ROI is toast. Use EVA instead.

Last year it became common knowledge among eLearning professionals that ROI (Return on Investment) is more than a number. It’s a metric that requires you to state projected costs and benefits explicitly. It forces you to evaluate whether you’re proposing a sound investment or a loser. It provides a standard of comparison to other demands on the company’s resources. It makes you think like a business decision-maker. Too bad it’s obsolete.

ROI has a fatal flaw - it assumes that the funds that make up the “I” are endlessly available. And free. In the real world, funds are limited. There’s only so much to go around. Cash comes with a price-tag - what it costs your company to borrow the money. Alternatively, the price of money (“cost of capital” to your CFO) approximates what you could get from investing the funds outside of the company (which you’d presumably do if you didn’t have better investments inside).

Your company’s cost of capital is related to how risky investors think it to loan you money, your bond or credit rating, and the availability of investment capital in the economy. Luckily, we don’t have to be picky about the specific number. Ask your CFO. Or use 10%. It’s not going to be that far off the mark, and it takes into account the reality that investment funds are neither free nor unlimited.

“Economic Value Added,” EVA for short, is a measure of ROI that takes the cost of funds into account. Unlike ROI, EVA is an amount, not a ratio. This keeps you focused on overall value. You won’t trade off a project with a 2000% ROI that only yields $10,000 in returns against a project with 30% ROI that nets $850,000.

EVA is not difficult to calculate. Assume you’re making the case for a new program that you expect to return $32,000 for your $200,000 investment in its first year. Your ROI would be 32,000/200,000 = 16%.

The EVA for this project deducts the cost of using the $200,000 ( x 10% = $20,000). Your EVA is based on your return less what you must pay for tying up the company’s capital, $32,000 - $20,000 = $12,000. Your EVA ratio is 12,000/200,000 = 6%.

“What’s in it for me?” you ask. Several things:

  1. By charging for the use of scarce capital, EVA may lead you to outsource activities that would otherwise tie up your resources. Let someone else bear the cost of capital for those.
  2. EVA recognizes that there’s no free ride. Projects don’t get funded because they have a hefty ROI. They get funded when they are the best use of funds available. No company can afford to pursue all its upside opportunities.
  3. EVA gets everyone thinking like owners. The carrying cost of excess inventory gripes the manager who’d like to use those funds for a new project.

Posted by Jay Cross at March 1, 2003 01:28 AM | TrackBack

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