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Issue of July 2002 
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Banking on an ROI model

V. K. Ramani

IT Heads are often faced with one of the most important and confusing question: How to calculate and justify the ROI on IT investment? Planning the IT budget and getting it cleared from the senior management just isn't adequate anymore. Sooner or later the question of calculating the ROI, either tangible or intangible arises.

Over the last decade, as user awareness has grown, the need to invest in IT resources has increased significantly. It's high-level of criticality in an enterprise and the attached high base cost makes it necessary for the IT Heads to properly calculate and justify ROI on IT budgets.

UTI Bank

Industry: Banking & Finance
Revenue: Rs 134.14 Crore (Year ended 31st March 2002)
Employees: 1,721
IT Budget: Rs 21 Crore
IT budget as percentage of revenue: 15.65 percent

Measurement of technology ROI in an organization depends on the type of investment one has made and should be looked at on a case-to-case basis. There are some complex financial models that allows you to calculate the ROI. However successful organizations view IT as an asset and do not search for value in IT

Attaching a value
Before attaching a value on technology returns, one needs to note some important aspects in order to get a clear picture on ROI:

(a) ROI is best justified when the results are expressed in monetary terms. The value may be a result of either reduction in cost or increase in revenue.

(b) IT helps in the process of product development, allowing the company to stay ahead of competition and retain or gain market share.

(c) Deploying efficient IT systems adds to customer convenience.

(d) A well-designed IT infrastructure can adequately meet the company's MIS and BI (Business Intelligence) needs.

(e) IT systems can help a company leap-frog to new processes and totally new business models.

The means to attach a particular value to returns on IT also depends on the type of investments you have made.

Here are two examples to explain this: ROI of new feature-rich software application can be assessed by the effectiveness of marketing the service that has been enabled by the technology. A hardware upgrade for meeting a transaction volume growth can be measured by factoring the loss of business opportunity if the upgrade was not carried out.

Assessing the ROI
The assessment of ROI should be made on a case-to-case basis. Calculating the ROI on IT differs from industry-to-industry, service-to-service. Let's discuss some instances.

UTI Bank has invested in WAN infrastructure for connecting various branches to a centralized database. In this case the results were measured in terms of impact on business growth. The impact was immediate on two counts:

  1. The cost of hardware and software license per branch decreased by a factor of 45 percent.
  2. The rate of expansion of the branch network doubled in 12 months mainly due to the ease with which a branch could be opened with a few desktops and network connectivity. 49 branches were added in nine months, a healthy growth compared to 43 branches in the last two years.

UTI Bank has installed over 500 ATMs (Automated Teller Machines) nationwide. There was IT expenditure on elements like the ATM switch, software licenses, training, and other network components. But the deployment opened up an additional delivery channel for banking operations. As a result we observed a significant migration of retail transactions. 85 percent of cash withdrawal transactions from the branch migrated to the ATM channel. The transaction cost in ATMs is lower by around 60 percent. This percentage value may be treated as a payback to the IT Department and shown as cost recovery or profit earned by the IT Department.

Here, although a direct ROI was not worked out, the assessment of the values of the investments could be made by recognizing the following:

(a) An increase in revenue from operations

(b) A steady business growth possible due to branch expansion in a compressed timeframe

(c) Acquisition of new customers

(d) Fewer requirements for skilled IT manpower to manage operations at each branch

The perplexing question still remains Is IT a profit center? To answer the question, I prefer the following approaches:

(a) Treat core infrastructure expenditure as the cost of doing business. The expenses associated with its maintenance and support can be distributed across all business units in proportion to the percentage of transaction supported by the system.

(b) In case of specific projects, in order to meet requirements of a business group that has to achieve a profit target, the entire incremental investments, maintenance and support costs may be allocated.

(c) All major technology-related expenditure which has an impact on business processes that lead to increase in efficiency (measured in terms of reduced turn-around time or employee productivity) may be treated as a separate class of investments. The recognition of benefit from IT may be measured by an empirical approach, which is acceptable to accountants and business groups.

This will enable a residual flow as returns on IT investments, which can justify similar projects.

There are two main approaches to calculating ROI on IT: The Simple approach and the Quantitative approach. The Simple approach is based on classifying IT investments into different categories, while the Quantitative approach is based on complex financial models.

The Simple approach
A simple approach to calculate IT investments is to classify them into different categories. (Refer to table 1 and table 2)

IT Investment Category
Core Infrastructure A
Maintenance B
Product Development C
Process Engineering D
Business Intelligence E
(Table 1)
Category A & B To be absorbed as cost of being in business
Category C & D Rationalize the benefit & plough-back a share of benefit accrued as return on IT investment
Category E Impact difficult to quantify. Quantitative impact on strategic decision is long term
(Table 2)

The Quantitative approach
There are several quantitative approaches that lets you calculate the ROI on IT. Here's an overview:

NPV Method: Using an appropriate discount factor we can arrive at the Net Present Value of the total cash flow over the estimated period for which we expect returns. This is represented by:

This approach assumes that the predicted benefits will actually occur. This uncertainty can also be factored by arriving at three types of NPV-optimistic, probable, and pessimistic assumptions. A risk-averse approach will imply that we take the pessimistic projections. This approach does not take into account the value of options. If an IT head needs to satisfy more rigorous demands from the CFO/CEO, he has no choice but to justify the expenditure by emphasizing on the qualitative benefits and the overall impact on business growth. He can also submit the total estimated cost to the CFO/CEO and wait for a favorable nod.

Option Pricing Model: Black and Scholes (1973) developed a model to value options in finance. This method takes into account aspects like the returns that would have been possible if the investments were made in the stock options, capital market, and the price fluctuations in market value.

Cox & Rubinstein method: This method is also related to the Options Pricing Model which takes into account the current value of call, current value of underlying asset, value of option at the end of the period if stock prices rise or fall to an estimated level, and the present cost of capital. These are essentially financial projections for returns. Here, the management decides the acceptable risk.

Dwelling into complex financial models, may be necessary only if the total value of IT investments is proportionately large for the organization and the risk of failure of the project to generate returns is almost equivalent to closure of business. To adopt these methods, one would presume that the entire exercise or approach is that of an accountant and not a visionary. I want to emphasize on the fact that all investment models are subject to uncertainties. The essential point to be noted is that successful organizations view IT as an asset. They do not search for value in IT, they create value.

V.K. Ramani is President, IT at UTI Bank

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