Before making any IT investment, identifying the value of ROI is important to clearly demonstrate the financial gains of the proposed project, compared to the relative cost. The metric is so important that more than 80% of companies typically do an ROI calculation prior to approving IT projects costing $50,000 or more.
An ROI calculation is fairly straightforward. ROI examines the cash flows of a project over a specified analysis period, typically between three and five years for an IT investment. The cash flow is a summary of the costs -- the total incremental investment in the project, and benefits -- the cost savings, productivity improvements and revenue gains for the project. The ROI calculation examines the ratio of the net gain from a proposed project, divided by its total costs. In a formula, ROI is represented as:
ROI = cumulative net benefit/total costs * 100%
For example, if a project has an ROI percentage of 200%, the expected net benefits of the project are double those of the expected implementation costs. In more basic terms, every $1 invested in the project will yield $2 in net returns, along with the original $1 back.
The ROI calculation typically uses the total investment costs over the analysis period, and considers all cost savings and revenue benefits. The cash flows from such a project may appear as follows:
[TABLE]
ROI% = $425,000/$175,000 = 243%
The ROI was calculated by taking the cumulative net benefits o
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f $425,000 divided by the cumulative total costs of $175,000. Hence, the net benefits are more than double the investment, yielding an ROI percentage of 243%. Every $1 invested will yield $2.43 in net returns.
Typical returns should be between 50% and 300%, according to 62% of respondents in a 2003 International Data Corp./Alinean survey of IT executives. Regardless of the results, to create as conservative a business case as possible, the costs and benefits should be scrutinized to assure that all costs were considered and that all benefits are achievable, with a stakeholder willing to assure realized results.
The ROI calculation is valuable because it creates a ratio between the expected net benefits of a project in relation to its costs, one that the team can use to compare to other proposed projects and against internal investment goals and criteria. As a simple percentage of calculation, it's easy to understand and explain the results. The ROI calculation will yield high percentage results when the net benefits outweigh the costs in relative terms, regardless of the magnitude of the costs or benefits. Therefore, it's a great indicator of project value, but it does have several of the following shortcomings:
As a result of these shortcomings, although ROI is a great summary financial metric for assessing and measuring project viability and performance, it should be used with several other financial measures including NPV, payback period and internal rate of return calculations.
Tom Pisello is the CEO of Orlando-based Alinean, a ROI consultancy that helps CIOs, consultants and vendors assess and articulate the business value of IT investments. He can be reached at tpisello@alinean.com.
