As an accountant, I’m often asked about significant expenditures, such as a new piece of equipment or marketing campaign. The answer to this type of question depends on whether the benefits of the investment outweigh the cost of the financial outlay. How do you know whether the benefit outweighs the cost? One method — and the most common among finance professionals — is return on investment, which is a measure of how much you receive for what you put into a purchase. It can be measured in terms of:
■ Financial measures – This refers to dollars returned for a particular endeavor.
■ Cost reduction – This is based on an investment of time, money or other effort, how much did you save?
■ Improved performance – You want to reduce the time it takes to perform effectively.
■ Customer satisfaction – If you use customer surveys, how many high ratings did you receive?
■ Marketing metric – An increase of the number of pest contracts immediately following the rollout of a marketing initiative is a common example.
The formula to calculate return on investment (ROI) is straightforward and extremely powerful. To calculate it, the benefit (return) of an investment is divided by its cost. The result is expressed as a percentage or a ratio. The ROI formula is shown in Figure 1. The easiest way to visualize the formula is:
1. Assume you purchased a stock share for $10.
2. Two years later, you sell it for $14.
ROI = 40% = $14 – $10/ $10
You received a 40% ROI or a 20% annual return, which is used to rate this investment against another under consideration.
While this example is simple, ROI calculations can be complex. Careful analysis of the facts and a well-thought-out projection must be done. Look at Example 1 to see how this analysis is done. The ROI from the $20,000 bed bug equipment expenditure is 301%.
301% = $80,241 – $20,000/ $20,000
The annual return from this $20,000 investment of bed bug equipment is more than 57% per annum ($11,463 annual return / $20,000 investment). The total ROI is more than 300%, which seems like a no-brainer. We’re assuming you can keep the machine used at a rate of $500 per day (on average) and profit is a result of using the equipment. If you weren’t doing bed bug work, we could safely assume your technicians would be producing revenue by performing another service. But can we determine incremental profit made by performing bed bug work using the equipment over performing general pest control and not using the equipment? That incremental number is probably a better number to use because of the numerator in the ROI calculation.
Assume your ROI from purchasing the bed bug equipment will be positive. What would an acceptable ROI be? We know you can take your money, put it in the bank and earn about 2% interest if you’re lucky, so start there: What’s your cost of capital if you wanted to borrow money from the bank? Assuming you can borrow at a certain rate, say 7%, then an ROI of 7% would mean breaking even and probably wouldn’t be worth the investment because you need to exceed your cost of capital for an investment to make sense.
If we calculate a risk premium for putting your name on the loan — employing your knowledge and skills using the equipment to be purchased, and your capital or capacity to borrow — you won’t have that capital or borrowing capability to use on another investment. Be sure the risk premium you earn is acceptable. Every pest management professional (PMP) has to determine what that risk premium should be in each situation. If the risk premium is 10%, it should be added to the cost of capital (7% used in the example) for a total minimum acceptable ROI of 17%. In this case, you wouldn’t purchase the equipment unless the ROI was at least 17%.
How do you determine the ROI of a marketing campaign compared to an asset purchase? Look at Example 2.
The ROI from the $5,850 marketing expenditure is 92.3%.
92.3% = $11,250 – $5,850/ $5,850
If you’re able to create a marketing campaign that achieved the aforementioned results, you’d do as many of these campaigns as possible because the ROI is extremely positive and will clearly add to your income, and to the long-term value of your company.
ROI is a powerful financial tool used to determine the feasibility of various expenditures. Using the appropriate variables in your ROI calculation will ensure the correctness of the information provided by the calculation for your conclusion. Use risk assessment, ROI and sound judgment before any significant expenditure. Be extremely careful when drawing conclusions from an ROI calculation because, in many instances, your assumptions might not come to fruition.
Let’s purchase a bed bug heat set up using the following assumptions:
1. Purchase Price: $20,000, 100% financed through the bank
2. Revenue Produced: Assume $500 per day (This should be the average. Some days the unit will be idle, while other days it will be fully utilized. Come up with the daily average.)
3. Financing: Interest-only payments at 6% annual paid monthly
4. Insurance: $1,100 per year (the incremental insurance necessary for the unit)
5. Depreciation: 7 year property straight line
6. The unit will have no value at the end of 7 years.
7. Combined federal and state tax rate on ordinary income: 40%
8. Assume that net profit on pest control operations is 15%.
Assume: No inflation and no tax rate changes. We will not consider the time value of money. (Though, these are significant assumptions.)
• Profit per Annum = $500 per day x 260 working days x 15% profit = $19,500 less 40% taxes: Net profit of $11,700
• Depreciation Tax Benefit = $20,000 cost / 7 years x 40% combined tax rate = $1,143
• Insurance Cost = $1,100 less tax benefit 40%: Net insurance costs of $660
• Interest Cost = $20,000 cost x 6% = $1,200 less tax benefit 40%: Net interest cost of $720
Total Return from Equipment: $11,700 + $1,143 – $660 – $720 = $11,463 x 7 year life = $80,241
Daniel S. Gordon is a CPA in New Jersey and owns an accounting firm that caters to PMPs throughout the United States. Visit www.pcobookkeepers.com for information about his firm, PCO Bookkeepers. He can be reached at firstname.lastname@example.org.
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