As the late 1990s came to a close, many companies had invested heavily in the Internet, e-business, and information technology. As the technology bubble burst in 2000 many executives were asking, “Where is the return on investment?” When capital to invest is scarce new e-business and information technology (IT) projects must show a good return on investment (ROI) in order to be funded. This chapter will give the reader the key concepts necessary to understand and calculate ROI for e-business and IT projects. In addition, the limitations of calculating ROI, best practices for incorporating uncertainty and risk into ROI analysis, and the role ROI plays in synchronizing IT investments with corporate strategy will be discussed.
THE INFORMATION PARADOX
The greatest increases in productivity have historically been associated with “general-purpose technologies.” Examples are the steam engine and the electric motor. These inventions were applied in a variety of ways to revolutionize production processes. One would expect that computers and the Internet because they are also general-purpose technologies, should dramatically increase productivity.
REVIEW OF BASIC FINANCE
In this section, we review the basic finance necessary to calculate ROI. The key concepts are the time value of money and the internal rate of return (IRR). For a complete introduction to corporate finance see Brealey and Myers (1996). In the following section, a general framework is given for ROI analysis, and the ROI is calculated for a case example e-business project. The reader should note that ROI analysis for e-business investments and IT is in principle no different from ROI analysis for other firm investments such as plant and equipment, research and development, and marketing projects. All use the same financial tools and metrics and follow the general framework discussed in the next section.
The Time Value of Money
As an example, consider two e-business investments. Assume that both projects cost the same, but the first (Project 1) will have new revenue or cost-saving benefits of $5 million (M) each year for the next five years, and the second (Project 2) will have benefits of $11 M at the end of the first and second years, and nothing after that. If we only have enough capital to fund one project, which of these e-business projects is worth the most cash benefit today?
We might argue that the first investment’s cash flows are worth $5 M times five years, which is $25 M, and the second project’s payouts are $11 M times two years, or $22 M. From a purely financial perspective, assuming all other factors are equal, we would conclude by this reasoning that we should invest in the first project instead of the second. However, intuitively we know that $1 today is worth more than $1 in the future—this is the “time value of money.” The dollar today is worth more because it can be invested immediately to start earning interest. So just adding the cash flows ignores the fact that $5 M received today has more value than $5 M received five years from now.
CALCULATING ROI FOR AN E-BUSINESS PROJECT
The overall process of calculating IRR for a new project business case is straightforward. The first step is to calculate the base case revenue and costs expected in the future if the business continues as it is now. The next step is to calculate the net cash flows with the new proposed project; this includes total revenue, potential cost savings, and all costs of the project. Finally, the base case cash flows are subtracted from the projected cash flows with the new project. The results of these subtractions are called the incremental cash flows for the project. The IRR is then calculated from these incremental cash flows. An equivalent approach is to calculate the additional benefits of the project directly to obtain the incremental cash flows.
Incorporating the E-business Project
The Web portal case example has two primary business objectives:
(1) Enable self-service order entry by customers, thus reducing costs, and
(2) Enable access into a broader market for customers, potentially increasing revenues. In addition to these business goals, the Web portal has strategic value, because in the electronic components manufacturing industry a Web portal is becoming a requirement for conducting business.
The author gratefully acknowledges Sandeep Shah for his help preparing the manuscript and the ROI analysis with Monte Carlo simulations. He also thanks Professor Robert Sweeney at Wright State University and Joe Norton of the Norton Solutions Group for useful discussions.