What Is Return On Investment (ROI) on an IT Project, And Why Is It Important?

Abstract

If you've led or managed large IT initiatives for clients, you’ve likely learned a key lesson by now: in today's IT landscape, executive sponsors and business leaders increasingly demand that every project include a clear ROI metric. A high-level requirement document, basic estimates, and a plan won’t suffice for steering committees anymore. Enterprise IT leaders are now being evaluated based on the financial impact and cost-effectiveness of the initiatives they champion. Return on Investment (ROI) is a crucial metric that measures the financial return generated by an IT project, factoring in all investments and expenses. In essence, it calculates the financial benefit achieved after the successful implementation of the project.

Why is it important

There are several reasons why calculating an ROI is vitally important for any IT initiative or any investment for that matter, but for the purposes of this article, let us focus on IT projects.

Prioritization: By comparing the ROI of various projects, business can prioritize those projects that have the highest potential return on investment, thus ensuring resources (funding and people) are allocated effectively.

Justify Investment: A strong ROI can help the IT team justify the project's cost to stakeholders by clearly demonstrating its financial value.

Monitoring Success: Tracking ROI of an IT project over time allows companies to assess its actual performance vs project performance and identify areas for improvement. It also allows companies to compare and contrast various projects across the enterprise and adjust investments as needed.

Most IT managers tend to shy away from the financial thought process and opine that this is not what they do, and it is best left to the finance and accounting perso. But if you make that little investment in yourself and go the extra mile in learning the basics, it will go a long way to the success of your careers and more importantly the success of the projects you will lead. This, I believe, is one of the best ways of separating yourself from the pack.

Calculating ROI

The following is a step-by-step process to calculate ROI for your projects:

1. Define Costs (Investment)

The total investment in the IT project includes both direct and indirect costs:

Direct Costs:

• Initial Capital Investment: This includes the cost of software, hardware, licenses, infrastructure, etc.
• Operational Costs: Ongoing costs like maintenance, support staff, upgrades, and training.
• Implementation Costs: Costs related to project management, consulting, and other external resources.

Indirect Costs:

• Opportunity Costs: Any potential revenue or value lost due to redirecting resources to the IT project. This may mean moving resource from an ongoing project and potentially delaying that initiative. We discussed prioritization in the initial section, and this can be one way to prioritize.

2. Estimate Benefits (Returns)

Identify and quantify the expected benefits from the project. These can be both tangible (measurable) and intangible (difficult to measure but important for long-term success). Common benefits include:

• Increased Revenue: Any new revenue streams created by the project (e.g., new products, services, or markets). Check with your business partners for this information. This kind of information is not hard to get if you know who to talk to.
• Cost Savings: Reductions in operational costs due to automation, efficiency improvements, or better resource management.
• Productivity Gains: Improved employee efficiency, reduced downtime, or faster decision-making that leads to indirect financial gains.
• Customer Satisfaction: This may lead to the retention of new customers, which can translate into long-term revenue growth.
• Risk Reduction: Avoidance of fines, penalties, or loss of reputation from outdated technology or compliance issues. A seasoned operations or production support manager can provide this information.

3. Calculate ROI Formula

Once you have the costs and benefits, you can use the following formula to calculate the ROI. This is the simplest ways of calculating ROI.

ROI = Net Profit / Total?Investment × 100

Where:

Net Profit = Benefits (Returns) - Costs (Investment)

Total Investment = The total costs incurred in the IT project.

Example:

Let’s say the total investment in an IT project is $200,000, and the estimated benefits (savings and revenue increase) over a year are $300,000.

Net Profit = $300,000 (Benefits) - $200,000 (Costs) = $100,000

ROI=100,000/ 200,000 × 100=50%

In this case, the ROI is 50%, meaning that for every dollar spent on the IT project, you project a $1.50 in return.

4. Consider Timeframe and Risks

Now that you have the basics in place. Let’s take this concept a little bit further and add time and risk.

Timeframe: ROI should be assessed over a realistic period. Some IT projects take several years to yield their full benefit.

Risk Adjustments: The calculated ROI should be adjusted based on risks and uncertainties, such as project delays, cost overruns, or lower-than-expected benefits.

5. Refine with Additional Metrics

For a more comprehensive analysis, you might also consider other metrics like:

Payback Period: How long will it take for the project to pay back its initial investment.

Net Present Value (NPV): A more advanced calculation that takes into account the time value of money. A simple definition of NPV is the difference between the present value of cash inflows and present value of cash outflows over a period of time.

Annual Contract Value (ACV): A metric that is used to measure the average annual revenue from a customer’s contract.

By using ROI and these additional metrics, you can get a clear financial picture of an IT project’s value. Your company’s accounting staff will be able to help you understand and speed up this process as they will have this information available. Once you grasp this concept, your proposal for any future projects will look a lot different.

Advanced ROI calculations using payback period, NPV and ACV

To calculate ROI using additional metrics like Payback Period, Net Present Value (NPV), and Annual Contract Value (ACV), you can follow these detailed steps. Let’s break down each metric and how it contributes to ROI calculation:

1. Payback Period

The Payback Period is the time it takes for the project to recoup its initial investment. It's important because it shows how quickly the project can return its initial costs, which is vital in evaluating the risk.

Formula for Payback Period:

Example:

If the initial investment is $200,000 and you expect the project to generate $50,000 per year in cash inflows (cost savings, revenue increases, etc.), the Payback Period would be:

Payback?Period=200,000/ 50,000=4?years

This means it will take 4 years for the project to pay back its initial investment.

2. Net Present Value (NPV)

Net Present Value (NPV) is used to assess the value of future cash flows by discounting them to the present value using a discount rate. It considers the time value of money, which is essential for long-term projects.

Formula for NPV:

Where:

• Cash Inflows- Expected cash flows (savings, and additional revenues) from the project at the end of each year.
• r = Discount rate (interest rate or cost of capital)
• t = Time period (usually years)

Example:

Let’s assume:

The initial investment (I0) is $200,000.

Annual Cash Inflows (Ct) are $80,000 per year for 5 years.

The discount rate (r) is 10%.

We can now calculate the NPV:

Calculating each term and breaking the value down for each of the 5 years:

Year 1: 80,000/ 1.10 = 72,727

Year 2: 80,000/ 1.21 = 66,116

Year 3: 80,000/ 1.331 = 60,084

Year 4: 80,000/ 1.4641 = 54,721

Year 5: 80,000/ 1.61051 = 49,688

Now, sum up these values:

NPV = [72,727.27 + 66,115.70 + 60,146.86 + 54,687.80 + 49,692.56] ? 200,000

NPV=303,370.19?200,000=103,370.19

So, the NPV of the project is $103,370.19. Since the NPV is positive, this indicates the project is expected to generate more value than it costs.

3. Annual Contract Value (ACV)

Annual Contract Value (ACV) is typically used for subscription-based businesses and IT projects involving recurring revenue, like SaaS solutions. It is the total value of a customer contract, normalized over a year.

Formula for ACV:

ACV=Total?Contract?Value?(TCV)/Number?of?Years?in?Contract

Example:

Let’s assume:

The total contract value (TCV) of the IT project is $300,000 over 3 years.

The ACV is:

ACV=300,000 / 3 = 100,000

This means the project is expected to generate $100,000 per year in revenue over the contract period.

4. Combining Metrics for ROI

Once you have these metrics, you can refine the ROI calculation by integrating them:

ROI Formula (with additional metrics):

ROI = Net?Profit?from?the?Project / Total?Investment × 100

Where:

Net Profit from the Project = Total benefits (from NPV, ACV, etc.) - Total investment.

Total Investment = The sum of initial and operational costs.

Example:

From the earlier examples:

Initial Investment = $200,000

NPV = $103,370.19 (Net profit from project)

ACV = $100,000 per year (if we consider recurring revenue)

Now, calculate ROI based on NPV and ACV:

1. Net Profit = $103,370.19 (NPV) + $100,000 (ACV, if considered for 1 year) = $203,370.19.
2. Total Investment = $200,000.

ROI = 203,370.19 / 200,000 × 100=101.69%

This means the project has a 101.69% ROI, indicating that for every dollar invested, you will gain approximately $2.02 in return. Not bad, isn’t it? Especially if you are taking this proposal to your business sponsor and need their approvals.

Conclusion

• Payback Period: 4 years.
• NPV: $103,370.19.
• ACV: $100,000 per year.
• ROI: 101.69%.

These advanced metrics provide a more holistic view of the financial impact of the IT project, covering aspects like time-to-repay, long-term value (NPV), and recurring revenue potential (ACV). So, next time when you plan to present a project proposal, make sure to include the ROI and increase your chances for executive approval. ?

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Syed Aiyaz Ahmed is a seasoned Senior IT Program Manager who has led several large initiatives in his career spanning 25 years. You can connect with him on LinkedIn at: https://www.dhirubhai.net/in/syed-aiyaz-ahmed/ ?

Acknowledgement: Thanks largely to my professors at Jack Welch Management Institute?(JWMI) and my mentors over the years who imparted this knowledge in me.