ROI: A deceptively simple budgeting yardstick

Trying to decide how well your next project will pay off for your company in five years? Knowing how to calculate return on investment (ROI) can help you in your decision.

Each week, our TechRepublic financial team fields a question from working IT pros about the mysteries of making those budget sheets balance. This week’s question deals with return on investment (ROI), a deceptively simple financial yardstick that means a lot to revenue planners but may not be entirely applicable to infrastructure initiatives.

So, what exactly is ROI?
TechRepublic IT team: Say that we were proposing a rollout from our old Exchange-based system to a new Lotus Notes platform. A senior VP asks about the project's projected ROI. How do we calculate ROI, and is it the correct tool to use?

The Budget Crunchers: When faced with a big financial decision, it’s wise to look at the numbers involved and measure your alternatives in a way that allows you to make a meaningful comparison. Return on investment, commonly called ROI, is one tool that will help in this process.

Here’s the basic formula used to determine ROI:

ROI=Return/Assets Invested

Although ROI can be applied in the case you described, it isn’t the tool I would choose. Many of your technology investments are not made for financial return but, more simply, because you need the equipment or software in order to operate.

The benefits you reap will be intangible and difficult (but not impossible, as we shall see) to measure. Cost is your main concern, and it might be simpler to compare the expense of switching to the Lotus platform with that of staying in your current setup.

ROI lends itself much better to situations where, along with cost, there will be a clearer return. It is a valuable tool, however, so let’s take a look.

Financial gains
Return includes any financial gains received from the project in question. Usually, these are expressed in the form of cash inflows. Of course, return might be viewed differently dependent on your corporate culture.

You should also consider any cost savings that may result. Some of the benefits associated with a project can be difficult to quantify. For example, you may consider purchasing new software because it is easier to use. How do you translate “easier to use” into dollars and cents? Perhaps the ease of use will result in fewer help desk calls, freeing up some of your employees’ time.

What you pay for that time is a savings that should be considered part of your return. Maybe training requirements will be reduced, resulting in a lower expense. Be thorough, but also be realistic. You don’t want wild, far-fetched estimations to cast a shadow of doubt over your entire proposal.
Ask our TechRepublic Budget Crunchers for pointers on making financial sense from all those IT expenditures. Due to the number of requests, we may not be able to answer every question we receive, but we will review all the e-mails you send us.
On most projects your main investment will be the direct cost of the equipment and services purchased. But here again, be careful not to overlook other, less obvious outlays. If equipment is added, what will maintenance cost? Will any employees be added as a result? What about upgrades?

ROI is a useful fiscal yardstick because it takes alternatives with unequal returns and/or costs and compares them on an equal footing. For example, let’s say your department is evaluating two hypothetical projects.

Project 1 has a cost of $79,000 and a return of $40,000. Project 2 has a cost of $84,000 and a return of $47,000. Which is the better project? Let’s check the math.

With all other factors being equal, we can see that Project 2 yields a better return on our investment. Unfortunately, all other things are not normally equal, and ROI cannot stand alone as a decision tool.

Let’s look at another hypothetical. Project A has a cost of $10,000 and a return of $7,500. Project B has a cost of $100,000 and a return of $40,000.

Project A clearly has the ROI upper hand. But let’s assume these projects are mutually exclusive and that you have $100,000 to invest. Project 2 will hand you $40,000 in return, as compared to the $7,500 from Project 1. If you wind up having to hold the remaining $90,000 that would remain uninvested if you chose Project 1 in a low-yielding corporate account, then suddenly Project 1 becomes less attractive. The return on what is actually invested in the project is good, but the return on what you have to invest is poor.

The fine print
Of course, budgeting is never as easy as it seems at first, and that’s certainly true of ROI calculations. In reality, unless your total investment and return will be realized within a short period of time, you must also consider the time value of money (TVM). A more realistic project analysis would involve an initial investment, additional costs that will occur throughout the coming months or years, and returns that will be received throughout the coming months or years.

For example, a project will cost $100,000 up front but will result in $10,000 cash inflows at the end of each of the next 10 years. Quick math would seem to present you with a 100 percent ROI initiative.

Wow! You’ve really stumbled on to something here, haven’t you? Yes and no. It may be a good project, but it’s not as good as it looks. The calculation fails to consider that a payment of $10,000 10 years from now is worth much less.

For example, I could put a little over $5,000 into a money market account at 7 percent interest today, and in 10 years the account would be worth $10,000. In a drawn-out project such as this, you will want to calculate the present value (PV) of all costs and of all returns and then use your PV numbers to calculate true ROI. (Unfortunately, TVM is a lengthy topic on its own, so we’ll save the rest of that discussion for another day.)

Now, as I mentioned, in the scenario you described, I wouldn’t use ROI. Instead, I would simply focus on the investment part of the equation we’ve been discussing. In your case, figure all the costs associated with keeping your current platform. Use the ideas already discussed (and be thorough), and then figure all the costs associated with switching to Lotus.

Now you can see how much the new system will cost over and above what you would have spent anyway. Or, perhaps you’ll actually realize a cost savings, in which case this decision is a no-brainer.

Bottom line
ROI can be an easy-to-use and helpful tool in analyzing spending decisions. You should take care to consider all costs and returns that will result from your decision. This will involve assigning dollar values to less tangible benefits and obligations that are involved in the proposed course of action.
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