Executive Guide: ROI |
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| 15 Feb 2006 | SearchCIO.com |
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ROI: It's probably the most common term tossed around in any IT or business organization today. Many executives are now requiring an ROI analysis before approving any given project or investment. So what's involved in calculating ROI and how effective is this metric to the overall success of IT investments and implementations? This CIO Executive Guide includes resources on measuring ROI, understanding the metric and more.
This Executive Guide is part of the SearchCIO Executive Guide series which is designed to give IT leaders strategic guidance and advice that addresses the management and decision-making aspects of timely topics. For a complete list of topics covered to date visit the Executive Guide section. To be alerted when new Executive Guides are available subscribe to the free monthly e-newsletter, CIO Advisor.
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Before making any IT investment, identifying the value of ROI is important to clearly demonstrate the financial gains of the proposed project, compared to the relative cost. The metric is so important that more than 80% of companies typically do an ROI calculation prior to approving IT projects costing $50,000 or more.
An ROI calculation is fairly straightforward. ROI examines the cash flows of a project over a specified analysis period, typically between three and five years for an IT investment. The cash flow is a summary of the costs -- the total incremental investment in the project, and benefits -- the cost savings, productivity improvements and revenue gains for the project. The ROI calculation examines the ratio of the net gain from a proposed project, divided by its total costs. In a formula, ROI is represented as:
ROI = cumulative net benefit/total costs * 450px
For example, if a project has an ROI percentage of 200%, the expected net benefits of the project are double those of the expected implementation costs. In more basic terms, every $1 invested in the project will yield $2 in net returns, along with the original $1 back.
The ROI calculation typically uses the total investment costs over the analysis period, and considers all cost savings and revenue benefits. The cash flows from such a project may appear as follows:
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Initial
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Year 1
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Year 2
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Year 3
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Cumulative Total
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Total Costs
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$ 100,000
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$ 25,000
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$ 25,000
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$ 25,000
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$ 175,000
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Total Benefits
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$ ---
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$ 200,000
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$ 200,000
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$ 200,000
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$ 600,000
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Net Benefits
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$ (100,000)
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$ 175,000
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$ 175,000
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$ 175,000
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$ 425,000
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ROI% = $425,000/$175,000 = 243%
The ROI was calculated by taking the cumulative net benefits of $425,000 divided by the cumulative total costs of $175,000. Hence, the net benefits are more than double the investment, yielding an ROI percentage of 243%. Every $1 invested will yield $2.43 in net returns.
Typical returns should be between 50% and 300%, according to 62% of respondents in a 2003 International Data Corp./Alinean survey of IT executives. Regardless of the results, to create as conservative a business case as possible, the costs and benefits should be scrutinized to assure that all costs were considered and that all benefits are achievable, with a stakeholder willing to assure realized results.
The ROI calculation is valuable because it creates a ratio between the expected net benefits of a project in relation to its costs, one that the team can use to compare to other proposed projects and against internal investment goals and criteria. As a simple percentage of calculation, it's easy to understand and explain the results. The ROI calculation will yield high percentage results when the net benefits outweigh the costs in relative terms, regardless of the magnitude of the costs or benefits. Therefore, it's a great indicator of project value, but it does have several of the following shortcomings:
- It does not indicate the time to returns. Projects that take a long time to achieve payback might be riskier than projects with faster paybacks.
- It does not assign the time value of money into the calculation. In other words, companies can't assess investment requests, which need to occur immediately, against risk-adjusted, discounted benefits several years down the road. To account for the time, value of money and adjust the calculation for risk, certain companies instead use a risk-adjusted (RA) ROI formula: NPV (net benefits)/NPV (costs), where NPV stands for net present value. The RA ROI formula variation is Alinean's preferred method for calculations.
- It does not take into account that some projects' total cost and benefit value may be so small that the net benefits are not worth considering. For example, the ROI percentage of a planned project might be 500%, but the net benefits of $10,000 on a $2,000 investment just isn't worth it for many corporations.
- It does not highlight that investment costs may be so high that even though the net benefit and ROI yield is high, the project exceeds a reasonable budget or investment risk. For example, if a project has a projected net benefit of $100 million and an expected ROI percentage of 1,000%, but it costs $10 million, the risk might be too high for a cash-strapped company.
As a result of these shortcomings, although ROI is a great summary financial metric for assessing and measuring project viability and performance, it should be used with several other financial measures including NPV, payback period and internal rate of return calculations.
Tom Pisello is the CEO of Orlando-based Alinean, a ROI consultancy that helps CIOs, consultants and vendors assess and articulate the business value of IT investments. He can be reached at tpisello@alinean.com.
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