For retailers, profit margins are extremely thin. According to Fortune Magazine, the department store segment of retail is the most profitable, and those margins stand at 3.2%. With this in mind, no one should wonder why obtaining approval for capital funding is such a daunting task. Earning 2 or 3 cents per dollar makes available capital very limited. To help illustrate why senior executives have difficulty choosing to whom capital will be given, one need not look any further than the sales impact. Sales are the lifeblood of any retail business. For a retailer with a 2.5% profit margin, it takes $4 million in sales to generate $100,000 in profit.
Making Sense of Making Cents
With this in mind, it is understandable why senior retail executives insist on a positive Return on Investment (ROI) analysis from any internal department before handing over the cash. Because net profit margins are so low, it only takes a few bad investments to put a tremendous amount of financial pressure on an organization. When financial pressure is felt, tough decisions are made. These tough decisions may involve staff reductions, a decrease in company benefits, price increases, and perhaps elimination of profit-sharing initiatives.
In an effort to assist Loss Prevention professionals, Gatekeeper Systems, the leading international provider of Pushout Theft prevention and shopping cart management solutions, has spent time with some of the most successful Loss Prevention executives, asking how they go about building a successful ROI analysis.
The Core of an ROI Analysis
First, it is important to define an ROI analysis and determine how it is calculated. Simple online research reveals that “ROI measures the amount of return on an investment relative to the investment’s cost. To calculate ROI, the benefit (or return) of an investment is divided by the cost of the investment, and the result is expressed as a percentage or a ratio.” Therefore, the formula for ROI calculation is as follows:
To better understand this concept, we will analyze each of these components. The Gain from Investment, also known as the “Return”, is comprised of all the benefits that will be realized such as an increase in sales, a decrease in shrink, a decrease in labor, or some other cost savings. We must then subtract the Cost of Investment, which is the actual cost of the project components such as equipment, software, licensing, installation labor, and employee training. Once the answer to this subtraction problem is determined, it is then divided by the same Cost of Investment number that was already determined, then multiplied by 100 to show as a percentage.
As an illustration, let’s assume a proposed Loss Prevention initiative will cost $100,000 and will yield a Gain from Investment (Return) of $150,000. The ROI calculation would be as follows:
We can now see that the numerator equates to $50,000, and when we divide that by $100,000, our quotient is 0.50. We simply multiply this by 100 to express our ROI as a percentage. In this illustration, our ROI is 50%.
Keep in mind that although an ROI analysis is a quick way to determine the level of benefit a proposed solution will deliver, it does not take into account the Time Value of Money or TVM. In order to get to this level, many companies require Loss Prevention executives to dig deeper and calculate what’s called an Internal Rate of Return, or IRR. This is a much more complex exercise, but it is important to at least understand its purpose.
Understanding the TVM Principle
The financial principle of TVM states that any amount of money available today is worth more than that same amount of money in the future due to its capacity to earn a return on investment. Therefore, CFOs and senior executives will often consider the TVM when making investment decisions between two or more projects.
For example, assume there are two projects up for funding consideration. Project X and Project Y each requires $500,000 of funding. Project X will add $400,000 to the bottom line the first year, and $250,000 each year for the next 6 consecutive years. Project Y will add $400,000 to the bottom line the first and second years, then nothing thereafter. If the company executives can afford to choose only one project, which project is worth the most cash value today?
The concept of TVM is important to grasp because before asking for a large chunk of capital, the most successful LP executives take time to learn what other capital projects the other senior executives are considering. By having this knowledge, they can be sure all the potential cost-savings or new revenue their proposed project will yield is either in line with or better than the others, thereby increasing the chances their projects get selected for funding.
The field of Loss Prevention and Asset Protection (LP/AP) is small and competitive. Because of this, it is important for LP/AP professionals to stay relevant. In order to accomplish this, understanding ROI analysis is paramount. It is also vitally important professionals stay innovative. In the words of William Pollard, “Learning and innovation go hand in hand. The arrogance of success is to think that what you did yesterday will be sufficient for tomorrow.”
To learn more, read Gatekeeper’s latest whitepaper entitled, Staying Relevant: The Importance of Innovation in Asset Protection.
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