By Richard White.
If you are having trouble justifying your prices then you need to REALLY understand Return on Investment (ROI) – it’s the key to achieving higher margins whilst your clients still think you are providing excellent value.
Here is an outline of key concepts and I will be writing more about how to approach your sales meetings from an ROI perspective. It’s simple and painless and actually makes selling easier! Why do I need to think about ROI?
Sales professionals take return on investment (ROI) very seriously, especially when selling business-to-business. They know from bitter experience that their prospects want to see a return on their expenditure, whether capital or operating expenditure.
Many, many years ago when I was an accountant I used to be the one in my company that ran the slide rule over projects and in those days my commercial awareness was not as finely honed as it is today. I was good with the numbers but I just calculated what I was given and if the manager had not got all the details right then that would affect the results.
As a business developer you cannot take the risk that some accountant sat in an office, with no clue about the finer points of your product or service, misses out on some more subtle benefits. The business developer needs to take charge of the numbers to ensure the accountant sitting in the back office has all the numbers and calculates the correct ROI.
Another reason to take an interest in ROI is to ensure you are not wasting your time trying to close a project with a poor ROI. You can use ROI as a way of qualifying a sale and not wasting time that could be spent finding prospects with a much better prospect for ROI.
ROI is all about cash flow
If you make an investment it implies shelling out some cash in the expectation of getting more cash back. It’s all about cash flow. In more complex projects, like investing in a new machine, you will have cash flows relating to the purchase of the machine and additional operating costs and then some form of cash benefits such as increased sales or reduced costs. Some ROI calculations can be calculated on the back of an envelope but most require an Excel spreadsheet to total up all the cash inflows and outflows. The important thing about the cash flows is that they are done over time as opposed to being lumped altogether.
Incremental Cash Flows
The only thing that matters in ROI calculations is how cash flows will change as a result of your decision. In simple isolated investments you might be able to calculate the incremental cash flows directly but in more complex investments you do a full cash flow of the affected parts of the business and compare that with an alternative cash flow as a result of the change. Calculating the difference between the two will give you the incremental cash flows.
Cumulative Incremental Cash Flow
Cumulative cash flow is simply the net of all cash flows up to one point in time. When looking at the cumulative incremental cash flow it is easy to see where “payback” occurs. This is when any initial outlay has been fully recovered. The payback period is the amount of time it takes to achieve payback.
One of the most simple and yet most effective indicators is the payback period. It tells you how long it takes to get your money back. It is normally expressed as a measure of time, for example 3 .5 weeks, 6 months, or 2 years. Projects that can show a fast payback are normally looked on favourably. It should be possible to look at the cumulative incremental cash flows and see the point at which the change from negative to positive occurs. There is also a way in Excel of calculating payback periods using cell formulae. [public_post]
Jason has a decision to make. He has the chance to save money on his monthly phone bills. He has found a new supplier that can save him about 50% on his monthly phone bills. There is, however, a large set up charge that he must pay for. His initial outlay is £300 but he saves £50 per month on his phone bills. What is the payback period?
The answer is 6 months.
Simple ROI Calculation
ROI % = 100* (Incremental benefits – incremental costs)/Incremental costs
The simplest ROI calculation is just a straight calculation of net benefits over project costs. It’s ok for short projects of a finite length but not much use for projects like the one above with ongoing benefits. Where do you draw the line? Including 3 years of benefits would give a different return to 2 years.
Net Present Value (NPV)
Would you rather have cash now or cash later? If I were to offer the choice of £100 now or £100 in 2 years time then most people will go for the £100 now. Its money in the bank – less risk and it can be earning interest or be used to finance other projects. What if the choice was £100 now or £800 in 2 years time? You might be inclined to wait for the larger payment although £800 in 2 years time will probably not be worth the same as £800 today. This is because inflation will eat away at the value. Net present value helps to translate future net cash flows into what it might be worth in today’s money terms. This helps in making investment decisions between projects of differing duration.
If you ever need to calculate NPV then I suggest you seek out an accountant who would get incredibly excited at the prospect! Believe me, it will make their day! If you are selling items of a capital nature then you may want to invest in an Excel template such as Financial Metrics Pro by Solution Matrix (www.solutionmatrix.com). You can download a free lite version if you are in least bit curious!! The process of calculating NPV is called discounting and an incremental cash flow that has gone through the discounting process is known as a discounted cash flow. A company will have their own internal rate they use for discounting projects which is based on the cost of raising finance.
Internal Rate of Return (IRR)
The prospect of calculating IRR gets accountants even more excited!! It’s a calculation that works out a rate of return of a future income stream. It effectively discounts the cash flow and comes up with a single rate of return at the same time. The calculation effectively works out the return from immediately reinvesting any cash flows arising from the project. A company assessing a proposal will expect the IRR to be higher than their own cost of raising finance or it’s not worth the bother (financially anyway). If the company has competing projects then they will compare the IRRs. There is an Excel formula (=IRR) for calculating the IRR and Financial Metics Pro also includes IRR as one of its metrics.
ROI and the sales process
If ROI is so important for prospect then it makes sense to seek prospects with a high likelihood of ROI and weed out those prospects that are unlikely to get the customers accountants excited! The initial fact find stage of the sales process is the time to get as much information as possible to be able to assess the early likelihood of a good ROI. The prospect will normally be pleased to help so that they are not wasting time. You can get an idea of the relevant cash flows by considering the implications to the specific business areas affected by your product or service.
Discovering the APR
The incremental cash flows necessary to determine ROI come from the difference between the future cash flows and the current status quo. It is as important in the sales process to uncover the cost of continuing with business as usual as it is to find out how the business will change following a decision to go ahead. APR is a simple aide memoire to make sure you uncover the main elements areas of cash flow impact.
A – Alternative P – Price R – Return
The business developer should be sure to use open questions and an open mind to discover the required detail.
What would be the alternative to going ahead with the project? This is about discovering the cost of the status quo. What are the main areas of current or future pain that will occur if there is a decision to do nothing? Just finding this information alone is normally good enough to qualify a lead and overcome most price objections.
What would be the costs associated with going ahead with the project? The business developer should be careful not to just consider the deal price but should also investigate the indirect costs that the prospect will incur as a result of going ahead with the decision. For example, the price of replacing a software system for a large organisation will normally be much more that the investment in the software. There will be costs associated with migration to the new software such as user acceptance testing, training, project management, even process re-engineering. The business develop should be thorough in this area as this is the area that the accountants focus on.
What would be the returns arising from going ahead? This can be the increases in revenues or reduction in costs. Many of the cost reductions will become clear as a result of discovering the alternative.
‘No Brainer’ ROI
You can have hours of fun doing return on investment calculations! The best type of ROI is what I term a ‘No Brainer’. It’s a decision that can be made without much thought at all, let alone doing full ROI calculations. The payback period is less than a year and the cost of the alternative, the price and the returns are all clear. Business developers would make much more progress developing accounts if the first sale to a new prospect has a ‘No Brainer’ ROI to it. Once the account is established and a good relationship has developed then it will be much easier to get access to the information that would be required for a more complicated project.
ROI is a fact of life for business to business sales so its makes sense to make friends with the calculations and build it into your sales process. Have fun!