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Issue of December 2006 
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The ROI on IT investments

Navjot Sidana, Consultant, PricewaterhouseCoopers, on how to measure the return on investment in information technology.

Why ROI?

Gone are the days when CFOs easily agreed to allocate a certain percentage of their budget to IT investments. Nowadays, IT executives are required to justify IT spending stronger than ever. Senior management needs to be convinced thoroughly, and their crucial buy-in needs to be taken before proceeding with an IT investment. This is where Return on Investment (ROI) analysis comes into picture and plays a decisive role. Another area where ROI analysis can be used is to analyse an investment after it has been made so as to gauge whether IT rupees are being spent wisely or not.

What is ROI?

Traditionally, ROI is calculated by dividing net profits (after taxes) by total assets. However, the above formula is not relevant in the case of IT investments. When IT managers talk about ROI, they are essentially seeking answers to the following questions:

  • What do I get back for the money I am spending?
  • How much time will it take before I start reaping the benefits of the investment I am making?
  • Are the benefits tangible and quantifiable?

In other words, ROI analysis evaluates the investment by comparing the magnitude and timing of expected gains to the investment costs.

How do you measure ROI?

Conventionally, ROI used to measure only financial paybacks (for example, increase in revenues or decrease in costs) of IT investments. However, ROI methodologies have evolved with time and now include the non-financial paybacks as well. These non-financial benefits (also known as ‘intangibles’) include increase in customer satisfaction, increase in employee productivity, and faster and more accurate availability of information. These new metrics go beyond the traditional measures that focus on cost analysis and savings.

In fact, many IT professionals believe that these ‘intangibles’ are the most important ones although they are very difficult to quantify. The problem in the case of non-financial measures is dual in nature: what to measure and how to measure. And the problem is compounded by the fact that IT is inextricably linked to all aspects of a business. One of the benefits of considering intangibles is that it helps to connect IT with what’s really important to top management—the achievement of strategic business goals.

Nowadays, IT executives are required to justify IT spending stronger than ever. Senior management needs to be convinced thoroughly, and their crucial buy-in needs to be taken before proceeding with an IT investment

One of the pre-requisites of any ROI analysis is to understand the context of the IT investment. This will involve listing the costs and benefits in each of the following areas: technology infrastructure, business processes and organisation.

Let’s take the example of an ERP investment, the area where IT executives most often have to justify expenditure. The infrastructure-associated costs will be the costs of connectivity, hardware, software, etc, whereas the benefits will be more efficient automation and access to information. The business process-associated costs will be on things like training, whereas the benefits will be in areas such as improvement in the efficiency of processes. From an organisation perspective, the costs will be in terms of time of senior management and the like, whereas the benefits will be increased integration between departments and accurate MIS reporting.

The next step is deciding whether to quantify the business benefits or to let them remain as they are. The answer lies in the nature of the audience. If the audience is the concerned department staff, they will be more interested in the performance measures, whereas if the audience consists of the CEO and CFO, they will be more interested in the rupee impact. Whatever is the case, the temptation to jump immediately to rupees should be resisted.

The next step is translating performance measures into rupees. Let us take the example of a new software which is projected to result in an employee productivity gain of 20 percent. If there are 10 employees there will be a capacity gain of two employees. This will translate into an annual savings of the compensation of two employees, excluding the money saved by not having to hire and train the two new employees.

One of the factors which should be kept in mind while doing ROI analysis is the timing of the benefits which accrue from IT investments. For many IT projects, the resulting value does not occur immediately but rather over a period of time

One of the factors which should be kept in mind while doing ROI analysis is the timing of the benefits which accrue from IT investments. For many IT projects, the resulting value does not occur immediately but rather over a period of time. Some of the other factors include how many people will be affected (either positively or negatively) by the investment, and how often the new application/system will be used.

If, for some reason, the ROI turns out to be less than expected, the following can be used to fix the same:

  • Spread costs (like training) over a period of time
  • Try to reduce the price by negotiations
  • Go for a phased or a step-up approach, spreading your investments over time.
Summary
  • ROI metrics can be used to increase the recognition and acceptability of IT as part of the business by measuring the tangible and intangible benefits of IT investments.
  • The ROI of IT is best articulated and delivered in what is done with the technology. In other words, what it enables, not the technology itself.
  • ROI analysis ensures that the correct technology projects are funded, and that the investments deliver the promised returns.
  • IT executives should not use ROI as a tool simply to get approvals from the top management. They should also use ROI analysis to show the effectiveness of past IT investments.n A good ROI need not be the only factor for giving a go-ahead for an IT project. There can be several other aspects involved like governmental compliance, strategic alignment, etc.
  • At times it might make more sense to calculate the ROI twice: once for the expected ROI and once for the worst-case scenario.
  • A systematic approach should be followed towards valuation of IT projects so that the credibility increases in front of the senior management.
  • Since ROI calculation is based on assumptions, the assumptions should be given due consideration and be as realistic as possible.
  • If an IT project is intended to provide a strategic value, then cost and revenue ROI may take a backseat and soft ROI can become significant.
  • IT executives need to track results carefully to be sure the investment is paying off.
  • IT managers should proactively communicate to the stakeholders the value delivered by investing in IT projects.
 
     
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