Does 'return on investment' hold any real meaning?

Return on investment - ROI - used to be a simple way of measuring how soon new IT would start to pay for itself; now it's become a headline metric for contract negotiations. But has its value been squeezed too far?

ROI - return on investment - is an acronym that looms large in the IT lexicon, but try to pin down a standard definition for it, and you'll soon be foxed. The principle reason why it is so hard to define is because the term's meaning changes broadly, depending on the project and the clients' needs.

Its multiple definitions do not stop the term from being bandied around, however, and in erratic economic conditions it is important that IT professionals who may be engaged in negotiation with vendors or integrators are familiar with them. According to Phil Loughlin, customer solutions architect at IT management company CA, ROI is considered to be the 'acceptable' return on investment; but then, what defines acceptable?

"From a vendor point of view there are a number of ROI tools and methodologies that are adopted; however, from an accounting perspective, the key to the success of ROI is in choosing an appropriate accounting methodology," says Loughlin. "Should this be net present value (NPV), internal rate of return (IRR), or payback period? Each has its limitations.

"Whichever methodology is used it is very important to always verify the results. Verifying results is about validating whether the cost assumptions were accurate to confirm if the expected benefits were actually realised."

Loughlin adds: "It really does vary, but the most common factors in the process are cost and time. Many customers may just look for the cheapest possible option, but this might not give them the full ROI they are seeking matched to their own corporate objectives and IT strategy." The ROI should essentially be about balancing the value of the IT investment and what level the organisation is prepared to invest in, he avers.

ROI measurement

ROI is often measured using a mixture of tangible and intangible factors. Larger organisations are able to see financial returns much more clearly, and can devise an ROI focused on cost savings, etc; but for smaller IT departments, such as Malcolm Burrows' team at petfood brand Butchers Pet Care, the focus is on building relationships.

"Our ROI is the relationship we have with the vendors to do the small things later on, such as maintenance and support," Burrows explains.

"I've had contact with other companies where the milestone has been on money saved, but you tend to find these IT departments are very large. As we have a small department we look to pull in support and advice from externals. Because we have these relationships, the information comes from them rather than having to pay a consultant to come in."

Intangibles may be important to some organisations; however, the changing economy is creating a move towards a 'hard', quantifiable, cost-based ROI outlook.

"ROI is nowadays being measured purely in cost management and reduction terms," says Colin Rowland, vice president of EMEA operations at OpTier. "It is not uncommon for customers to say to us that for every pound they spend they want to see a saving of two in the next 12 months."

Indeed, vendors are seeing more pressure to offer returns, and quickly. In some cases expectations are beginning to verge on the unrealistic, according to some anecdotage.

"From a customer perspective we are seeing more conversations about ROI than ever before, and the reality is that customers are expecting a lot more from their IT investment," reports CA's Phil Loughlin.

"There is a huge pressure on IT costs, and every cost incurred has to be justified by the customers IT department with help from the vendor."

In terms of payback, CA is also seeing pressures on faster benefits realisation, such that if a payback will not occur until year three, it is becoming more unlikely that an investment will be made: "We are seeing customers expecting paybacks as soon as 12-to-18 months," Loughlin admits, "and these expectations are, in some cases, unrealistic."

ROI payback metrics

IBM site and facilities business executive Andrew Brown has certainly seen the ROI models for data centres ramped-up in regards to payback. "It has accelerated over the last 18 months or so, such that we have to build an ROI model that would give the client real-term benefits within 12 months - or at the absolute maximum 18," he says. "I think we're not far off unrealistic [requests] now, to be honest. I think the most aggressive you can get is a nine to 12 month [payback] framework, and I don't think we're a million miles off that. Could they get more aggressive? I doubt it. If they do we're going to have to go and find something really quite innovative."

ROI is increasingly being used as a means to negotiate better deals with vendors. As Rowland puts it, "they don't have time for hot young start-ups talking about how they can plug a gap in the IT infrastructure with their 'fabulous' new product". Vendors need to establish the business case up front, and that is ROI.

Senior people don't sign-off on great ideas, they sign on the dotted line for cost savings or a real measurable impact on revenue.

Contract negotiation

Negotiations, meanwhile, are tougher than ever, with many vendors coming up against new levels of scrutiny. Additional levels of detail are now required of them, and many believe even when budgets improve, this new approach to negotiating will remain. With such tough expect-ations, some IT professionals believe that vendors may potentially be agreeing to things they cannot directly provide.

"A lot of the vendors supplying companies aren't admitting that they can't do something, and are having to pull in a third party to supply what has been required," Butchers Pet Care's Burrows believes. But what happens if these ROI commitments cannot ultimately be met? Are there payback penalties involved? This is often an assumption, but in practice it is not the case; however, there are many other considerations to fear, as Howard Frear, sales and marketing manager of Easy Software highlights.

"Unless you are contracting to some performance/reward-based agreement, then there is typically no penalty paid by the supplier in terms of non-performance," he says. "This doesn't mean, however, that there is no medium-to-long-term penalty in terms of loss of business reputation, cancellation, or non-renewal of maintenance contracts."

Aside from these concerns, it appears that the IT sector is moving more toward a risk/reward environment, where more contracts are being signed that agree to full payment on client approval. A percentage of the final remuneration is held back until the contracted project is delivered in its entirety. Once the client is confident it will, or have got its ROI, then the final payment is made. This means that markers and quantifiable ROI definitions are laid out in the contracts.

These agreements have been commonplace to the sector for a long time, with on average 10-20 per cent of the payment held back until completion. However, some organisations believe that the skew of the apportionment of those final charges may be increased by clients, in line with the rise of ROI's importance in negotiations. Even with talk of ROI at the negotiation stage, many organisations are not verifying returns once work has been undertaken; very rarely, if ever, are vendors not receiving full payment. So is ROI simply a negotiating tool, or does it have real meaning?

"ROI is a throwaway catchphrase," according to Burrows. "In reality, most companies probably only hit 75-80 per cent of ROI. If you're a large corporate it's easier to state what your ROI will be; but does anybody go back and calculate whether that has been achieved?" Burrows suspects not.

"ROI tends to be discussed at the front of a project, but never at the end. It is your justification for doing something rather than the reality of achieving something," he continues. "For us, if the project has gone in, users are using the software and systems OK, and it's been implemented in a reasonable timescale, and we haven't overspent our budget, [then] as far as we are concerned it is a well done, completed project."

Both definitions and views on ROI are fractured, some companies verifying and validating results and others content with project completion. But wherever you stand in the debate, it is clear that ROI's bargaining role in contract negotiations is here to stay.

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