Operating Figures, Return on Investment (ROI)

Software Investments: The ROI as Decision Support (Part 1)


Investing in new software solutions often results in heavy costs—especially if the implementation of an ERP or a Business Intelligence system is considered. You do not face expenses only in the initial booster phase but also in later stages, like integration, operation, maintenance, support or further developments of the software.

The main reason for a company to invest personal, temporal, and especially financial resources in new software is to enhance its productivity and realize potential savings in the medium and long terms. The status quo is often characterized by ineffectively used legacy systems as well as expanded process structures. This makes the examination and evaluation of economically more viable software alternatives a pure necessity.

But compared with the general procedure a decade or just a few years ago, IT budgets today tend to be smaller, at least in parts, and are subject to a painstaking and ongoing scrutiny. Therefore, the questions of whether the potential software investment shows signs of profitability, and if so when, come to the fore.

 
The return on investment as an evaluation parameter
The return on investment (abbr.: ROI) is a business ratio and model to measure profitability. It quantifies the return of a (software) investment compared with the capital invested (earned profit / employed capital). So, it makes a statement on whether the specific funds can be used in a cost-effective manner, and if so how, and thus, tries to minimize the investment risk.

While the initial costs of a software investment can by way of comparison be measured relatively easily, the quantification of its value (that is, the outcomes that flow from using the software) to an organization is a harder task. Generated value inflows—for example, an increase in staff or customer satisfaction, quality improvements in services, cumulative orders or abolished sources of error in processes—have to be calculated using estimated variables to some extent.

That is, for sure, one of the main disadvantages of the ROI concept. Nevertheless, it should not be a reason to banish ROI and only trust some kind of “gut instinct” when making an investment decision. To quantify the value of software based on estimated variables coincidentally means that you have to reckon with some inaccuracies of estimate and margins of error, which means that the ROI cannot provide an ultimate answer to the question, “Invest or disinvest?” However, especially in cases of a multitude of investment alternatives, ROI offers a reasonable decision support and a chance to prioritize, which lays the groundwork for any ongoing decision process.

Usually, software suppliers tend to promise quick returns and amortization, which means high-margin positive ROIs if an investment is made in their specific product. The ROI calculation models provided shall further emphasize these statements. Yet, those models are quite often based on too approximate, rigid and escapist basic assumptions that do not sufficiently match practical experiences and requirements. Hence, companies performing software selection processes are well advised to deal intensively with business ratios like ROI on their own and develop as well as adopt customized calculation methods correlating with their practical needs.

In the following sections, we will introduce in detail the application of an ROI calculation concept, which has been adjusted for specific risk factors. Furthermore, we will show how this helps you prioritize the implementation of several software projects in your company, depending on their individual ROI performance.

 
General calculation of an ROI adjusted for risk components

Step 1: Evaluating the value of a software investment
Buying software creates value inflows that arise from using it after its implementation; otherwise, you could confidently dismiss those thoughts of making the investment. Generally, value is generated by either increasing both financial and non-financial positive effects (e.g., gains in returns, market shares, production capacity, employee motivation, and reputation) or reducing negative influences on the company’s business (decreases in costs, processing time, training requirements, administrative expenses, etc.).

Examples of potential value inflows from a software investment:

Each value inflow needs to be quantified (estimation of a yearly accrued value outcome). Normally, a software project will not result in all the benefits described above, but only contribute to some of the positive effects. For example, a new order tool is planned to be bought because the software currently used is no longer enhanced and supported by its supplier. So, the main value of a software acquisition can be seen in the ensuring of both continuity and sustainability of the ordering and stockholding procedures within the organization; other effects are only secondary.

While evaluating the value of specific software, it is necessary to keep multiplier (or synergy) effects in mind. Can the implementation of new software in Department A also have a positive impact on other departments/divisions? Or will it enhance the value of already existing software applications in general? For example, can a new helpdesk program dedicated to external customer support also be used for the internal IT support and thereby generate benefits?

The expected useful life of software after its implementation—that is, the time for which it generates value inflows—plays an important role while estimating its value because software markets are usually fast-paced. Some software might already be outdated and no longer match internal requirements after three to five years, which makes a replacement investment necessary.

A reasonable indication of software’s useful life is the time required for its rollout. The implementation phase usually comprises installation and configuration, system checks and integration, tests relating to user acceptance and guidance, launching/extending an internal support and administrator team as well as the training of end-users.

It is more likely that software with a shorter rollout stage will get replaced sooner than one that needs a longer time to be operational. The longer the implementation process, the more the financial, temporal and personal resources required, which potentially leads to more intense disruptions in day-to-day business. So, in the end, you will think twice about replacing software if you have already suffered stretched rollout phases. Examples:

  • Smaller software applications (implementation lasting one to three months) have a useful life of three to five years after their rollout
  • Major ERP or Business Intelligence solutions (rollout period up to one year and longer) can be expected to be used for five to ten years

The sum of all quantified annual benefits, including multiplier effects, multiplied by the software’s expected useful life will give you the gross value of your potential software investment.

Gross value = (total value of benefits incl. multiplier effects) * useful life

 
Continued in Part 2:
Software Investments: The ROI as Decision Support (Part 2)

  • General calculation of an ROI adjusted for risk components—
    Step 2: Reducing the estimated gross value by risk components
    Step 3: Calculating ROI
  • Simplified ROI sample calculation

 
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Karsten

Karsten

Being a management accountant himself, Karsten has worked in the discipline of management accounting for various companies in different roles, and in both national and international contexts. He holds a Master’s degree in Business Administration from the University Mainz, Germany. Currently, he lives near Frankfurt, Germany, and works as a management accountant for a company group that specializes in waste management and recycling. For further information, you can visit his LinkedIn profile given below.

http://www.linkedin.com/in/karstenbauer


About this blog
Must-read blog posts about management accounting and financial control—classical topics, as well as modern subjects, latest trends, and current challenges in the management accounting discipline. Aimed to inform, inspire, and entertain management accountants and anyone with a deeper interest in management accounting.
Karsten
Filed under: Operating Figures, Return on Investment (ROI)

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Being a management accountant himself, Karsten has worked in the discipline of management accounting for various companies in different roles, and in both national and international contexts. He holds a Master’s degree in Business Administration from the University Mainz, Germany. Currently, he lives near Frankfurt, Germany, and works as a management accountant for a company group that specializes in waste management and recycling. For further information, you can visit his LinkedIn profile given below. http://www.linkedin.com/in/karstenbauer About this blog Must-read blog posts about management accounting and financial control—classical topics, as well as modern subjects, latest trends, and current challenges in the management accounting discipline. Aimed to inform, inspire, and entertain management accountants and anyone with a deeper interest in management accounting.