, 2010)
- Costs
The cost factor in the ROI metric captures all the costs that are incurred in generating the projects’ revenue. In addition, cost varies with some businesses using the initial investment capital while others include the subsequent costs of the investment. (Phillips, 2012)
- Time period
The period in consideration varies hence making ROI’s interpretation more complex with some organizations using one year while others discount the cash-flows of costs and benefits over a number of years hence the variation in ROI equations. (Agar, 2005)
- Other considerations
ROI’s standards depend on its application with different standards being applied as companies vary the benefit and investment concepts depending on the desired evaluation. In that respect, some businesses use invested capital and assets while others use the total cost of the project as an investment. (Bodie, Kane & Marcus, 2008) In addition, benefits are classified into tangible and intangibles but it is difficult to identify the intangible benefits hence a common use for the tangible benefits. However, some cases require inclusion of the intangible benefits as a way of achieving an effective measure of a project’s suitability where the project involves a lot of intangible benefits. In addition, benefits can also be varied as benefits before or benefits after tax. (Phillips, 2012)
The ROI measure can be applied to various aspects of business and investments ranging from company returns, assets investment, personal investments as well as projects investments. Therefore, the metric lacks a standard formula since its formula vary with businesses and operations needs as different standards addresses different aspects of a business operation or a project. (Phillips & Philips, 2006)
ROI’s application trend
Businesses are increasingly focusing their measures on a complex mix of costs, business objectives as well as risks. An example of the ROI use trend is the change in Citibank Global Securities Services that involved a shift from using ROI as a performance measure to a new approach that seeks to maximize it. However, just a few organizations are using ROI’s broad definition with about 8% of all businesses applying the measure to analyze and plan for their investments including IT investments among others. Another case of ROI’s application involves Schneider National Inc which is a Logistics and Tracking Company with an annual service value of $2.4 billion and which sought to move from the simple ROI measure to complex ROI metrics that address various aspects of the business. The change was crucial with realization that allocating resources and capital to technology and other aspects including marketing needed an evaluation against other competing investments. (Baker, Erik & Gary, 2005)
Thus, with application of ROI metrics on various aspects of businesses, companies are identifying the value of aspects as IT investments, customer service and marketing campaigns hence and ability to enhance investment in those operations that enhance value creation. In that respect, the various metric standards are gaining increased application by service based organizations including businesses and social enterprise organizations. Specifically, the metrics various standards are gaining popularity in the service industry including healthcare providers, operation managers and consultant practitioners including law firms as well as international development practitioners. Finally, the current standards in measuring ROI involve detailed review and identification of cost reduction & avoidance opportunities as well as revenue growth and customer satisfaction. (Phillips, 2012)
Various ROI standards
Various ROI standards that vary from the simple ROI formula include Return on Invested capital that can be applied with the use of income before or after tax, Return on invested equity and Return on assets. The variations reflects the advanced application of ROI measure that seeks to deviate from the use of the general evaluation of investments and business as a whole to a new approach that focuses on a different aspect of the business including assets applies and shareholders’ equity. Further, businesses increasingly apply specific ROI standards to measure returns on operations as IT investments that can be termed as assets as well as on marketing operations. (Meng & Berger, 2012)
For example, Learning and development services and investments within organization are gaining popularity from a growing need for constant skills’ development that is necessary for addressing increasing market competitiveness. In that respect, ROI measures are increasingly being integrated with other performance measures in the service industry. Thus, ROI measures are currently being applied as process improvement tools rather than performance evaluation measures providing a way of generating micro level scorecards. Further, ROI is increasingly being applied to analyze services costs and benefits considering even intangibles that are not necessarily converted to monetary terms. A good example is the application in Law firms, where the businesses are increasingly tracking and quantifying their investments on various operations including marketing and IT investments. A study by the Law Society Gazette in 2011 indicated that law firms are spending more on marketing and planning with 42% of law firms taking the ROI measures on those operations. However, the fact that marketing operations do not have immediate recognizable benefits on service businesses makes use of ROI metric crucial before engaging in such operations hence the increased use of Return on capital, assets and equity. (Oracle, 2012)
ROI calculation in the service sector involves tracking of what the business does. An example with law firms would involve tracking their business development and marketing programs. For example, a sponsor of the program by the firm is tracked on a basis of how many of the company’s attorneys attend, and the time taken in addition to the business that the program generated. In that respect, the metric is used to weigh the cost and benefits of such programs in terms of the attorneys’ time and resource allocation as well as the business revenue hence achieving a suitable allocation of the firm’s resources. (Damodaran, 2010)
Thus, ROI evaluation procedures for service industry with businesses that have business development and marketing programs like advertising through electronic and print would include the following:
- Tracking all advertising impressions including print and electronic
- Estimate the cost of the service delivery including staff time
- Dividing the cost by the number of impressions distributed in the market
- Estimate the revenue that was generated from the impression’s response.
- Use the cost and the revenue to calculate the programs’ ROI. (Buzachero, Phillips, Phillips, & Phillips, 2003)
In sectors like healthcare, projects improvement range from technology implementation, medical procedures, risk management, systems integration, and nurse retention to leadership. In that respect, ROI measures are crucial tools that seek to prove the worth of the projects to the decision makers hence a need for standards that break down the investments to a specific operation. (Buzachero et al, 2003)
However, the main ROI standards that take into consideration the business investments in its entirety are the most common with companies. That involves applying return on invested capital, equity and assets to measure the return on their investment in various business aspects ranging from marketing, IT and Learning and Development. (Phillips & Philips, 2006)
- Methodology
This study was done with a purpose of analyzing the various ROI standards that are applied in the marketplace with a focus on the service industry. In that respect, this section seeks to explain the research methodology applied by discussing the applied research design, data collection and the research questions involved.
Research design
In a bid to answer the research questions that address the various ROI standards, the research applies exploratory methodology by basing the analysis on the existing studies on the topic as well as conducting a qualitative analysis of the standards’ application and their efficiency. (Patricia & Nandhini, 2013)
Data collection
Data collection has been done through secondary methods that involve review of existing literature and empirical studies on the topic. In addition, the method has been used to collect the financial statement data for the purpose of calculating and evaluating the various ROI standards.
Data analysis
The data collected will then be analyzed with the key parameters being the Return on Investment ratios. Further, the analysis seeks to find the most suitable ROI standard by evaluating and comparing the various standards effectiveness in measuring performance. That will be done through computation of various ROI’s and a presentation of the results in graphical form for the purpose of comparison. In addition, the analysis seeks to find convergence between the findings from the literature review and the analysis. (Patricia & Nandhini, 2013)
Research Questions
The analysis will be seeking to answer the following two research questions that are in line with the study’s objectives.
- What are the various ROI standards applied in the marketplace?
- Which is the most effective and efficient ROI standard in the marketplace?
- Analysis
The analysis uses the case of HSBC Bank that is one of the world’s leading companies in banking and financial services market offering services to more that 60 million customers across 80 territories and countries. (HSBC, 2014) Using the company’s financial statements shown below, the various ROI standards are calculated. Those include the Return on invested capital before tax, return on invested capital after tax, and return on invested equity as well as return on assets.
Source: (Msn, 2014b)
Using the standard ROI formula of [Benefits-Cost] / Investment, four ROI standards are calculated with their differences being the investment factor that varies from invested capital, invested equity to assets. On the other hand, there is also a variation with the use of benefits before tax and benefits after tax. In that respect the net benefits (Benefits-Cost) refers to the operating income or the net income while investments refers to equity, capital or assets. (Kurowski, 2011) Thus, using excel, the various ROI’s are computed as shown.
Calculated ROI Ratios
ROI’s comparison
In respect to the most efficient and effective ROI standard, the three ROI’s for HSBC are summarized by the chart below.
In view of the company’s performance, the most effective and efficient performance measure in respect to return on investment is the one that presents a figure that is comparable with the market benchmarks. (Schoenebeck & Holtzam, 2012) In that respect, market benchmarks for return on investment for HSBC’s investors would be alternative investments like treasury bonds. In that view, the most efficient and effective return measure is the one that addresses the return on capital after tax. (Bernstein & John, 2000). That is because the metric captures all the costs of generating the company’s profit. In view of the calculated ratios, the return on capital after tax is the gives the lowest values hence do not overvalue the business earnings and presents a better measure for comparison with other investments. In summary, the analysis indicates that service sector firms have adopted an approach that applies breaking down investments and resources allocation to specific operations and programs. Those approaches include evaluation of return on assets applied as IT and the equity applied. However, Return on Capital presents the most efficient and effective measure that allows comparison between industry peers and alternative investments. (Vinci, 2010)
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