Whether you are upgrading your building’s lighting system, setting up a recycling program, or greening your supply chain, dollars will be spent and those dollars should be considered an investment. Which is the best financial metric to use for investment decision making? It depends on what is important to you, and it is crucial to understand the differences in the information each metric provides. Return on investment and payback period seem to be the two most commonly used financial metrics for making sustainability investment decisions. Let’s review those two.
Return on Investment (ROI):
Simple ROI is the incremental gains of an action divided by the cost of the action. This metric will predict the percentage or ratio of gains to cost. You will hear ROI given as a number, usually a percentage. For example, if someone tells you that your $100,000 investment has an ROI of 25%, you can expect your incremental gains to be 25% more than the investment.
Simple ROI = (Gains – Investment Costs) / Investment Costs =
($125,000-$100,000) / $100,000 = 0.25 or 25%
The problem with looking at simple ROI alone is that this tells you nothing about time. How long will it take for your business to see that 25% return on investment? 2 years? 10 years? 50 years? Simple ROI also doesn’t illustrate the risk of an investment.
Payback period is the length of time that it takes for the cumulative gains from an investment to equal the cumulative cost. In other words, how much time it takes for an investment to pay for itself. Investments with shorter payback periods are considered to have lower risk than those with longer payback periods. The calculation is more cumbersome than that of simple ROI. However, like simple ROI, payback period analysis does not tell the whole story. What are the gains once the investment has paid for itself? Payback period doesn’t calculate this information.
In reality, there is no single best financial metric that will tell you “go or no go” on an investment decision. The key is to know what is important to your business and to understand the information you are working with.