Oversimplified ROI often sells, even when it's wrong
The technology analyst industry has dumbed down the definition of ROI. It's easy to understand, but ignores fundamental financial principles, and contributes to IT's poor investment results. This article offers you three ways to protect yourself.
Influenced by the ROI calculation industry, technology buyers and sellers often sink to the simplest, lowest common measure to track the performance of their investments.
The consensus definition from the ROI industry skips to the tune of:
"ROI is the most important metric to use for choosing an application and prioritizing projects within a company during budgeting. ROI = average benefit over three years/initial cost." Source: research note from Nucleus Research, a leading technology analyst firm
Though sinfully simple and useful as a finger-in-the-air estimate, this definition has serious shortcomings:
- Ignores the timing of cash flows. Unless you are divesting, costs come before benefits. And beyond a year, the timing of cash flows matter.
- Ignores the risk of the projected future cash flows. Costs like to increase and benefits prefer to fall short.
- Ignores the cost of capital or assumes it's free. In good times, the high failure rate of technology projects should attract hefty capital charges. In a capital depression, capital costs even more.
- Assumes every technology asset has a three year economic life and no residual value. Every valuation professional works hard to estimate a residual value. Assuming it away is wrong and ignores the long, useful lives of well-made software, for example.
Part of the price for this easy thinking is the 70% failure rate (reported by Standish and others) for technology project investments.
How to protect your investments?
- Use the net present value (NPV) technique to value your technology investments -- always. Preparing a professional NPV analysis means you have to charge for capital, account for risk, estimate economic life, and decide a residual value. In short, NPV forces you to make a rigorous, professional investment decision.
- Be careful of advice. The technology analyst firm introduced above, boldly proclaims: "in general the use of NPV should be avoided when assessing technology." Such confident dismissal, despite NPV's robust 70-year history, recommendation by McKinsey, and daily use in valuing businesses, real estate, and intellectual property.
- Use a business case. ROI (built around NPV) is the core of a good business case, but must be preceded by several key steps. ROI on its own is only half an argument. Of the 10 steps in how to write a business case, a financial model (or ROI calculation, if you insist) should not begin before step 6. Business plan writers don't just send a spreadsheet (what most ROI calculators amount to). Instead they write an investment proposal and build careful arguments for investing in the venture. The thinking behind a business case should be similar.
Protect yourself from ROI calculators and their salesmen by performing thorough IT due diligence. To learn more see The Business Case Checklist.