Computing The ROI for IT Projects and Other Investments
Here are two formulas for calculating financial ROI for an IT project or any other investment. An example of how each formula is used is provided below.
The simple ROI calculation is commonly used for short-term (e..g., less than one year) investments and benefits. It is uncomplicated and most people can understand it. For example, say $1,000 is invested and it earns $1,250. This is a gain of $250. Divide the $250 by $1,000 (the amount invested) gives an ROI of 25%.
However, the simple ROI calculation is less accurate when the investments and/or benefits involve future years because future dollars are worth less than current dollars. The general rule for greater accuracy is to use the discounted ROI calculation method when the investments and/or the benefits involve future years.
Information Required to Calculate ROI
A. Before the Investment : Measure the Baseline Performance
The planned improvement over present performance is what is important. Therefore, a BASELINE of current performance measurements must be established so a before-and-after comparison can be made.
Suitable measures of the performance that exists BEFORE the IT-enabled change can involve measures of cost, time, quality, flexibility, customer service, staffing and other factors. Any measure used must be expressed financially if it is to be included in a financial ROI calculation. (For example, a reduction in staff can be calculated in terms of annual dollar savings from salary, fringe benefits, and office overhead expenses. A reduction in staff turnover can be calculated in terms of cost savings in such areas as recruitment, training, production, and quality.)
B. After the Investment : Determine the Change in Performance
AFTER the IT-enabled change has been implemented, the performance needs to be measured to determine whether and how well the performance improved.
The same performance measures used to establish the baseline performance are used to measure the performance after the IT-enabled changethis is necessary so comparisons can be made.
The change in performance from the baseline that resulted from the IT investment is used to calculate the financial return on the investment.
Expect some complexity in arriving at the IT ROI result. For example, did all of the change in performance result from the IT project/investment? If not, your need to make a fair apportionment of the change caused by IT and the change caused by other factors. For example, a 35% improvement in performance might be partly due to a new incentive program that went into effect before the IT project was completed. A fair allocation might be that 10 percentage points can be attributed to the incentive program and 25 percentage points can be attributed to the IT project.
Examples of ROI Calculations
Comparing Simple and Discounted ROI Calculations for Company XYZ
Objective: Reduce the baseline cost of business process "A" by 25% or more and achieve a breakeven point (i.e., all costs have been recovered) by the end of the first year of operation and a cumulative ROI of 500% or greater is achieved by the end of the third year of operation.
Present (Baseline) Annual Cost of Business Process A (BPA) is $10 million
Investment in IT-Enabled Performance Improvement in BPA is $1 million
Amount of Time Required to Implement BPA Improvement is 6 Months
Benefits: Cost Savings For BPA After Implementation is $1 million in year 1 (because of only 6 months of benefits) and $3 million each in years 2 and 3.
Calculate the Simple and Discounted ROIs. This is done below. To simplify and make the concepts more understandable, the calculations assume that all investments and savings take place at the end of the year
Simple ROI Calculation Example
(Using the Formula Above)
$1 mill. benefit less $1 mill. investment = $0 divided by $1 mill. investment means that Simple ROI at the end of Year 1 = 0%
$4 mill.cumulative benefit less $1 mill. invest.= $3 mill net savings divided by $1 mill. invest. = 300%, which is the Cumulative Simple ROI at end of Year 2
$7 mill. cumulative benefit less $1 mill. invest. = $6 mill net savings divided by $1 mill. invest. = 600%, which is the Cumulative Simple ROI at end of Year 3
Because there is no discounting to reflect the time value of money, the results of the simple ROI calculation become increasingly less accurate the further it extends into future years.
Discounted ROI Calculation Example
(Using Formula Above)
This method takes into account the time value of money, the fact that a dollar received today is worth more than one received in a future year. This method is more complicated because we must first calculate the net present value of the costs and the net present value of the benefits and we must know the organization's discount rate to make these calculations. Then we can calculate the discounted ROI.
The example assumes that the annual discount rate used by Company XYZ is 6% (see your CFO for the figure your organization uses)
The table below shows the effect of a 6% discount rate on the present value of $1000 spent or received in future years. Note the formula (on the right side of the table) for calculating the present value figures in the table.
This table can be used to determine the present value of $1000 spent or received in up to 7 future years. The table is in thousands.
Using Present Value Data to Calculate ROI
In the materials below, our example is in millions. We can simply move the decimal point three places to the right in any figure we take from the table for our calculations to take account of the shift from thousands to millions. PV stands for present value.
PV of Benefits: $1,000,000 received at end of year 1 = $943,400
PV of Investment: $1,000,000 paid at the end of year 1 = $943,400
(PV benefits less PV cost) divided by PV cost = ($943,400 less $943,400) divided by $943,400 = 0% This is same as for the Simple ROI calculation because both all of the investment and all of the savings occurred at the same time in the first year.
PV of Benefits: $1,000,000 received at the end of year 1 ($943,400) and PV of another $3,000,000 received at the end of year 2 ($2,670,000) = $3,613,400
PV of Investments: $1,000,000 made at the end of year 1 = $943,400
(PV benefits less PV cost) divided by PV cost = ($3,613,400 minus $943,400) divided by $943,400 = 2.830, or a cumulative ROI at the end of year 2 of 283%
Notice that the calculation for the Simple ROI shows 300%, which overstates the true (discounted) cumulative ROI by 17 percentage points.
PV of Benefits: $1,000,000 received at the end of year 1 ($943,400), PV of $3,000,000 received at the end of year 2 ($2,670,000), and PV of still another $3,000,000 received at the end of year 3 ($2,518,860) = $6,132,260
PV of Investments = $1,000,000 made at the end of year 1 = $943,400
(PV benefits less PV cost) divided by PV cost = ($6,132,260 minus $943,400) divided by $943,400 = 5.500, or a cumulative ROI at the end of year 3 of 550%
Notice that the calculation for the Simple ROI showed 600%, which overstates the true (discounted) cumulative ROI by 50 percentage points. An important point is that the Simple ROI calculation is always less and less accurate as the future years increase.