ROI Classis (2002)

The tried-and-true formulas for determining whether a software
project is worth doing? All are nearly meaningless if you’ve done a
bad job of predicting the benefit numbers that you plug into them.

+ Internal Rate of Return (IRR) The equivalent of the interest rate you could expect to receive if you took the software project money and invested it in something else, like a Treasury Bill, for example. Some companies like to figure their IRR minimum based on their own cost of capital and the minimum percentage return they’d like to see from the investments they make. If you’re going to take on the risk and trouble of doing a technology project, for example, you may want to set your IRR relatively high—at 15 percent, maybe. This becomes the discount rate that you plug into your NPV calculations.

+ Net Present Value (NPV) The most-favored formula among finance people, NPV is valuable for ranking one project against another. The main problem with NPV is that it doesn’t tell you when you will see benefits. For that you need to calculate payback time. NPV’s main components are the discount rate (DR), which is the interest rate you decide you could get if you invested the project budget elsewhere (since you really want IT to prove its mettle you decide to peg it at 15 percent—see “Internal Rate of Return,” above); benefits for each year (B1, B2 and so on); and project costs (PC). Let’s say your software project will cost \$15,000 and that you expect to resell it to another company at the end of five years for \$5,000. You expect the software to net \$3,500 in benefits per year. The NPV of the project is \$1,351. Generally, anything above zero is worth doing. Do the same calculation for other potential projects and prioritize them according to their NPV. Here’s the math:

NPV = PC + B1 / (1 + DR) + B2 / (1 + DR)2 + B3 / (1 + DR)3 + B4 / (1 + DR)4 + B5 / (1 + DR)5

+ Payback Period A critical calculation in these times of fast-changing technologies, payback period is simply the point at which you expect the yearly benefits of the project to cover the costs (see “NPV,” above).

+ Total Cost of Ownership (TCO) The cost component of the NPV equation, the total cost over time of buying, installing and maintaining software. TCO is good to know, but when used in isolation it can drive you to seek the lowest cost solution.