Thursday, August 05, 2010

Is ROI a Good Way to Make the Case for Change?

Buying and selling of B2B solutions has fundementaly and permanently changed, an evolution called Frugalnomics, requiring buyers to provide quantifiable proof to executives that proposed solutions will deliver bottom-line impact, and requiring vendors to help create and deliver the quantified proof-points and business case if they want to win the deal and avoid stalled sales cycles.

One of the best and most commonly used methods used to calculate bottom-line value of proposed projects is via an ROI analysis. Although many  may be familiar with what ROI analysis is, it is important to standardize the definitions as to what a typical ROI analysis is, and what key calculations are required.

An ROI analysis, more descriptively called a discounted cash-flow analysis, is used to measure the value of a proposed project over time. The analysis compares the cost savings and other benefits of a proposed solution versus the total investment in order to determine whether the project makes sense. Because of this, ROI analysis is often referred to as “making the case for change”, providing the analysis and proof points as to whether the proposed project / change makes fiscal sense.

The analysis compares the “business as usual” scenario, where the organization continues to operate as it intends to without the solution (often called As Is), with the scenario where the solution is implemented (often called To Be). The analysis usually is performed over 3 to 5 years to match the proposed lifetime/lifecycle of the investment.
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.

When the difference is calculated, if the results are negative over time in total, a negative cash flow, this means the project, the To Be scenario, costs more over time than the As Is. This can be a result of the investment being too high, or the benefits being too little to make up for the incremental investment.
If the cash flow is positive, it means that the incremental investment to implement and manage the solution is compensated for by savings and benefits.

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.

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