5 Metrics for the Books

Here's a cheat sheet of the financial metrics your CFO is most likely using to calculate return on IT investments.

"Show me the money." That's really what executive purse tenders want when they ask for the ROI on a proposed IT project.

The problem is that most IT managers don't know how to point out the financial potential of an IT project in terms that business managers want to hear or can understand. In a Computerworld poll conducted in March of more than 150 senior-level IT executives, two out of three said they lack the knowledge and/or the tools to even compute ROI calculations.

We asked three experts about five ROI metrics that financial and business managers consider basic tools of the trade. The following is a summary of how and when the metrics can be applied to IT projects.

1 Metric: Return on Investment (ROI) What It Is: A catchall phrase commonly used for any of several ways to measure the business value of a project. In financial terms, ROI means profit divided by investment, expressed as a percentage. As the numerator, profit can be replaced by cost reductions or productivity gains derived from the operational improvements an IT project yields.

How To Calculate: Revenue or cost savings divided by investment.

Advantage: Best applied to projects where all costs that will be incurred or all cost reductions that will be realized are known ahead of time, usually from experience on a similar project.

Disadvantages: Difficult to apply to entrepreneurial, or "transformative," IT projects that are designed to help launch new products, services or businesses that translate to new sources of revenue and profits. ROI also doesn't consider risk as a factor.

2 Metric: Net Present Value (NPV) What It Is: NPV refers to the future net cash flow that a project is expected to deliver, minus the investment. It defines the value of a project in "today's dollars."

How To Calculate: Cash inflow minus cash outflows calculated in today's dollars. Example: Kay Carr, CIO at St. Luke's Episcopal Hospital in Houston conducted an NPV analysis in connection with the purchase and implementation of a document imaging and management system. Carr determined cash inflows by calculating what the hospital spends annually on microfilm, records storage, medical records staff and other record management overhead costs, which would all be reduced or eliminated with the new system.

Advantages: Includes all cash flow related to a project. Considers the time value of money, or the difference in the value of a dollar today and what it might be three years from now.

Disadvantage: The highest NPV doesn't always correspond to the most efficient use of a company's capital.

3 Metric: Internal Rate of Return (IRR) What It is: One of several metrics that considers the time value of money, IRR expresses the dollar returns expected from a project as an interest rate. Once the rate is established, you can compare it to rates you would earn by investing in other projects.

More informally, IRR is also known as the "hurdle rate" because it's usually the lowest rate of return that management will accept. Typically, a project must earn an IRR that is several percentage points higher than the cost of borrowing, to compensate the company for its risk exposure and time.

How To Calculate: Determine all costs associated with the project and call it "C." Estimate all returns that will result from the project and call it "R." Then figure out how many months or years the company will realize returns. Call that "T." Determine your firm's minimum acceptable rate of return, given the risk and the cost of capital.

Now, calculate the interest rate using the formula C=R x T (i). Once you've calculated a factor, reference an NPV chart listing the value of a $1 annuity and find the interest rate that corresponds to your factor based on the number of months or years the project will generate returns. Compare that interest rate to the minimum acceptable rate and determine whether your project will leap over the hurdle rate.

Advantages: Includes all cash flow related to a project. Considers the time value of money.

Disadvantages: Assumes cash flows are reinvested at the IRR. Cumbersome to calculate interest rate when cash flows vary widely year to year.

4 Metric: Payback Period What It Is: How long it will take an investment to pay for itself. How To Calculate: Initial project investment divided by cash inflows (or cost reductions) per year.

Advantages: It's simple and understandable.

Disadvantages: It doesn't recognize the time value of money. It also ignores cash or other benefits received after the payback period, which is typically what determines profit.

5Metric: Economic Value Added (EVA) What It Is: Measures a corporation's true economic profit. The idea behind EVA is to understand which business units best leverage their assets to generate returns and maximize shareholder value. Some CFOs are beginning to experiment with applying EVA to individual functions, including IT.

How To Calculate: Consulting firm Stern Stewart & Co. in New York (www.eva.com) is most often associated with EVA and has developed proprietary methods and metrics for constructing accurate assessments of it.

Advantage: Precisely defines value in terms specific to an enterprise.

Disadvantages: Complex and not widely used.


Copyright © 2002 IDG Communications, Inc.

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