Mark Jeffery, Northwestern University Introduction The Information Paradox Review of Basic Finance The Time Value of Money ROI, Internal Rate of Return (IRR), and Payback Period Calculating ROI for an E-business Project Base Case Incorporating the E-business Project Incremental Cash Flows and IRR Uncertainty, Risk, and ROI Uncertainty Sensitivity Analysis 1 2 4 4 6 6 7 8 10 11 11 11 Project and Technology Risks Monte Carlo Analysis Applied to ROI Executive Insights The Important Questions to Ask When Reviewing an ROI Analysis A Framework for Synchronizing e-Business Investments With Corporate Strategy Beyond ROI: Trends for the Future Acknowledgments Glossary Cross References References 12 13 14 14 14 16 17 17 17 17
As the late 1990s came to a close, many companies had invested heavily in 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. What is ROI? One conceptual deﬁnition is that ROI is a project’s net output (cost savings and/or new revenue that results from a project less the total project costs), divided by the project’s total inputs (total costs), and expressed as a percentage. The inputs are all of the project costs such as hardware, software, programmers’ time, external consultants, and training. Therefore if a project has an ROI of 100%, from this deﬁnition the cash beneﬁts out of the project will be twice as great as the original investment. (In the section Review of Basic Finance we will discuss how this deﬁnition of ROI, although qualitatively correct, does not accurately include the time value of money, and we will give a more accurate deﬁnition based upon internal rate of return [IRR].) Should a manager invest a company’s money in an e-business project if it has a projected ROI of 100%? There are many factors one should consider when making an investment decision. These factors include, but are not limited to those listed below: The assumptions underlying the costs of the project. The assumptions underlying the potential beneﬁts.
The ability to measure and quantify the costs and beneﬁts. The risk that the project will not be completed on time and on budget and will not deliver the expected beneﬁts. The strategic context of the ﬁrm; that is, does the project ﬁt with the corporate strategy? The IT context of the project: that is, does the project align with the IT objectives of the ﬁrm, and how does it ﬁt within the portfolio of all IT investments made by the ﬁrm? As discussed in the section Review of Basic Finance, the simple deﬁnition of ROI given above is not rigorous enough for good investment decision-making. In addition, the assumptions underlying the model and risks associated with the IT project are key drivers of uncertainty in any ROI analysis. Awareness of these uncertainties and the impact of risks on ROI can signiﬁcantly improve the likelihood of successful investment decisions. The return on investment for corporate information technology investments has been the subject of considerable research in the last decade. (For reviews see Brynjolfsson & Hitt, 1998; Dehning & Richardson, 2002; Strassmann, 1990.) The most recent research suggests that investing in IT does on average produce signiﬁcant returns (Brynjolfsson & Hitt, 1996). See the next section, The Information Paradox, for a discussion of this research. Jeffery and Leliveld...