A Note on Indirect Benefits
The decision to include or exclude indirect benefits into the financial return and ROI calculations varies by organization, and often by the organization's CFO. For example, what's the indirect value if a CRM application achieves the goal of centralized information and a complete 360 degree view of the customer history and relationship and thereby empowers all staff to speak with a consistent voice and make customers feel like they are dealing with a single, unified company that recognizes them at every touch point? While this particular example demonstrates a significant value, and even competitive advantage, it is an indirect value and difficult to quantify.
While more conservative analysis may choose to exclude benefits which are less tangible or do not directly remove an expense item, case study analysis clearly demonstrates that indirect benefits are material and even if they are not directly observed they are nonetheless realized. A Nucleus Research paper on the topic of indirect benefits and calculating ROI concludes "Many companies will find that direct returns from technology could pale in comparison with indirect returns once they start quantifying the impact of other returns that are indirect but equally impressive in terms of the business value generated. In fact, more than 82 percent of the case studies Nucleus has published over time have included some form of measurable indirect return, with 50 percent of the technology ROI being attributed to indirect returns."
A consistent and quantifiable measurement process is needed to assure indirect benefits are accurate and supportable. The most common indirect measurement metric is FTE (Full Time Equivalents) in which benefits or costs are associated in terms of percentage change to a full time role.
Options for Financial Measures
There are many different techniques to measure the financial attractiveness of any large financial endeavor such as an IT project. The vast majority of companies use one or more of the following different approaches to make their go or no go investment decisions:
- Present Value
- Return on Investment (ROI)
- Net Present Value (NPV)
- Payback Period
- Internal Rate of Return (IRR)
Money held now could be invested in a bank account and is therefore more valuable than money to be received in 12 months. Present value seeks to account for this. It equals the rate by which you have to discount future benefits for you to be indifferent between a benefit received now and a benefit received at the end of the specified time period. The equation for present value is: benefit / (1+discount rate). Let's say you are an IT manager at a manufacturing company planning a small new software roll-out.
If the current discount rate is 10% and your benefit at the end of year 1 is $5,000, the present value of that benefit right now is equal to $5,000/(1+.1)= $4,545.45. $4,500 received now is the same to you as $5,000 received in 1 year if the discount rate is 10%, since if you invest that $4,500 and take inflation into account, it will be the equivalent of $5,000 in 1 year. Since software often provides a benefit over a number of years and interest is compounded, present value calculations can often be complex. For example, if your annual net benefit is $5,000 for three years, the present value would equal:
$5,000 / (1.1) + $5,000 / (1.1)^2 + $5,000 / (1.1)^3 = $12,434.26
It would not equal $5,000+$5,000+$5,000 = $15,000. The basic principle of present value or the time value of money is central to several of the different ways of measuring the financial attractiveness of one investment over another.
Return on Investment
Return on Investment (ROI) is arguably the most popular metric when you need to compare the attractiveness of one business investment to another. Your return on investment equals the present value of your accumulated net benefits (gross benefits less ongoing costs) over a certain time period divided by your initial costs. It is expressed as a percentage over a specific amount of time; in IT purchasing, 3 years is the most common time span since technology is often effectively obsolete after 3 years. The equation for a 3-year ROI is:
(net benefit year 1 / (1+discount rate) + net benefit year 2 / (1+discount rate) + net benefit year 3 / (1+discount rate)) / initial cost.
So if the initial cost for your manufacturing company's small new software roll-out was $10,000, your annual benefits minus annual costs are constant at $5,000 for the next three years, and the discount rate is 10%, your 3-year ROI would be:
($5,000 / (1 + .1) + $5,000 / (1 + .1)^2 + $5,000 / (1 + .1)^3)/$10,000 = 124%
While ROI tells you what percentage return you will get over a specified period of time, it does not tell you anything about the magnitude of the project. So while a 124% return may seem initially attractive would you rather have a 124% return on a $10,000 project or a 60% return on a $300,000 investment? That is why you will often want to know the Net Present Value.
Nucleus note: Why use an average annual number rather than adding the cumulative benefits from all three years and dividing by the initial cost? The average annual ROI calculation is directly comparable to other investments, the cost of capital, or to simply placing the money in the bank. It's the right way to calculate ROI. The cumulative ROI calculation generates a number 3 times higher than the real ROI calculations and is more commonly used by less scrupulous vendors in marketing material and quick calculators.
Net Present Value
The Net Present Value (NPV) gives you a dollar value of your expected return and therefore indicates the magnitude of your project. It is calculated by summing the present value of the net benefits for each year over a specified period of time and then subtracting the initial costs of the project. A positive NPV means that the project generates a profit, while a negative NPV means that the project generates a loss. The equation for a three year NPV is:
(net benefit year 1 / (1+discount rate) + net benefit year 2 / (1+discount rate)^2 + net benefit year 3 / (1+discount rate)^3) - initial costs.
If we take the hypothetical manufacturing company's new software roll-out example, the NPV would equal:
$5,000 / (1 + .1) + $5,000 / (1 + .1)^2 + $5,000 / (1 + .1)^3 - $10,000 = $2,434
The great thing about NPV is that it tells you about the dollar value of your savings; the downside is that it doesn't tell you when savings will occur.
Simple payback period is used to find out how long it will take for an investment to show a profit. It is important when time and cash flow are an issue. It is the time it takes for your project to recoup the funds expended and is normally expressed in years or months. The equation for a simple payback period is: initial cost / annual net benefit. So if we use the same new software roll-out example as before, your simple payback period is:
$10,000/$5,000 = 2 years
Payback is an indicator of risk - the shorter the payback the less risk you incur. Payback is very easy to calculate but it does not tell you about the magnitude of your savings or even how your investment performs after your benefits equal the initial costs.
Internal Rate of Return
Internal Rate of Return (IRR) is the most sophisticated of the above metrics and is often used to analyze large, multi-year investments. IRR equals the percentage rate by which you have to discount the net benefits for your time period until the point that they equal the initial costs. IRR is closely related to net present value. The rate of return calculated by IRR is the discount rate you would need to apply to your benefits to obtain a net present value of zero. The expression for IRR (in this case, a three year IRR) is:
initial costs = net benefit year 1 / (1+IRR) + net benefit year 2 / (1+IRR)^2 + net benefit year 3 / (1+IRR)^3.
IRR is often calculated through a trial and error process or data table since solving the above equation is very time-consuming. If we use the same new software roll-out example as before, the IRR would equal 23%. This gives an NPV of ($5000 / 1.23 + $5000 / 1.23^2 + $5000 / 1.23^3) - $10000 = 0, which follows the relationship between NPV and IRR.
IRR may be thought of as a kind of turbo-charged ROI, but it still suffers from ROI's main weakness which is that it does not give any indication of the magnitude of the project involved.
The Bottom Line
Each of these financial measures has its strengths and weaknesses. Different companies will place varying amounts of emphasis on each of the different metrics. To get a clear and complete picture of a prospective investment, you will benefit from having access to all of these measures
The top variables associated with SaaS CRM and ERP ROI
- Using software automation to replace user manual efforts
- Accessing information - getting the right information to the right users at the right time
- Using a single enterprise-wide information system (instead of multiple disparate information systems)