Return on Investment Metrics: An Army Perspective Presented by Noel Bishop

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1 Return on Investment Metrics: An Army Perspective Presented by Noel Bishop

2 Purpose To provide a Headquarters Department of the Army (HQDA) cost analyst s perspective on what Return on Investment (ROI ) analysis is all about, when the analysis is required and some common pitfalls to avoid.

3 Agenda What is Return on Investment (ROI)? When are ROI metrics used in the Army? ROI Metric discussion Definitions Sample of calculations The most important ROI Metrics Avoiding the ROI Pitfalls Summary

4 What is ROI? Is ROI a. Single Metric (Discounted Benefits/Discounted Investment) Investment or a Collection of Metrics? BIR or SIR BCR NPV Payback IRR Savings or Cost Avoidance The Answer is Both.

5 When are ROI Metrics used in the Army Economic Analysis (EA) Required for Major Automated Information Systems at MS A (may be combined with AoA), MS B, and the Full Deployment Decision Review (FDDR) DoDI Cost Benefit Analysis (CBA) Required when an unfunded requirement and new or expanded program proposal submitted to the Secretary of the Army, Chief of Staff, Army, Under Secretary of the Army or Vice Chief of Staff, Army USA/VCSA Memo, 30 Dec 2009

6 ROI Metrics Benefit to Cost Ratio (BCR) - The ratio of the present value (PV) of the total benefits (savings and cost avoidances) divided by the present value of the total costs. It does not include sunk costs. BCR = PV Benefits / PV Costs Benefit to Investment Ratio The ratio of the present value of the quantifiable benefits (savings and cost avoidances) divided by the present value of the investment (development, production, military construction, and fielding) of the alternative. It does not include benefits that are associated with sunk cost. BIR = PV Benefits / PV Investment Savings to Investment Ratio The ratio of the present value of savings to the present value of the investment required to produce savings. It does not include sunk costs. SIR = PV Savings / PV Investment

7 ROI Metrics Break-Even Point The point in time, for example, number of years or fractional years, at which the savings in current dollars equals the investment in current dollars. It does not include sunk cost. Break-Even Point = Cum Investment = Cum Savings Net Present Value The difference between the present value of the benefits and the present value of the costs. NPV = PV Savings PV Investment All definitions are from the U.S. Army Cost Benefit Analysis Guide.

8 ROI Sample Return on Investment Metrics Example Discount Rate 1 2.2% Annual Discount Factor RDTE BY 2010 Composite Rates OMA BY 2010 Composite Rates FY 2010 FY 2011 FY 2012 FY 2013 FY 2014 FY 2015 FY 2016 FY 2017 FY 2018 FY 2019 Total Investment Costs BY2010 $M Investment Costs PV $M Status Quo Cost BY2010 $M Status Quo Costs PV $M Alterative Costs BY2010 $M Alterative Costs PV $M Savings BY2010 $M Savings PV2010 $M Other Benefits BY2010 $M Other Benefits PV$M Total Benefits BY2010 $M Total Benefits PV$M Investment Costs TY $M Cumulative Investment Costs TY$M Savings TY $M Cumulative Savings TY $M Cum Savings - Cum Investment (30.4) (56.1) (66.5) (29.4) Year Real Discount Rate Per OMB Circular 94, December 2009 Savings to Investment Ratio (SIR) Mid-year discount factor equation: 1/(i+1)n-.5 Benefits to Investment Ratio (BIR) Army Inflation Indices, January 2010 Benefits to Cost Ratio (BCR) Army Inflation Indices, January 2010 Net Present Value SIR equation: PV Savings/PV Investments Break Even Year BIR equation: PV Benefits/PV Investments 7. BCR equation: PV Benefits/PV Costs 8. NPV equation: Discounted Savings-Discounted Investment 9. Break Even: Year that cumulative savings - cumulative investment >1

9 The Most Important ROI Metric Cost Reductions Savings Cost Avoidances Cost Reductions A reduction in the number of dollars needed to meet an established requirement. There are two type of Cost Reductions: Savings and Cost Avoidances. Savings occur when an Army Manager can remove funds that are already programmed or budgeted and apply them to other needs. Cost Avoidances are cost reductions that are not savings. For example, a cost avoidance may be renegotiating lower server prices for an approved Army program that has not yet budgeted for that particular requirement. Enhancing productivity through a more efficient process does not necessarily mean there will be a cost reduction.

10 Determining a Cost Reduction Economic Efficiency Improvement Will economic efficiency improvement result in a cost reduction? No Productivity Improvement Yes Will cost reduction enable a manger to remove programmed or budgeted funds and apply them for other uses? No Cost Avoidance Yes Savings

11 Avoiding the ROI Pitfalls Know your audience and pick metrics that help make a good case while are easy to explain. Do not arbitrarily add years to your analysis to beef up your benefits so the ratios look better. Be careful to select the correct discount rates for the PV calculations. Nominal discount rates are used for current year dollar flows Real rates are used for constant year dollar flows Select the correct rate corresponding to the number of years of your analysis Nominal Interest Rates on Treasury Notes and Bonds of Specified Maturities (in percent) 3 -Year 5-Year 7-Year 10-Year 20-Year 30-Year Real Interest Rates on Treasury Notes and Bonds of Specified Maturities (in percent) 3 -Year 5-Year 7-Year 10-Year 20-Year 30-Year

Avoiding the ROI Pitfalls continued When discounting, use the mid-year discounting formula. End-year formula is used when one expends money at the beginning or the end of the year.

12 Avoiding the ROI Pitfalls continued When discounting, use the mid-year discounting formula. End-year formula is used when one expends money at the beginning or the end of the year. Typically, the Army expends money all through out the year. Discount Factor = 1/ (i+1) n-.5 Clearly label all dollars as either constant or current year dollars and use the most recent inflation indices. Be 100% certain that a cost reduction is a savings before submitting a cost reduction initiative. Budget folks are always looking for a bill payer!!!!! Make sure that all the stakeholders are aware and in agreement that there is truly a Savings before submission.

13 Summary ROI can either be a single or collection of metrics. The Army uses ROI analysis in EAs and CBAs Clearly defined Cost Reductions are the most important metrics. Avoid falling into a ROI Pitfall! Contact Noel Bishop at noel.d.bishop@us.army.mil with questions

Cost Benefit Analysis (CBA) Economic Analysis (EA)

Cost Benefit Analysis (CBA) Economic Analysis (EA) This is an overview of the preliminary work that should be completed before launching into a full CBA to determine the net economic worth of a proposal