Three Must-Know Financial Tools for Effective Decision Making

As IT professionals, we are faced with many challenges in the course of carrying out our responsibilities. Some of these challenges may have to do with making decisions about significant investments in support systems, tools, headcount, or even key process changes. You may need to decide:

• Should I remain with the status quo or implement a new service management system (SMS)?
• If I implement a new SMS, which vendor’s system should I choose? 
• Is it worthwhile for us to implement a knowledge management process along with a supporting system?
• Should I invest in remote access tool A, B, or C?
• Is it wise for me to consolidate our multiple help desks to a centralized service desk, or should we remain decentralized?

These decisions require careful consideration so that risks and costs can be minimized and benefits can be assured and maximized. In addition, your career and future advancement in the organization may at times hinge on making the right decision that leads to success! Using a business-case approach to decision making and utilizing the right steps and three must-know financial tools can help you identify the right course of action and the right decision.

These decisions require careful consideration so that risks and costs can be minimized.

Why Take a Business-Case Approach?

What is a business case? Very simply, it’s a written justification for a significant amount of investment or a decision support tool. The idea is that when you have a new tool, support system, software application, or anything that requires capital investment over a certain threshold, you should have a written business case to tell you why you should make that investment. A business-case approach includes a simple process and a template for writing up the justification and typically includes five sections:

1. An overview of the proposal (the system, tool, application, etc.).
2. Limiting factors/constraints. The time frame that must be adhered to for this proposal to work, or the regulations that you must be comply with, for example.
3. The financial and non-financial anticipated impact to the organization. This is where the three must-know tools come into play, to help justify the proposal from a financial and non-financial standpoint, to illustrate financial impact:
4. Total cost of ownership (TCO)
5. A cost/benefit analysis (CBA)
6. Projected return on investment (ROI)
7. Risks and contingency plans.
8. A recommendation.

Using a business-case approach, along with a combination of the financial tools, will help you improve the quality of your decision. Let’s consider each of these financial tools in turn and then apply them to a common scenario many IT managers face from time-to-time: Is the investment in a new service management system justified?

Uncovering ALL the Costs: Total Cost of Ownership

TCO can be defined as an effort to identify all costs of owning and operating an asset over its expected useful life. Many times the cost of an asset—whether that be a support system, an IT tool, or piece of software—is not only the initial purchase cost, but also the ongoing cost of using and maintaining that asset throughout its useful life. Calculating and applying TCO to your decision-making process ensures that you account for all the associated costs of that asset over its expected life.

Note that there are also some challenges to using TCO. For example, the TCO calculation does NOT consider the benefits of various options—only on uncovering and understanding the total cost of each option being considered. It also does not include a calculation of return on investment of one option vs. another. TCO also does not provide insight into the timing of costs. For example, Product A, which may have a lower acquisition cost and high ongoing maintenance costs, is likely to be less attractive than Product B, which may have a higher acquisition cost, but lower ongoing maintenance costs. Yet both may have a similar TCO over the period analyzed!

TCO is only a general formula for calculating the total cost of ownership over the life of the asset, with a focus mainly on tangible assets. It offers no help for how to value intangible assets, nor does it provide any insight to the relative risk of options being considered. Companies that rely solely on TCO end up following a strategy that minimizes expenditure rather than maximizes return! That is why TCO needs to be combined with CBA and a calculation of ROI for quality investment decisions!

Follow these steps to calculate TCO:

1. Employ a spreadsheet tool to organize your data
2. Gather ALL relevant costs. Gather costs on all types, including hardware, software, installation, and conversion; initial costs and ongoing costs over the life of the asset; both direct and indirect costs (direct costs are those chargeable directly to the project; indirect costs are those not tied directly to the project).
3. Fill in all the data into the TCO spreadsheet, including direct and indirect costs and first year and recurring costs over the useful life of the asset.
4. Use the tool to calculate the TCO over the useful life of the asset. Optionally, compare the TCO of this option with that of another option, and the TCO of the status quo.

Finally, determine which option has the lowest TCO over the life of the investment. This has now allowed you to identify the lowest cost option of the choices. Your next step is to use this information in a CBA exercise. This tool will factor in the costs that you have just identified and enable you to then identify the benefits—both tangible and intangible—associated with each option. As a result of using CBA with TCO, you will get a more complete picture of each option.

Weighing Costs vs. Benefits: Cost/Benefit Analysis

CBA is a relatively simple and widely used technique for deciding whether to make a change. You simply add up the value of the benefits of a course of action and subtract the costs associated with it. A CBA exercise estimates and totals up the equivalent monetary value of all of the benefits and costs of the proposal, to establish whether or not the proposal is worthwhile. The project might be a new software tool, a new service management system, or a project to plan to deploy a significant new process such as knowledge management. It doesn’t matter; a CBA can be used in all these cases to help determine whether or not the benefits outweigh the costs.

Note that costs for an investment might be initial with the purchase of the technology, or they may be ongoing. Benefits derived from the technology tool, system, or process are most often received over time. Since the value of benefits are received over time, you build this effect of time into your CBA analysis by calculating a payback period—the time it takes for the benefits of a change to repay its costs. Many companies look for payback on projects over a specified period of time (e.g., three years).

In carrying out a CBA, your objective is to assign a financial value to both tangible and intangible benefits. It’s easy to quantify most tangible benefits. For example, a reduction in labor costs (fewer headcount needed), or higher productivity equals more work with the same amount of staff. Intangible benefits must also be quantified as much as possible, but this is not always so easy. You might need to make assumptions to list intangible benefits in specific financial terms. As an example, let’s say your project should result in more satisfied employees. Does this improve productivity? Can you estimate by x% and quantify the impact of that change?

Follow these steps to carry out a CBA:

1. Establish a common unit of valuation ($). The most convenient common unit is money. This means that all benefits and costs should be measured in terms of their equivalent monetary value.
2. Identify the tangible and intangible costs. This is where the results of your TCO exercise come in.
3. Total the costs, based on the results of your TCO calculation—upfront and ongoing, direct and indirect.
4. Identify the benefits—tangible benefits (where it is easy to quantify the savings), as well as intangible benefits (assign values based on acceptable estimates, justifiable assumptions).
5. Total the value of benefits in year one and beyond.

Determine payback time: divide [costs] / [benefits]. The payback time is often known as the break-even point. Sometimes this is more important than the overall benefit a project can deliver, for example, because the organization has had to borrow to fund a new piece of machinery. You can determine the break-even point graphically by plotting costs and income on a graph of output quantity against $. Break-even occurs at the point the two lines cross. Inevitably the estimates of the benefit given by the new system are quite subjective.

Don’t Ignore the time value of money. For longer payback times, the time value of money should be factored in. A dollar five years from now is not worth the same as it is today! A dollar available now can be invested and earn interest for five years and would be worth more than a dollar tucked away for five years!

When the dollar value of benefits at some time in the future is multiplied by the discounted value of one dollar at that time in the future, the result is the discounted present value of that benefit of the project. The same thing applies to costs; future costs must be brought back to their net present value (Net Present Value = sum of the present value of the benefits less the present value of the costs).

Calculating the Bottom Line: Return on Investment

The third tool we will look at is an ROI calculation. The purpose of an ROI calculation is to compare the costs of a project (investment) with the projected value of its results to determine if the result is worth the cost. An ROI calculation can also be used to evaluate the value of one investment versus another.

ROI is normally expressed as a percentage. For example, a 25% annual ROI means that a $100 investment would return $25 on the initial investment in one year. A basic equation for calculating the ROI follows:

ROI = [(Payback - Investment)/Investment)]*100.

Investment relates to the amount of resources put into generating the given payback (time, money, etc.). Your payback is the total amount of money earned from your investment (savings, increased revenue-generating capability).

Managers often underestimate the amount of investment required. Hence ROI calculations can be skewed. A common mistake is not factoring in employee time required to implement the project (resources include money as well as human resources or time). Don’t under value time. Another mistake is not factoring in the cost of capital. A dollar today is not worth the same as it will be tomorrow! If the costs and benefits are to be realized beyond the first year of implementation, the present value (PV) of future costs and benefits needs to be calculated, using your organizations cost of capital.

Follow these steps to calculate ROI:

1. Determine the total amount of investment required—for example, all the resources, such as financial, people (time), etc.
2. Calculate the amount of return—savings, revenue, and productivity growth.
3. If calculating over time, calculate the PV of future costs and returns by your organization’s discounted cost of capital.
4. Calculate the ROI by dividing the return by the investment, and multiply by 100 to express as a percentage.

ROI can be expressed for different time periods: one year, one month, one week, one day. For example, if a $100 investment earns $150 after one month, then the ROI would be 50 percent monthly ($50 profit/return divided by $100 investment = 0.50, or 50 percent). Calculators and computer spreadsheet programs can be very useful in calculating ROI.

When comparing ROI for different investment opportunities, be sure all fees and expenses have been included to ensure a fair comparison. And, remember, one option is always to do nothing. Ensure you calculate this ROI! Be thorough. Include all factors: all investments required (people, time, money, etc.); opportunity costs—people not able to do their regular job due to being involved in a project; and all returns (savings realized, revenue enhancements, increased productivity, and employee and customer satisfaction).

Applying the Three Must-Know Tools to a Scenario

A support center manager is deciding whether to implement a new service management system. His department has been in set-up mode, with mostly new support associates. He is aware that with a more automated incident tracking system he will be able to handle calls more effectively and efficiently, with a higher level of quality and faster delivery.

Calculating the Total Cost of Ownership. Let's assume the useful life of the investment is three years. Be sure to calculate both direct and indirect costs.

New help desk computer equipment:  $36,200

• 10 network PCs with software @ $2,450 ea.: $24,500
• 1 server @ $3,500
• 3 printers @ $1,200 each: $3,600
• Cabling & Installation @ $4,600
• Maintenance included for first 12 months
• Ongoing maintenance costs after first year: $3,930/yr (x2 years = $7,860)

Software:  $15,000

• SMS Software, 10 user license @ $15,000 (includes first year support
• Ongoing support (Silver):  $2,700/year (x3 = $8,100)

Staff training costs:  $14,800

• Customer Service Skills, 10 people @ $400 each: $4,000
• Incident Management System, 12 people @ $900 each: $10,800

Other implementation costs:  $48,000

• Lost time: 40 person days @ $200 / day: $8,000
• Lost productivity through disruption estimate: $20,000
• Lost sales through service inefficiency during first month estimate: $20,000

Total costs (first year):  $114,000. Total Cost of Ownership (initial costs plus ongoing costs) amounts to $129,860 over three years.

But what are the benefits and the value to the organization? And what’s the payback time and return on investment (converting future returns in present dollars)?

Applying a Cost/Benefit Analysis.

Tangible Benefits (estimated annual tangible benefist = $180,000/year):

• Handle more work with same staff—savings: $40,000 / year. Improved average resolution time means more incidents with the same level of staff.
• Improved uptime through prevention—estimate: $20,000 / year. End users experience less down time, meaning higher productivity and cost savings.
• Improved efficiency and reliability of call handling—estimate: $50,000 / year. Fewer lost calls, better management end-to-end; fewer calls outstanding, lower backlog.
• Improved service and retention—estimate: $30,000 / year. Improved service levels means customers realizing value of services, more willing to pay, stay.
• Improved accuracy of information—estimate: $10,000 / year. No longer need to spend time correcting incident logs, following up on errors—time savings.
• More ability to support the sales effort—$30,000 / year. Customer support center cannot only handle internal calls now, but more effectively support the sales effort as well.

Intangible Benefits (no dollar amount assigned):

• Higher employee morale, resulting in higher productivity (we are not quantifying this in this example, but one could make assumptions based on industry practices).

Calculating the Payback Time (breakeven point):

• Total Benefits: $180,000/year
• Payback time:  $114,000 first year costs / $180,000 benefits = 0.63 of a year = approx. 8 months

Calculating the Projected Return on Investment

• Assumed discount rate (cost of capital) of 1.75%
• Total Cost of Ownership amount to $129,860 over three years, discounted to Present Value = $123,369.
• Benefits of $540,000 over three years discounted to Present Value = $512,614.
• NPV of three year Benefits vs. Costs:  $512,614 - $123,369 = $389,245.
• Projected ROI: $389,245/ $123,369 = 3.15551 * 100 = 315% ROI over three years!

Note: What is the appropriate discount rate to use for calculating the NPV of a project? Many companies use their weighted average cost of capital (WACC) if the project's risk profile is similar to that of the company. But if the project’s risk profile is substantially different from that of the company, the Capital Asset Pricing Model (CAPM) is often used to calculate a project-specific discount rate that more accurately reflects its risk.

Bottom line: Rapid payback of initial investment and high ROI over the life of the asset, with acceptable TCO. Although the estimates of the benefits given by the new system are subjective, the IT director is very likely to approve the proposal, given the short payback time and high ROI over the life of the asset.

Build a Stronger Business Cases with These Three Tools

Using a business-case approach, along with these three financial tools—TCO, CBA, and ROI—will help you minimize risk and costs through informed, higher quality decision making. You will also increase credibility with management and build stronger business cases, with increased chances for approval. You will be able to better align with business goals and support the vision and mission of the business, ensuring more successful business outcomes with your projects. And finally, you will be known as a good steward of investments in IT services.

Paul is the president and principal consultant of Optimal Connections LLC. With more than 30 years of experience in planning and managing technology services, Paul has held numerous positions in both support and management for companies such as Motorola, FileNet, and QAD. He is also experienced in service desk infrastructure development, support center consolidation, deployment of web portals and knowledge management systems, as well as service marketing strategy and activities. Currently Paul delivers a variety of services to IT organizations, including Support Center Analyst and Manager training, ITIL Foundation and Intermediate level training, Best-Practice Assessments, Support Center Audits, and general IT consulting. His degrees include a BA and an MBA. Paul is certified in most ITIL Intermediate levels and is a certified ITIL Expert. He is also on the HDI Faculty and trains for ITpreneurs, Global Knowledge, Phoenix TS, and other training organizations. For more about Paul, please visit www.optimalconnections.com.