ROI is King
- 15 June, 1998 11:14
Many CIOs talk a lot about "aligning IT with business". If they are really serious about this, then an excellent place to start would be to bone up on their calculation of return on investment (ROI).
A friend of mine had his IT chief come to him with a project for a new, IT-fuelled business that -- if all went well -- would deliver a pre-tax return of 16 per cent. Since my friend's existing operations returned 25-plus per cent, and since his boss expected him to play in that ball park, he was not exactly thrilled. Like many people new to the business side of business, that CIO had little idea of what constituted an acceptable return on investment in this particular company.
I consider the first thing is to acquaint yourself with what your company regards as an acceptable ROI for its overall business, and what its different business units individually return. Once you know what your company (and industry) expects to earn from operations, that gives you a useful benchmark for IT investment.
Each type of industry, and each company's owner or board, has its own idea of what constitutes a good return. If you were CIO to world champion investor Warren Buffett, then you'd soon realise that he wants his businesses to maximise the "average annual rate of gain in intrinsic business value on a per-share basis". Clearly, if you wanted to get an IT proposal past Buffett you would highlight how it would increase intrinsic value (ie the discounted value of the cash that can be taken out of a business during its remaining life), since this is how Buffett evaluates the relative attractiveness of investments and businesses.
For many businesses, a sizeable investment in IT is rapidly becoming part of the price of entry to the game, so the ROI of putting in basic LANs, e-mail, and word processing is fairly irrelevant. The dilemmas start once you have the basics in place and have to choose where to head next. New IT applications promise the ability to reduce time to market, increase market share, and enter new markets. The siren songs of data warehouses, call centres, and Internet projects beckon. You need to choose among them, so you need to know the relevant ROIs.
For instance, a recent Meta Group survey of medium to large US companies demonstrated that different types of intranet projects delivered widely varying ROIs. Most companies were using intranets to publish documents -- manuals, newsletters and so on. This sort of project supposedly delivered an ROI of about 18 per cent. Companies that used intranets for database applications claimed they were achieving an ROI of some 68 per cent.
If you want to develop from a CIO into a business person, then you must know how to estimate business returns realistically. Calculating ROI is not an exact science, but you can estimate it reasonably well using a variety of metrics, starting with good old cost/benefit analysis. More sophisticated is an attempt to calculate the net present value of an IT investment. Other people favour other approaches, such as economic value added (EVA) or shareholder value added (SVA). Sears, the large US retailer, uses the latter.
It's important to realise that, like most things in life, IT spending obeys the Pareto principle. It is likely that some of your projects cost 20 per cent of the total IT spend but produce a gratifying 80 per cent of the results, while, conversely, some projects use up 80 per cent of spending, but produce only 20 per cent of the profits.
In the present climate, ROI is becoming increasingly important. Year 2000 work is straining budgets, and many organisations are contemplating big investments in enterprise resource planning projects. Hard decisions need to be made, and they require some sophisticated analysis of ROI.
At the end of the day, if you don't know how to calculate ROI, then you're not investing in IT, you're just speculating.
Steve Ireland is publisher of ComputerWorld newspaper