Pros and Cons of Return on Investment

Return on Investment (ROI) is a method of determining the profit a company will gain by spending money on a project. A company can use ROI to determine the project that will earn the most money for each dollar invested. ROI includes money from equity as well as money from borrowing, so the company can borrow money if it'll earn a higher return in the long run.

Individual Project

A disadvantage of ROI is that this metric only tells the company whether a specific project will earn a profit, not the company as a whole. According to the Federal Chief Information Officers Council, sometimes a company will gain a greater overall benefit by investing in a project that has a negative return on investment. For example, hiring more technical support workers may cause the company to lose money on its technical support operations. However, customers will be more satisfied and subsequently purchase additional products from the company's sales representatives.

Time Frame

Another disadvantage of ROI is that it requires a well-defined time period. A project may require several years to earn a profit, and will incur losses in the earlier years. The company will need to predict interest rates in future years, and will also need to decide whether it's likely that more profitable projects will be available to invest in later.

Comprehensiveness

ROI isn't as thorough as other investment metrics. A cost-benefit analysis includes the effects of other factors, even if it's difficult to assign a price to these factors. For example, building a dam may provide a city with a million gallons of water, but it may cause environmental damage. The cost-benefit analysis attempts to assign a value to additional factors, such as the value of a pristine wilderness, that are difficult to value in the market.

Simplicity

An advantage of ROI is that it's a very simple method to help management decide whether a project is worth approving. If a project costs $500,000 and earns the company $700,000 in the next five years, it is profitable, as long as the company wouldn't have to pay more than $200,000 in interest over the next five years to finance the project. If the project will earn the company $400,000, it's not profitable, and a for-profit company can reject the project. If the company has two projects to choose from, which each cost $500,000, but one project earns $600,000 and the other earns $700,000, the company can choose the one that earns $700,000.

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