ROI is a Responsibility – Part 4

We have been reviewing comments made by Jacob Varghese in a 2003 article. In our Part 3 we noted that he had more to say about how and why ROI (return on investment) might not be a good way to make determinations regarding IT investments. In doing so, he references work by Ross and Beath:

"In 'New Approaches to IT Investment,' Jeanne W. Ross and Cynthia M. Beath break all IT investments along two dimensions: (1) strategic objectives (short-term profitability vs. long-term growth) and (2) technological scope (shared infrastructure vs. business solutions)…. Based on those two dimensions, all IT investments can be broken into one of the following four categories:

"Transformational: IT investments that aim to remove the infrastructural barriers to long-term growth across the organization (for example, integrated CRM, enterprise information portals, or end-to-end processing). Given the organization-wide impact and the imperative that such investments must be in line with organizational strategy, the CEO must own these investment decisions. The success of these projects should be his responsibility.

"Renewal: The aim of renewal IT investments (such as legacy modernization and platform conversion) is to improve the service levels of the existing shared infrastructure or reduce the cost of support and maintenance. The ownership of such projects should lie with the CIO, since the boundaries of these projects are well defined and benefits accrued can be quantified up front. Moreover, it is the CIO's responsibility to ensure the service levels from the shared IT infrastructure are constantly improved.

"Process Improvements: The end objective of IT investments that focus on short-term profitability or incremental process improvements might be to speed time to market, lower the cost of operations, or to differentiate services/product offerings. The ownership of such investments should lie with the business unit head, functional head, or the process owner, depending on how the organization is structured.

"Experiments: New technological trends that present significant opportunities for long-term growth should be the focus of IT experiments that use pilot programs to validate the technology's promise and impact. There is no fixed home for these projects. In one the industry, they might reside within the R&D organizations, in another, the enterprise architecture teams of MIS departments might take responsibility." (Varghese 2003)

I have concurred that there is, of course, legitimacy surrounding each of these classifications, but I wanted to take a closer look at each since it is my firm belief that business organizations really should be seeking ongoing improvement and, for for-profit organizations, real improvement should lead to making more money. In Part 3 we discussed "Transformational" IT projects. In this portion, we will try to cover, in a more brief way, the other three Ross and Beath categories for IT projects.

Renewal IT projects

Ross and Beath describe "renewal" IT projects as "investments (such as legacy modernization and platform conversion) is to improve the service levels of the existing shared infrastructure or reduce the cost of support and maintenance."

It seems clear from this description that most "renewal" projects will not contribute in any significant way to an increase in Throughput (T). However, it is likely that such projects will lead to reducing Operating Expenses (OE), and, in some cases, it may be possible that a "renewal" project could reduce the demand for (other) Investments (I). If this is true, then is it too much to ask for the IT department or the executive team to actually sit down and put some rational numbers (i.e., estimates) to the potential savings from investments in proposed IT "renewal" projects?

For example, if investment in SAN or virtualization technologies will contribute to savings in support or drive down the need for investments in new servers or other types of data storage in the future, then let the IT department bring forth such estimates and present them for consideration by the executive management team. There is a place for such projects, and the more the firm emphasizes and prioritizes around IT projects that increase Throughput (based on calculated ROI for projects competing for the investment dollars), the more cash flow will increase and the less difficulty the enterprise will have in coming up with the funds when ROI calculations show that a "renewal" project makes a lot of sense.

However, I would like to suggest another approach. One of the former managers for the New York Yankees used to have a strict policy: "Put a rookie in the lineup every year." This makes sense because then your team never gets "old" all at once. This approach makes sense, too, in the IT infrastructure world. Organizations should build into their regular annual budgets an Operating Expense amount allocated to "renewal" of their IT infrastructure. Some years the full renewal budget will be spent. Other times the renewal budget will not be spent in full. In that case, any budget balance should roll-over into the next year when a larger renewal project may be required.

If this approach is used, then "renewal" projects in IT become a part of operating expenses necessary to maintain the enterprise's health. In this case, a "renewal" project's ROI is still calculated in the same way using the same formula. The calculations would run along these lines:

ROI = (delta-T – delta-OE) / delta-I
where T = Throughput (Revenue less Truly Variable Costs),
OE = Operating Expenses, and I = Investment

Since, for IT "renewal" projects there is not likely to be rationale for concluding that the project will contribute to increasing Throughput, then that leaves only reductions in Operating Expenses and Investment as factors. If a "renewal" project requiring an investment of $25,000 will reduce annual maintenance and support costs by $6,000, but will also reduce a potential additional investment in year 2 by $18,000, then one can calculate as follows:

ROI (Year 1) = ($0 – (-$6,000))/$25,000 = 24%

ROI (Year 2) ($0 – (-$6,000))/($25,000 - $18,000) = $6,000/$7,000 = 85.7%

Note: When comparing multiple projects that produce multi-year variable cash-flows it may make sense to compare projects based on NPV (net present value) or, potentially, FMRR (financial management rate of return).

The bottom line

To reiterate: the bottom line is "the bottom-line." Do not succumb to accepting the concept that it is not possible to calculate ROI for an IT project destined for "renewal." We have just proven that, if your executive management and IT staff will commit to thinking through estimates and causes for changes in T, OE and I, then it is possible to rationally calculate the benefits to proposed IT projects – "renewal" or otherwise.

We will continue with the other kinds of IT investment from Ross and Beath in future posts.

[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.