The Importance of ROI

Return on Investment (ROI) is an objective method for allocating resources.

Companies, individuals and families all have limited resources, and using ROI can help those resources be used in the most efficient way possible.

Only the government seems to believe it has unlimited resources, or that money grows on trees. Unfortunately, the government is wrong, and all it does is incur more debt … debt that will have to be repaid, someday, somehow.

For most people, money that’s spent on an investment that doesn’t pay off for 20 years, uses money that could have been spent on an investment that pays off in a year or two.

Obviously, there are instances where money is spent on staples, such as on food, or on necessities, such as refrigerators and washing machines, and even TV sets.

But, buying a new refrigerator when the existing one still works, isn’t a necessity, it’s discretionary.

Companies have multiple opportunities for using their cash, beyond paying for labor and materials and other day-to-day operating expenses. It’s how they use their excess cash where ROI becomes important.

For example, should they invest in machine X or machine Y? If X recovers the investment in 2 years and Y recovers the investment in 10 years, the company will invest in X, as it is the better economic decision.

For an individual, excess cash can be put into savings account A, which pays 2% interest, or in savings account B that pays 5% interest. The best economic decision, assuming the risks are equal, is savings account B.

It’s at this point that reality begins to be stretched by those with an agenda.

The most obvious agenda today is where politicians and organizations want to cut CO2 emissions.

It’s one reason they want to put a price on carbon, actually CO2. If carbon has a price, the price can be put into the equation when evaluating the ROI of certain investments.

Given a sufficiently high price for carbon, a wind turbine can have a better ROI than a natural gas-fired power plant.

It’s also why these organizations, including the government, extol the virtues of energy efficiency.

Energy efficiency is touted as a resource, which is a complete distortion … and more Orwellian Double Speak.

Energy efficiency can have important benefits, but it can also be manipulated.

LED Lamp
LED Lamp

Certain calculations are straight forward. For example, an LED lamp that costs $8 may have an ROI that’s better than a 100 watt incandescent bulb that burns 10 hours a day where the electricity costs 12 cents per kWh. But it will have a worse ROI if the incandescent bulb only burns for 10 minutes each day.

The result? Don’t replace an incandescent bulb with an equivalent LED if the incandescent bulb only burns a few minutes each day … even though the efficiency of the LED is better than the incandescent lamp3.

But this is where subjective reasoning comes into play, which attempts to demonstrate that it’s always better to buy the LED.

The first rationale is: The LED cuts CO2 emissions, and, therefore, buying the more expensive LED is for the common good.

The second rationale is: When enough people replace incandescent bulbs with LEDs, less electricity will be used, which can prevent building a new power plant.

While the homeowner or business may be better off financially by not buying the LED, the utility will save money by not having to build a new power plant. Actually the power plant will have to be built someday if the economy grows, but there is a time value to money so the community, using this logic, is better off always buying expensive LEDs1.

But this logic is somewhat fuzzy. Is it better for some people to make bad economic decisions so that the utility can delay its investment?

What if the investment by an individual or a company is much larger than an $8 LED?

For example, a refrigerator can cost $1,000. A new energy star refrigerator uses less electricity than the existing unit, but it will take years for the savings to offset the investment. Buying the energy star unit to replace a refrigerator in good working order is actually a bad economic investment of some import to the family.

Utilities promote scrapping the extra refrigerator that some families use for extra storage. Commonwealth Edison will pay the homeowner $35 for scrapping the old unit, because it will save electricity … and improve energy efficiency.

But, if the family needs the old unit, it will have to buy a new refrigerator for $1,000, and it’s actually a bad economic decision for the family.

Many organizations, including the government, are promoting a variety of so-called energy efficiency improvements.

For example, in addition to refrigerators, organizations promote replacing furnaces with new energy star units costing a few thousand dollars, replacing old windows in a home with energy efficient windows that could cost $20,000, and adding expensive insulation to existing homes or office buildings4.

While each of these actions will improve energy efficiency, they may or may not be good economic decisions. When the government attempts to force the changes, such as with cap and trade legislation, it’s forcing people to make bad economic decisions2.

Improving energy efficiency may be good, but it may also be bad. Distortions, such as calling energy efficiency a resource, leads to bad economic decisions.

Government should step aside, and not force or cajole people, or companies such as utilities, to make bad economic decisions.

People and companies can use ROI to determine which decisions are best for them, without the government rigging the decision, such as by putting a price on carbon.

The free market is best at allocating resources, and ROI is an effective tool for making investment decisions.

  1. This is an oversimplification since lighting is usually used during off-peak hours, while reducing electricity usage during peak hours is what could delay the need for a new power plant.
  2. The Waxman-Markey cap and trade bill of over 1,400 pages, included a section requiring the energy efficiency of homes to be recorded on the deed. This would require homeowners to make these investments if they want to be able to sell their home, since no buyer would purchase a home having this liability facing the buyer.
  3. In this example, if the bulb only burns 1 hour each day, it would take nearly 2 years to recover the cost.
  4. Having an energy audit performed and spending a few dollars to plug up holes isn’t at issue.

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0 thoughts on “The Importance of ROI

  1. Pingback: Weekly Climate and Energy News Roundup | Watts Up With That?

  2. Hi Donn,

    I saw a note on the TV channel that I was watching yesterday that incandescent bulbs were going to be phased out as items for sale in stores.  Is this correct?  If so, it is the EPA’s way of forcing individuals to buy expensive LED bulbs for $8 each even for items like attic lighting or porch lights that are usually not used very often or for longer periods than the ROI payback period would dictate.

    Craig

    ________________________________

    • The Democrat controlled congress passed this law when it was intent on establishing cap & trade. Specifically it passed the Energy Independence and Security Act of 2007, that required the elimination of most incandescent bulbs. It is a stupid law that the EPA is now enforcing.

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