By: Peyton Marshall, CEO LeveragePoint
Being a CFO has its perks. One of them is that you get to ask hard questions.
I ought to know. I used to be a CFO.
When you sign the checks, it’s acceptable behavior to ask tough questions. About spending plans. Even if you don’t understand what the spending is supposed to achieve or how. Even if you never intend to.
I had a favorite question when someone wanted to spend money we didn’t have.
It worked best if I paused and stared over my glasses. “So…, what’s the ROI on this?”
It was a math question that required a math answer. The speaker usually got flustered. The answer usually got bungled. It was a good way to save money.
Now I work with B2B professionals who sell differentiated, big ticket products and services. They don’t necessarily have access to their customer’s CFO, even when the CFO is asking the math question. But the math question keeps them awake at night: “What is the ROI of your product?”
There are different methods that B2B companies use in doing customer math. The methods are less important than doing the math on results that matter to your customer: profitability and cash flow. Each method comes with its challenges but they all get the same answer if applied appropriately.
Of these, ROI is the calculation that even liberal arts students can’t avoid. When you Google the three primary methods of estimating the dollar value of differentiated products to customers, ROI wins by an order of magnitude over TCO and by two orders of magnitude over EVE®. If you are trying to speak the economic language of your customers, ROI is an acronym you can’t avoid.
That should come as no surprise. ROI is a core concept in finance that extends its reach way beyond the choice of different products and services. It is impossible to get an MBA without coming across ROI somewhere in a business school curriculum. Other measures (TCO, EVE) are deployed to ask a narrower range of strategic and operating questions. But ROI is ubiquitous. It runs through discussions of investment, marketing, manufacturing, development and finance.
ROI is a language everyone in B2B sales and marketing needs to speak. Unfortunately, it is so universal that it is often spoken by people who forget how it relates to the numbers that matter, business profitability and cashflow.
Carelessly applying ROI can result in confused value messages about your products. Sloppy answers to the ROI question can lead to two traps:
- You can get stuck with the wrong goal post.
- You can get the wrong answer in comparison to some competitors.
Trap #1: The Wrong Goal Post: An ROI is invariably compared to a hurdle rate. An ROI aims to get above the cross-bar of a goal post, to get a passing grade in a pass-fail class, a thumbs up or a thumbs down from the Emperor.
Hurdle rates are set above zero because of two facts of life:
- Costs and benefits come at different times. In decisions about purchasing a product, ROI is a natural and interesting metric when a meaningful amount of time elapses between spending money and obtaining benefits. Costs frequently occur in advance of benefits, hence ROI needs to be above a hurdle rate that accounts for the time value of money.
- Outcomes are risky or uncertain. Benefits are often less certain than the cost of obtaining them. The benefit of making a change is almost always more uncertain than doing nothing. The benefits and costs of a product that has been on the market for four years are typically less risky than those of a new product. An ROI, calculated on the basis of an expected outcome, needs to be above a hurdle rate that reflects the risk or uncertainty of obtaining that outcome.
If the net economic benefits of a product were immediate and certain, the ROI hurdle rate for that product would be zero. A positive hurdle rate is a useful decision criterion when there is time value and uncertainty involved. It is no accident that ROI is often compared to a cost of capital imported from Finance. A cost of capital deployed as a hurdle rate for decision-making is generally applied as a discount rate that captures both the time value of money and the risk/uncertainty of the business decision. Discount rates always have a period of time attached to them, usually annual, and are set at levels that reflect both the time value of money and a risk premium.
This is all nice in theory, but not everyone in business got an MBA. And not all MBAs remember what they learned in Finance.
(Benefits – Costs)/Costs
with no adjustment for the time that elapses between costs and benefits to obtain an annualized rate. A 4% return obtained over a three month period is a 16% return per annum. In this case, 16% per annum is the appropriate rate for comparison to a hurdle rate based on a standard annual cost of capital. Claiming a 4% ROI for your product based on a simple, non-annualized, three-month return would be a blunder. It needs to be translated into annual terms comparable to your customer’s goal post.
Trap #2: The Wrong Answer. When comparing alternative products or purchases, ROI is a clearer, less ambiguous decision criterion for some decisions than it is for others.
ROI is useful in a decision between buying a product and doing nothing. Finance executives love to ask the zero-based budget question of why spend anything at all. That is part of their job description. It is a fair question when the proposed outlay is to spend more than before on something new.
The comparison between buying something versus buying nothing (the status quo) is almost always the comparison a CFO has in mind when asking for the ROI. The simple math in computing the ROI in this case usually puts the total spending on the product in the denominator. That makes sense when comparing buying the product to doing nothing (and therefore spending nothing).
Using ROI is error-prone when comparing competing products. There are at least two ways that ROI can yield the wrong answer when there are two (or more) directly competing products in addition to the status quo. This is easiest to see in a simple example. Consider a situation where your product (Product B) is being compared both to a direct competitor (Product A) and to doing nothing (Status Quo). Just to make choices clear, assume identical risks of obtaining the benefits from Product A and from Product B. The simple example is shown in Table 1:
The ROI vs Status Quo for Product A and for Product B are each calculated in Table 1 as:
These are natural ROIs to calculate. They are the ROIs that the CFO has in mind in comparing buying a product to doing nothing and spending nothing. Given the timing of the benefits in the example, the first ROI trap is not a problem in Table 1; these ROIs are calculated appropriately relative to hurdle rates, on an annual basis.
Which alternative is the right choice? Some comparisons are clearer than others.
ROI, as calculated in Table 1, provides strong numerical support for buying Product A in comparison to doing nothing. Calculated ROI also provides strong numerical support for buying Product B in comparison to doing nothing. Unless (i) the buyer has a very high corporate cost of capital or (ii) the risk of obtaining the benefits from Products A and B are very high, the 30%+ ROI of either product versus the Status Quo would exceed most corporate hurdle rates. Doing nothing (the status quo) is a distant third in this example. The worst choice is clear.
Which of Product A or Product B is the best choice? One possible answer is to look at the two ROIs in Table 1. Product A has a higher ROI so it must be better.
Neither of the ROIs in Table 1 is based on a direct comparison between Product A and Product B. The reference point for both of these two ROIs is the Status Quo. This reference point is irrelevant for the choice to be made between Products A and B.
An expanded Table 2 (below) includes two standard approaches* to calculating ROI for a direct comparison between Products B and A:
- ROI on Total Outlay vs Product A. The calculated formula is:
- Incremental ROI vs Product A. The calculated formula is:
The two direct numerical comparisons in Table 2 give different quantitative answers:
- Product B has an 8% ROI on Total Outlay vs. Product A, making for a close call between the two alternatives depending on hurdle rates.
- Product B has a 25% Incremental ROI relative to Product A, creating a strong argument in favor of Product B (at least for most corporate hurdle rates).
The second direct approach, Incremental ROI, results in Product B as a clear best choice. This result contrasts with: (i) the opposite conclusion you might draw from the indirect comparison of ROIs vs Status Quo and (ii) the ambiguous conclusion that you might reach based on the first direct approach, ROI on Total Outlay.
Incremental ROI is the best approach for making comparisons between two competing products. Incremental ROI calculates the incremental net benefit from choosing Product B relative to Product A, in comparison to the incremental net outlay required to purchase Product B relative to Product A. If your microeconomics teacher beat you over the head as hard as mine did, you wouldn’t hesitate to say that Incremental ROI is the right way to make the choice. Simply put, if the marginal benefit of a decision exceeds its marginal cost, then it is a good decision. In case you were subjected to less head trauma than I was, the algebra comparing the present value of cash flows arising in Tables 1 and 2, discounted by the hurdle rate, clearly supports the use of Incremental ROI. Click here to see the algebra of NPVs.
The use of ROI is one place where dueling spreadsheets can cause confusion. Different approaches. Different methods. Spreadsheets don’t provide a common framework. They don’t build fluency in a common language understandable by the customer.
To make customer math work for your organization, you need a scalable platform with clear methods that…
- Is easy to follow and use
- Helps avoid mistakes
- Provides consistent graphics and messages that others can understand and use
- Utilizes customized but QA’ed materials to leave behind
- Gathers data from each customer
- Aids in creating effective, tailored customer conversations
No matter how it is expressed, a value message is incomplete without an answer to the ROI question. Make sure you give the right answer by communicating an annual rate that is comparable to your customer’s goal post. Make sure you provide the right ROI for comparing the alternatives that your customer is considering.
*To my knowledge, alternative approaches to calculating ROI in comparing products are more discussed among practitioners than they are defined or debated in specific literature. We are grateful to several LeveragePoint customers for their questions and insights. One approach in the literature to using ROI in comparing products is provided in a very good paper by Alex Beram and Mark Burton, “The Case ROI Method: Versatile Sales,” The Journal of Professional Pricing 20.4 (2011): 26-29. My perspective is that the Beram & Burton paper is focused on laying out a framework for analysis and a methodology for obtaining data, not on defining a specific calculation method for the results or the best numerical way to communicate an answer.
About Peyton Marshall
Peyton Marshall is CEO of LeveragePoint. Previously, he served as CFO and Acting CEO at PanacosPharmaceuticals, Inc., CFO of EPIX Pharmaceuticals, Inc. and as CFO of The Medicines Company through their initial public offering and the commercial launch of Angiomax®. Previously, he was an investment banker in London at Union Bank of Switzerland, and at Goldman Sachs where he was head of European product development. He has served on the faculty in the Economics Department at Vanderbilt University. Dr. Marshall holds an AB in Economics from Davidson College and a PhD in Economics from the Massachusetts Institute of Technology.