P E T E R  S. C O H A N  &  A S S O C I A T E S

In concept, estimating the return on investment (ROI) of a technology initiative is a like any other capital budgeting process.  The objective is to estimate the cash flows likely to be generated by the technology initiative and determine whether these cash flows exceed the costs of designing, building and operating the systems and processes associated with the initiative.

The practical challenges of putting this concept into practice are considerable.  It is generally difficult to quantify the benefits of technology initiatives.  Often it is more fruitful to estimate the cost savings of technology initiatives by applying activity-based costing, a procedure that assigns costs to activities based on the amount of time they consume.  Analysts can estimate the cost savings of a technology initiative by mapping out the steps in the current process and assigning costs to each step.  Next, analysts can map out the steps of the new process and cost out each of its steps.  Finally, analysts can calculate the cost savings of the new process by subtracting the costs of the "to-be" process from the  "as-is" process.

Often technology initiatives are sold to senior management on the basis of related increases in revenue.  While such estimates are often fuzzier, in practice some technology initiatives do generate tangible revenue increases.  For example, a division of Eaton Corporation was able to increase by 20% its sales of certain motor control panels after the division began using an online ordering process that let customers' engineers tailor these panels to their specific requirements.

The next practical challenge in calculating the ROI of a technology initiative is estimating the cost to design, build, and operate the new process.  While it is often relatively straightforward to estimate the cost of the hardware, software, and communications for the technology initiative, the costs of "softer" resources are often underestimated.  For example, companies generally spend several times the cost of hardware and software for systems consulting services.  Furthermore, firms tend to underestimate the amount of training required to get the organization to actually use the system.

Finally, there are many ways to determine whether the numbers work.  Companies can calculate a project's net present value (NPV), its internal rate of return (IRR), or its payback period.  The calculation of the NPV depends to a certain extent on the discount rate used in the formula which in theory is equal to the risk free (e.g., treasury bill) rate plus a factor to adjust for the riskiness of the project.  Since there is often debate about the right interest rate, analysts should use a reasonable range of assumptions.  If the technology initiative's NPV is positive, it should be funded.

The IRR calculation also uses assumptions about the right discount rate.  With the IRR approach, analysts compare the IRR to the company's cost of funds -- a figure which may be easy to estimate if the company is borrowing money for projects.  If the technology initiative's IRR exceeds the company's cost of funds, then the project should be funded.

Finally, the payback period method -- in which analysts calculate how many months (or years) of the initiatives' benefits it will take to surpass the initiatives' costs -- has the advantage of using fewer assumptions -- however, what makes an acceptable number of months for payback is somewhat subjective.  If the project has what is deemed a reasonable payback period, then the project should be funded.

In general, it may make sense to use all three methods to decide whether a technology initiative has an acceptable ROI.  In today's economic climate, such disciplined analysis will probably limit a company's technology initiatives to a handful of high payoff projects.