Bill Gates and the president of General Motors were having lunch. Gates boasted of the innovations his company had made. "If GM had kept up with technology the way Microsoft has, we’d all be driving $25 cars that get 1,000 m.p.g."
"I suppose that’s true," the GM exec agreed. "But would you really want your car to crash twice a day?"
I think of this story whenever we’re asked by a client to justify the return on their technology investment (ROI). The latest and greatest may be better, but is it right for you, and how will it show up on the bottom line?
Take the healthcare industry for example. Institutions are spending hundreds of millions and in some cases, billions of dollars to meet new federal electronic healthcare (EHR) guidelines. Taxpayer dollars are in part funding the transition so that doctors can talk to the emergency room, radiology can talk to oncology, nurses can talk to the pharmacy, and everybody can talk to the accounting department. Linking all systems together will invariably help improve patient care and no doubt provide accountability when it comes to paying for it all. That should help Washington’s bottom line as well as those of the insurance industry. But what about the hospitals? Hundreds of millions of dollars in up-front expense and tens of millions of dollars in annual system maintenance costs later, will it all be worth it?
We've examined how to do more with less in a number of recent posts, but a discussion on IT ROI took place recently on a LinkedIn forum and the arguments for and against, can, quite frankly, be made for any business, inside or outside the healthcare world.
- Technology reduces fraud, waste, and abuse.
- When used correctly, inter-department communication will drastically improve, making for a more efficient organization and happy customers (patients).
- New data analysis can identify strengths and weaknesses, driving process improvement, lowering costs, and improving ROI.
- Cost. Installing and integrating software that in the case of EHR, costs $250 million dollars. An additional $30 million dollars a year will need to be spent to keep it all running. That can only be recouped, some say, through massive cutbacks in personnel (either that or as one on line forum participant suggested, “reduce the average physician’s salary by $100,000 a year!). That’s not going to happen.
- The system is broken. Hospitals, like many businesses, are being asked to improve quality even though they will need to spend more to operate, and be paid less to do it.
So how do you judge ROI when it comes to a technology investment for your business? Start by doing a thorough LEAN analysis of your organization and industry. Begin by asking yourself two simple questions:
- Why am I doing this? It may be something thrust upon you by the state or federal government, an industry group, the age and/or performance of your existing infrastructure, or security concerns.
- How will it make my business better? Technology is often touted as making an organization more efficient, augmenting existing or opening up new capabilities, or allowing for increased capacity.
If you’re satisfied with the answers, make sure you then have a solid understanding of your existing network because that needs to be the benchmark for your comparison. You don’t have to join the local “Geek Squad” but you should be asking the bits and bytes experts for a reasonable overview of your current systems, processes, and personnel. If you can’t understand it, tell them to go back to the drawing board. Throw out the acronyms and have them make their pitch again. You want an understanding of all the hardware and software you’re using today. You want assurances that all processes are documented and reviewed for optimal performance. And finally, you want to know that you have the right team in place to run what you have now, and handle the changes ahead.
Overall, IT budgets are expected to remain flat in 2017 (meaning there’s no sudden windfall of cash just waiting for you to spend it on the latest tech). Unless you’re in marketing, then you’re probably in pretty good shape if you’re looking for a technology budget – but those dollars are coming from a larger percentage of company revenue. According to Gartner, larger companies with more than $5 billion in sales, spend about 13% of annual revenue on marketing, while smaller companies with between $250 million and $500 million in annual revenue spend about 10% of it on marketing, much of it going to MarTech investments.
So now that you’ve justified your technology investment, there’s a good chance you’ll still be asked to prove your proposed idea further with a projected ROI. How will these IT dollars translate into company revenue? It’s a fair question, but how do you go about calculating the ROI of an IT project? Let’s take a look.
How to Calculate ROI on IT Projects
Calculating ROI for IT projects can be a tricky endeavor. There are a lot of variables that can impact the outcome, so first you’ll need to figure out what financial benefits you stand to gain. Enfocus Solutions suggests that the financial benefits of IT investments typically fall into five buckets:
- Revenue enhancements, such as upsells. That means any IT investment that allows you to offer a new product or service – which, naturally, will increase your revenue.
- Cost reductions. This refers to the benefits that will help you reduce costs (but not necessarily eliminate them). Some examples might be reducing travel expenses by holding online instead of in-person meetings, or lowering your ongoing maintenance costs with better technology (this is a big one for IT projects).
- Cost avoidance. Rather than reducing costs, this means eliminating a cost completely. Wouldn’t that be nice? That can happen thanks to fewer errors, reducing the number of customer support issues, or, something everyone wants – better productivity.
- Capital reduction. Some benefits help you reduce your capital expenses. For example, reducing the cost of storage and server capacity.
- Capital avoidance. Again, we’re talking about the difference between reduction and avoidance, so a benefit that would help you get rid of a capital expense entirely would fall into this category. (An IT investment that means you don’t need to build a new data center would fall into this bucket.)
The funny thing is the basic ROI calculation equation is stupidly simple:
ROI = (Gains – Cost)/Cost
This equation works for calculating ROI for any investment – not just IT. If your IT team uses Agile methodology, they’ll want to consider things like project velocity. But first, what’s the overall cost of your project? Your total cost might be nothing more than an estimate at this point, but that’s perfectly okay.
Then you need to figure out how to quantify your gains. Concrete ROI numbers should (and will) reflect only measurable gains. It’s difficult to come up with numbers for the non-quantifiables – the soft benefits like customer satisfaction, better customer support, better usability, forecasting and analysis, and so on, but don’t let that trick you into thinking the non-quantifiables aren’t important. They are, and you should still consider them, especially when you’re faced with making your case to the people who hold the checkbook.
As My Accounting Course says, the financial focus of an ROI calculation is valuable because it makes it easy to compare two different investments that aren’t really the same on the surface. Think about comparing an investment in stock vs. purchasing new equipment. They’re two different animals, but ROI makes for an easy point of comparison by looking strictly at the financial gains minus the cost.
Here’s something else that’s important to remember: While the ROI equation is pretty simple, it can also be manipulated. That depends mostly on how someone decides to quantify their costs and revenues (or which revenues and costs to include in the calculation). So, this is where things start to get hairy for many people.
There’s no clearly defined, set rule regarding what gains should be considered in an ROI calculation. Really, it’s up to the company to decide what they consider a gain. If those gains happen to be quantifiable, then they need to decide whether to include them in the ROI calculation. At the end of the day you need to figure out what value means to your organization.
Maybe you prefer to stick to concrete revenue gains without considering the revenue you might generate from increased productivity. It’s up to you. But choose wisely. And remember that coming to a consensus about what should or shouldn’t be included in these calculations can be a sticking point with stakeholders.
You can calculate ROI in two completely different ways by focusing exclusively on reduced costs or exclusively on revenue gains. In other words, if you can calculate the specific amount of revenue you’ll generate over a specified time for improved customer satisfaction, you can choose to include this metric – or you might narrow your focus to the ROI you’ll gain from reducing capital expenses. You might even decide to calculate ROI in several ways to make your case for the many potential benefits your company stands to gain for investing in your project, and when it’s time to move forward, run a pilot to find out if things are likely to turn out the way you think they will.
But wait, that’s not all! You’ll also want to consider the project timeline and how soon you can expect to start seeing some of those returns. Some investments cost millions of dollars to implement, yet the company doesn’t see returns for several years. If you’re concerned about cash flow, that’s definitely something to take into consideration. Some experts (mostly the accounting types) call this the payback period. And, those same accounting-minded folks will probably want to know whether any IT assets involved in the project are appreciable or depreciable and over what time frame.
A real estate purchase appreciates indefinitely (well, at least in an ideal world), but IT hardware is depreciable over a certain length of time. When you start to figure in the payback period and want to know other numbers (like present value), your calculation gets even more complex.
Finally, don’t confuse profit with cash. Harvard Business Review says this is the most common mistake people make when calculating ROI. If you confuse cash with profit, you’ll end up skewing your figures. Your ROI calculation might show that you’ll see a bigger return than you’ll actually get in the real world.
The cash flow method is the savvy investor’s preferred method of calculation.
There are a lot of other factors that come into play when you’re deciding on technology investments. Think about:
- The risk factors. What could go wrong? Can you plan for the worst-case scenario and still get a good outcome?
- Who it impacts. There’s a good chance that any IT investment will impact more than just the people directly working with the technology. Your customers, other departments, etc. It’s a good idea to think about who a project will affect and how. Are the impacts positive or negative?
- Adapting to new technology. Some IT investments are behind-the-scenes and don’t require changes to the way people work. Others do. Will your people have to re-learn existing technology or adapt to something new entirely?
- Benchmarks. Do you have established benchmarks? Where does your IT investment fall in relation to industry/company benchmarks?
- Value vs. dollars. Thought leaders in some fields like EdTech recommend placing more emphasis on VOI (Value on Investment) than ROI, as the “soft” benefits (the ones you can’t define by numbers) are more important. That’s a call for you to make.
If you do want to evaluate your VOI (or use it as part of your overall analysis), here’s a handy graphic that illustrates the process from EdTech Magazine:
Examples of ROI
Tricky financial calculations are easier to understand with real-world examples for most people. So let’s look at a few. Peter Campbell provides a good one in an article at TechSoup:
- A company spends $2,000 to upgrade its fundraising system for better data visualizations and reporting.
- This helps the company increase each salesperson’s donations by 10 percent.
- Overall, the company expects the investment to generate an additional $10,000 each year in donations.
- The benefits of the upgrade are expected to last two years.
- The ROI in financial terms is $18,000. (The $10,000 additional donations per year x 2 years = $20,000, minus the $2,000 initial cost of the upgrade.)
But, this simple figure doesn’t really take the whole picture into account. The salespeople don’t know how to use the new technology, so they’ll need to be trained (which comes at a cost). It also assumes that the technology works as it’s expected to, which anyone who has ever taken on an IT project knows is rarely the case out of the box. Also, what if you can’t sustain the staffing level required to generate that extra $10,000 in donations for two years?
Campbell says, “The concept here is pretty simple: it is easier to bake a cake from a recipe if you buy the ingredients beforehand. Then you need to have all of the required mixing implements and receptacles, clear the necessary counter space, and know how to turn on the oven.”
Did you buy your ingredients first? Do you have the necessary counterspace, receptacles, and other tools you need? Most importantly – do you know how to turn on the oven?
Karen Graham also provides a useful example in a post for Idealware where she analyzes the choice between buying a new server or migrating to the cloud using ROI. This example illustrates just how much an ROI comparison can lean one way or another depending on what factors you consider:
- It’s easy to look at decisions like this in terms of upfront costs. One option probably costs more upfront and is a tougher pill to swallow, while another may have the same costs spread out over a few years.
- Cloud-based file management provides better mobility, but does that matter to your organization? Is it worth asking your employees to give up the technology they know to learn something new?
- If you consider the cost of the technology itself and nothing else, the cloud comes at a slightly higher cost than a traditional server.
- If you factor in things like the cost of implementation and support, you’ll get a clearer picture of the full cost.
- But adding other costs like downtime, productivity, and training make the cloud look like the cheaper option.
Graham illustrates her calculations in the graphic below:
As you can see in these examples, ROI is a figure that you can manipulate somewhat (not quite to your every whim, but you can tweak it using selected variables to impact your final numbers). That’s why it’s important to get a group consensus on what benefits matter, decide what among those benefits are quantifiable, and whether you’ll rely on one ROI calculation or a few different methods to visualize exactly how some of the influencing factors could impact the outcome.
With all of these answers in hand, you can now weigh the capital expense of the hardware or software against the resulting increases in operating expense and determine if the spending is appropriate for your business size and complexity.
So take a breath, maybe have a drink, and buy a really good calculator. Return on investment is not a simple A + B calculation. But if you follow the process, you just may keep your ROI from turning into an IOU.