Home
 > Research and Reports > TEC Blog > Is ROI King In Evaluating IT Investments? Part 1. Should ...

Is ROI King In Evaluating IT Investments? Part 1. Should We Make the Investment?

Written By: William Friend
Published On: July 23 2002

<

Introduction

Companies 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 flow assumptions.

In 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.

This is Part One of a two part tutorial. Part Two will discuss measuring the impact of IT investments.

The Accounting Perspective on Investment

There 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.

Companies often establish cash flow improvement thresholds using one of two financial analysis tools:

  • 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.
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.

Can All Technology Investments Be Measured In Terms of Cash Flow Impact?

Perhaps 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.

Have 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.

Generally, 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.

Second, 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.

Where Cash Flows Might Be Overlooked

There are several issues to keep in mind when developing a financial case for technology investments.

  • 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.

Even 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.

About the Authors

William "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 bill@wrfriend.com.

Olin 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 olin@processerp.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, www.chemcioforum.com, and www.lifesciencecioforum.com.

 
comments powered by Disqus

Recent Searches
Others A B C D E F G H I J K L M N O P Q R S T U V W X Y Z

©2014 Technology Evaluation Centers Inc. All rights reserved.