Tag Archives: internal rate of return

Should You Quantify IT’s ROI? (Part 1)

What is a quantitative business case for an IT investment? It is a quantifiable measure of benefit, in dollars, that can be realized by making a quantified investment of resources. While resources can be capital, human, intellectual property, etc., in the end it can all be reduced to money. What money is one putting in and what return is one getting out as a result?

Making the quantitative case is a long- practiced ritual in many insurance organizations. I may be committing heresy by asserting that the quantitative case is much overrated, doesn’t serve the purpose it was intended for very well and may, in fact, be an exercise in futility. I’m not making a general statement: I’m speaking about various IT modernization or transformation initiatives in the insurance industry, which I work in and serve.

I took enough corporate accounting and finance courses to qualify as a finance major and as a result am familiar with the mechanics of discounted cash flow analysis, valuation of initiatives, calculations of NPV, IRR, payback, etc., etc. While the theory of the quantitative approach has always seemed compelling, 20 years of practice has taught me the reality and informed my views very differently.

Why, then, is the quantitative case typically so favored? There are two primary reasons. First, quantifying helps with understanding the return on investment for any individual undertaking. Second, and perhaps more important, when many initiatives vie for scarce capital, quantitative cases can allow for comparisons. And in most organizations, one of the most important responsibilities of an executive team is to allocate capital to the most beneficial initiatives.

All this sounds quite straightforward. What, then, is the problem with the quantitative case, especially for initiatives that require big capital expenditures? The problem is not with the mechanics of quantifying. Once the investment and income streams over a reasonably desired time horizon are identified, weighted average cost of capital (WACC), discounted cash flow (DCF), net present value (NPV) and internal rate of return (IRR) sorts of metrics are quite mechanical to calculate. The real problem with so-called insurance modernization or transformation initiatives is with establishing the variables of investment stream, income stream and time.

There are two ways to try to establish these three variables. First, if one can precisely establish the required investments and expected returns over a period. If I know that I have to travel 300 miles and know that I will drive 75 mph, I can mathematically say that I will complete my travel in four hours. Second, if a vast body of empirical evidence exists, then one can at least probabilistically try to establish the three variables with associated confidence levels.

But I would argue that with initiatives in the insurance industry that require large capital-expenditures, neither approach works.

With insurance industry initiatives, quantifying income returns, investments and time period with precision is extremely difficult, if not impossible. On the investments front, projecting increase in premiums and profits, cost savings through headcount reductions and other items and cost avoidance are all an exercise in sheer guesswork. Estimating the costs and timelines of large technology projects also remains elusive. No matter how diligently and hard people work to identify these, the estimates end up being wrong–often, not by some tolerable deviation but rather by orders of magnitude in overruns in costs and time.

Because the vast body of insurance initiatives suffers the same fate, there isn’t reliable empirical evidence to probabilistically establish income, investments and time period with any degree of confidence. And there are other variables that further undermine the attempts at calculations – differential in resources and execution approaches from one initiative to the other, culture of organizations, market changes, technology changes, and much more.

Despite the problems associated with the quantitative business case, most organizations still pursue it. Internal teams work on project portfolios and appropriation of funding exercises. Vendors are always at hand to help the teams develop the business case to sell it to the C-Suite and the board. Within the organization, committees and councils are established to review the “case,” “wisely adjudicate” and pick “winners” and “losers” among candidate initiatives. All these various constituents are well-intentioned and are following the rules of the game. The problem is with the current “rules of the game” and not with those who play.

Are there alternative approaches, then, both to decide whether to fund a given initiative and, once funded, to determine how best to use the funding to ensure that an initiative is yielding benefits? In several instances, I have been fortunate to witness bold leaders abandon the traditional method and take a more pragmatic approach. I’ll discuss this in Part II.