Thursday, August 05, 2010

Is using an ROI Analysis Good Enough to Make Critical Investment Decisions?

Traditional ROI analysis examines the cash flow of a proposed project over time to determine if it makes fiscal sense. The investment is tallied and benefits contrasted against the benefits to see if the project generates a positive cash flow, and as a result, can deliver bottom-line impact to the organization.

Although in today’s frugal environment a bottom-line impact is required of almost every business project, when determining which projects to invest in, only comparing the financial impact of these projects can lead to a one dimensional analysis and perhaps, near-sighted decisions.

It is recommended that the ROI analysis methodology be extended to consider elements of the investment beyond financial alone, supplementing the cash flow analysis with some additional measurements and dimensions.

The Alinean ROI Dashboard is an ROI analysis methodology recommended to extend traditional ROI analysis to include additional analysis dimensions beyond the Net Tangible (quantifiable) Benefits, to include Strategic Impacts and Alignment (Intangible Benefits) and Risks.


Traditional ROI Analysis and Net Tangible Benefits

To revisit, traditional ROI analysis examines the net tangible benefits of a project, those that can be quantified in financial terms. The tangible benefits of a solution measure the investments / costs of implementation, against projected savings, incremental revenue and benefits, to calculate the quantifiable financial benefits of the solution.

The investment portion of the tangible benefits equation measures all of the up-front and on-going costs for implementing the project, seeking to capture the total cost of ownership of the proposed solution (all of the costs over the useful investment lifespan).

For an IT project as an example, these typically include:

• Capital Expenses - the investment in systems, software, networks, peripherals, supplies and equipment to deploy and maintain the project

• Implementation Labor - the staff and contract labor to research, purchase, plan, test and deploy the proposed solution

• On-going Management and Support - the staff and contract labor to manage and support the solution after it is deployed

• Operations and Contracts - the recurring fees, leases, facilities and power costs, and the on-going maintenance and support contracts

• Business Unit Costs – the change management, project management and user training fees and labor

The savings / benefits portions of tangible benefits tallies the positive impact the project will have on the organizations costs, cash and revenue, and are typically grouped into four categories:

• Labor Savings - the savings due to expected headcount reduction, overtime avoidance or strategic resource re-allocation from implementing the planned project.

• Expense Reductions - the savings in expenses such as equipment expenses, facilities, net fixed assets, inventory, accounts payable and accounts receivable from implementing the planned project.

• Strategic / Revenue Benefits - the gains in revenue and associated profit, such as incremental sales from new customer acquisitions and conversion percentage improvements, reduced sales cycles and increased customer retention reduced churn.

• Working Capital Improvements – reduction in needed working capital investments for items such as inventory or facilities.

Intangible Benefits

Many projects have benefits to an organization that are strategic and may be difficult to quantify in absolute monetary terms.

Intangible benefits represent strategic benefits that are difficult, or impossible, to accurately predict and measure in financial terms, but are an important aspect of the project, making an impact beyond financial to the organization.

Some intangible benefits to be considered when evaluating and measuring the performance of a project include:

• Brand Advantage -reinforcing, advancing or changing a company's brand

• Strategic Advantage - working towards or meeting overall corporate objectives

• Competitive Advantage - releasing solutions faster, developing solutions less expensively, better addressing customer needs, meeting changing market demand, scaling easily and more cost effectively, and gaining market share

• Intellectual Capital - increase in relevant knowledge gained by the staff, and the perceived market value from those gains

• Organizational Advantage - enabling an organization to function more effectively, or reinforcing or recreating a corporate culture

Although not quantifiable easily or credibly in financial terms, these intangible benefits can often be quantified into Key Performance Indicator impacts such as improvements in employee satisfaction scores, customer satisfaction scores, brand sentiment rankings, or industry position rankings. Quantification of these benefits versus a KPI will help the team understand the proposed improvements and assure success post deployment (post-implementation analysis).

Risk

Risk is a future issue that may affect a project, and lead to increased costs or reduced tangible and intangible benefits. Risk can be measured based on the probability of occurrence, and the likely impact on the costs and benefits, in some instances discounting the value of the project significantly.

The risk measurement may include items such as:

• Labor Resources - the risk that required resources may not be available, not have the proper skill set or training, or rely on a small group of experts that cannot be retained easily

• User Acceptance - users may not accept the solution and rebel, or more likely, they will not adopt all or some of the key features, which reduces the benefits substantially.

• Compatibility - the solution may not be compatible with current or future operating systems, platforms or other applications.

• Vendor - the vendor may not be able to deliver the solution in the promised time frame or to the required specifications. The vendor may be a start-up, or not financially sound, so they may not be around in several years to support the solution and deliver required updates and upgrades.

• Management Commitment and Funding - the senior management and the stakeholders may not be fully committed to the project with management support, and especially funding.

• Market or Strategic - the market may shift, competitors may change their strategy, or the company may change strategic direction, changing the project requirements, or changing the business benefits equation.

• Schedule - the project requirements may drive a schedule that is unrealistic. The overruns in schedule may cause cost overruns, delays to benefits, and impacts to other dependent projects.

• Legal and Governance - there may be legal and governance risks and exposures in the project, such as not being able to implement the project in time to meet legal regulations, or a failure that may risk legal exposure. The project or issues with the project may also affect compliance with governance issues such as financial reporting requirements.

• Organization - there may be risks to the organization as a whole, should issues occur, such as a risk involving employee morale or organizational dynamics

• Dependencies - there may be risks that can affect a family of dependent projects, such as delays, resources or budgets.


The Bottom-Line
Extending the traditional ROI analysis model can help factor in other important elements into the buying decision, and assure that the best projects are selected from a portfolio of proposed options. Although financial analysis is required now on most projects, Frugalnomics is in full effect, focusing only on financial gains of a proposed project often can lead to decisions that don’t take other key aspects into account, such as strategic benefits or risks.

It is not proposed to avoid quantifying financial costs and benefits , risking that decisions don’t make fiscal sense, but rather to extend the analysis slightly to include strategic and risk elements that can be compared and contrasted versus the financial gains to assure a more well rounded and sound decision.

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