Calculating the ROI of an IT Project

ROI communication & calculation can make a difference in a project getting funded or not

roi-pictureIn today’s economic climate justifying the cost and benefits of an IT initiative has become more important than ever. Often the fate of an IT project depends on the justification of benefits and recuperation of the costs. Therefore calculating, presenting, and demonstrating the benefits of a project in an appropriate manner can make the difference between getting a green light and getting stuck in an endless review cycle.

Value-statements can help bridge the communication gap

During my interactions with various IT departments I have noticed that the IT staff values a project differently than the business sponsors or executive team. Calculating and communicating the value of an IT project puts the IT staff in an uncomfortable and unfamiliar role which requires financial, sales, and technical skills. Quite often even when the IT staff tries to focus on business benefits they fail to align the benefits of a project to the business concerns in a manner that resonates with the executive team. The use of appropriate terms and prioritization of business concerns is key to grabbing the attention of the business sponsors and the executive team. A value statement [i]can be a useful tool to summarize and contextualize benefits of a project in almost all circumstances. Sometimes there are cases when ROI is not clearly defined, is impossible to define, or simply not that important to the stakeholders. Under such circumstances a value statement can be instrumental or even a must. They help overcome resistance, bind together stakeholders, and focus the project around delivering real business value. To summarize, they help you see the forest from the trees where as ROI calculations help you count the trees.

A value statement can take many shapes and formats depending on the context of the project and audience reviewing it. However, it is always a good idea to try and tie it back to the mission or value statement of the project. For example consider the following sample value statement:

roi-table

The benefits need to be tied back to the capabilities by linking them to preferably operational measures. Financial measures although are more accurate they typically lag operational measures.

Calculating ROI

When calculating direct [i]and indirect [ii]benefits of a project it is important to keep three important aspects in mind:

  • The Rate of Return of the Investment
  • Capital Recovery Horizon
  • Variance Potential

The rate of return of the investment is not just returns exceeding the original investment plus the cost of capital but it should also include compensation for the risk of undertaking the project. For example if a project returns 20% and cost of capital is 18% then the additional 2% may not be sufficient justification even for a “sure shot” of a project. As a very rough rule of thumb ROI of less than twice the cost of capital should be considered high-risk. A ROI of 4 times or more of the cost of capital is considered ideal. Capital recovery horizon is the time that a project will need to generate enough benefits to recover the original investment. The rapid pace at which technology, business environment, trends, and preferences change (especially in the IT industry) pose a significant risk of future benefits not being realized. Changing market conditions and new competition can create new more lucrative opportunities as well diminish the value of existing ones. Therefore it is highly desirable to recoup the original investment as quickly as possible to minimize exposure to sudden changes in market conditions. The ideal recovery time can vary significantly and depends significantly on the market conditions and maturity of a given vertical. For fast moving verticals recovery time of 1 to 2 years is ideal. Variance potential portrays the risk associated with changes or variances in the calculations and estimates of the future benefits of a project. Indirect benefits are hard to calculate accurately and are most susceptible to errors and variances. If indirect benefits constitute a high percentage of the overall benefits or a project then the variance potential for the project is high and vice-versa. Indirect benefits that are less than 50% of the overall benefits are ideal whereas a number of 90% or more indicates high risk to the project.

Calculating the ROI with appropriate level of rigor can be a daunting task. Coming up with a justification for a project is not a “one size fits all” exercise and does not always have to result in punching numbers and formulas into a spreadsheet. Depending on the type of project and the company the right type of benefits calculation has to be tied to the appropriate level of rigor. Sometimes a clear and well articulated value-statement can be sufficient while at other times you have to have hard numbers to backup your claim. A simplified ROI sheet that ties the benefits to the operational levers (operational capabilities) is presented below.

roi-spreadsheet


[i] A value statement focus more on the qualitative aspects rather than the quantitative ones, it is simply narrates the benefits without tying it to the bottom-line.

[ii] Direct benefits are the ones that are only one step removed or are a direct consequence of the implementation of the project (e.g. hardware/software/staff consolidation, time savings, inventory reductions, increase in revenue, etc.).

[iii] Indirect benefits are the sub-consequence of the change brought about the project implementation or are the unquantifiable side-effects (e.g. improvement in morale & good will, more knowledgeable support staff, increase in revenue, etc.).

3 thoughts on “Calculating the ROI of an IT Project

  1. Pingback: ROI and the InfoSec Value Statement : Information Security Resources

  2. Pingback: Tweets that mention Calculating the ROI of an IT Project « Edgewater Technology Weblog -- Topsy.com

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