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Financial Analysis of IT Projects Using NPV, Payback Period, IRR and Others

February 22, 2018

This week, I’ll finish this brief series on financial analysis of IT projects by writing about the usefulness of other financial tools like payback period, internal rate of return and net present value. I’ll also get into total cost of ownership, base-case analysis and intangible or soft measures.

ROI Is One of Many Measures   

As I discussed last week, return on investment (ROI) analysis is one of a number of ways to measure the financial impact of a proposed IT project. ROI analysis is a well-established practice that is frequently discussed. ROI is often used as one of a series of measures used concurrently, in fact, you could think of ROI analysis as the category of analysis that contains:

•    Net Present Value (NPV), which is the value of future benefits in present dollar value. For example, $10,229.
•    Payback Period, which is the time is takes the project benefits to repay the cost of the project. For example, two years.
•    Internal rate of return (IRR), which is the benefits of the project expressed as an interest rate. For example, 41 percent.

Tools Available to Quickly Perform Calculations

To calculate the NPV, payback period and IRR in the examples above, I used a simple tool like the one made available from Setpoint Systems. The tool requires four input estimates: cost, benefit, years and interest rate (see  below):

Estimated equipment cost: $10,000.00
Annual benefit: $5,000.00
Number of years in production: 5.00
Annual minimum interest rate: 7.50%

Using those inputs, the tool calculated the three important financial measures:

NPV: $10,229.42  
Payback, in years: 2.00 years  
IRR: 41.05%  

The results are so strong and timely that this type of project would be easy to get approved.

The Non-Financial ROI of IT Projects
In addition to the financial ROI measures discussed, it is useful to list and discuss the non-financial or soft benefits of a project. For example, a modernization project that seeks to deploy Java will likely address challenges like the difficulties of finding COBOL programmers as Java programmers are now more plentiful and less likely to age out of the work force in the next five or ten years.

Total Cost of Ownership and Base-Case Analysis

In last week's IT Trendz, I wrote that ROI analysis is sometime used to quickly justify IT projects. Total cost of ownership (TCO) is often used in the same way. Like ROI, TCO can be quick and simple or deep and detailed. A quick and simple example is the IBM LinuxONE TCO Calculator. By answering a few questions about hardware, workload type and software, the LinuxONE TCO calculator provides a high-level TCO assessment based on your answers and industry-proven assumptions.

If the IBM LinuxONE TCO calculator is quick and simple then base case analysis is at the other extreme. Base case analysis can be very specialized, for example if a company is considering outsourcing their IT operation, base case analysis would be performed to establish current costs as well as to present the cost saving for years one to five of the proposed contract. As you can imagine, this would be a highly detailed worksheet requiring specialized skill and experience to develop.

The Business Case for Complex IT Projects 
When you use simple tools to create ROI analysis, you quickly realize that they are not so useful for complex projects. For example, if the project is for the development of a revenue-generating IT service then the analysis must include revenue projections. These projections should come from leaders in the countries that are committing to sell the service that generates the revenue. In these situations, the simple tools become part of a larger set of questions and processes needed to develop a sound business case for this complex project.

What’s Next?

Next week, I’ll start a new series on computer security. My focus will be on today’s threats and solutions to the many challenges that face individuals and companies.  

Posted February 22, 2018 | Permalink

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