Operating Figures, Return on Investment (ROI)

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


Software projects bind great financial and temporal capacities, and center questions around their profitability and general provision of benefits. The (risk-adjusted) return on investment (abbr.: ROI) provides support to the evaluation of cost-effectiveness and the prioritization of multiple software alternatives.

In Part 1 of this topic, we introduced the concept of ROI as an evaluation parameter in general and started with extending ROI to a risk-adjusted model. Part 2 goes on with that and closes with a simplified sample calculation of ROI.

 
General calculation of an ROI adjusted for risk components

Step 1: Evaluating the value of a software investment
See Part 1:
Software Investments: The ROI as Decision Support (Part 1)

 
Step 2: Reducing the estimated gross value by risk components
In terms of a conservative and realistic estimate, we adjust the software investment’s gross value for the potential risks involved. These include risks based on internal estimation errors (e.g., overassessment of benefits) as well as those emerging from the project’s failing or achieving of only a fraction of the expected ROI. Accounting for these risks is the main impact of Step 2 described in the following section.

Optimism regarding a project’s successful progress is definitely important—especially at the kick-off stage—to motivate its participants. But the phenomenon of numerous project teams is a disproportionate optimism as the project goes on further (also called optimism bias). On the one hand, this behavior happens unconsciously as some kind of natural “project blindness” prevails, blending out or underestimating risks and problems.

On the other, it is also based on conscious decisions. In terms of a project’s public relations, problems occurring in its progress often also cast a negative light on its participants (justified or not)—a circumstance that project teams normally seek to avoid. As a consequence, project advancements and prospects that are reported to company staff not participating in the project are described in an exaggeratedly positive way. If the worst comes to the worst, such behavior might even result in the pursuance of unprofitable, too risky and foredoomed projects despite better knowledge—instead of drawing a definitive line and turning towards more lucrative project initiatives.

Though projects have been described in general so far, the above-mentioned points are also valid for a specific software-selection project. For example, it could possibly happen that the benefits that flow from using the software (its gross value) are estimated too optimistically—consciously or unconsciously.

Besides, one always has to take into account that the potential software investment needs to be considered in a much bigger context: if enterprise software is bought, it is usually done in the context of a larger project. The software generates value inflows, but both amount and the probability of occurrence depend on other non-project-related variables and external successes. That means, for example, an improvement of operational efficiency and business processes in general, the commitment of different departmental units, training programs for staff or the launch of new customer services.

So, you have to ask yourself what else, besides the specific software, is required to achieve overall value and success for your organization. Then, use your judgment to reduce the contribution of the software by an appropriate amount: for example, you might come to the conclusion that the software implementation itself contributes to the project’s total value inflows by only 70%.

In addition to the problems resulting from an overoptimistic estimation of the benefits of a software investment, each software selection or implementation project also has to face some generic risk factors, due to which it either fails completely or achieves the planned ROI only partially. A few reasons are:

  • Previously inadequate comparison of the internal requirements with the opportunities (or limits) the software features
  • An important employee in the software implementation process is leaving the company
  • During the rollout stage, newly accrued business processes, products or divisions cannot be adequately reproduced or edited with the software
  • Provided budgets are cut during the project’s course because the company is headed for hard economic times

These risk factors need to be quantified and decrease the software investment’s gross value—rather, the gross value multiplied by the expected likelihood that the project-related expectations will be fully met (<100%). For example, after using individual risk portfolios (segmenting the risks into different levels) in detail, you finally come to the conclusion that the software purchase could generate its planned ROI with an 80% chance.
 
After reducing the gross value by the effects of optimism bias as well as the generic risk factors, you get an estimate of the risk-adjusted value of the software investment.
 
Risk-adjusted value = gross value * optimism bias * generic risk factors

 
Step 3: Calculating ROI
To finally calculate the ROI, you have to estimate the total costs of using the software over the course of its expected useful life (total cost of ownership, or TCO). The TCO figure comprises full costs, which means not only costs of purchase or license fees, but also yearly expenses for service and maintenance, training and support, software modification and implementation, data storage and hosting, the adding of additional modules and functions as well as the resolving of disruptions and bugs.

The ROI can now be calculated by using the following formula:

ROI = (risk-adjusted value / total cost of ownership  -1) * 100%

Software projects with a weak and only marginal ROI do not tend to be pursued further; they face the most severe risk of being canceled before being fully completed. The first compelling indication for making the software investment is when the ROI has been estimated on a conservative and risk-adjusted basis, and yet, the project turns out to be very positive and worth undertaking. If you have to choose from several possible software purchases—all of them rated with a benefiting ROI—you can easily prioritize them based on their maximum value for your organization.

 
Brief and simplified sample calculation
Suppose ABC Machinery Ltd., a medium-sized manufacturer of machinery and vehicles, is planning to buy a new customer relationship management (CRM) system that optimizes its existing customer service.

ABC expects the new CRM software to diminish its sales team’s administrative expense considerably. Because of full order books and positive economic prospects, ABC does not plan to lay off parts of the sales staff but aims to intensify proper sales activities as well as customer contact and acquisition.

Based on conservative estimates, the reduced administration efforts might lead to an effective outcome of two additional salespersons, who can use their capacities completely for operational business and order acquisitions. Besides revenue from existing contracts, each full-time sales team member averages $5 million revenue per year from new orders.
Value inflow A of a new CRM software = additional operational salesforce headcount (+2) = $5 million * 2 = $10 million

Furthermore, better information management and reporting tools being implemented in the CRM software itself could, as being reckoned, result in direct competitive advantages by giving the chance to react on prospects, problems and risks in ABC’s markets much faster and more effectively. The sales management is currently rating that potential with an additional value of about $2 million per year.
Value inflow B = $2 million

Total value of benefits = $10 + $2 = $12 million

In addition, the new CRM solution has been planned to be integrated into the customer care program that the key account management department already uses. Multiplier or synergy effects arising from enhancements in customer satisfaction and a reduction of customer churn amount to—according to an internal ABC estimate—yearly potential benefits of about $3 million.
Multiplier effects = $3 million

The implementation process is expected to take about half a year. Furthermore, ABC reckons that the useful life of this software investment will last for about six years before the application no longer fulfills external requirements of the competitive environment.
Expected useful life = 6 years

Gross value of the investment = ($10 + $2 + $3 million) * 6 years = $90 million

The calculated value of the CRM software still reflects a valuation that is somewhat too optimistic because the sales program’s success also depends on external project influences and measures. Having discussed this issue intensively at the management level, ABC estimates that implementing the CRM software will only increase efficiency and overall success by 65%; the remaining 35% will result, for example, from general (non-software-related) training courses for marketing and customer care staff.
Optimism bias = 65%

By using risk portfolios, ABC also determines generic project risks as well as their amount and incidence rate. The likeliness to achieve an entire project success and planned ROI figures is estimated to reach 80%.
Generic risk factors = 80%

Risk adjusted value = $90 million * 65% * 80% = $46.8 million
The risk-adjusted value resulting from a newly implemented CRM system amounts to $47 million.

In the next step, ABC calculates the CRM’s total cost of ownership (TCO), which means overall costs of using the software for an expected useful life of six years. In total (costs of purchase, maintenance, support, etc.), the TCO amounts to about $6.4 million.
Total cost of ownership = $6.4 million

Finally, the ROI of the CRM software investment now can be calculated:
ROI = ($46.8 million / $6.4 million -1) * 100% = 631%

So, the average ROI per year over the useful life = 631% / 6 years = 105%

 
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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.