Calculating the value of IT

10 February 2006

IT executives are expected to make more rigorous business cases to back up their spending plans. An industry of consultants and academics has grown up to help them calculate accurate returns on IT projects.

IT executives are expected to make more rigorous business cases to back up their spending plans. An industry of consultants and academics has grown up to help them calculate accurate returns on IT projects.

Chips and beans

It is rare for IT proposals to inspire high-fives around the boardroom these days. Chastened by recent experiences, many executives are only too aware of the downside of pursuing an unquestioned belief in technology's ability to create wealth.

And while formal cost-benefit analysis is still a rarity, the threshold at which Fortune 200 companies mandate a comprehensive ROI analysis for new projects has dropped on average from $1 million to $250,000 over the past three years, according to CIOview.

But those looking for prototypes for their financial arguments are faced with a forbidding array of acronyms and equations founded on classical capital market theory. To cope with the special needs of technologists, new ones have been created - as well as plethora of software to work them out.

Whichever one an organisation picks, all of them are founded on two assumptions: that companies should invest in projects that deliver the greatest benefits; and, more profoundly, that it is possible to predict, and put a value on, the costs and the associated business changes.

IT projects often fall outside the first of these because they are often necessities: no one expects email or antivirus to be subjected to a strict quantitative analysis.

Nevertheless, many believe it is a useful discipline to try to translate all of IT's activities into costs and benefits. And often the real value is not in the final numbers themselves, but in the engagement with other parts of the business needed to work them out.

Alphabet soup

The total cost of ownership (TCO) of an IT project is the purchase price of the hardware, software and services used to create the system plus all the additional on-going costs such as training and maintenance. The purchase of software is usually less than one-third of the total cost. Added to this is the opportunity cost - the cost associated with not being able to pursuing alternative projects.

But TCO needs to be weighed against a given time period. A project that costs so much that it will not show a return on investment for decades may not be ideal. So the calculation of the payback period, which is the number of years it will take for the project to rise from a negative value to break-even, is critical.

Often, though, things are not that simple. Today, projects are typically implemented in phases. So the investment in further phases is on-going even as the organisation tries to assess the benefits of the initial phase - and often it is difficult to pin a discrete cost on any particular phase.

But one problem is that any forecasts of the returns likely to be made will use current figures, and as such they ignore the fact that cash has a habit of losing value over time. The net present value (NPV) compensates for that by adding up the cash flows in terms of the amount of cash that an organisation would need to invest in the bank now to have that figure in the future year under consideration.

The return on investment (ROI) of an IT project is often used as a generic term to cover all forms of project valuation. But in its technical sense the ROI of a project at a certain time represents the net present value of a project as a percentage of the initial investment. So a project costing £100 to set up, promising to deliver a net present value of £120 in three years, delivers ROI of 20% in three years.

The internal rate of return (IRR) of a project at a given time is one of the more difficult concepts, describing the bank interest rate that would deliver a net present value of zero. Calculating this number is not an easy job, but most spreadsheet packages can be set up to do so.

A la carte

There is a wide variety of formulae for calculating the value of IT projects. Among the oldest of the non-standard measures is the balanced scorecard system, which looks to consider the pluses and minuses across a whole range of key performance indicators.

Stern Stewart &Co, a US consultancy, recommends the use of economic value added (EVA) - net operating profit minus capital charges. But figuring out the net operating profit of an IT project may be a problem.

Another way of valuing an IT system is in terms of the options it gives a company, quantified using the 'real options' model. Among the options that commonly carry a value in CIO portfolios are scalability and flexibility. Portfolio management system, meanwhile, encourages IT executives to allocate values to each of their projects and resource them accordingly.

Critical eye

"Deploying technology without changing process and organisation will create little impact. Naked technology wipes out productivity improvements, hurts ROI and dulls the bright edge of well-conceived strategies."
George Colony, Forrester Research

"By consistently using the same approach to business case design, your organisation should improve its ability to understand and act on case results effectively. But too many people and too many organisations begin each case-building project starting from nothing."
Marty Schmidt, Solution Matrix

"To anyone who can count, an ROI of 125% looks better than one of 55%. However, behind this facade may reside deceptive calculations, faulty logic, and erroneous conclusions... In the pantheon of abused words, ROI stands tall."
Jack Keen, author of Making Technology Investments Profitable

"The ROI of an ROI is zero. The quality of the process behind the number is what is valuable."
'The ROI of ROI', Digital Mosaic

"It's not the widespread promotion of ROI in the software industry that is misplaced, but the use of a single, narrowly defined concept as a proxy for an entire hierarchy of activities concerned with financial and strategic analysis."
Hakan Erdogmus, National Research Council, Canada

Anatomy of failure

John Jordan of Capgemini, a principal in the office of the chief technologist at the IT services giant's Americas operation, outlines why he thinks technology return-on-investment models are so flawed:

Systems designs typically take a technology-first approach: the problem is that that ignores the aspect of the business that creates by far the most economic value: people. The most critical factor in achieving the goal to which technology is put - improving business and process effectiveness - remains human capital. ROI calculations typically ignore usability and neglect co-evolution of systems and users as costs to be considered."

"People don't know what they don't know. Email is a good example of a technology which has had dramatic benefits without anyone doing any complex calculations on payback."

"Adding complexity to the system is not free - it needs maintenance and that maintenance can affect the maintenance of others."

"Where is the ROI for the long term implications of a better product idea, a faster allocation decision, a prevented misstep? Such measures live at the heart of most businesses as opposed to crude output per unit of input."

Valuation software and services

Building a business case for IT projects has never been harder. So it is not surprising to see a whole sub-industry of consultancies, analysts and specialist tools providers has sprung up to lend a hand:

Alinean supplies research, consultancy and software for valuing IT investments, focusing on return on investment (ROI), total cost of ownership (TCO), value, analysis and management tools. Its products have been adopted as a sales tool by Microsoft, Dell, Compaq, IBM, HP, Veritas and Novell to help customers justify the purchase of systems. Alinean ROI tools have been developed to analyse and cost-justify purchases in storage, systems management, computing platforms, operating systems, eCRM, wireless, security, database management, e-business procurement, ERP, supply chain management, outsourcing, business intelligence, collaborative commerce, content and document management, asset management and office automation.

CIOview provides tools for calculating the TCO of and ROI from software projects. They include thousands of data points, an advanced configuration engine and automatically generated reports for over 60 different software areas.

Nucleus Research provides an 'ROI-focused' advisory service that it claims is the only one to mix a financial analysis approach with comprehensive technology expertise.

Businesscase.com boldly proclaims that "you do not have to be an expert to create a business case for your IT initiative". The company's CaseBuilder provides templates and guidelines in Word, Excel and PowerPoint formats.

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