IT Investment - Calculating the Value of an IT Investment

Using Financial Techniques to Justify the Aquisition of an IT Asset

Office desk with computer made from US dollar bills
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Justifying IT investments is a critical skill for anyone working in technology. While many IT investment decisions will be made by the leadership in the IT organization, often the proposals for new equipment or services will come from the IT staff. It's important to understand the terminology and basic techniques for making a case to invest in a new piece of equipment. It's one thing to ask to replace your help desk software.

You will likely hear, "we will look into that - blah blah blah". Alternatively, say something like "replacing our help desk software will save IT $35,000 a year and will pay for itself in 3 years", you will get a much more positive response from your IT management. I can assure you of that.

This article will give you the basic skills necessary to analyze and create a valuation for a proposed IT investment. You need to understand the basics before taking a deep dive in these financial techniques. Watch for future articles where I will provide more advanced analytical techniques for justifying an IT investment in equipment or service.

Basic IT Investment Analysis Terminology

Capital Expenditure (CAPEX): Capital is a term used to distinguish a purchase that has a useful life of more than a year. For example, when a company purchases a laptop for an employee, it is expected that the laptop will last for 3 or 4 years.

Accountants require this kind of IT investment to be expensed over that period instead of being expensed in the year it was purchased. A company typically has policies on the useful life of equipment as well as a minimum dollar amount for a capital expenditure. For example, a keyboard costing $50 would not be considered capital.

Depreciation: Depreciation is the method that is used to spread the expense of a capital IT investment over the useful life of the purchase. For example, assume that the accounting policy for capital uses straight line depreciation. This just means that the depreciation will be the same in every year. Let's say you buy a new server for $3,000 with an expected life of 3 years. Depreciation on that IT investment will be $1,000 each year for 3 years. That's depreciation.

Cash Flow: Cash flow is the movement of cash in and out of the business. You need to understand the difference between cash and non-cash items. Usually, cash is used when calculating the value of IT investments. Depreciation is a non-cash expense meaning that the underlying asset has already been paid for but you are spreading the expense over the life of the asset. The original purchase of the IT investment would be considered the cash outflow when doing financial analysis.

Discount Rate: This is a rate used in analysis to account for the fact that a dollar today is worth more then a dollar in 5 or 10 years. Using a discount rate in IT investment analysis is a method to state future dollars in terms of today's dollars.

The discount rate itself is the subject of many text books. If you need a highly accurate discount rate for your company, contact your accounting department. Otherwise we will use something like 10% which represents inflation and the rate a company might be able to earn on money not invested in your piece of IT equipment. It's kind of an opportunity cost.

IT Investment Analysis Techniques

There are many methods to help in evaluating IT investments (capital). It really depends on the kind of investment you are making and the maturity of the IT organization in evaluating capital purchases. The size of the organization can also play a role. But keep in mind this is something that doesn't take a lot of time and even if you work for a small to medium sized organization, this effort will be appreciated.

In this article, we will look at 2 simple IT investment techniques. I would encourage you to use both as together they tell a more complete picture of the value of the proposed IT investment.

  1. Net Present Value
  2. Payback Period

Net Present Value (NPV)

Net Present Value is a financial technique that lines up a series of cash flows over time and discounts each to the current period. Net Present Value takes into account the time value of money. It's typical to look at cash inflows and cash outflows over a 3 to 5 year period and discount the net inflow less the net outflow into a single value. If the number is positive, then the project would add value to the organization and if the NPV is negative, it would lower value of the organization. The real power of NPV analysis is when comparing alternative IT investments. NPV provides a relative value of IT investment scenarios and the one with the highest NPV is usually taken over the other alternatives.

The difficult part of the Net Present Value calculation is the actual numbers to use in the analysis. On the outflow side of the equation, you can use the total cost of the investment along with maintenance expenses and implementation costs. The inflow side can be more difficult to attain. If the IT investment generates incremental revenue, this is pretty straight forward and you can use these numbers in your analysis. When the inflows (or benefits) are on the soft side meaning that they are more subjective such as savings in time, it's much more difficult to estimate.

The best you can do is to document assumptions and go with your gut. Let's take an example where you make an IT investment in a help desk software package. The benefit of such an investment is time saved by IT staff and possibly increased satisfaction from the user community. If you are replacing an existing help desk software package, you might also save money in maintenance from that system. You need to break down the inflows and outflows in order to conduct a Net Present Value (NPV) analysis for your IT investment proposal.

Inflows: The inflows or benefits resulting from an IT investment can be subjective and less exact. Often times, the benefit of an IT investment is savings in time, client satisfaction or other "soft" numbers. Here are a few examples of inflows.

  • Saved maintenance costs from retired software
  • Time saved by IT staff because of increased efficiencies
  • Increased revenue

Outflows: Outflows are typically easier to estimate but some can be subjective as well. Here are a few examples of outflows.

  • Cost of the software (license fees, etc.)
  • Maintenance
  • External implementation costs

This larger image shows a simple IT investment analysis using Net Present Value (NPV) analysis. Excel makes this type of analysis really simple. It also has a function to calculate NPV. As you can see from the image, I have laid out inflows and outflows by year and then calculated the NPV based on the discount rate of 10%.

Payback Period

The result of the Payback Period analysis indicates how long the IT investment takes to recover the cost of the investment. It is usually stated in years but this depends on the analysis time horizon. Payback Period can be a simple calculation but only with very simple set of assumptions. Here is the formula to calculate the Payback Period on a IT investment. In general, the shorter the Payback Period the less risky the IT investment.

[Cost of IT Investment] / [Annual Cash Generated from IT Investment]

Let's look at the scenario where you are purchasing a piece of e-commerce software for $100,000. Assume that this piece of software increases revenue by $35,000 each year. The Payback Period calculation would be $100,000 / $35,000 = 2.86 years. So, this investment would pay for itself in 2 years and 10 months.

There is a significant drawback of calculating the Payback Period using such a simple set of assumptions. It's highly unlikely that the revenue resulting from the IT investment will actually come in evenly over an extended period of time. It's much more realistic for the revenue stream to be uneven. In this case, you have to look at the cumulative annual increase in revenue until the original IT investment is "paid for".

Consider the same example from above. Let's assume that in year 1, the net increase in revenue from the IT investment is $17,000.

In years 2, 3, 4 and 5 it is $29,000, $45,000, $51,000 and $33,000, respectively. While this is an average annual increase in revenue of $35,000, the Payback Period is different because of the uneven revenue generated from this investment. The Payback Period in the example is actually more then 3 years which is longer than the original calculation using an average.

Looking at the cumulative increase in revenue, you can see when the original investment is covered. In this example, just find where the cost of the IT investment ($100,000) is covered. You can see it occurs between year 3 and year 4.

Cumulative Increase in Revenue:

  • Year 1 - $17,000
  • Year 2 - $46,000
  • Year 3 - $91,000
  • Year 4 - $142,000
  • Year 5 - $175,000

Take a look at the sample IT investment Excel spreadsheet for the detailed formula for calculating the Payback Period.

IT Investment Proposal

While the calculations are important in an IT investment analysis, it's not everything. I strongly recommend that you put together a proposal instead of just printing out your spreadsheet or emailing the results. Think of your CFO as the audience when putting together the proposal. Ultimately, if may end up on her desk anyway.

I would recommend that you start the proposal with a short summary of the IT investment (capital) you are proposing followed by a brief summary in words of the results of your analysis (along with summary calculations). Finally, attach the detailed spreadsheet analysis and you have a professional proposal that your boss will appreciate.

Your IT investment proposal package might include:

  • Summary: a paragraph or two summarizing the IT investment you are proposing.
  • Justification: a paragraph or two summarizing the results of your analysis along with the technique you used (include a summary table)
  • Printout: a clean printout of the Excel spreadsheet showing the detailed analysis

Sample Excel Spreadsheet

The sample Excel spreadsheet has 3 sheets including:

  1. Summary
  2. Net Present Value (NPV) Calculation
  3. Payback Calculation
  • IT Investment Analysis - Excel 97-2003 Version

If you have any questions regarding the justification of IT investments, drop me an email or post in the New Tech Forum.