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D14:   Justification of Payoffs from Information Technology Investments
    By Paul A. Strassmann
    45 Pages
    Date Published: 02/2004
    Online Price: $8.95

Summary

Requiring the calculation of a project ROI (Return-on-Investment) is a generally accepted method for evaluating business ventures. ROI calculations have been a prerequisite for just about every corporate capital request since it was introduced by DuPont in the 1920s and then rapidly adopted by the automobile industry and subsequently by most corporations as models for investment analysis.

The purpose of this paper is to set forth some of the most important principles to be applied when calculating the value of IT ROI. The paper presents a firm-level view of analysis and does not deal with questions how to justify individual projects or how to address the balancing of a diverse portfolio of projects that have different levels of risk or varying time horizons when one can expect payoffs. Those topics will be tackled in subsequent papers.

The important principles presented here are as follows:

1. The imperative to present ROI estimates in the context of generally accepted accounting and financial analysis methods.

2. The necessity to apply risk adjusted cash flow analysis for comparing investment alternatives.

3. The application of the concept of "residual value" whenever IT investments are expected to have long-term effects.

4. The importance to present proposals in terms of "Best", Expected and "Worst" cases so that corrective measures can be taken to focus management attention on timely preventive actions.

5. An emphasis that every IT budget request requires a summarization of the proposed spending as an investment portfolio. Corporate management will be less interested in discuss the merits of individual projects than to obtain an overall insight in of how and where money will be spent.

Table of Contents

Introductory Remarks6
The Role of ROI in I.T. Planning9
The ROI Backlash11
Quality of ROI Calculations13
The "Intangible" ROI14
The Uniqueness of ROI15
ROI as a Test16
The Microscope Test.16
The Sight Test.17
The Telescope Test.18
The Survival Test18
The Institutional Setting18
Calculating a Firm’s ROI Gain20
Residual Value - A Long View26
Calculating a Project’s ROI Gain29
Observations About ROI Calculations35
IT Portfolio Management37
A Portfolio view of an I.T. Infrastructure43

List of Illustrations

Table 1 - Balanced Score Card for Ranking Project Priority19
Table 2 - Results of CFO Review of IT Budget Proposal20
Table 3 - An Example of a Base Case Business Plan21
Table 4 - Discounts from Sum of Payments Rise with Time and Risk23
Table 5 - Net Present Worth of Pretax Income of Base Case24
Table 6 - Proposed Improved Business Plan24
Table 7 - Proposed Market Share Gains25
Table 8 - Proposed Back-Loaded Plan25
Table 9 - Base Case Must Consider Long Range Worth27
Table 10 - The Net Present Worth of Cash Flows plus Residual Value27
Table 11 - The Worst Case ROI Useful for Testing Assumptions28
Table 12 - Exceptionally High ROIs to be Viewed with Caution28
Table 13 - Simple ROI Calculations for a Short-Term Project29
Table 14 - Partial View of the HP ROI Calculator31
Table 16 - Partial View of Sungard Benefits Calculator34
Table 17 - Partial View of Nucleus Research Consultants ROI Tool35
Table 18 - Profile of Proposed IT Investment Portfolio39
Table 19 - Proposed IT Investment Portfolio - I.T. Costs Only40
Table 20 - Proposed IT Investment Portfolio - Full Costs40
Table 21 - Financial Profile of Proposed IT Investment Portfolio41
Table 22 - Proposed IT Investment Changes to Financial Projections42
Figure 23 - Most of the IT Budget Absorbed in Infrastructure Spending43

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