have retrenched from their previously typical IT investment pattern. Behind
the change is an increasing reliance on financial measures to justify
IT investment. IT investments are not well suited to traditional financial
analysis. Nevertheless, IT managers should recognize that cash flow measurements
are being increasingly used to evaluate IT investments. Initial estimates
of cash flows from IT projects are often hard to determine because underlying
business assumptions can change. One way for IT managers to meet financial
analysis requirements is to develop Key Performance Indicators (KPIs)
for IT projects that can logically be associated with the original cash
the June 2002 issue of Managing Automation there was a continuation of
the theme that characterizes this "post dotcom" era. According to the
article, "Manufacturers are clamoring for a tool that will let them quantify
returns and analyze the results of technology purchases". At this point
in the evolution of technology applications it is time that companies
look for new strategies that will provide valid metrics to evaluate the
returns they get from technology investments.
is Part One of a two part tutorial. Part Two will discuss measuring the
impact of IT investments.
Accounting Perspective on Investment
is no question that financial criteria now governs IT investment decision
making. For accountants, Return on Investment (ROI) is measured by the
impact an investment will have on cash flows. Simply stated, investments
that result in increased net cash flows (returns that exceed the cost
of the initial investment) are the ones that businesses want to make.
often establish cash flow improvement thresholds using one of two financial
Both these tools have the common purpose of attempting to put a value
on the cash flows that will be generated in the future from investments
that are made today. For IT managers the message is pretty clear that
IT projects have to pay off but IT veterans all know that reconciling
IT investments to the bottom line has been problematic.
- NPV (Net Present Value) tells you how much richer in terms
of dollars you will become by making the investment.
- Internal Rate of Return (IRR) calculates the discount rate
percentage generated by the project. In IRR calculations the greater
the discount rate percentage, the greater the return on the project.
All Technology Investments Be Measured In Terms of Cash Flow Impact?
the increased scrutiny that IT investments are now receiving is a reaction
to the Y2K build out that justified "what ever it takes" technology investments
to keep the enterprise safe. Nevertheless, today there are more constraints
than ever on capital expenditures and the reality is that CFOs have taken
a renewed interest in all capital expenditures and IT is under now under
the same microscope as all other investments.
you ever wondered how the first person to buy a fax machine did a convincing
cash flow analysis for the capital investment or how early adopters of
e-mail made their case to a CFO. These investments required a "leap of
faith" that the technology would bring competitive advantage in the longer
term. We all know that when companies try to confirm a "leap of faith"
in financial terms they are on a slippery slope.
putting monetary returns on IT investments involves three common problems.
First, a critical part of cash flow analysis relates to how long the equipment
or software will be useful. It is hard to estimate the useful life of
information technology investments. We all have had the experience of
having IT equipment or software become obsolete much earlier than expected.
Conversely, sometimes software is used much longer than expected.
it is difficult to isolate the financial impact related to a change in
technology. For example, a major software project is likely to have an
impact on more than one business process and may enable new business practices
that were unforeseen at the time of the initial purchase. And third, the
costs associated with maintaining IT equipment and software are not easy
to understand at the time of purchase. Lurking behind the whole topic
is the fact that many of the important costs and benefits of an IT project
cannot be measured in monetary terms and may be better evaluated qualitatively.
Nevertheless, IT managers are now challenged to create financial analyses
to justify new IT investment.
Cash Flows Might Be Overlooked
are several issues to keep in mind when developing a financial case for
- Look for places where the project will freeze current costs over
time. If a project results in holding costs at the current level for
a projected period of time it will have a positive cash flow impact.
- Look for revenue generating opportunities. Some projects may work
to free working capital. Projects that increase inventory turns fall
into this category. Other projects may help generate more sales. Projects
that improve sales information, manage inventory, or shorten the order-to-cash
process may have revenue-generating potential.
- Consider the impact of support costs. If the new technology will
require less in terms of staff support, include those cost reductions
in the cash flow analysis.
- Plan to deliver the cash flow generating parts of the project first
where possible. The sooner cash flow benefits are seen the better
the project will look in terms of NPV or IRR.
after considering these issues IT managers need to realize that initial
estimates of cash flows from IT projects are often unreliable because
underlying business assumptions can change. Events as simple as corporate
reorganizations and as complex as divestures or mergers can make the cash
flow projections for a project meaningless. In Part 2 we discuss how IT
managers can develop Key Performance Indicators (KPIs) for IT projects
that are logically associated with the original cash flow assumptions
can still indicate the results of the IT project even if the underlying
business assumptions change.
"Bill" Friend and Olin Thompson are consultants who specialize
in the application of IT to business problems in the process industries.
Bill is a principal of WR Friend & Associates (www.wrfriend.com)
and has over 25 years executive experience in food and chemical manufacturing
and can be reached at firstname.lastname@example.org.
has over 25 years experience in the software industry and is the founder
of Process ERP Partners (www.processerp.com).
He can be reached at email@example.com
They co-write a monthly column for Food Engineering (www.foodengineeringmag.com)
and are the co-founders of the Food, Chemical and Life Science CIO Forums
which are found at www.foodcioforum.com,