How To Think About Return On Investment

Dec 1, 2005 12:00 PM, By Michael Fickes

Few security directors have mastered the concept of return on investment or ROI. For starters, it seems complicated. “It looks like a hard nut to crack, because the security industry has not had any historical experience cracking this particular nut,” says Steve Hunt, president of 4A International, a Chicago-based consulting firm that works with physical security technology manufacturers.

But the basic concept of ROI is simple, although a security director may need to discuss some of the related financial calculations with the firm's chief financial officer or CFO. But factoring return on investment into security planning is really no big deal.

What is return on investment? In the simplest terms, it is a payback or a benefit that comes from an investment of some sort.

Suppose an investor buys an old house for $50,000 and spends $50,000 to repair the roof, paint the walls, upgrade the heating, ventilating and air conditioning system and generally fix up the place. What if he or she sells the house for $125,000 in five years? That would be a $25,000 return on $100,000 invested for five years.

Most people will sense that this $25,000 ROI is not very good, but why not? What's wrong with it? What's the financial case?

If the investor had put the money into an investment that generated a five percent compound annual return, $100,000 would have become $127,629 in five years. So why go to all the trouble of finding the house, negotiating the price with the broker, designing the improvement, hiring and supervising contractors to do the work, and selling the house. Just find a five percent investment and put the money there for five years.

Now change the terms of the question: Suppose the $100,000 represented business capital that a security director needs to get from the CFO to purchase and install an access control system and a video surveillance system. The CFO will want to know why that $100,000 should not be invested in something else. What economic return will this $100,000 security investment produce?

All too often, security directors respond to this question by making the security case: After careful study, the security director explains, he has identified the company's assets, evaluated the threats to those assets as well as the vulnerabilities in the company's facilities. A sophisticated security director might go a step further and rank the vulnerabilities in a way that suggests which ones are the most important to address right now.

The security director has done all the right security things. But that's not enough. A marketing director can do all the right marketing tasks: Create advertising and sales programs that will cost $5 million to implement. But when the CFO asks what the $5 million investment will generate in the form of a return on company capital, the marketing director cannot say, well, the company will get $5 million of marketing plans and advertising.

A more appropriate answer would itemize the economic benefits that will flow to the company as a result of implementing this marketing plan. The security director, too, must make a business case for the security program.

“Security directors would do well to purge the word security from their vocabulary when having this discussion,” Hunt says. “To anyone outside of the security profession, security is an annoying layer of cost and inconvenience. The benefits of security should be the point of your presentation. If we can identify what benefits a company can enjoy with appropriate security measures, then we can have a useful discussion of ROI.”

Return on an investment is the benefit or the value added to the original investment. Without a number that quantifies a set of investment benefits, it will be virtually impossible for the director of any corporate department to sell a capital-spending program to the CFO or any other C-level executive.

Like the marketing director, the security director is responsible for helping the company grow and to protect the company's employees and assets, and the marketing director's job is to sell. Both are working for a company that must generate profits to stay in business.

So how can a security director justify a $100,000 investment in security? What is the return on investment? Is the ROI large enough to justify the commitment of corporate funds?

There are two kinds of return on investment: The first increases revenues, and the second reduces costs. If a $100,000 investment in access control and video can increase revenue or reduce expenses enough to offset the investment and provide a return in the bargain, a CFO might look favorably on the proposal. While revenue increases probably are not impossible, it is more likely that a strategic security investment could reduce existing security costs.

Suppose, for example, that a company stations a security officer at the main entrance to the facility every day, to control access. Another security officer patrols the grounds. The officer at the main entrance works a 10-hour shift and then locks up and goes home. The patrolling officer works an eight-hour shift. Two other security officers in turn patrol in eight-hour shifts to cover an entire 24-hour day. A couple of part-timers cover the 48 hours over the weekend.

“If you can find a way to reduce employee hours, you will generate a very quick payback or ROI,” says Sam Ingwersen, president of Columbus, Ohio-based CADAFIS Inc., which sells software designed to crunch numbers related to investments in building security systems.

Suppose that in the case of this hypothetical building, the security director determined that an access control system and a video surveillance system could reduce the company's security staff by two people at a savings of say $50,000 per year.

After two years, most of the system would be paid off and the company would be generating a return on the security investment of $50,000 a year until it comes time to replace or upgrade the technology. An attractive return on investment will factor in financing for the next round of technology purchases that will become necessary.

A CFO may find such a financial case difficult to turn down — because it provides a return on investment that the company would find difficult to generate by other means.

Does a security director have to become an MBA or financial whiz to make this kind of financial case? Probably not, although it would not hurt. The formal process of determining ROI involves financial concepts that may seem unusually sophisticated to people who have not made a study of corporate finance. ROI calculations involve analyses of capital expenses, operating costs, labor costs, the time value of money and other financial measures.

“My first instinct is that you should avoid an ROI discussion that gets deeply into financial details,” Hunts says. “Remember, you are talking to people with sophisticated financial capabilities. A security professional ought to be a security professional, and a financial analyst ought to be a financial analyst. If a security director tries to make a financial presentation and is not comfortable with financial concepts he or she can end up looking very foolish.”

Perhaps it is best for security professionals to confine their presentations to a level of financial analysis with which they are comfortable. If a security director feels competent about discussing how the present value of money can contribute to a return on investment, he or she should by all means make the case.

In the end, however, if the benefit combined with the return on investment makes sense in terms of the corporation's financial strategies, the CFO will see that without a lecture from the security director.

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SHARE YOUR STORY…

This page offers an opportunity for readers to share management lessons they have learned and to provide other helpful information to their peers in the industry. To offer suggestions, or to contribute to this page, contact Larry Anderson at (770) 618-0118 or e-mail landerson@primediabusiness.com

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ABOUT THE COMPANIES

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CADAFIS Inc.

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FOR MORE INFORMATION

To learn more about calculating return on security investments, visit the CADAFIS Inc. Web site: www.CADAFIS.com. Check out the firm's Building Security Assessment or BSA software, which consists of a continuous security planning and budgeting system that includes return on investment calculations.

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