14 January 2010

ROI Is a Responsibility - Part 1

I have, of late, been challenged in my thinking from two quarters: first, in a LinkedIn discussion I had an entrepreneur tell me that entrepreneurs had to be too much "right-brained" and could not be cornered into decisions based on such things as calculated ROI (return on investment).

Next, I was going back through some old articles I had collected and discovered this excerpt from an May/June 2003 article by Jacob Varghese:

"Basing IT priorities on ROI rankings is a fool's game, a game in which the biggest liar wins. By relying solely on ROI figures to approve a project or decide between projects, managers are shirking their responsibility for understanding how technology will affect their businesses. ROI numbers do not ensure that technology initiatives will be in line with business strategy. The success of any technology initiative depends on whether the person responsible for implementation has the required incentives, authority, and credibility across the span of the organization that would be affected by that initiative. ROI figures should merely be used as a means to ensure that the planning is as comprehensive as possible and the totality of impact has been considered. And managers should avoid approving the entire funding up front. Rather, funding should be an ongoing contingent upon the project team meeting key milestones and realization of planned benefits." (Varghese 2003)

Now, I remain at two-minds regarding the Varghese article. On the one hand, I might agree with him on some matters, but I cannot be quite sure because there are other statements that run so outrageously against my inner sense that I cannot be certain of his meaning in the other statements. So, let me break this down sentence by sentence:

"Basing IT priorities on ROI rankings is a fool's game, a game in which the biggest liar wins."

Who is the "liar" here?

I suppose if the ROI figures are coming from a salesperson working for a software vendor or VAR (value-added reseller), then Varghese might have a point. However, it is the firm's executive team that is the "fool" in that case, for believing the ROI numbers provided by the very persons who stand to gain the most – and lose the least – by selling new technology to the firm.

However, if the executives and managers are doing their job properly and they have the right tool set, they should be the inventors of their own ROI figures. Furthermore, those figures should not be predicated on industry averages or "round-numbers" or rules-of-thumb. The executive team should figure out – for each proposed investment in IT – the following three factors (at a minimum):

Change in Throughput or delta-THow much will Throughput increase, where Throughput is defined as incremental revenues less truly variable costs (only those costs that will vary directly with the change in incremental revenue change)Investing $85,000 in technology X should increase our sales of Product Lines A, B and C in the Y market segment by 15% over the next 12 months. We estimate that this will result in $215,000 per annum in additional Throughput when fully up-to-speed. We believe that minimal change in Operating Expenses will be necessary to support this increase it Throughput.
Change in Investment or delta-IHow much will total assets changeOf the $85,000 investment in technology X, we expect that $50,000 will be capitalized. We also expect that about $22,000 in additional inventory will be required to support the $215,000 per annum in additional Throughput. Therefore, total change in Investment (first year) is estimated to be $72,000 ($50,000 + $22,000).
Change in Operating Expenses or delta-OEHow much will day-to-day expenses increase or decreaseAs previously stated, our estimates indicate that we will be able to support the $215,000 in additional Throughput with no additional staffing. However, the carrying costs for the additional $22,000 in inventory are estimated at 23.2% or $5,104 per annum. We also know that software maintenance costs will 18% of $20,000 or $3,600. Total estimated change in Operating Expenses are, therefore, $8,704 per annum.

In the first year, we must add the non-capitalized part of the $85,000 IT project, or $35,000. First year delta-OE is, therefore, $8,704 + $35,000 = $43,704.

How, then, do we calculate the ROI for this "technology X" project? Quite simply using the following formula:

ROI = (delta-T – delta-OE) / delta-I


First-year ROI = ($215,000 - $43,704) / $72,000 = $171,296 / $72,000 = 238%

Now, perhaps Mr. Varghese can explain to us all why comparing various IT projects on this basis is "a fool's game."

"By relying solely on ROI figures to approve a project or decide between projects, managers are shirking their responsibility for understanding how technology will affect their businesses."

Here, again, I guess we need to ask the question: Whose ROI figures? If the figures upon which the executive team is relying come from the vendor or the VAR or are otherwise based on non-specifics, then I would concur with Varghese.

However, if the ROI figures are coming from sound analyses as I just set forth in the examples above, then I would say that it would be managers who do not "rely solely on ROI figures to approve" IT projects, or to "decide between projects" that are "shirking their responsibility for understanding how technology will affect their businesses." In fact, by not preparing an ROI analysis with the kind of stringency suggested by my example above, then managers and executives are simply throwing in the towel and confessing outright that "We do not know how technology will affect our business. Instead, we just have hope that if we spend money on technology, that somehow our company will magically improve."

That, folks, is not a strategy.

[To be continued.]

©2010 Richard D. Cushing

Works Cited

Varghese, Jacob. "ROI Is Not a Formula, It is a Responsibility." Journal of Business Strategy, May/June 2003: 21-23.


Tim said...

I think Varghese is implying “Basing IT priorities on ROI rankings [ALONE] is a fool's game”.
In terms of his comments “a game in which the biggest liar wins” I believe he is saying that when we use phrases like “should increase” and “We estimate” and “We believe” and “we expect” and “is estimated” to present ROI the associated calculations contain assumptions not explicitly detailed. Varghese is saying that it is within these assumptions that the “lie” slider can be manipulated, intentionally or unintentionally.
My read is that Varghese’s implicit comments relate to ROI, in its purest form, not taking into account the whole system. By whole system I mean the economy and marketplace within which the organisation operates, the system that is the organisation, plus the various sub systems comprising or influencing the organisation. When ROI calculation are utilised in conjunction with the array of assumptions (i.e. all of the known system assumptions are explicitly called out along with the unknowns) then the model has more validity provided that it is used consistently period on period.

RDCushing said...

I do not disagree with you. My very argument is that, while all estimates of future results must bear a measure of uncertainty, insofar as is possible, the estimates offered by the various proponents of any business investment should quantify, qualify and detail the how much, when, where, why and how their proposed investments are expected to produced results.

Far too many businesses rely almost exclusively on "we estimate," "we believe," and "we expect" as the sole descriptors of anticipated results.