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An ROI primer: Learn the basics and the key shortcomings of this metric

Although return on investment is a very popular metric, it may not always be the right choice when evaluating IT projects. Learn your way around ROI with this step-by-step tutorial and find out some of the key drawbacks of this metric.


The virus is the nemesis of the Exchange administrator. The software bug is the nemesis of the support tech. And a pesky financial metric known as ROI is often the nemesis of the CIO.

Although many CIOs are convinced that return on investment (ROI) is not an appropriate way to measure the value of an IT project, it remains one of the most commonly used metrics. Business and financial leaders often require it before they approve project funding.

CIOs know they must understand ROI if they have any hope of helping other business leaders understand why it needs to be used with caution—especially when evaluating IT projects.

We’ll review how to calculate ROI, and we’ll outline a few of this metric's key drawbacks.

ROI definitions
TechRepublic’s Carmen Barrett, director of planning & analysis, provided the information for this primer. She begins by explaining how to define ROI in the simplest terms: “If we pay for this, what do we get for our money?” Figure A displays the basic formula for ROI.

Figure A


A case study using ROI
To illustrate ROI, Barrett created a hypothetical case study in which Company XYZ wants to buy a new server. This example is a revenue-generating capital project for an IT department (see Figure B). The return and investment figures are as follows:
  • The equipment cost is $100,000. Installation is $50,000, and maintenance is $10,000 per year.
  • The server has a useful life of eight years. (While this lifespan is not typical of most servers, we’ll use this number just for this example.)
  • The company will need to add another salesperson ($35,000 salary per year), but it expects sales to increase by $70,000 each year.

Figure B


Barrett warned that this example is oversimplified. Your organization may require many more figures to calculate return or assets invested. For example, some businesses include tax savings or overhead savings when calculating return.

Determine the present value of money
After you calculate the return and the assets invested, it would seem that you have the necessary figures to determine ROI, which is return divided by the assets invested.

However, Barrett recommends that you also factor in the time value of money (TVM) before you calculate the annual returns expected on the project. It’s a step that is typically recommended but often neglected.

Calculating the TVM takes into account the impact of inflation on future returns. The $25,000 cash inflow that Company XYZ expects to receive each year is not worth the same amount each year. Remember, the server is expected to last eight years, so the $25,000 cash inflow that our example company will receive eight years from now will be worth much less compared to the $25,000 that we receive this year (see Figure C).

Figure C


So how do you calculate the TVM in order to arrive at the $164,559 return figure? Here are two quick-and-easy methods that are commonly used:
  • Use a financial calculator, such as the Texas Instruments BAII Plus or Hewlett-Packard 10B financial calculators. (For a helpful tutorial on using an HP financial calculator, check out the Calculator Tutorials Index on the Metropolitan State College of Denver Web site.)
  • Use the TVM calculator that’s provided in Excel (see Figures D and E).

Figure D


Figure E
This is Excel's Present Value (PV) formula that you'll use for the calculation in the cell described in Figure D. To find this formula, click on fx on the toolbar and locate PV from the drop-down menu.


Plug in your numbers to calculate ROI
With the returns and assets calculated, we can use our figures in the formula to arrive at ROI for the server project (see Figure F).

Figure F


The limitations of calculating ROI for IT projects
If the financial gurus and business leaders in your organization are like most, they would prefer to have ROI calculated for just about every project.

“The reason that it’s so popular to look at IT projects [by ROI] is because it boils everything down into similar metrics, so everybody gets a percentage ROI, and it’s really easy to compare different projects,” said Barrett.

But Barrett cautions that calculating ROI for IT projects has a long list of disadvantages. We'll discuss some of these problems below.

ROI is a metric that favors cost-saving projects
ROI calculations for cost-saving projects are more accurate because the enterprise already has the data needed for the equation. When calculating ROI for a revenue-generating project, estimates are often used, which makes the ROI calculation less accurate. The result is that revenue-generating projects are at a disadvantage if they are competing against cost-savings projects based on ROI.

ROI can’t calculate valuable, intangible qualities
One metric can’t characterize the entire value of a project. Barrett recommends that when a CIO is faced with justifying an IT project, he or she should remind business leaders of the overall impact it will have for the enterprise.

“You really need to look at things like: How does this project fit strategically with your business? Is this going to position you for better growth or make you a first mover in the market? You may not be able to measure what those exact benefits are.”

For example, a research-and-development project may not show direct returns, but there is no doubt that not investing in R&D will hinder the long-term success of the enterprise.

IT will most likely be charged for project costs
Depending on how your organization assigns costs, it may be difficult for IT to charge a project cost to a particular department—especially when a project benefits the entire enterprise.

In our example of Company XYZ’s new server, Barrett predicts that the sales department wouldn’t accept being charged for the cost of the new server, although Sales would likely benefit the most from it.

“When Sales completed their budget, they assumed they would have the server all year long, and they built their sales projects based on that. Well, when IT built their budget, they didn’t know about this project. They didn’t think they had to include it in their budget.”

Keeping ROI in perspective
Barrett recommends that CIOs who don't wish to use ROI work with the company CFO or financial department to find an appropriate alternative metric to measure IT projects. Such alternatives include calculating one of the following:
  • Payback
  • Net present value
  • Total cost of ownership

But don’t be surprised if the financial team views any alternative metric as subordinate to ROI. In some organizations, ROI will remain a required figure for any project.

“You will never get a financial person to approve a project without a metric or number behind it. You can’t manage what you can’t measure,” said Barrett.

Has ROI ever killed an IT project in your shop?
Tell us about the impact of financial analysis on IT in your shop. Post a comment to this article or send us an e-mail.

 

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