Basic ROI Calculation

A review of the basic ROI calculation and its use within IT project proposals
ROI (return on investment) is a widely used measure to compare the effectiveness of IT systems investments. It is commonly used to justify IT projects, but can measure project returns at any stage.

Definition of ROI

The basic ROI calculation is to divide the net return from an investment, by the cost of the investment and express this as a percentage. ROI, whilst a simple and extremely popular metric, it may be easily modified for different situations.

The ROI formula is:

ROI % = (Return – Cost of Investment) divided by the Cost of Investment x 100

Additional definitions:

  • The basic roi calculation is also known as: ROR (rate of return), Rate of profit.
  • The return is also known as: money gained or lost on an investment, profit or loss, gain or loss, net income or loss.
  • The cost of investment is also known as: investment, capital, principal, costs.
  • Using ROI within IT projects

Comparing the ROI of different projects / proposals provides an indication as to which IT projects to undertake. ROI proves to corporate executives / shareholders / other stakeholders that a particular project investment is beneficial for the business.

A project is more likely to proceed if its ROI is higher – the higher the better. For example, a 200% ROI over 4 years indicates a return of double the project investment, over a 4 year period.

Financially, it makes sense to choose projects with the highest ROI first, then those with lower ROI’s. Whilst there are exceptions, if a project has a negative ROI, it is questionable if it should be authorised to proceed.
Issues with using basic ROI calculations

ROI calculations can be manipulated if you are not careful.

Project savings / income and expenditures should be measurable and realistic. But sometimes they are not always easily measurable and their realism is questionable.

Project benefits may be attributable to more than one improvement – so care needs to be taken to ensure no double counting.

It is not always possible when forecasting costs and benefits, to obtain a high degree of certainty with the project costs and benefits.

Tangible benefits

IT system projects ROI should be based on tangible (or hard) benefits. Examples of tangible IT benefits (project savings / income) include:

  • travel reduction eg online meetings replacing face-to-face meetings, remote support replacing onsite support
  • time saved eg increased productivity and reduction in time to complete tasks
  • time saved eg from reduced length / number of customer service calls
  • time saved from reduced numbers of errors
  • time saved from improved system reliability and having less maintenance or fewer problems to resolve
  • time saved with improved software vendor support eg quicker responses, faster fixes

Intangible benefits

Intangible (or soft or non-financial) benefits should not be included within ROI calculations. Whilst they are often as important as tangible benefits, they are very difficult to financially quantify. Instead intangible benefits should be fully explained within the business case and where possible details given of any quantification or measurement. Examples of intangible IT benefits include:

  • increased customer satisfaction
  • ability to offer improved customer service and support
  • increased usability leading to increased sales
  • increased user satisfaction
  • improved / automated business processes that the new system supports and enables
  • faster and more accurate information
  • improved analytical solutions
  • better forecasting
  • better controls to improve data input accuracy
  • improved software vendor support and service, improved communications, better knowledge of software, system set up

Calculation criteria

The total time scale for calculating ROI for IT projects may vary. Three years is common for hardware projects, as technology is often obsolete after 3 years. However, 5 or more years may be used for a new software system. For example, a new HR system is unlikely to be completely replaced within this time scale, though likely to be kept up to date with regular maintenance. Consider calculating ROI with either quarterly or yearly timelines.

Consistency: The ROI calculations should be consistently applied across all IT system projects. Consistency also applies to the assumptions behind the ROI calculations eg treatment of inflation, taxation (corporate and VAT/sales taxes).

Over-precision versus overly rounded figures. Details shown to the last $ leads users to believe in a spurious accuracy, when $’000 would be more appropriate. Equally, every figure being rounded with two or more zeros, leads users to believe that calculations are fairly inaccurate. A balance has to be struck, combined with the need to be as certain and accurate as possible.

Ways to improve the project ROI include:

  • increase project benefits / cost savings – easier to quantify, but costs can only be reduced so much
  • increase project benefits / revenues – harder, if not impossible to quantify – but can be much larger
  • decrease project costs – easy to quantify, but potentially limited
  • timing – deferring project costs or bringing project benefits forward

Whatever changes are made, they have to be realistic and measurable.

Situations when a ROI calculation may not be useful

ROI may not be useful in every IT project situation eg:

  • expenditure such as IT consumables, replacing broken PC’s
  • projects that do not produce cost savings / income – as any ROI will be zero or negative
  • projects which only have intangible benefits and no measurable financial benefits

Other ROI calculations 

Other calculations that are typically produced at the same time as calculating ROI are:

NPV (net present value) ie the return a project will make at a specified discount rate. Ideally this should be a high / positive value.

IRR (internal rate of return) ie the yearly return % of the investment – the higher, the better.

Payback years (also known as break even point) ie the number of years it takes to get the investment back. The shorter the payback, the better.

Today, no project has an automatic right to approval and a budget. Decisions to invest in IT systems projects have to compete with all other business areas and their needs / proposals. But achieving a good ROI and high NPV / IRR with a quick payback, will put IT systems proposals to the top of any choice.

Visit return on investment calculator to download a free ROI calculator for your IT system projects.

http://www.axia-consulting.co.uk/html/basic_roi_calculation.html
ROI (return on investment) is a widely used measure to compare the effectiveness of IT systems investments. It is commonly used to justify IT projects, but can measure project returns at any stage.

Definition of ROI

The basic ROI calculation is to divide the net return from an investment, by the cost of the investment and express this as a percentage. ROI, whilst a simple and extremely popular metric, it may be easily modified for different situations.

The ROI formula is:

ROI % = (Return – Cost of Investment) divided by the Cost of Investment x 100

Additional definitions:

  • The basic roi calculation is also known as: ROR (rate of return), Rate of profit.
  • The return is also known as: money gained or lost on an investment, profit or loss, gain or loss, net income or loss.
  • The cost of investment is also known as: investment, capital, principal, costs.

Using ROI within IT projects

Comparing the ROI of different projects / proposals provides an indication as to which IT projects to undertake. ROI proves to corporate executives / shareholders / other stakeholders that a particular project investment is beneficial for the business.

A project is more likely to proceed if its ROI is higher – the higher the better. For example, a 200% ROI over 4 years indicates a return of double the project investment, over a 4 year period.

Financially, it makes sense to choose projects with the highest ROI first, then those with lower ROI’s. Whilst there are exceptions, if a project has a negative ROI, it is questionable if it should be authorised to proceed.

Issues with using basic ROI calculations

ROI calculations can be manipulated if you are not careful.

Project savings / income and expenditures should be measurable and realistic. But sometimes they are not always easily measurable and their realism is questionable.

Project benefits may be attributable to more than one improvement – so care needs to be taken to ensure no double counting.

It is not always possible when forecasting costs and benefits, to obtain a high degree of certainty with the project costs and benefits.

Tangible benefits

IT system projects ROI should be based on tangible (or hard) benefits. Examples of tangible IT benefits (project savings / income) include:

  • travel reduction eg online meetings replacing face-to-face meetings, remote support replacing onsite support
  • time saved eg increased productivity and reduction in time to complete tasks
  • time saved eg from reduced length / number of customer service calls
  • time saved from reduced numbers of errors
  • time saved from improved system reliability and having less maintenance or fewer problems to resolve
  • time saved with improved software vendor support eg quicker responses, faster fixes

Intangible benefits

Intangible (or soft or non-financial) benefits should not be included within ROI calculations. Whilst they are often as important as tangible benefits, they are very difficult to financially quantify. Instead intangible benefits should be fully explained within the business case and where possible details given of any quantification or measurement. Examples of intangible IT benefits include:

  • increased customer satisfaction
  • ability to offer improved customer service and support
  • increased usability leading to increased sales
  • increased user satisfaction
  • improved / automated business processes that the new system supports and enables
  • faster and more accurate information
  • improved analytical solutions
  • better forecasting
  • better controls to improve data input accuracy
  • improved software vendor support and service, improved communications, better knowledge of software, system set up

Calculation criteria

The total time scale for calculating ROI for IT projects may vary. Three years is common for hardware projects, as technology is often obsolete after 3 years. However, 5 or more years may be used for a new software system. For example, a new HR system is unlikely to be completely replaced within this time scale, though likely to be kept up to date with regular maintenance. Consider calculating ROI with either quarterly or yearly timelines.

Consistency: The ROI calculations should be consistently applied across all IT system projects. Consistency also applies to the assumptions behind the ROI calculations eg treatment of inflation, taxation (corporate and VAT/sales taxes).

Over-precision versus overly rounded figures. Details shown to the last $ leads users to believe in a spurious accuracy, when $’000 would be more appropriate. Equally, every figure being rounded with two or more zeros, leads users to believe that calculations are fairly inaccurate. A balance has to be struck, combined with the need to be as certain and accurate as possible.

Ways to improve the project ROI include:

  • increase project benefits / cost savings – easier to quantify, but costs can only be reduced so much
  • increase project benefits / revenues – harder, if not impossible to quantify – but can be much larger
  • decrease project costs – easy to quantify, but potentially limited
  • timing – deferring project costs or bringing project benefits forward

Whatever changes are made, they have to be realistic and measurable.

Situations when a ROI calculation may not be useful

ROI may not be useful in every IT project situation eg:

  • expenditure such as IT consumables, replacing broken PC’s
  • projects that do not produce cost savings / income – as any ROI will be zero or negative
  • projects which only have intangible benefits and no measurable financial benefits

Other ROI calculations 

Other calculations that are typically produced at the same time as calculating ROI are:

NPV (net present value) ie the return a project will make at a specified discount rate. Ideally this should be a high / positive value.

IRR (internal rate of return) ie the yearly return % of the investment – the higher, the better.

Payback years (also known as break even point) ie the number of years it takes to get the investment back. The shorter the payback, the better.

Today, no project has an automatic right to approval and a budget. Decisions to invest in IT systems projects have to compete with all other business areas and their needs / proposals. But achieving a good ROI and high NPV / IRR with a quick payback, will put IT systems proposals to the top of any choice.

Visit return on investment calculator to download a free ROI calculator for your IT system projects.