The days when management regarded a company's continued investment in information technology (IT) as necessary to stay competitive are long gone. Nowadays, companies have adopted more prudent policies requiring a financial justification for nearly every IT initiative.
Industry studies have repeatedly demonstrated that business intelligence (BI) initiatives are among the IT investments that yield the highest returns. Last year's IDC study, "The Financial Impact of Business Analytics," reinforces that organizations who implemented analytic applications have realized returns ranging from 17 percent to more than 2,000 percent with a median return on investment (ROI) of 112 percent. According to the study, analytics implementations generate an average five-year ROI of 431 percent with 63 percent of the companies having a payback period of two years or less.
Yet project champions sometimes find it more challenging to develop a business case for a BI initiative than other IT investments. This article addresses these challenges and provides guidelines for developing a solid cost/benefit analysis to support the identification, communication and ongoing monitoring of the value of a BI initiative.
ROI calculations are based on assumptions and projections that must be revisited and calibrated along the way. Measurement reduces uncertainty. Thus, the ROI study should be a part of a more holistic management process that takes business objectives, priorities, risk and technological feasibility into consideration (with a healthy dose of business judgment) while fostering buy-in and accountability of business unit managers. In other words, the process of getting to an ROI number is more important to the success of the BI initiative than the number itself.
ROI as Part of a Holistic Planning and Management Process
The ROI study should be an integral part of the strategy and planning phase of a BI initiative and involves the senior management team as well as the operational business units. The strategy and planning phase contains the following steps:
- Assess the business environment
- Assess the IT environment
- Gather business requirements and objectives
- Identify and quantify potential benefits
- Prioritize the requirements
- Identify gaps (process, people/
- Create high-level data model and validate requirements
- Define solution architecture
- Develop a phased implementation plan
- Identify the cost
- Develop business justification and calculate ROI
Steps 1 through 5 are heavily dependent on input and feedback from senior management, stakeholders and subject-matter experts in the business units. Anticipated benefits get the early attention in the project (Step 4) not the costs (Step 10). Benefits are closely tied to the business requirements, which in turn support specific business objectives.
Figure 1 depicts the requirements gathering process of aligning executive vision with the daily operational execution realities, presenting a balanced view of business objectives.
Figure 1: Requirements Gathering Process
This also identifies quantified benefits that are used to define priorities for the execution and represent specific goals.
Identifying and Quantifying the Benefits of a Project
When quantifying anticipated benefits, it is critical to understand that the BI solution itself does not provide financial returns. ROI is derived from the processes that the BI solution supports or enables. The key to identifying these benefits is to ask business users probing questions during the requirements gathering process.
The benefits of a BI-enabled process fall into two broad categories:
- By increasing efficiencies: A common example is the closing cycle for the budgeting process. If the current closing cycle requires 10 days and involves several versions of spreadsheets being sent back and forth between departments, there is a good chance that the BI solution will save a significant amount of time. Let's assume that 20 people are involved in the budgeting process and the total amount of time required for the process is 60 person-days. The goal is to reduce the closing cycle time to five days with the help of the BI solution, reducing the overall person-days to 15. Assuming that the average person-day costs the company $480, savings of $21,600 per closing cycle is achieved. Another example comes from marketing. By improving the granularity of customer segments as input to marketing campaigns, the vice president of marketing believes that the cost of acquiring a new customer can be reduced by $20 per customer. The company acquires approximately 10,000 new customers per year resulting in potential annual savings of $200,000.
- By eliminating redundant systems: Are there one or more data extracts stored in databases on departmental servers currently used for reporting purposes? Is there infrastructure from a previously failed data warehousing initiative or unused software licenses? Does the company own licenses of an enterprise resource planning (ERP) module that is currently used to support a subset of the reporting requirements? The corresponding annual software license, maintenance fees and the current book value of the associated hardware are possible components where cost savings can be achieved.
Successful BI initiatives go beyond cost savings and enable business transformation. This is the area where you will most likely find the payback for a BI initiative. Three examples follow.
- Staying with the previous example from marketing, if the company can acquire 10 percent more customers per year through better targeted campaigns as a result of the BI initiative and those new customers generate estimated additional profits between $800,000 and $1,500,000, we can factor those values into the ROI calculation as benefits using a more conservative scenario and a second, more aggressive scenario. A sensitivity analysis will help with assessing the probability of each scenario and understanding the overall risk.
- You may be able to estimate profit resulting from the likelihood of existing customers purchasing more due to the process. For example, as part of the specific business objective to increase annual sales by 20 percent, a manager defines the requirement to identify opportunities to convert more one- time buyers into repeat customers who buy multiple products through improved customer segmentation analysis. Having the ability to target one-time buyers with a high propensity to buy additional products would result in an increased conversion rate, boosting annual sales by 10 percent from $20,000,000 to $22,000,000. Given a 15 percent profit margin rate, this results in an increase in profit of $300,000. This is a benefit that can be attributed to the BI initiative in the ROI calculation.
- You may also be able to estimate profit from sales not lost to competitors. For example, a company could reduce customer churn by 40 percent through early detection of those customers who might switch to a competitor. With targeted offerings, these customers would generate annual profits of $1,500,000 from revenues of $10,000,000, which would otherwise have been lost to the competition.
Even though some benefits are difficult to quantify, they should be incorporated into the business case because they demonstrate additional value for the proposed solution. Examples are:
- Improved information dissemination.
- Improved information access.
- Improved data quality and feedback to the operational systems.
- Improved collaboration across business units.
Attempt to quantify these benefits and make more assumptions if necessary, but identify a meaningful dollar value that can be attached to a potential benefit. Attach a defendable value to a benefit to make it more tangible and specific. Taking a conservative approach to your assumptions will help to deter challenges to the analysis. Also, clearly state all assumptions. This will help you defend your case.
Identifying the Cost for a Project
Identifying the cost components of a BI initiative is usually more straightforward than identifying and quantifying the benefits. The costs associated with a project are determined by the selected solution architecture (hardware and software), and the implementation plan (resource and time requirements).
Figure 2 shows how the deliverables from the strategy and planning phase contribute to the identification of the cost for the project.
Figure 2: Deliverables from Strategy and Planning Phase
There are two types of cost components. Initial cost components include hardware, software, internal labor, external labor and training. Recurring cost categories are maintenance and support fees for hardware, software and labor costs for operational staff.
Training costs should include training for the administrative staff required to operate, maintain and expand the solution, and the initial and recurring training for the business user community.
Figure 3 can be useful in determining the initial internal and external labor costs for a BI initiative.
Figure 3: Table for Determining Internal and External Labor Costs
Not all project roles are full-time. One person can perform multiple roles, and one role may require multiple persons.
Now that we have discussed how to identify and quantify both benefits and costs for the BI initiative based on information gathered throughout the strategy and planning phase, it is time to put the pieces together in order to understand the project's financial viability. The following section provides the financial foundation for the ROI calculation, which shows you how the costs and benefits are applied to calculate ROI, net present value (NPV), internal rate of return (IRR) and payback period. It also introduces the concept of the sensitivity analysis, which provides a what-if analysis to understand the risk based on several outcome scenarios.
ROI The Financial Foundation
ROI is the most commonly accepted financial measure for evaluating the benefits of a project. It allows us to assess the benefit of a project over the initial costs and evaluate the NPV of projected cash flows derived from the savings (or gains) generated by the project divided by the initial investment. The formula to calculate ROI is as follows: ROI = ((NPV of Savings) / (Initial Investment)) * 100.
How do we calculate the NPV of the projected gains? The NPV allows us to determine the value of $1 one or more years from the date of the calculation considering a discount rate or investment yield rate for the organization. The formula to calculate NPV is: NPV = (Net Gains1 / (1+r)1) + (Net Gains2 / (1+r)2) + (Net Gains3 / (1+r) 3) + ... + (Net Gainsn / (1+r)n), where Net Gainsi is the net cash flow for each year i that the NPV is to be applied, r is the discount rate or investment yield rate at the time the NPV is being calculated and n is the total number of years for which the NPV calculation is to be applied.
Other Financial Metrics Commonly Used to Justify Projects
The IRR calculates the inherent discount rate or investment yield rate produced by the project. The IRR determines whether the yield of the investment in the project exceeds the regular investment yield rate. The same formula that is used for the NPV calculation can be used to calculate the IRR; however, the initial investment must be substituted for the NPV and the equation has to be iteratively resolved for the variable r because, in general, there is no closed-form solution for IRR. Numerous programs and spreadsheets are available to help calculate IRR.
The payback period determines the number of years for the project to break even (i.e., for the discounted projected cash flows to equal the initial investment). The formula to calculate the payback period is as follows: Payback Period = (Initial Investment) / (NPV of Gains / Total Number of Years in the Planning Horizon).
Sample Calculation of Common Financial Measures
Figure 4 illustrates how these financial metrics are calculated based on an example with a time horizon of three years.
Figure 4: Calculation of Financial Metrics
The calculation of the net present value of the savings or gains requires a more detailed discussion. To determine the net cash flow for each year, we need to understand the cost and the benefits, expressed in savings or gains derived from, or influenced by, the project.
Analyzing the Risk
Perform a sensitivity analysis and analyze scenarios for a variety of project outcomes (successful, partially successful, failure). Applying the sensitivity analysis to ROI can help highlight the risk and potential gain or loss associated with the BI project. Figure 5 is an example based on the sample ROI calculation in Figure 4.
Figure 5: Sensitivity Analysis
The total weighted financial outcome should be significantly greater than zero for the project to be worthwhile. The sensitivity analysis provides a conservative perspective on projected gains.
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