Internal Rate of Return (IRR) Tends to Overstate Education Return on Investment (ROI)

With dwindling government appropriations for higher education and elevated student loan default rates, more colleges and universities are conducting Return on Investment (ROI) analysis to demonstrate that higher education is a sound investment for students, taxpayers, and society at large. Those institutions include for-profit colleges, community colleges, and public and private not-for-profit four-year colleges.

Some of these studies borrowed a measure from finance, called Internal Rate of Return (IRR), as a measurement of return on investment for students and taxpayers. The origin of IRR can be traced to investment analysis, where the goal is to achieve a positive net present value (NPV) for an investment. Net present value depends on the discount rate chosen in the analysis and there is a need to see the break-even discount rate, which gives rise to IRR. IRR is defined as an annual percentage rate where the net present value of an investment (benefit minus the cost) is zero. So an IRR higher than the commonly used discount rate means the investment has a positive NPV, and vice versa.  In a sense, a higher IRR points to a better return on the initial investment.

However, IRR is not the same as return on investment (ROI), which is defined as the benefit of an investment with respect to its cost. ROI can be expressed as benefit/cost ratio—the total benefit of an investment divided by the total cost. If an investment spans over multiple years, an average annual rate of return can be calculated based on the investment benefit and cost.

While IRR and ROI are related, and tend to move in the same direction, caution is needed when using IRR to represent the ROI of an investment.

A simple example can illustrate the difference. Let us assume that Al and Bob each place $10,000 in a savings account for 20 years with a 5% annual interest rate that is compounded once a year.

Al and Bob have different investment strategies. At the end of each year, Al takes that year’s interest income out ($500) and puts it under his mattress, while Bob keeps the interest in his account, which will generate interest for future years.[1] Bob’s strategy will generate a higher return over the 20 years. At the end of 20 years, the total amount of money for Al is $20,000 (including the initial $10,000), while that for Bob is $26,533—much higher than Al’s total.

The surprising part is that both Al and Bob’s investment strategies yield the same IRR at 5%. So, based only on IRR, the decision makers will think those two investments have the same return. But we have just seen that Bob’s investment results in an amount about 30% more than Al’s; and thus, has a higher ROI.  More specifically, the benefit and cost ratio for Al is 2.0, which is equivalent to a 3.5% annual rate of return. Meanwhile, the benefit and cost ratio for Bob is 2.6, which is equivalent to a 5.0% annual rate of return.

Investing $10,000 at 5% Annual Interest
  IRR Annual Average ROI Savings at Year 20
Al (Spends Annual Interest) 5% 3.5% $20,000
Bob (Leaves Annual Interest in Bank Account) 5% 5% $26,533

 

In this case, using IRR will overestimate the rate of return for Al’s investment strategy. In fact, the IRR is equivalent to the annual rate of return on investment only if the annual benefit is reinvested at the same rate of the IRR.[2] That is the case in Bob’s strategy, where he invests interest income in the savings account that earns 5% interest.  However, when the annual benefit is not reinvested (like Al), or is reinvested in something with less than a 5% annual interest rate, the actual annual rate of ROI is smaller than the IRR.

In ROI studies for higher education, the benefits are typically measured as the incremental income due to more education, and those are not universally reinvested. We rarely see college graduates save or invest all of that incremental income and maintain a lifestyle based on the income level of high school graduates. Some of the graduates may save a little more, but that amount is still only a small fraction of the incremental income.  As a result, using IRR will overstate the actual rate of return for both students and taxpayers in ROI studies for higher education institutions.

Moreover, the longer the time horizon, the higher the degree of distortion with IRR.  For example, in Al’s investment strategy, when the investment horizon is 20 years, IRR overstates Al’s ROI by 40% (5.0% IRR and 3.5% annual rate of ROI). If the investment horizon is 40 years or more (typical for education ROI studies because students typically will work more than 40 years after college), the actual annual rate of ROI is only about half of IRR.

When some reports claim that the IRR for higher education is 15% per year for community college students, the actual return on investment might only be half of that.

[1] This is called interest compounding—the interest income of prior years is treated as principal in future years and generates interest of its own.

[2] Source: Internal Rate of Return: A Cautionary Tale, The McKinsey Quarterly, 2004.

Hot-Jobs and Cool-Moves

Are you wondering what area of study your recent college-bound freshmen will choose? Maybe you can help by giving them something to aim for! And let them know where they can find a job once they’ve earned that degree, as some people may like warmer weather while others prefer cooler climates. In fact, providing information about the wages they could earn with that potential degree might be the best advise you can give them as they prepare for their upcoming campus experience!

Let’s consider the Austin-Round Rock, Texas metropolitan statistical area (MSA), as an example of a potential scenario for the freshman that loves technology.

Austin-Round Rock MSA, Texas
Employment in Computer Systems Design and Related Services Industry
NAICS Industry Empl Avg. Ann
Wages
Avg. Ann
Growth %
541511 Custom Computer Programming Services 18,951 $102,648 3.5%
541512 Computer Systems Design Services 12,333 $104,833 3.5%
541513 Computer Facilities Management Services 252 $82,476 3.6%
541519 Other Computer Related Services 1,219 $99,321 3.5%
5415 Computer Systems Design and Related Services 32,755 $103,246 3.5%
Source: JobsEQ - Note Employment is a 4-quarter average for the four quarters ending with 2016 Q1

If this college-bound student is interested in living in Austin—a trendy location—the computer systems design services industry is booming! And with industry employment expected to grow at an average annual rate of 3.5% over the next decade, job prospects in this industry look promising in four years at graduation.

Some well-paying jobs in the computer systems design services industry include the following for the Austin region:

SOC Title Current
Empl
Regional
Avg
Wage
15-1143 Computer Network Architects 250 $120,200
17-2061 Computer Hardware Engineers 115 $110,100
17-2199 Engineers, All Other 17 $102,900
15-1122 Information Security Analysts 146 $102,200
15-1133 Software Developers, Systems Software 864 $100,700
Source: JobsEQ - note Employment is a 4-quarter average for the four quarters ending with 2016 Q1. Regional average wage is as of 2015.

In terms of the number of people employed as computer hardware engineers, Austin is ranked as having the 9th most jobs of all metro areas in the nation for this occupation. There are 1,985 computer hardware engineers working in the Austin-Round Rock, MSA. With a cost of living index of 107.8 (where the U.S. is 100), Austin is about 8% more expensive than the national average. In the San Jose-Sunnyvale-Santa Clara, CA MSA, the top MSA for employment of computer hardware engineers, the cost of living is a whopping 206.4—or about twice the national average. The wages for computer hardware engineers in San Jose region are much higher at $141,000 but housing in the San Jose MSA is expensive with a median house value of $654,800; the median house value in the Austin MSA is significantly lower at  $196,500.

And speaking of hot jobs, Austin’s average July temperature is 96 degrees (F) while the San Jose region is a bit cooler with an average July around 82 degrees (F). 

Federal Budget Cuts Could Hamper Growth in Some Metro Areas

The map below shows non-defense contract spending by MSA from FY 2000 to 2015. The circles are proportional (i.e., they are scaled to the value of defense contracts in that MSA). Beginning in FY 2001, the color of each circle indicates whether non-defense contract spending in the MSA declined (red) or increased (green) from a year earlier. The map can be manually advanced or will advance automatically when you click on “Play.”

The table below the map shows DoD contract spending in the top 100 MSAs and updates each time a new fiscal year is selected.

To learn more about Chmura’s expertise and research regarding defense spending and supply chain mapping, contact us here.

The federal government spends billions of dollars buying goods and services from private sector firms each year.

Just as the fortunes of businesses dependent on federal spending ebb and flow with federal budgets, so do the budgets of the metropolitan statistical areas (MSAs) where those employers are concentrated.

Although non-defense contract spending has supported economic growth in many MSAs over the past decade, contract spending by federal agencies besides the Department of Defense will decline when budget reform becomes a priority. When that happens, MSAs whose budgets are more dependent on that spending may experience shortfalls.

In the fiscal year (FY) that ended on September 30, 2015,[1] federal contracts decreased by $5 billion or 1.2%. Sixty-four percent of the purchases made in the most recent fiscal year were driven by the Defense Department.[2] While the majority of federal contract awards support the Defense Department, numerous other federal agencies enter contracts to purchase goods and services.

For example, the Department of Health and Human Services contracts with pharmaceutical companies to produce vaccines and the Department of Energy awards contracts for, among other things, research and development.

Non-Defense Department contract spending advanced at a modest 32% from FY 2005 to 2010 compared with a 49% gain in Defense Department contract spending over the same period. The non-defense spending was particularly strong, jumping by $30 billion from FY 2008 through 2010, as fiscal policy expanded in response to the recession.

After peaking at $152.9 billion in FY 2010, annual non-defense contract spending has declined by only 1%. That compares with a 19.4% drop in Defense Department contract spending after it peaked at $336.7 billion in FY 2009. Annual non-defense contract spending, which peaked at $152.9 billion in FY 2010, hovered around $145 billion from FY 2011 to 2014 before inching up to $151.2 billion in FY 2015.

U.S. Defense and Non-Defense Contract SpendingU.S. Defense and Non-Defense Contract Spending

Over the entire ten-year period from FY 2005 to 2015, non-defense contract spending increased $35.2 billion or 30.3%. This represents a 2.7% average annual increase compared with a 1.9% increase in defense contract spending over the same period. The five largest increases in spending from FY 2005 to 2015 occurred in metropolitan statistical areas (MSAs) with populations of at least 2.5 million. On a per capita basis, however, nine of the ten largest increases in non-defense contract spending were in MSAs with populations of less than 1,000,000.

Non-DoD contract spending increased $3,554 per capita from FY 2005 to 2015 in the Idaho Falls MSA. Battelle Energy Alliance operates Idaho National Laboratory, a Government-owned, contractor-operated facility conducting nuclear energy research for the Department of Energy in the Idaho Falls MSA.

On a per-capita basis, non-DoD contract spending increased $3,214 from FY 2005 to 2015 in the Gulfport-Biloxi-Pascagoula MSA. This region is home to the John C. Stennis Space Center, a NASA rocket testing facility. Contractors including Computer Sciences Corporation and HP Enterprise Services perform work at Stennis Space Center.

From FY 2005 to 2015, non-DoD contract spending in the East Stroudsburg, Pennsylvania MSA rose $3,118 on a per capita basis. Global pharmaceutical company Sanofi Pasteur received large contracts from the Department of Health and Human Services to produce vaccines in its Swiftwater, Pennsylvania manufacturing facility.

Non-Defense Contract Gains by MSA, FY 2005 to 2015
MSA Total Non-Defense Contract Gains FY 2005 to 2015
Washington-Arlington-Alexandria, DC-VA-MD-WV MSA $16,814,165,419
Baltimore-Columbia-Towson, MD MSA $2,718,937,331
Boston-Cambridge-Newton, MA-NH MSA $2,561,989,563
Philadelphia-Camden-Wilmington, PA-NJ-DE-MD MSA $1,793,736,449
Los Angeles-Long Beach-Anaheim, CA MSA $1,526,046,564
Durham-Chapel Hill, NC MSA $1,475,297,394
Gulfport-Biloxi-Pascagoula, MS MSA $1,251,186,212
Denver-Aurora-Lakewood, CO MSA $734,444,088
Augusta-Richmond County, GA-SC MSA $719,503,522
East Stroudsburg, PA MSA $518,907,310
Idaho Falls, ID MSA $496,698,414
Huntsville, AL MSA $485,735,682
Palm Bay-Melbourne-Titusville, FL MSA $479,553,829
Austin-Round Rock, TX MSA $478,263,087
Indianapolis-Carmel-Anderson, IN MSA $467,981,002
New York-Newark-Jersey City, NY-NJ-PA MSA $459,152,692
Tampa-St. Petersburg-Clearwater, FL MSA $442,855,923
Harrisburg-Carlisle, PA MSA $402,595,975
Pittsburgh, PA MSA $390,683,897
Virginia Beach-Norfolk-Newport News, VA-NC MSA $383,699,861
 
Non-Defense Contract Gains per Capita by MSA, FY 2005 to 2015
MSA Total Non-Defense Contract Gains FY 2005 to 2015 $ Gain per Capita
Idaho Falls, ID MSA $496,698,414 $3,554
Gulfport-Biloxi-Pascagoula, MS MSA $1,251,186,212 $3,214
East Stroudsburg, PA MSA $518,907,310 $3,118
Washington-Arlington-Alexandria, DC-VA-MD-WV MSA $16,814,165,419 $2,757
Durham-Chapel Hill, NC MSA $1,475,297,394 $2,670
Coeur d'Alene, ID MSA $356,418,728 $2,371
Kennewick-Richland, WA MSA $340,687,406 $1,221
Augusta-Richmond County, GA-SC MSA $719,503,522 $1,219
Houma-Thibodaux, LA MSA $243,455,945 $1,147
Huntsville, AL MSA $485,735,682 $1,092
Baltimore-Columbia-Towson, MD MSA $2,718,937,331 $972
Manhattan, KS MSA $85,662,766 $869
Palm Bay-Melbourne-Titusville, FL MSA $479,553,829 $844
Missoula, MT MSA $94,157,102 $825
Hagerstown-Martinsburg, MD-WV MSA $203,291,497 $777
Morgantown, WV MSA $100,274,121 $726
Harrisburg-Carlisle, PA MSA $402,595,975 $713
Hanford-Corcoran, CA MSA $101,700,075 $674
Fargo, ND-MN MSA $149,126,315 $638
Lansing-East Lansing, MI MSA $277,034,010 $587
 
Non-Defense Contract Cuts by MSA, FY 2005 to 2015
MSA Total Non-Defense Contract Cuts FY 2005 to 2015
Albuquerque, NM MSA -$1,172,664,844
Las Vegas-Henderson-Paradise, NV MSA -$864,425,494
Amarillo, TX MSA -$856,455,560
Knoxville, TN MSA -$734,016,405
Albany-Schenectady-Troy, NY MSA -$641,739,567
Kansas City, MO-KS MSA -$527,221,645
San Francisco-Oakland-Hayward, CA MSA -$383,575,742
Cincinnati, OH-KY-IN MSA -$363,333,301
Nashville-Davidson--Murfreesboro--Franklin, TN MSA -$307,156,592
Charleston-North Charleston, SC MSA -$290,371,099
 
Non-Defense Contract Cuts per Capita by MSA, FY 2005 to 2015
MSA Non-Defense Contract Cuts 2005 to 2015 $ Cuts Per Capita
Amarillo, TX MSA -$856,455,560 -$3,268
Albuquerque, NM MSA -$1,172,664,844 -$1,292
Knoxville, TN MSA -$734,016,405 -$852
Iowa City, IA MSA -$137,893,317 -$828
Albany, GA MSA -$113,479,615 -$739
Albany-Schenectady-Troy, NY MSA -$641,739,567 -$728
Canton-Massillon, OH MSA -$190,377,222 -$472
Brunswick, GA MSA -$48,652,325 -$419
Las Vegas-Henderson-Paradise, NV MSA -$864,425,494 -$409
Jackson, MS MSA -$231,060,733 -$399

[1] The U.S. federal government’s fiscal year begins on October 1 of the previous calendar year and ends on September 30.

[2] Based on Chmura’s FedSpendTOP data that are derived from USASpending.gov data but provide a more accurate picture of federal spending based on the time and place of performance when compared with published federal awards data. The data are adjusted for the length of the contract as well as for an associated subcontract’s place of performance (i.e., regional spending is based on place of performance with out-of-region awards subcontracted into the area added in and in region awards subcontracted out of the region subtracted out); FedSpendTOP data also include purchases by non-DoD agencies which end up in DoD products and have been corrected for errors identified during Chmura’s quality control process.

Economic Impact: Federal budget reform could have impact on Virginia's fortunes

The federal government spends billions of dollars buying goods and services from private sector firms each year.

Just as the fortunes of businesses dependent on federal spending ebb and flow with federal budgets, so do the budgets of the states where those employers are concentrated.

And while non-defense contract spending has supported economic growth in many states over the past decade, it will contract when budget reform becomes a priority.

When that happens, states like Virginia whose budgets are more dependent on that spending may experience shortfalls.

In the fiscal year that ended Sept. 30, federal contracts decreased by $5 billion, or 1.2 percent. And 64 percent of the purchases in the most recent fiscal year were driven by the Defense Department.

In Virginia, federal government contracts decreased more sharply, falling 4.4 percent — or by $2.4 billion — based on data from USASpending.com that Chmura Economics & Analytics adjusted for place and time of performance.

Virginia is more dependent on DoD spending than the nation.

Sixty-five percent of the purchases in Virginia during the most recent fiscal year are from Defense Department spending — and those purchases made up 7.1 percent of the state’s gross domestic product, compared with 1.5 percent in the nation.

While the majority of these awards support the Defense Department, numerous other federal agencies enter contracts to purchase goods and services. For example, the Department of Health and Human Services contracts with pharmaceutical companies to produce vacc-ines, and the Department of Energy awards contracts for, among other things, research and development.

The state also is more dependent on non-Defense Department federal spending, which makes up 3.8 percent of its GDP compared with 0.8 percent in the nation.

Since non-Defense Department contract spending has been less volatile than the department’s spending over the past 10 years, it has contributed to more stable growth in some states — like Virginia — that are dependent on defense spending.

In Virginia for the fiscal year that ended Sept. 30 compared with the prior 12 month-period, a $1.4 billion increase in non-Defense Department contract spending partially offset a $3.8 billion decrease in the department’s contract spending. In other words, Virginia would have been impacted more severely without the expansion in non-Defense Department contract spending.

Non-Defense Department contract spending advanced at a modest 32 percent from fiscal year 2005 to fiscal year 2010 compared with a 49 percent gain in Defense Department spending over the same period. The non-defense spending was particularly strong, jumping by $30 billion from fiscal year 2008 through fiscal year 2010 as fiscal policy expanded in response to the recession.

After peaking at $152.9 billion in fiscal year 2010, annual non-defense contract spending has declined by only 1 percent. That compares with a 19.4 percent drop in defense contract spending after it peaked at $336.7 billion in fiscal year 2009.

Non-defense contract gains by state

Here are the non-defense contract gains by state from fiscal year 2005 (12-month ended Sept. 30, 2005) to fiscal year 2015. (The per capital gains are in parentheses.):

  • Virginia: $8,542,008,667 ($1,019)
  • District of Columbia: $5,839,744,820 ($8,687)
  • Maryland: $5,593,916,049 ($931)
  • Pennsylvania: $3,285,748,606 ($257)
  • Massachusetts: $2,857,615,828 ($421)
  • California: $2,039,365,210 ($52)
  • North Carolina: $1,173,863,398 ($117)
  • Florida: $1,173,274,726 ($58)
  • Colorado: $939,922,764 ($172)
  • Mississippi: $929,920,035 ($311)

Source: Chmura Economics & Analytics

 

Demystifying GDP

Gross Domestic Product (GDP) is one of the most widely used and cited economic indicators.  One cannot discuss the economy of a country or a region without talking about the national or regional GDP. However, many often misunderstand GDP. Specially, some may confuse GDP with the value of the total output (revenue) of an economy.

The reason GDP is misunderstood can be traced to its intended use. The origin of GDP is the need for an economic indicator to measure the overall size of a national or regional economy, so that people can compare which country has the largest or second largest economy in the world. When we think of a business such as a retail shop or a manufacturing plant, we typically use their total sales or revenue as an indicator of the size of their business. For example, Fortune magazine routinely publishes America’s 500 largest companies based on their total revenue. Similarly, when we need a measure of the size of a national or regional economy, it is natural for people to think of this measure as the sum of the revenue (output) of all businesses in a country or region.

While that thinking has its merit, total output (revenue) it is not a good indicator of a true size of the national or regional economy because it allows the possibility of double counting, which could inflate the size of an economy. Consider a business, which buys cotton from famers, and make shirts for the consumer. It has two plants—one turns cotton into fabric, and the other plant has sewing machines to stitch fabrics into shirts. Each shirt sells for $50 dollars. If the business makes only one shirt, the total revenue for the company is $50. 

What if the owner decides to split the two plants into two separate businesses: one produces fabric and the other purchases the fabric and produces shirts?  If the price of the fabric is $20, the total revenue of those two separate companies are $70, while the total sale of the company prior to split is $50. Even though only one shirt is produced in the process, the total output jumps from $50 to $70. One would think the economy represented by two companies is larger, even though only one shirt is produced. The difference is that the value of the fabric is included in both the revenue of the fabric and shirt companies.  This example shows that summing up total output (revenue) of all businesses in a country or region is not a good measure of the true size of the economy due to the fact that the value of the intermediary goods (in this case the fabric) is counted twice or multiple times.

Thus, the concept of GDP was born. GDP is the sum of all companies’ total sales minus the value of the intermediary inputs.  The difference between the total sales and the intermediary input is also defined as the value added of a business. Another commonly used definition of GDP is that it is the sum of consumer expenditures, business investment, government spending, and net exports. This definition is equivalent to the total value added of a country or region, because this definition counts only the value of final products and services; and not the value of intermediary products.

What types of values are added to the intermediary inputs and turned into another product? As the following diagram shows, the main components of value added are the labor income, business tax, and gross surplus.  In addition, gross surplus is made up of the consumption of capital (or depreciation), corporate profits, and other income such as rents, interest, and proprietors’ income. 

In 2014, U.S. GDP (or value added) was 54% of the total output of the country. Within GDP, more than half (53%) of it is labor income, with the rest making up gross surplus and business tax.

De-mystifying GDPDe-mystifying GDP