ROI is a dangerous tool – here is how to use it

19/08/2011 at 09:35 6 comments

ROI (Return On Investment) has become the tool which HR increasingly use to show that they are adding value to the company’s bottom line. And rightly so. HR has the potential to create a lot of value to a company – also Shareholder Value. And this value  should be shown and highlighted.

ROI is a very simple tool. Too simple in many ways. The calculations is:  (return-investment)/investment. The return is the monetary gain from a HR activity and the investment is the full all-inclusive cost of the activity.

Despite the obvious problems in actually measuring the financial benefits of say a leadership development program, the ROI calculation is something  in itself to be careful about.

When I worked as a financial analyst, we didn’t use ROI that much. We used more ‘sophisticated’ metrics such as Enterprise Value metrics, ROIC (Return On Invested Capital), RoOFCF (Return on Operating Free Cash Flow), CRONCI (Cash Return On Net Capital Invested). What is common about all these ratios is that they recognise that ‘return’ and ‘investment’ is something quite complex.

When I still believe that ROI has a lot offer for HR executives it is because that when used right, it has a lot to offer.

The advantages with ROI are:

  • Easy to understand
  • Focuses on input and output of an HR activity
  • Show the bottom-line effect
  • Gives HR a language to talk to top management (and CFO in particular)
  • Makes it possible to make better HR investment decisions
  • Connects well with HR Balance Score Card
  • Potentially show the important assumptions behind the activity

The weaknesses of ROI are:

  • It is very sensitive to a few assumptions (in particular about productivity gains)
  • Reduces complex things such as people and leadership skills to simple causal relationship and a single number
  • Difficult to see the most important assumptions behind the calculation

So when you use ROI to show the financial value of your HR activities please remember that it is a very simple tool which should be used very careful. When I help HR executives to use ROI in their business I always emphasize the importance of process, structure, explicit assumptions and base line data.

Good luck

Entry filed under: Measurement. Tags: , , , , , , , , , , .

Wrong assumptions lead to bad decisions Should Human Capital be fully capitalized on the Balance Sheet?

6 Comments Add your own

  • […] is a simple tool – and also a tool to be used carefully as it has many pitfalls. However, at is core it has two components; benefits and costs. To improve ROI you need to focus on […]

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  • […] have written before about the pitfalls of ROI measure (read this blog on how to use ROI on Human Capital). It is not without dangers. LD_AddCustomAttr("AdOpt", "1"); LD_AddCustomAttr("Origin", […]

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  • […] can tell you if you are creating value. ROI does that. It is not without complications (read about ROI dangers) but I think it is the most appropriate one to […]

    Reply
  • […] get me wrong I believe ROI is a great tool for HR to use (if used right). When I was working as a financial analyst I always tried to measure the shareholder value. For a […]

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  • […] I argued in a blog last week that ROI is not always the answer for HR. I argued that if it was just about getting approval for a project then ROI was too complicated and time consuming. If on the other hand it is used to make better HR investment decisions and/or to evaluate HR projects then ROI is an excellent tool. In many respects, I am a big fan of ROI but I think you should be aware of the pitfalls of ROI. […]

    Reply
  • […] ROI is used more and more in HR when justifying or evaluating HR projects. But it has at the same time come under a lot of criticism for being too difficult to use in HR. The first alternative I suggested was another financial ratio – CROCI – which may be better due to its focus on cash and the balance sheet. But while it is a much better ratio than ROI, it is more complicated to use. The second alternative was friction & flow, which is highlighting that HR should create flow and remove friction allowing employees to get on with their day-to-day things. This alternative is very common sense (its strength) but very vague (its disadvantage). […]

    Reply

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