The virus is the nemesis of the Exchange administrator. The software bug is the nemesis of the support tech. And a pesky financial metric known as ROI is often the nemesis of the CIO.
Although many CIOs are convinced that return on investment (ROI) is not an appropriate way to measure the value of an IT project, it remains one of the most commonly used metrics. Business and financial leaders often require it before they approve project funding.
CIOs know they must understand ROI if they have any hope of helping other business leaders understand why it needs to be used with cautionââ,¬"especially when evaluating IT projects.We'll review how to calculate ROI, and we'll outline a few of this metric's key drawbacks.
ROI definitions
Carmen Barrett, director of planning and analysis for Tech Republic, provided the information for this primer. She begins by explaining how to define ROI in the simplest terms: -If we pay for this, what do we get for our money?" Figure A displays the The basic formula for ROI.
Figure A
A case study using ROI
To illustrate ROI, Barrett created a hypothetical case study in which Company XYZ wants to buy a new server. This example is a revenue-generating capital project for an IT department (see Figure B). The return and investment figures are as follows:
- The equipment cost is US$100,000.
- Installation is $50,000, and maintenance is $10,000 per year.
- The server has a useful life of eight years. (While this lifespan is not typical of most servers, we'll use this number just for this example.)
- The company will need to add another salesperson ($35,000 salary per year), but it expects sales to increase by $70,000 each year.
Figure B
Barrett warned that this example is oversimplified. Your organisation may require many more figures to calculate return or assets invested. For example, some businesses include tax savings or overhead savings when calculating return.
Determine the present value of money.
After you calculate the return and the assets invested, it would seem that you have the necessary figures to determine ROI, which is return divided by the assets invested.
However, Barrett recommends that you also factor in the time value of money (TVM) before you calculate the annual returns expected on the project. It's a step that is typically recommended but often neglected.
Calculating the TVM takes into account the impact of inflation on future returns. The $25,000 cash inflow that Company XYZ expects to receive each year is not worth the same amount each year. Remember, the server is expected to last eight years, so the $25,000 cash inflow that our example company will receive eight years from now will be worth much less compared to the $25,000 that it receives this year (see Figure C).
Figure C
So how do you calculate the TVM in order to arrive at the $164,559 return figure? Here are two quick-and-easy methods that are commonly used:
- Use a financial calculator, such as the Texas Instruments BAII Plus or Hewlett-Packard 10B financial calculators. (For a helpful tutorial on using an HP financial calculator, check out the Calculator Tutorials Index on the US Metropolitan State College of Denver Web siteââ,¬"http://clem.mscd.edu/~ mayest/calculators/calculator_tutorials_index.htm.
- Use the TVM calculator that's provided in Excel. (See Figures D and E).
Figure D
Figure E
This is Excel's Present Value (PV) formula that you'll use for the calculation in the cell described in Figure D. To find this formula, click on fx on the toolbar and locate PV from the drop-down menu
Plug in your numbers to calculate ROI
With the returns and assets calculated, we can use our figures in the formula to arrive at ROI for the server project (see Figure F).
Figure F
A portfolio view of SOA ROI
<a href="http://it.toolbox.com/blogs/the-soa-blog/soa-costs-and-roi-16794">SOA ROI Calculator</a>