Fostering better decisions through holistic ROI estimates

Recent volatility has added new layers of complexity to a topic that already challenges business leaders: prioritizing investments.

When executives want to understand the trade-offs between different initiatives, they typically compare the projects’ net present values (NPVs)—the measure of an investment’s worth over its entire lifetime discounted to today. In theory, these analyses should balance near-term and long-term financial viability. In practice, however, that’s increasingly difficult to do because uncertain macroeconomic, regulatory, and geopolitical environments make future outcomes hard to predict. Additionally, business leaders tend to make many implicit but untested assumptions—and sometimes chains of assumptions—in the discounted-cash-flow calculations that inform NPV, multiplying the chances of getting unreliable results.

We believe the solution lies in supplementing NPV analyses with metrics that cover other priorities the investments aim to advance, such as resilience, adaptability, and sustainability. In theory, NPV calculations take these factors into account, but separately analyzing the nonfinancial value drivers (which we will call complementary factors) can help business leaders think through their assumptions and can potentially reveal hidden biases or misconceptions. Furthermore, assessing these factors in a rigorous way gives management teams a fuller picture of how a given combination of investments can help them achieve strategic imperatives. For public sector organizations, such an approach can be particularly useful given their mandates may not prioritize financial returns (see sidebar, “Expanded ROI in the public sector”).

To be sure, some of these complementary factors are difficult to measure, especially those that are qualitative in nature. This reality makes it essential for management teams to agree on what metrics best capture the information they need to make investment decisions. Additionally, many complementary factors often don’t correlate with near-term economic performance. For example, investing in onshore manufacturing capacity to boost operational resilience may not create an immediate financial benefit but could prove critical to a company’s ability to adapt to future external shocks and sustain long-term cash flows.

Organizations can take a multistep approach to get comprehensive ROI projections of different investment options. Calculating NPV remains the bedrock on which investment decisions are based but is supplemented by identifying the complementary factors that are material to the investment decision and selecting metrics to measure them. Finally, management should review the results to ensure they align with the organization’s priorities. This process forces business leaders to make their implicit assumptions explicit—both in terms of the relative importance of organizational priorities (and the trade-offs they may require) and how different investment options would influence them. The steps for the approach are as follows:

1. Calculate NPV. NPV is the primary measure by which each potential project is assessed. Once business leaders have spelled out their assumptions and calculated all the NPVs, they can rank the investment options based on their potential for financial value creation.
2. Define complementary factors. In parallel, leaders should define the nonfinancial factors that matter most to the organization. These could include operational resilience, innovation, sustainability, or agility in adapting to changing market conditions. Management teams should then decide which factors are the most significant contributors to strategic priorities before zeroing in on a handful that they incorporate into their broader analysis.

3. Define the metrics for each complementary factor. Next, leaders should decide how they will measure each complementary factor (table). Some key performance indicators may be easy to identify—days of inventory for supply chain resilience, for example, or Scope 1 carbon emissions for sustainability. Other scenarios, however, may require relying on proxy metrics.

   Business leaders should align on the best metrics for assessing the complementary factors, which can be quantifiable or qualitative. For example, when a luxury-fashion company was developing a decarbonization strategy, the leaders first ranked each project based on profit and cash impact, then added quantifiable nonfinancial metrics in the form of a marginal abatement cost curve to estimate potential reductions in carbon emissions from each project’s implementation. This helped them identify the trade-offs for each investment and the options with the best mix of cost-effectiveness and sustainability impact.

   Organizations can also find proxies for qualitative nonfinancial metrics. Marketing ROI, for example, typically combines qualitative metrics with quantitative measures of impact on brand reputation, such as viewer impressions, changes in buying behavior, and loyalty.

4. Assess each project against complementary factors. To compare a range of complementary factors, the respective metrics can be normalized to a score. This can be done by attributing a relative significance to each factor, as well as identifying the point of limited return. For example, a business may decide that cybersecurity is more critical to operational resilience than supply chain security—up to a point beyond which incremental gains don’t significantly contribute to resilience. This kind of analysis can help the team understand the impact of each project on strategic priorities.
5. Rank the projects. Once leaders have combined the NPV and complementary factor analyses, they can rank the projects under evaluation across all the metrics to get a comprehensive view of projected investment outcomes. For example, a project could generate a large financial return but detract from operational resilience or sustainability goals, resulting in a midrange total score.
6. Assess the results against organizational priorities. The ultimate goal of this exercise is to facilitate objective, transparent leadership discussions and decisions. Leaders can use the calculated scores to compare projected performance of projects across the different value drivers and determine which investments to pursue.

To see how this process works in practice, consider the experience of a chemicals company with a portfolio of approximately 300 capital improvement projects it needed to prioritize. About 60 percent of the projects were related to maintenance to keep facilities working, an additional 30 percent would improve margins through reductions in costs or energy use, and the final 10 percent focused on growth. In analyzing the benefits of each investment, the management considered three corporate priorities beyond financial performance: reliability of chemical processes, supply chain resilience, and sustainability, which would enable it to tap demand for green offerings.

When the team assessed each project’s NPV and its contribution to the three complementary priorities, it realized that some margin-related projects also improved plant reliability by modernizing the infrastructure. They then ranked the projects according to the combined ROI, based on which they decided to shift more than 50 percent of the spending to investments that would both improve margins and foster growth.

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To get a full picture of the value that different investments can deliver, business leaders can combine an ROI analysis with assessments of nonfinancial complementary factors that matter most to the organization. By aligning on which complementary factors are most important and how to measure them, management can decide which investments will make the biggest contribution to strategic priorities.