One of the main pillars of effective managerial decision making for modern enterprises is their ability to evaluating and compare alternative investments in projects, marketing initiatives, and other expenditures. In this direction, most companies used capital budgeting metrics such as Return on Investment (ROI) and Internal Rate of Return (IRR) to evaluate their technology projects. For instance, technology ROI is one of the most popular to evaluate the profitability of technology investments. It is calculated as a ratio that measures the amount of return relative to the amount of money invested. As another example, IRR is the discount rate that makes the net present value (NPV) of all cash flows from an investment equal to zero. In other words, IRR is the rate at which the present value of the expected future cash flows from an investment equals the initial investment cost. Beyond IT ROI and IRR there is a host of other metrics that can be used to evaluate the financial performance of a project, such as the payback period of a project and its cost-benefit ratio.
While these metrics are very well known and widely used, their application in practice is always challenging. Most challenges stem for the uncertainty of specific parameters that are required for their calculation. For example, it is usually very difficult to calculate future cash flows. This is particularly true in the case of technology investments, which deliver several intangible benefits that do not always translate to monetary cash flows. To overcome financial performance calculation challenges in this context, companies had better consider the following guidelines.
1. Provide Realistic and Credible Estimates of Monetary Benefits
Estimating the monetary benefits of a project can be challenging for several reasons. One of them is uncertainty: Many projects involve a degree of uncertainty, which can make it difficult to accurately estimate the monetary benefits that will be realized. For example, a new product launch may be impacted by unexpected market conditions, changes in consumer behavior, or the entry of new competitors. Moreover, technology projects’ ROI calculations often involve multiple interconnected elements, each of which can have an impact on the overall benefit of the project. It can be challenging to accurately assess the impact of each individual element, and to understand how they will interact with each other to determine the outcome. Also, the benefits of a technology project are often subjective in nature and may be perceived differently by different stakeholders. For example, one stakeholder may value increased efficiency, while another may place a higher value on improved customer satisfaction. To overcome these challenges the following steps are suggested:
- Conducting thorough research: Conducting thorough research and gathering as much data as possible can help reducing the uncertainty associated with monetary benefits estimation. This includes market research, customer surveys, and competitor analysis.
- Develop a detailed project plan: Having a project plan that outlines the various elements of the project and their interdependencies can help you to better understand the potential benefits and how they will be realized.
- Involve stakeholders: Involving stakeholders in the estimation process can help to ensure that all relevant perspectives are considered. This can also help to build consensus around the estimated benefits and reduce subjectivity.
2. Factor Intangible Benefits
The intangible benefits of a technology project (e.g., improved customer satisfaction, increased employee morale, enhanced brand reputation) can be difficult to quantify. However, there are several approaches that can be used to factor these benefits into the estimation process:
- Expert engagement: Consult with experts in the relevant field, such as customer satisfaction specialists or branding experts, to help estimate the value of intangible benefits.
- Financial modeling: Use advanced financial modeling techniques (e.g., discounted cash flow analysis) to estimate the future financial impact of intangible benefits. This can help to put a monetary value on the long-term intangible benefits.
- Stakeholder feedback: Solicit feedback from stakeholders (e.g., customers) to understand the value they place on intangible benefits. This can provide valuable insights into the impact that these benefits are likely to have on an organization.
- Case studies: Review case studies of similar projects to understand the intangible benefits that have been realized in analogous situations. This can help to provide a better understanding of their value and how this value could be accounted for.
3. Take in Account the Time Value of Money
When calculating the financial efficiency of a project, make sure that you consider the time value of money. The latter is the idea that the value of money changes over time, due to inflation and other factors. The value of a dollar received today is worth more than a dollar received in the future. We are experiencing this during the past two years, where investments take place in a highly inflationary environment. There are metrics that consider the time value of money and others that do not. To provide a more accurate reflection of the actual profitability of an investment, it is imperative to dispose with metrics that consider inflation (e.g., IRR).
4. Consider the Social Impact of the project
In an era where sustainability, environmental and social factors are at the very top of the strategic agendas of modern enterprises, the evaluation of an investment must consider its social impact. In this direction, classical ROI calculations must be extended with calculations that address social impact i.e., the Social Return on Investment (SROI) method must be used. SROI is used to evaluate the social impact of a project. It is quite similar to traditional financial return on investment (ROI) in that it measures the impact of an investment relative to its cost. However, it also goes beyond just financial returns and considers the social and environmental outcomes as well. The SROI process quantifies the social, environmental, and economic outcomes of a project, in monetary terms, where possible. This is done by gathering data and information on the impact of the investment, both in terms of its benefits and its costs. The data is then used to create a SROI ratio, which measures the social impact generated relative to the resources invested.
5. Compare Alternative Investments
Financial performance calculators are not only about understanding and assessing the expected benefits of a technology project. Rather, they are also about comparing alternative investments on different projects, including IT projects and non-technological projects. Various financial performance metrics can used as a basis for the comparison, such as IRR, ROI, Payback and NPV. Each of these metrics provides a different perspective on the financial performance of a project and has its own strengths and limitations. For instance, NPV is a measure of the present value of an investment’s expected future cash flows. It considers both the magnitude and timing of expected cash flows and the cost of the investment. To compare the financial performance of two or more projects using NPV, you can calculate the NPV for each project and compare the results. The project with the higher NPV is generally considered to be the more financially successful. As another example, IRR indicates the average annual rate of return that the project is expected to generate over its lifetime. To compare the financial performance of two or more projects, you can therefore calculate the IRR for each project and compare the results. The project with the higher IRR is generally considered to be preferable from the financial performance perspective.
Overall, using financial performance metrics to compare alternative projects is a best practice that helps companies to take optimal decisions. While there are many different methods to do the comparison, the final choice depends on the specific needs and goals of the organization making the comparison.
Companies are increasingly using financial performance metrics to assess the value and expected benefits of their IT investments. To make their assessments credible and effective they had better adhere with some of the above listed best practices. Moreover, they must make sure that they clearly define the project’s objectives and goals and that they develop a realistic budget. Also, they need to select and establish proper performance metrics, while at the same time managing risks associated with monetary estimations and the factoring of intangible benefits. These best practices can greatly improve the effectiveness of their managerial decisions and increase the likelihood of delivering a technology project with the desired financial outcomes.
I admire your piece of work, thanks for all the great articles.
https://www.smortergiremal.com/