Introduction
This is a continuation of my blog series on ROI models. In my previous blogs, I have covered the topics Big ROI- Reality or Myth? and Ways to Implement Predicted Labor Savings.
CEOs and CFOs seek IT/other investment proposals that yield a good Return on Investment (ROI). These executives also favor projects that support, promote and implement their business vision for growth.
The growth and profit objectives are obviously not mutually exclusive. The executives would want both. The question is- Would (or should) the executives still consider IT projects which are not attractive or even anemic from ROI standpoint?
Typical project scenarios with modest ROIs
The following project situations may result in modest ROIs:
- “Strategic” projects that help build “bridge” to the future. Such projects are not always aimed at realizing quick returns, but have a different purpose- to accelerate achieving the business goals
- “Foundational Projects” that prepare the company for implementing IT/Business solution in future. A typical example is project to upgrade technology infrastructure- which is often cost intensive and hard to translate to tangible benefits. However, a strong technology infrastructure can set the foundation for the company to implement business critical and profitable projects in future. Another example of a foundational project in the context of SAP Programs is implementing a “Center of Excellence”
- Projects with considerable “value-added” or “soft” benefits, and relatively small quantifiable benefits typically have lower ROIs. For example, if one of the major benefits by implementing an IT Project is improved customer satisfaction, it can reasonably be assumed that this should enhance customer goodwill and hence result in revenue benefits. But the link between customer satisfaction and increased revenue is tenuous and hard to justify at times. It is even harder to calculate this benefit with some accuracy. So while such benefits are typically documented in business cases and in the discussion on “value proposition”, it does not feature in the ROI calculations.
What is a “modest” Return on Investment?
Let us first define what a modest return on investment is? For doing this I am using “Internal Rate of Return (IRR)”- one of the better scientific measures that also factors in time value of money concept.
Internal Rate of Return (IRR) is described in Wikepedia as follows:
- The internal rate of return on an investment or project is the discount rate at which the net present value of costs (negative cash flows) of the investment equals the net present value of the benefits (positive cash flows) of the investment.
- IRR calculations are commonly used to evaluate the desirability of investments or projects. The higher a project's IRR, the more desirable it is to undertake the project. Assuming all projects require the same amount of up-front investment, the project with the highest IRR would be considered the best and undertaken first.
Typically, the IRR of a project (or investment proposal) is compared with those of other projects, as well as with the “cost of capital” of alternative investment.
Whether an IRR is modest or weak, is a matter of judgment. However, I am using a simplified way to get my point across:
- Modest IRR- Any project with relatively low IRR compared to those of alternative investment proposals
- Weak IRR- Any project with IRR marginally higher than the cost of capital
- Negative IRR- Any project with Net Present Value of cost-stream exceeding that of benefit-stream. Such a project is usually “undesirable”.
So, how would a smart executive evaluate these scenarios? Insist on reviewing the full picture…
The executives are faced with alternative investment proposals, and have choices to make. While IRR/ROI numbers are important measures, they must be used with caution. The project scenarios mentioned above if evaluated on a standalone basis, the IRR/ ROI would not be attractive.
The executives therefore should insist on reviewing the full picture covering business case, benefits realization and ROI model. It is therefore necessary for consultants/ managers preparing the ROI model and business case to use the following key guidelines:
- Build a comprehensive business case- identifying and evaluating the overall “value” instead of using just ROI/ IRR- these are after all just numbers- and only one part of a bigger picture.
- Focus on benefit realization - Make sure that the business case provides details of how the benefits will be realized and can be optimized- both for hard and soft/ value-added benefits
- Create a comprehensive ROI model- including not just the standalone projects, but other related/impacted projects as well. This exercise will avoid any “skewed” numbers generated by standalone projects such as “foundational” or “strategic”.
Please feel free to share your perspective on this topic, by responding on SCN.
I am a Sr. Principal with Value Engineering Group in SAP America. Prior to SAP, I worked at a large consulting firm as Partner and management consultant. You may contact me directly over email (anil.joshi@sap.com) or Twitter (@aniljoshisap)
