Is ROI a Good Way to Make the Case for Change?
The difference between the revenue and costs in the As Is (before) scenario with those in the To Be (after) scenario determines the bottom-line impact , and the overall cash flow of the project.
To calculate the opportunity, the analysis first starts with an understanding of revenue and cost projections over the analysis period. The team gathers current revenue and costs, and projections of how the revenue and costs are expected to grow without implementing the proposed solution.
It should be noted that in many cases, if the project may only be focused on cost savings, and revenue is not relevant. Therefore, only the cost portion of the equation is tallied for these cost savings projects and analyses.
Next, the impact of the proposed project is simulated on the As Is revenue / cost projections to determine:
- What incremental investment is required
- What are the benefits – savings in IT and Business Costs, or improvements in Revenue
The simulation lets the business tally the level and duration of required investments, which add to costs initially, usually as capital investment such as hardware / software, and over time, usually in the form of incremental operating expenses such as service agreements, support and management costs.
The simulation also estimates the magnitude of benefits such as cost avoidance, savings and revenue improvements, and importantly, how quickly the benefits can be realized.
Comparing the incremental costs versus the benefits, the difference between As Is and To Be, creates a cash flow over time.
To make sure the cash flows make sense financially, and to compare the project with other projects and investment options, an ROI analysis typically summarizes the cash flow into financial key indicators. These indicators are typically:
- Return on Investment (ROI) – a ratio of the net benefits divided by the total investment. A higher ratio means that the projects net benefits are much higher than the investment, and the project is often judged as less risky as a result. To calculate the value, ROI = net benefits / total investment, where net benefits are equal to total benefits – total investment.
- Net Present Value (NPV) Savings – a calculation that measures the net benefit of a project in today’s dollar terms using a discount rate to discount future cash flows. Many times a project requires up-front investment, and this is more expensive in time value of money terms compared to future benefits, so looking at the cash flows over time assures that all cash flows over time are made equivalent. Sometimes a project may have a positive cash flow, but because of a large upfront investment and a long time to accumulate benefits, may actually have a negative NPV savings. A high NPV savings indicates that the project can deliver real bottom-line impact to the organization.
- Payback Period- The payback period is the time frame needed for the project to yield a positive cumulative cash flow, which is typically specified in months. The payback period starts by comparing cumulative costs versus cumulative benefits by month from the beginning of a project until the point when the cumulative benefits exceed the cumulative costs. A quick payback on a project usually is a sign of less risk.
- Internal Rate of Return (IRR) – The IRR calculates the effective interest rate that the project generates. A higher interest rate than competitive projects means that the project has a higher return and generates more effective interest on the investment. In mathematical terms, the Internal Rate of Return is calculated as the projected discount rate that makes the Net Present Value calculation equal to zero. The method of calculation involves a series of guesses, making it the most difficult to understand, but when comparing projects, one of the most effective metrics in selecting the best comparative project.