Why conduct a Return on Investment analysis?
Some organizations require a Return on Investment (ROI) analysis because they have an internal “hurdle rate” that must be achieved before any new project will be considered. An ROI analysis provides an apples-to-apples comparison of an organization’s investment options so it can compare seemingly different projects across various departments.
However an ROI analysis is more than just a “score” to acquire project funding. Used appropriately, it’s a management tool that explicitly defines the incremental costs and benefits of a project as a means to commit management to specific behavior, or more likely, to a change in behavior. As a result, the final ROI number is secondary to the goal of meeting the individual manager’s objectives that have an impact on the bottom line. 1E views an ROI analysis as a roadmap to help the organization understand how it can maximize its returns and best deploy 1E’s ActiveEfficiency solutions. Using the initial Business Case ROI as a foundation, 1E then leverages its exclusive AOR (Analyze-Optimize-Realize) methodology to ensure that this roadmap is successfully achieved in collaboration with its customers.
The 1E Approach to Measuring Financial Impact of an IT investment
- Building the Business Case: ROI is the most popular way of measuring the financial merits of any type of corporate investment alternative. It is easy to understand and communicate, and once you have the right numbers, it is easy to calculate. However, ROI does not tell the whole story. It does not consider how long it takes to break even on the investment or the overall profits it will generate because ROI results are expressed in a percentage of return. Therefore, 1E includes an analysis of the payback period and net present value (NPV) in its business case analyses.
- Using standard financial assumptions: In its research, 1E uses one set of conservative financial assumptions across all initial case studies. This allows 1E to compare the results of organizations in different industries and financial circumstances. This set of assumptions is based on our extensive work with hundreds of the leading global organizations and supplemented with broad figures from industry analysts such as Gartner or Forrester.
- Simple ROI versus more complex analysis methods: Although ROI can be simply described as the return on costs of projected benefits, calculations based on cash flow are considered a much more representative measure of true bottom-line impact. Therefore, 1E’s business cases typically include a focus on internal rate of return (IRR) — the discount rate that must be applied to annual cash flows to achieve a project NPV of zero – in addition to simple return. The financial community generally regards this approach as a more conservative approach and a more representative measure of ROI.
- ROI time horizon: In our initial business case work with customers, 1E typically uses a three-year time horizon, which in most cases is the time horizon preferred by CFOs when considering significant technology investment decisions. Using this timeline, year 0 represents the development phase for the solution and the beginning of year 1 is regarded as the time frame of the initial production deployment phase.
- Costs included in the analysis: 1E considers only true incremental (out-of-pocket) costs incurred. The cost categories include: hardware, software, internal services, external services, networking and non-technology management/ staff costs.
- Classifying and measuring benefits: 1E analysts examine each organization to determine the benefits that accrue to the following three categories:
- Technology-related benefits: This category includes the savings associated with the reduction of technology expenditures, such as the cancellation of a software license or the redeployment of hardware that still has residual value.
- Productivity-related benefits: This category includes productivity enhancements of current staff, and the savings associated with staff redeployment and/ or reduced headcount.
- Business process enhancements: This category includes benefits that result from an organization fundamentally changing the way it conducts key business processes.