EXPERT RESPONSE
Return on Investment (ROI) is arguably the most popular metric when
you need to compare the attractiveness of one business investment to
another. Your return on investment equals the present value of your
accumulated net benefits (gross benefits less ongoing costs) over a certain
time period divided by your initial costs. It is expressed as a percentage
over a specific amount of time; in IT purchasing, three years is the most common
time span since technology is often effectively obsolete after three years. The
equation for a 3-year ROI is:
(net benefit year 1 / (1+discount rate) + net benefit year 2 /
(1+discount rate) + net benefit year 3 / (1+discount rate)) / initial cost.
So if the initial cost for your manufacturing company's small new
software roll-out was $10,000, your annual benefits minus annual costs are
constant at $5,000 for the next three years, and the discount rate is 10%,
your 3-year ROI would be:
($5,000 / (1 + .1) + $5,000 / (1 + .1)^2 + $5,000 / (1 +
.1)^3)/$10,000 = 124%
While ROI tells you what percentage return you will get over a
specified period of time, it does not tell you anything about the magnitude
of the project. So while a 124% return may seem initially attractive, would
you rather have a 124% return on a $10,000 project or a 60% return on a
$300,000 investment? That is why you will often want to know the Net Present
Value.
There are many different techniques you can use to measure the
financial attractiveness of any large financial endeavor, such as an IT
project. If you'd like to learn more about others, including Net Present
Value (NPV), Payback Period, and Internal Rate of Return (IRR), you can read
a white paper, Financial Primer: How to Calculate ROI, NPV, Payback and IRR,
http://www.cioview.com/resource_whitepapers_financial.asp
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