Money's tight? ROI to the rescue

Computerworld - You might think that measuring return on investment is one of those things that never changes. You'd be wrong.

To be sure, the workhorse measures of financial return haven't really changed, nor has the math behind them. But as fear of a recession spurs a renewed interest in value -- and as the strategic mission of IT shifts from saving money on back-office functions to enhancing revenue -- "return on investment" has taken on new meanings and importance.

At consumer products giant Procter & Gamble Co., ROI used to focus on cost savings. "ROI was about the bottom-line impact of projects," recalls Robert Scott, vice president of information and decision solutions at P&G. "Now we have moved to a phase called 'value creation,' which is a combination of bottom- and top-line ROI."

The "top-line" objective most often is sales, he says, but it could be something else, such as faster movement of cases of Tide, Pampers or Pringles through P&G's $76-billion supply chain. The new approach, which began in 2004, was important enough to be given a name: Global Business Services-Next Generation.

As companies increasingly try to include intangibles such as customer satisfaction in their return metrics, IT and finance people are finding new ways to deal with uncertainty.

"The biggest change I have seen in five years is what I call the bifurcation of technology between the operational and the strategic," says Steve Andriole, a professor of business technology at Villanova University. "It has phenomenal implications for project prioritization and ROI. To a great extent, Nick Carr was right -- operational technology has been commoditized."

How do you quantify the benefits of open-source vs. proprietary software, or the benefits of Web 2.0?"

Steve Andriole, Villanova University

"Operational" projects -- such as upgrading a network, replacing PCs or even automating a back-office function -- are usually all about cost savings and are subject to fairly straightforward, tried-and-true evaluation metrics, Andriole says. Of the metrics, and the projects themselves, he says, "IT people have gotten so much better over the past five years. The practice of the discipline has improved through use of business cases, the quantification of metrics, the use of benchmarking data and industry data."

While operational IT projects aim to save money, strategic ones try to make money, Andriole says. An example of the latter might be a project to integrate databases across business units to facilitate cross-selling. The cost of doing that could be relatively easy to estimate, but the benefits would be harder to quantify, he says.

At least the benefits of cross-selling are known qualitatively. But in some cases, the benefits from an IT investment may be dimly perceived or even unknown. For example, Andriole says, "how do you quantify the benefits of open-source vs. proprietary software, or the benefits of Web 2.0? Companies love Web 2.0, and they are deploying it like crazy. What impact is it having on collaboration or communication or business performance or customer service? No one knows."

The basics

Despite the difficulty of developing good estimates, four basic methods for comparing project costs and returns remain in vogue: return on investment, payback period, net present value (NPV) and internal rate of return (IRR). Many more have been developed, and some have briefly been in fashion, but these four metrics have endured for decades. Even so, experts warn, each of them can lure the unwary into pitfalls.

Return on Investment (ROI)

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"Return on investment" is often used as a generic term for any kind of measure that compares the financial costs and benefits of an action.

But in finance, ROI, sometimes just called "rate of return," specifically refers to a percentage calculated by dividing the annual return from an investment by the initial amount of the investment. If you put $100 into a savings account and have $105 a year later, your ROI is 5%.

ROI is very widely used, easy to understand and easy to compute. But it can be misleading if it uses a multiyear return instead of an annualized one, or if it is based on a year that is not typical of ongoing results. And it says nothing about the absolute dollar amounts involved or the company's cost of capital. (For examples, see our ROI chart.)

"There is only one way to do ROI," says Nucleus Research CEO Ian Campbell, and that's to average the benefits over the first three years and divide that by the initial investment. "Some people will say they need to do a five- to 10-year ROI, but that's ridiculous," he says. "What they do is take the third-year number and just guess out to the later years, and that doesn't increase the credibility of the numbers."