Computing Return on Investment (ROI) Oracle Tips by Burleson Consulting

The Data Warehouse Development Life Cycle

Economic Feasibility

COMPUTING RETURN ON INVESTMENT (ROI) 

Here, you enter the realm of the time value of money. Because you will have to wait a year to acquire the additional $50 in benefit, you need to consider your opportunity cost of capital. That is, if you freed-up your $20 investment by an immediate sale, how much additional revenue could you generate by having that $20 to invest in other antiques? To know the answer, you must computer your opportunity costs and determine the relative merits of each option. In corporations, the opportunity cost of capital has been carefully computed, and the answer can be determined by applying the discounting factor associated with the opportunity cost of capital to the future revenues.

The discounting factor must take into account more than just the opportunity cost of capital. For example, if our current inflation rate is 10 percent, then you must also factor this into your decision. The intangible costs of risk are also sometimes factored into a discounting rate. Remember, you are dealing with the probability that your Parrish print will take one year to sell for $250, and your confidence in this estimate must also be taken into account. If you are 95 percent certain that the print will sell within one year, then there is a 5 percent possibility that the print will remain in the store for a period longer than one year, and you must factor this risk into your equation.

Applying the discount rate to future costs and benefits is not as simple as subtracting the future amount by the percentage discount rate. When computing the net present value of a cost or benefit, you must recognize that the discount rate is applied in an iterative fashion according to specific time periods. For example, your opportunity cost of capital might be the rate of return that you could earn from a certificate of deposit that pays 8 percent compounded yearly. If this were the case, then you would reapply your discount rate on a yearly basis. However, matters get more complicated when opportunity costs are compounded more frequently. Some financial institutions pay interest compounded monthly, daily, and even continuously. In our picture example, the opportunity costs might be the inability to purchase other antiques which may sell faster, or at a higher profit margin.

Usually, the data warehouse manager can call the accounting department and ask for the discount rate for the company and the periods for the rates. Then, it is a simple mater of using net present value techniques to compute the present values of costs and benefits.

Regardless of the method, all of the return on investment calculations should result in a net dollar value. Remember, when doing a cost-benefit analysis, you must take into account the total accrued future costs and benefits, all the while expressing the terms in net present value dollars. Quantitatively, this involves using calculus to determine the space under the cost and benefit curves.

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This is an excerpt from "High Performance Data Warehousing", copyright 1997.

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