Sunday, April 19, 2009

Beyond the Hype of ROI: A Real World Model

How many times have you read vendor literature promising that their technology would “decrease TCO and maximize ROI”. All technology managers have, at some point, been promised Return on Investment (ROI) should he or she choose to invest in a particular technology. We all know that ROI is a “Good” thing and our business owners and senior management like it. Most technology managers understand in general what ROI means in that it affords their organization a chance to recoup or gain money by investing in a particular technology. What many technology managers do not know however is that ROI is not a purely theoretical concept. ROI is a specific number derived through a numerical analysis of the costs and benefits of a particular technology. My goal in this article is to give technology managers a high level understanding of what exactly ROI is and arm them with the facts to ask pointed questions to vendors who spout flowery prose to their management teams. I will work through a simple example explaining the important concepts at a high level. At the end of this article I also point you to a blank spreadsheet model that you can use to do your own ROI analysis. This is a model I have used many times and it has served me well with respect to cutting through vendor hype.

It’s All About the Journey

Before we start working through the example I want to emphasize a critical point. The actual number that pops out the bottom of the ROI model is much less important than the interactive conversations you will have with your stake holders while deriving the numbers to plug into the model. By forcing folks to sit down and think through the potential benefits and possible pitfalls of a particular technology investment you can be sure your decisions will be well thought out. The hours you will spend with folks debating things like “How much time will we actually save as a result of this technology?” or “Are we introducing cost elsewhere in the organization as a result of this investment?” are the most valuable dimension of this process. The numbers are important, yes. However, getting agreement and buy in on the assumptions being made to derive the numbers is absolutely critical to success.

Finance 101 in Ten Minutes or Less

You are a technology person, not a bean counter. You speak TCP/IP and .Net, not debits and credits, I get it. The cold fact is however that the folks in your organization holding the purse strings are Finance people. If you want to gain their respect and trust you need to make an attempt to speak their language. After all, you should never be making technology investments for technology’s sake. Every technology investment should have a solid business driver and a financial benefit for your organization. If you have made it to the level of Technology Manager or Director you have probably figured that out by now.
There are three main documents that serve to explain the financial performance of an organization. These are the Income Statement, the Balance Sheet and the Cash Flow Statement. In order to execute an ROI analysis you do not need to know the gritty details of these documents but you do need to know at a high level what each is used for. While you won’t directly use these documents, your ROI model is ultimately demonstrating the effect your proposed technology investment will have on each. Here we go, I know this is not as exciting as a reading a networking white paper or debugging C# code but stick with me….

Income Statement - At a high level this document shows the difference between revenue and cost. The result is a numerical entity knows as Net Income. Net Income is NOT the same as cash because some of the “cost” items on the Income Statement are things that do not represent real money being paid out (e.g. depreciation). Just remember that Net Income is the difference between revenue and cost but does not represent the amount of cash a company has.

Balance Sheet - When you think about the balance sheet think assets. Assets are the things a company owns. The Balance sheet also lists liabilities. Liabilities are the things a company owes. At a high level the Balance Sheet shows the difference between assets and liabilities. So, if a company sold everything it owned (its assets) would it have enough cash to cover everything it owes (its liabilities). All you really need to know in terms of ROI analysis is that the Balance Sheet is where your fixed assets such as servers and networking gear will go.

Cash Flow Statement - Cash is king and the Cash Flow Statement essentially defines the size of your organizations throne. The Cash Flow Statement shows how much cash your organization had on hand at a particular point in time. As the name implies it really shows the flow of cash in and out of an organization during a time period. For our purposes here and for your purposes as a technology manager just remember that the Cash Flow statement shows how cash rich an organization is.

OK, that was rough. In the next section we will start working through a tangible example and you will truly see that only a basic understanding of the documents outlined above will carry you through a detailed ROI analysis of your technology investment.

The ROI of Virtualization

Let’s work through an example. In order to follow along you can download the PDF of the analysis here. The link to a blank version of the spreadsheet model is available at the end of this article. OK, lets first look at the impact your virtualization investment will have on your organizations net income.

The Income Statement

There will be both benefits and costs to your investment represented in the model as Increased Operating Profit and Increased Operating Cost, respectfully. The Increased Operating Profit section is where you want to list the financial benefits of your virtualization investment. These are items that will reduce expense in areas of IT operations. As a practical matter, you should not enter these numbers directly in the ROI model. In the blank model you will find a tab called work. Use that area as your scratch pad and enter all you numbers there and have them roll up to your model. Remember, a huge part of the benefit you will receive from this process is in debating the actual amounts for each benefit. You will spend most of your time in the work tab actively debating what you will really get out of your investment. The Increased Operating Cost section is where you want to list the costs associated with your investment.
The cost section has two parts. The Depreciation cost is a calculated figure derived from your investment in fixed assets (described below). Basically, you do not need to enter anything for the depreciation line item, it is calculated for you in the model. Just in case you are curious, depreciation is an accounting method for matching the realization of an items expense to the realization of its benefit. The costs you want to enter on the work tab and actively debate are the ones that populate the SG&A (Sales, General and Administration) line items. These costs are NOT the one time cost you will have buying the hardware, and software needed for your project. These costs represent increased run rates in your I.T. operations that will be engendered by your investment. For example, you may incur additional yearly fees such as conference expenses that you did not have prior to the investment.
The final line items of the Income Statement section are EBIT, tax and Net Income. Earnings before Interest and Tax (EBIT) is an accounting measure meant to capture a company’s true operating profit before money is either added through investment income (e.g. income made through interest on savings accounts rather than through actual business operations) or taken away by non operating expenses such as tax. In the model EBIT is a calculated figure that is equal to operating profit minus operating cost. The model then subtracts a standard 35% U.S. Corporate tax rate from the increase in operating profit created by your project (Uncle Sam has to get his piece). Your organizations tax rate may be lower and you can usually get it from either you controller or your CFO. The difference between EBIT and tax is Net Income. Net Income represents from an accounting perspective the yearly benefit your technology investment will have on your organizations performance. Of course, a positive impact on Net Income is good, but it is not the ultimate factor that should drive your investment decisions. Remember earlier I said cash is king? The reason I emphasize that Net Income shows the benefit of your investment from an accounting perspective is that you should ultimately be concerned with the impact of your investment on your organizations cash flow. What good is a positive Net Income if you don’t have cash to pay the light bill? The rest of the model is concerned with getting at the actual increased cash flow your investment will provide.

The Balance Sheet

In our ROI model, the Balance Sheet section consists of one line item, fixed assets. This is the amount you are asking for with respect to your technology investment. The fixed asset number is generally the amount of CAPEX (Capital Expense) you will be asking your CFO to approve for your project. Again, as a practical matter, you should generally populate a separate tab with your investment costs and have them rollup to the model so that you can easily manipulate things as you negotiate with your vendor (you will negotiate with your vendor, right?). The fixed Asset number drives the calculation of depreciation in the income statement section and you will see it again as Net Capital Spending in the Project Cash Flow section below.

Project Cash Flows

OK, this is about to get a little hairy so stay with me because we are now getting to the heart of the whole ROI subject. Most of the line items in this section are auto populated from figures earlier in the model. EBIT, Depreciation and Tax are pulled directly from preceding values in the model. Operating cash flow is a derived value equal to EBIT plus depreciation minus tax. Why? Remember EBIT is what the company made before adding interest or taking away tax. EBIT also includes in it the depreciation figure. Remember, depreciation is an accounting entity, NOT a true cash expense. That is a key point. We are worried with the amount of actual currency we are taking in and paying out, cash money! So, to get at the true cash being generated here we have to take depreciation out. We take depreciation out by adding it BACK to EBIT because remember, we took it away before as an expense in the income statement. Now we take away the amount that we paid for tax because that is real cash (try giving Uncle Sam an accounting entity….). What we come out with is Operating Cash Flow, the TRUE amount of cash that your investment will generate (or consume) for your organization every year. This is a critical figure especially for smaller organizations or for those with long accounts receivable cycles (e.g. organizations that take a long time to make a product and get paid for it but who have to incur expenses while all that is happening, think Boeing making air planes). The last two line items of the Project Cash Flow section are Net Capital Spending and Increase in Net Working Capital. Net Capital spending represents the amount of cash your organization will spend on your investment in a year. For the first year it is the same as the amount you plan on spending on fixed assets. If your investment calls for any additional fixed asset spending in subsequent years this is where you would show that spending. If you put in additional capital spending after your initial investment be sure to adjust the depreciation accordingly to reflect the cumulative effect of the fixed asset addition. The final line item, Increase in Working Capital, is rarely used for technology investments. The best example for this is a project that will temporally increase inventory on the warehouse floor for the duration of the project. It is assumed that the cash spent on the increased working capital in year one is redeemed at the end of the project. Don’t worry about this too much. Again, it is rare that a technology investment will use this line item.
Great, now you have the cash flow your project will generate for your organization for each year over the next five years. It is now time for the grand finale, the introduction of the concept known as the time value of money and how it is used to calculate the ROI of your project.

The Time Value of Money

A bird in the hand is worth two in the bush, right? In the same vein, a dollar today is worth more than a dollar you get three years from now. Why, because the dollar you get today can be invested and earn interest. So, to really compare apples to apples the value of the cash you will give me today versus that you will give me three years from now I have to account for or discount those future dollars to reflect the loss in interest. The way you do that is to use a formula that takes each years cash flow and discounts it back to be equal to the value of dollars received in year one of your project. The formula is already in the model, all you need to do is plug in your organizations WACC (Weighted Average Cost of Capital) in the work tab. You can get this number from your controller or CFO and it represents what it costs your organization to acquire capital (technically it is the weighted average between what it costs your organization to raise equity and what it cost to raise debt). At a minimum, someone in your organization will be table to tell you what is the typical discount rate used for ROI analysis (often it is more of an art than a science and an organization may simply have a number they prefer to use).
Once you plug in the WACC value all of your project cash flows will be discounted and you will see a number appear for NPV (Net Present Value). NPV is the sum of the discounted cash flows for each year in your project. The NPV value gives you the total amount of cash your investment will generate in today’s dollars. Thus, NPV gives you a way to compare the amount of cash you will pay today for your investment with an equivalent amount of cash in today’s dollars that your investment will generate. In fact, when you divide the NPV by the amount of your investment the result is a mathematical entity called ROI! ROI is expressed as a percent and reflects the percentage return your investment will give your organization on the money you are asking them to invest.


The goal of this article was to give technology managers a high level understanding of the mathematical computation of ROI. I hope that after reading this article, you will be more informed and in a better position to ask punted questions to sales folks offering great “ROI”. While a Certified Public Accountant (CPA) or other finance professionals would quibble with the specifics of what I have explained here, there is no doubt that this model is a solid, high level tool for evaluating technology investments. It has worked for me for years and I have used it to evaluate everything from storage systems to complete Enterprise Recourse Planning (ERP) implementations. I can not stress enough that the exercise of thinking critically about the benefits and cost your investment will create is the highest generator of value in the ROI analysis process. I hope you use this model to help drive meetings and discussions and to gain alignment among key stake holders in your organization.

You can download a blank copy of the spreadsheet model here.

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