Simple Return on Investment The Trap Inherent In this Approach To Calculating a Project’s Cost-effectiveness

Many managers use the simple return on investment (ROI) method of calculating the cost-effectiveness of a project. The formula, as its name indicates, is simple: one only has to divide the cost of the project by its projected savings. A project costing $50,000 and saving $15,000 per year in fuel costs will result in a simple ROI of 2.97, i.e. a nearly 3 year payback.

Many companies use this formula to determine the cost-effectiveness of a project. If the resulting ROI is greater than one or two years, the project will not be greenlighted.  In the example above, the project risks not going ahead.

This simple calculation was somewhat reliable when bank interest rates hovered around 12% but, today, a 7% rate is regarded as very attractive.

In the current context, allocating money to a project implies doing a more detailed study of its cost-effectiveness.

Take the example of the $50,000 above. If that money is invested in a bank instrument bearing 7% interest (which is highly optimistic), it will earn $20,127 after 5 years.

If that money is invested in a project that results in $15,000 in savings per year over 5 years, the payoff will be $31,630 and the business will be richer by $11,502. However, the project at first does not meet the criteria for calculating simple ROI.

The above amount represents the net present value of the project, commonly referred to as its NPV. The project’s NPV is therefore $11,502, which is equivalent to a return of 15.2%. No investment today offers that high a rate of return.

In the current context, what manager can afford to leave that kind of money on the table? Is return on invested capital not the foundation of any business?

Actually, despite the relatively low price of fuel, energy efficiency projects continue to be very cost-effective when properly evaluated, and they will be even more so in the future. Investing today will ensure significant gains in the years to come.

The price of fuel will increase as we move forward; the process has already begun. If, according to estimates, its price increases by 4% per year over the next 5 years (it rose by nearly 40% from February 2016 to today), the resulting gain using the above example will be $16,225, for a yield of 18.4%

If one adds the potential subsidy by the Government of Québec for reducing greenhouse gases, the return rises to 56% and the NPV exceeds $41,000.

Not bad for a $50,000 investment…

Given such a return, borrowing to invest in energy efficiency becomes an option worth considering.

Energy efficiency projects should be examined and analyze with care. They offer interesting possibilities for all types of ships.

For a reliable and cost-effective study of your project, call the experts at GHGES.

A project that provides a ROI of 2.94 years and a yield of 18.4% should not be approved without first being adequately evaluated.