Evaluating the Profitability and/or Cost Savings of an Investment
As a small business owner, you often face the challenge of where to invest your time and money. “Should I invest in training, building out a new service, updating facilities, or hiring new employees?” are questions that we often help our clients think through.
Cathedral uses Return on Investment (ROI), Return of Investment, Payback Period, and
Internal Rate of Return (IRR) as useful tools to evaluate different investment opportunities. While there are other tools one can use to review an investment, these can be the most flexible evaluation tools. This paper also includes a discussion on
Lean principles and their connection to ROI.
Calculating the Return on/of Investment Strategy
ROI, Payback Period, and IRR can be calculated as follows:

Return on Investment=
(Gain from Investment-Cost of Investment)
Cost of Investment

Return of Investment
Cost of Investment
 Payback Period=
Return per year

Internal Rate of Return is the rate at which sum of PVs=Cost of
Investment. See detailed equations on page 4.
IRR is useful as it combines the return of and return on investment along with the
Payback Period.
Return on Investment
One of the most common tools for evaluating investments is ROI. ROI is determined by taking the gross profitability from an investment and dividing it by the cost of the investment. Gross profit is calculated by subtracting the Cost of Goods Sold from revenue. We use gross profit because it focuses specifically on the costs relating to the investment before including overhead expenditures.
Here are a few examples showing different ROI situations. Imagine you buy 10 shares of Netflix for a total of $1,200. If you sell those shares in year 1 for $1,800, you would have an ROI of 50%.
ROI (Example 1)
Investment Cost
Total Retun
ROI
Year 1
$ (1,200)
$ 1,800
50%
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The following table shows what would happen if you took the same investment and calculated the ROI as an annual rate (annualized the ROI) over a 3 year period:
ROI Over Time (Example 2)
Investment Cost
Total Retun
Total ROI
Number of Years
Total
$ (1,200)
$ 1,800
50%
3
Annualized ROI 17%
Taking example two a step further, the ROI of a stock investment includes the concept of compounding. Compounding occurs when previous earnings are invested to create new earnings. In other words, a company earns money, reinvests that money, and then earns on that reinvestment. Example three shows the effect of compounding on example two.
ROI Over Time (Example 3)
Investment Value
Annual Value Appreciation
ROI
Year 1
$ (1,200)
Year 2
$ (1,400)
Year 3
$ (1,600)
$ 200
17%
$ 200
14%
Number of Years
$ 200
13%
3
Average Annual ROI 14%
The fourth example is based on purchasing a new piece of equipment for your business. If you purchased a new machine for $300,000 and it saves you $400,000 in year 1, with no extra cost or further use, your ROI would be 33%. Because there is no further use for the machine, the $300,000 is recovered, then the additional $100,000 gives you the 33% return. If the machine has a long useful life, then the returns are based on the benefit net of depreciation.
ROI (Example 4)
Year 1
Investment Cost $ 300,000
Total Retun $ 400,000
ROI 33%
The following table shows what would happen if you took that investment, had to replace a part, and annualized its ROI over a 4 year period:
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Investment Cost
Annual Return
Gain on Investment
Total ROI
Number of Years
Annualized ROI
ROI Over Time (Example 5)
Year 1
$ (300,000)
$ 100,000
Year 2
$ 100,000
Year 3
$ 100,000
Year 4
$ (10,000)
$ 100,000
Total
$ (310,000)
$ 400,000
$ 90,000
29%
4
7%
*A part needed to be replaced in year 4.
The sixth example looks at an investment showing the Cost of Goods Sold. It specifically shows ROI over time based on Gross Profit. This would be the case of a purchase of a business.
ROI Over Time (Example 6)
Investment Cost
Revenue
Cost of Goods Sold
Gross Profit
Total ROI
Number of Years
Year 1
$ (300,000)
Year 2
$ 950,000
$ 900,000
$ 50,000
$ 1,030,000
$
$
900,000
130,000
Year 3
$ 1,200,000
$ 900,000
$ 300,000
Total
$ (300,000)
$ 3,180,000
$ 2,700,000
480,000
60%
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Annualized ROI 20%
The seventh example is based on the same machine in the fourth example, however, this shows a longer time period and includes the sale of the machine inclusive of depreciation in year 6.
ROI Over Time (Example 7)
Investment Cost
Revenue
Cost of Goods Sold
Gross Profit/Cost Saved
Sale of Equipment
Gain on Investment
Total ROI
Number of Years
Annualized ROI
Year 1
$ (300,000)
Year 2
$ 950,000
$ 850,000
$ 100,000
$
$
$
950,000
850,000
100,000
Year 3
$ 950,000
$ 850,000
$ 100,000
Year 4
$ (10,000)
Year 5
$ (15,000)
Year 6
$
$
925,000
825,000
$ 100,000
$ 1,000,000
$ 925,000
$ 75,000
$ 1,050,000
$ 850,000
$ 200,000
$ 150,000
Total
$ (325,000)
$ 675,000
$ 150,000
$ 500,000
154%
6
26%
*A part needed to be replaced in year 4.
**Required maintenance in year 5.
***Sold machine in year 6.
When calculating an investment’s ROI, keep in mind that the investment may be perpetual. The actual value of the investment may not go away.
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Return of Investment
A Return on Investment counterpart is the Return of Investment. Cathedral encourages our clients to keep this calculation close when evaluating investments because it focuses on the Payback Period of an investment. The Payback Period is the period of time needed to earn back the amount of money used in an investment. For example, if an investment costs $300,000 and returned and average of $160,000 a year, it would have a payback period of 1.88 years.
Payback Period (Example 8)
Investment Cost
Revenue
Cost of Goods Sold
Gross Profit
Year 1
$ (300,000)
$ 950,000
$ 900,000
$ 50,000
Year 2
$ 1,030,000
$ 900,000
$ 130,000
Year 3
$ 1,200,000
$ 900,000
$ 300,000
Total
$ (300,000)
$ 3,180,000
$ 2,700,000
480,000
Number of Years
Payback Period
3
1.88
Internal Rate of Return
IRR determines the rate of return on an investment taking into consideration the time period, cash inflows, and cash outflows. That being said, you want your investment to have a positive IRR percentage. If you are comparing different investments, the best investment from an IRR standpoint is the investment with the highest rate.
There are two steps to calculate IRR using Net Present Value and Present Value formulas. First, you use the Net Present Value formula set to 0 to determine a rate.
This rate will be close to the actual IRR. However, it must be tested to determine the actual IRR.
Σ 𝐶𝑎𝑠ℎ 𝐹𝑙𝑜𝑤𝑠
0 = −𝐶𝑜𝑠𝑡 𝑜𝑓 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 +
(1 + 𝑅𝑎𝑡𝑒)^𝑌𝑒𝑎𝑟𝑠
Next, you test and adjust that rate with the Present Value formula to find the true IRR.
The correct IRR will make the sum of present values equal to the investment cost.
Present Value:
𝐶𝑎𝑠ℎ 𝐹𝑙𝑜𝑤 𝑦𝑒𝑎𝑟𝑠
(1 + 𝑅𝑎𝑡𝑒) 𝑦𝑒𝑎𝑟𝑠
Check for IRR:
𝐶𝑎𝑠ℎ 𝐹𝑙𝑜𝑤
1
(1 + 𝑅𝑎𝑡𝑒)
+
𝐶𝑎𝑠ℎ 𝐹𝑙𝑜𝑤
(1 + 𝑅𝑎𝑡𝑒)
2
2
+
𝐶𝑎𝑠ℎ 𝐹𝑙𝑜𝑤
3
(1 + 𝑅𝑎𝑡𝑒) 3
… = 𝐶𝑜𝑠𝑡 𝑜𝑓 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡
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Below is a detailed example of how to find the IRR of an investment using the above calculations. If you are content with the IRR information given so far, you can jump to page 6 and continue reading.
Internal Rate of Return (in Detail)
Let’s say you were considering making an investment of $250,000 and wanted to find the IRR on that investment over a 3 year period. Below is a table of cash flows to guide this example.
IRR Cash Flow (Example 9)
Year
0
1
2
Amount
$ (250,000)
$ 50,000
$ 100,000
3 $ 175,000
Given the cash flow, we can now begin the process to find IRR. We will use the Net
Present Value formula set to 0 to determine a rate. This rate will provide a starting point for our calculation.
0 = −$250,000 +
($50,000+$100,000+$175,000)
(1+𝑅𝑎𝑡𝑒) 3
$250,000 =
($50,000+$100,000+$175,000)
(1+𝑅𝑎𝑡𝑒)
3
$250,000 =
$325,000
(1+𝑅𝑎𝑡𝑒) 3
(1 + 𝑅𝑎𝑡𝑒) 3 ∗ $250,000 = $325,000
3
√(1 + 𝑅𝑎𝑡𝑒) 3
3
∗ √$250,000
3
= √$325,000
3
1 + 𝑅𝑎𝑡𝑒 ∗ √$250,000
3
= √$325,000
1 + 𝑅𝑎𝑡𝑒 =
3
√$325,000
3
√$250,000
𝑅𝑎𝑡𝑒 =
3
√$325,000
− 1
3
√$250,000
𝑅𝑎𝑡𝑒 = 0.091393 ≈ 9.14%
Now we have a rate to start our next step with. Using this rate as a starting point, our goal is to find the rate that makes the sum of Present Values equal to the investment cost. This rate is the true IRR.
𝐶𝑎𝑠ℎ 𝐹𝑙𝑜𝑤
1
+
𝐶𝑎𝑠ℎ 𝐹𝑙𝑜𝑤
2
(1 + 𝑅𝑎𝑡𝑒) (1 + 𝑅𝑎𝑡𝑒) 2
+
𝐶𝑎𝑠ℎ 𝐹𝑙𝑜𝑤
3
(1 + 𝑅𝑎𝑡𝑒) 3
… = 𝐶𝑜𝑠𝑡 𝑜𝑓 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡
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$50,000
(1 + 0.0914)
+
$100,000
(1 + 0.0914) 2
+
$175,000
(1 + 0.0914) 3
≈ $264,377.67
The rate of 9.14% gave us a sum of present values of $264,377.67. This number is close, however it is not equal to the investment cost of $250,000. To lower the
$264,377.67, we must try the equation again, this time using a higher rate. When choosing your next trial rate, keep in mind how far off your first rate was and adjust accordingly. In this example, we will use 12% as our next trial.
$50,000
(1 + 0.12)
+
$100,000
(1 + 0.12) 2
$175,000
+
(1 + 0.12) 3
≈ $248,923. 79
The rate of 12% gave us a sum of present values of $248,923.79. This number is much closer to the investment cost of $250,000. However, the rate is a bit high given that the sum of PVs is lower than the investment cost. Now it is time to consider how many more trials you want to perform to find the exact rate. If you are comfortable with 12%, then that is your IRR. If you would like to get a more precise IRR, continue this step until your sum of PVs equals the investment cost. If you continue this process you will find that the true IRR is equal to approximately 11.792%.
Thinking Beyond ROI
It is important to remember that ROI, IRR, and Payback Period are financial, quantifiable evaluation strategies. Therefore, these calculations do not value investments that strengthen assets that are difficult to quantify, like reputation and customer expectations. For example, if a company specializes in quality products, a device that further strengthens product quality may not have a high ROI for the investment.
The device may advance the company’s reputation for ongoing quality development. These types of difficult to quantify strategic investments can create more of a return than what is shown by ROI, IRR, and Payback Period. ROI and Payback
Period can be very useful, however, they should always be paired with further analysis to form the most accurate profitability and cost savings predictions. Lean Principles provide some of the further analysis needed to compliment the ROI, IRR, and Payback
Period.
Continuous Improvement through Lean Principles
An example of a difficult to quantify investment is a Lean Principles review. As a business owner, you are constantly looking for ways to improve your business/operations whether it’s by cutting cost, reducing waste, or looking for a competitive edge. If you have thought of ways to improve your business, then you have begun the Lean process. The Lean process is a way of examining your business to discover waste and increase efficiency. The fewer resources you are able to use while producing products and serving customers, the more efficient your business can become. In relation to this subject of improvement, both tangible resources (ex. machinery, parts, and personnel) and intangible resources (ex. time) should be evaluated. Managing core processes to provide value for customers at the right time
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and adding value by cutting waste is key to achieving your objective as a business owner/decision maker through Lean principles.
There are eight types of waste that exist, and determining which one(s) relates to your issue is a step in the evaluation process that will help you determine if the investment is right for your business. The eight types of waste are:
•
Defects
– time spent on doing something incorrectly; not right after the first
• time.
Overproduction – too great a quantity produced before actually needed by
•
•
•
•
•
• a customer.
Transportation
– improper utilization of logistical operations or unnecessarily moving things around, which affects time.
Waiting – time lapse and improper use of employees’ time. Workloads are not level.
Inventory
– shortages and surpluses can affect your work space or capacity to be fully operational.
Motion – unnecessary movements by employees.
Over-processing
– having overly complicated operations.
Human Potential – a question of whether you are allowing your staff to reach their maximum potential. Ignoring employee ideas or having a restrictive environment that does not allow your employees to express his/her ideas or concerns, can be detrimental to your progress as a business owner.
Case Study: Company X
Company X is a manufacturing plant that produces metal components and stamping for a variety of products. Company X needs to produce 10 million perfect parts every year.
Currently, there are employees who complete Quality Control testing for Company X, but the company is now considering investing in an automated Quality Control (QC) device.
This QC device is a capital investment. It will not produce income for the business.
Company X does not have a capacity issue in producing its current orders for producing
10 million parts. However, the QC device will reduce costs and improve efficiency for
Company X. The QC device is expected to reduce the time and effort used to review parts, while creating more accurate Quality Control.
Implementing the Return on/of Investment Strategy
The QC device gets its Return on/of Investment out of its ability to reduce costs in the business. Keeping this in mind, the device’s ROI, Payback Period, and IRR can be calculated:

Return on Investment=
(Reduced Costs-$100,000)
$100,000

Payback Period= Number of years for savings to equal $100,000

Internal Rate of Return is the rate at which sum of PVs=Cost of
Investment.
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Investment Cost
Revenue
COGS
Gross Profit
Year 1
$
Total ROI
Number of Years
Payback Period (years)
(100,000)
$
$
940,000
925,000
$ 15,000
ROI and Payback Period
Year 2
$
$
960,000
935,000
$ 20,000
Year 3
$ 1,000,000
$ 960,000
$ 35,000
Year 4
$ 1,010,000
$ 970,000
$ 40,000
Total
$ (100,000)
$ 3,910,000
$ 3,790,000
110,000
10%
4
3.64
Year
IRR Cash Flow
Amount
0
1
2
3
$ (100,000)
$ 15,000
$ 20,000
$ 35,000
4 $ 40,000
Given the cash flow, we can now begin the process to find IRR. We will use the Net
Present Value formula set to 0 to determine a rate. This rate will provide a starting point for our calculation.
0 = −𝐶𝑜𝑠𝑡 𝑜𝑓 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 +
Σ 𝐶𝑎𝑠ℎ 𝐹𝑙𝑜𝑤𝑠
(1+𝑅𝑎𝑡𝑒)^𝑌𝑒𝑎𝑟𝑠
0 = −$100,000 +
($15,000+$20,000+$35,000+40,000)
(1+𝑅𝑎𝑡𝑒) 4
$100,000 =
($15,000+$20,000+$35,000+40,000)
(1+𝑅𝑎𝑡𝑒) 4
$100,000 =
$110,000
(1+𝑅𝑎𝑡𝑒) 4
(1 + 𝑅𝑎𝑡𝑒) 4 ∗ $100,000 = $110,000
4
√(1 + 𝑅𝑎𝑡𝑒) 4
4
∗ √$100,000
4
= √$110,000
4
1 + 𝑅𝑎𝑡𝑒 ∗ √$100,000
4
= √$110,000
1 + 𝑅𝑎𝑡𝑒 =
4
√$110,000
4
√$100,000
4
√110,000
𝑅𝑎𝑡𝑒 =
4
√$100,000
− 1
𝑅𝑎𝑡𝑒 = 0.024114 ≈ 2.41%
Now we have a rate to start our next step with. Using this rate as a starting point, our goal is to find the rate that makes the sum of Present Values equal to the investment cost. This rate is the true IRR.
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𝐶𝑎𝑠ℎ 𝐹𝑙𝑜𝑤
1
(1 + 𝑅𝑎𝑡𝑒)
$15,000
(1 + 0.024114)
+
+
𝐶𝑎𝑠ℎ 𝐹𝑙𝑜𝑤
(1 + 𝑅𝑎𝑡𝑒)
$20,000
2
2
+
(1 + 0.024114) 2
𝐶𝑎𝑠ℎ 𝐹𝑙𝑜𝑤
3
(1 + 𝑅𝑎𝑡𝑒)
+
3
+
𝐶𝑎𝑠ℎ 𝐹𝑙𝑜𝑤
(1 + 𝑅𝑎𝑡𝑒)
$35,000
(1 + 0.024114) 3
+
4
4
= 𝐶𝑜𝑠𝑡 𝑜𝑓 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡
$40,000
(1 + 0.024114) 4
≈ $102,665.24
The rate of 2.41% gave us a sum of PVs of $102,665.24. This number is close, however it is not equal to the investment cost of $100,000. To lower the $102,665.24, we must try the equation again, this time using a slightly higher rate. When choosing your next trial rate, keep in mind how far off your first rate was and adjust accordingly.
In this example, we will use 3% as our next trial.
$15,000
(1 + 0.03)
+
$20,000
(1 + 0.03) 2
+
$35,000
(1 + 0.03) 3
$40,000
+
(1 + 0.03) 4
≈ $100,984.46
The rate of 3% gave us a Present Value sum of $100,984.46. This number is closer to the investment cost of $100,000. However, the rate is still a bit low given that the sum of PVs is higher than the investment cost. Now it is time to consider how many more trials you want to perform to find the exact rate. If you are comfortable with 3%, then that is your IRR. If you would like to get a more precise IRR, continue this step until your sum of PVs equals the investment cost. If you continue this process you will find that the true IRR is equal to approximately 3.352%.
This IRR means that the investment will generate an average annual return of 3.352% over its life.
Company X
’s Reputation
Company X has a reputation for producing quality products. Their clients expect to receive excellent and accurate parts. A Quality Control device goes right in line with the expectations of Company X ’s clients and the business’ reputation. Therefore, although the ROI, Payback Period, and IRR numbers may not be as impressive as desired, reputation and client expectations can generate value in the investment.
If Company X decided to push their marketing to showcase the QC device, it could entice more customers and create an increase in revenue.
Articles for Further Reading
 “What is Lean?” gives some background and information regarding the Lean manufacturing principles. http://www.lean.org/WhatsLean/
 “Seven Wastes” explains seven of the different types of “waste.” http://whatis.techtarget.com/definition/seven-wastes
 “What is Over-Production Waste?” specifically focuses on the topic of “overproduction waste.”
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http://leanself.org/848/what-is-over-production-waste/
 “FYI On ROI: A Guide To Calculating Return On Investment” explains the calculation for ROI. http://www.investopedia.com/articles/basics/10/guide-to-calculating-roi.asp
 “What is the formula for calculating internal rate of return (IRR) in Excel?” explains the calculation for IRR. http://www.investopedia.com/ask/answers/022615/what-formula-calculatinginternal-rate-return-irr-excel.asp
 “Organic Quality Control: The Natural Approach to Manufacturing” discusses quality control processes in the manufacturing world. http://www.automationworld.com/quality-management/organic-quality-controlnatural-approach-manufacturing
 “Internal Rate of Return (IRR)” discuss the definition, calculation, and explanation of IRR. http://accounting-simplified.com/management/investment-appraisal/internal-rateof-return-irr.html#limitations
 “How to Build a Successful Business Case for an IT Project” discusses how to value an IT company. http://www.tomsitpro.com/articles/it-business-case,2-701-3.html

Fundamental Managerial Accounting Concepts by Thomas Edmonds, Bor-Yi
Tsay, and Philip Olds.
Mark Thorne is a Managing Director of Cathedral Consulting Group, LLC in the New
Jersey Office. Steven Toal is a Senior Associate of Cathedral Consulting Group, LLC in the New Jersey Office. Christine Kaufman and Stephen Sumner are Associates of
Cathedral Consulting Group, LLC in the New Jersey Office.
For more information, please visit Cathedral Consulting Group LLC online at www.cathedralconsulting.com
or contact us at info@cathedralconsulting.com
.
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