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FAQs:  Clear Answers to "Your" Questions

FAQs & Glossaries


 
 
Business Case, Cost-Benefit, & ROI

Question 9:  What approach would you recommend to help us make the “build vs. buy” decision for an application?

Answer:  Start by checking your organization’s IT / business strategy for guidance about the application build vs. buy issue. Some organizations are very clear about this matter (e.g., “in-house development of an application will only be considered when no viable commercial alternative exists….”). Let’s proceed as if there isn’t any helpful guidance.

Essentially, you are trying to answer the question: “Are we better off with alternative ‘A’ or ‘B’?” The preferred technique for systematically evaluating different means of accomplishing the same end is commonly referred to as “cost-benefit analysis” (sometimes, benefit/cost analysis). Simply stated, CBA compares the pros (“benefits”) and cons (“costs”) of viable alternatives in order to identify which alternative is most advantageous.

Anyone can perform a basic cost-benefit analysis; however, there are certain conventions that must be followed to ensure credibility. Use either an in-house CBA procedure, find one on the Web, or buy a step-by-step guide that is designed for non-financial professionals.

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Question 10:  I’ve searched online for a definition of ROI; I’m still confused. Can you clarify for me?

Answer:  Like many others, you may have searched hundreds of web pages (and print publications too) only to be left asking: “What is ROI?” and “How can I measure it?”. The difficulty is that return on investment (ROI), at least in the IT world, is a concept. It is like trying to find a definition of and formula for calculating the term “good”. This might help you.

The idea behind ROI is that decision-makers want a number that tells them what an investment in IT is worth. In other words, they want a quantitative measure the tells them what they get back (i.e., beneficial returns) for what they give (i.e., the resources they invest). The value or worth of IT may be financial or non-financial; sometimes, it is both.

Financial ROI is usually expressed in terms of one or more widely-accepted financial metrics or indicators (e.g., “payback period”, “net present value”, “internal rate of return”).

Non-Financial ROI is more problematic because we lack widely accepted measures (e.g., net present value). Non-financial value must be measured in terms of the business impact (i.e., the beneficial change) enabled by the technology investment.

All ROI metrics (financial or non-financial) produce a number representing a value that is meaningful to decision-makers.

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Question 11:  What is a “Business Case”?

Answer:  A business case is a structured proposal presenting the logical business argument (i.e., case) for undertaking a particular course of action. In a sense, a business case says to decision makers “this is what we should do and here are the reasons….”. A business case typically includes the facts developed by a cost-benefit analysis.

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Question 12:  What is a “Cost-Benefit Analysis”?

Answer:  Every business-IT decision involves choices. You can choose do “A”, or “B”, or nothing at all. Ultimately, only one of these choices is “best”. A cost-benefit analysis (CBA) compares the choices and reveals which is best.

A cost-benefit analysis (sometimes, “benefit/cost analysis” and other variations) is a systematic assessment of the costs and benefits of two or more alternative solutions to a problem. A CBA is undertaken to determine which alternative under consideration is the most advantageous. The CBA essentially tells interested parties: “here are our choices; here are the pros and cons of each; and, this one offers the best value for money”. The role of a CBA is to reveal key facts that can be used to make a good choice.

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Question 13:  Aren’t IT project decisions really based upon economics?

Answer:  Every decision-maker cares about the economics of IT decisions. The “economic” or “financial” consequences of a decision must be carefully considered in order to make wise choices. Just the way you or I would weigh the “economics” of a new car, home, or job.

Yet, many decision-makers consider more than just economic factors when weighing their options. They may also think about better information, improvements in customer service, faster time to market for products, reduction in error rates, better information security, compliance with government regulations.

It is true that sometimes economic considerations top the list of decision factors; e.g., when an organization is in the midst of a critical cost-reduction exercise. It is also true that pure economic considerations have not driven deployment of e-mail, adoption of the Internet and WWW, or the use of cellular technology for business purposes. All need to be justified based upon their benefits relative to their costs; but not all benefits are financial.

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Question 14:  How many years should a CBA include?

Answer:  Today’s decision-makers want to know more than the cost of an IT project and a vague reference to future benefits, they want to know what they will pay going-forward and what they will get back. Typically, the estimates must be developed for each year over a specific period of time. So, CBAs typically include a number of years in the analysis. When an CBA is conducted, the analyst must determine the appropriate number of years of benefits and costs to include.

In general, there is no hard and fast rule. First, check with your budget or finance expert to determine if your organization has a standard (sometimes, it depends upon the type of technology or cost of the project). If there isn’t a prescribed standard, consider dividing projects into two categories: (1) those that can be completed in 12-months or less, and (2) those that require more than a year to complete.

(1) For projects that can be completed in less than a year, a useful “rule of thumb” is to use of the “project year + 3”. Thus, the analysis of costs and benefits would span a total of four years.

(2) Multi-year projects are generally larger, more complex, and involve higher costs and deeper organizational impacts. They generally require a longer “analysis horizon” to get a reasonable picture of costs and benefits. Analysis periods would include the project years and can extend 5, 7, or 10 years beyond the completion of the project. Absent a standard, the decision about the appropriate number of years for such large projects should be made on a case-by-case basis in concert with your finance department.

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Question 15:  Do the terms “direct” and “indirect” have the same meaning as “tangible” and “intangible”?

Answer:  Your question suggests that you have been wrestling with IT investment decision-making issues for a while! Here is the short answer…No, they are two entirely different animals.

The terms “direct” and “indirect” are budgeting and accounting terms that refer to the “tracibility” of costs associated with a specific project or activity. “Tangible” and “intangible”, when used in connection with IT, are often used to characterize the “type” of benefits that are produced or enabled by a project. These terms are also used in finance and accounting to classify certain types of “assets”.

The application, or mis-application, of terminology drawn from different disciplines is a source of confusion when we attempt to have rational discussions of IT’s value. The use of the term “intangible” is one of the most common.

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Question 16:  What is Net Present Value?

Answer:  Net Present Value (NPV) is one of the most common financial performance metrics used to evaluate projects and compare alternative solutions to a business problem. In a nutshell, the NPV calculation translates future amounts of financial benefits into a single current (i.e., “present”) amount (i.e., “value”). The basic idea is that money that we expect to receive in the future is worth less than the same amount of money in hand today. NPV adjusts (i.e., reduces) future financial benefits and restates them as an amount in today’s dollars.

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Question 17:  What information do I need to calculate the return on investment for a project?

Answer:  There is no “universal” ROI metric for IT projects. IT projects can produce two broad categories of returns: (1) financial returns and / or (2) non-financial returns. There are many “ROI” metrics for each category. Even within the same category, metrics don’t always use the same information in the calculations. For instance, although simple “payback period” and “net present value” are both “financial performance metrics” only NPV uses a “discount rate” in its calculation.

Don’t despair! Here is a list of the information that you will need for most financial ROI calculations:

  • Project Cost · Maintenance & Operating Costs (Annual for each year included in the analysis period) · Financial Benefits (If any. Annual for each year included in the analysis period.) · Annual Cash Flow (Just subtract the annual costs from the annual financial benefits.)
  • The numbers needed for non-financial calculations depend upon the measure used. Generally, it will include a combination of costs over time and either a rate or amount indicating an non-monetary business improvement (e.g., timeliness, quality, or quantity).
  • More often than not, you will be expected to produce financial ROI numbers. Anyone can complete these calculations very simply and quickly with a commercial ROI calculator or a comparable tool developed in-house.

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Question 18:  Is a Business Case the same as a Cost-Benefit Analysis?

Answer:  There are similarities, but they are not the same. Both are formal techniques for generating facts to help decision-makers make more informed decisions. A “business case” is an advocacy document; it’s purpose is to persuade interested parties to follow a particular course of action. It is also more comprehensive than a cost-benefit analysis. For example, a business case will often include a discussion of strategic alignment while a CBA often does not. The cost-benefit analysis is a “neutral” assessment of a few viable alternatives. The CBA develops key facts regarding the costs, benefits, risks, and returns of alternative choices. It also compares the choices to identify which is most advantageous. A business case generally includes the results of a CBA.

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