Analyzing Projects with Payback, TCO, ROI

March 2, 2011

According to Michael Hammer and James Champy, “…reengineering is the fundamental rethinking and radical redesign of business processes to achieve dramatic improvements in …cost, quality, service, and speed.” Reengineering processes incur costs in its goal to achieve these improvements. In today’s competitive environment, you most focus on maximizing the value generated from cost expenditures. You have to prove that your project’s worth. It’s no secret: when a customer is spending money, they always want to make sure their getting exactly what they paying for. As your organization considers spending large amounts of money on replacing or maintaining their IT systems, they expect to gain money from increased productivity, and/or reduced maintenance or energy costs. Considering this new reality, you most show the value IT expenditures will provide the organization. How do you show the value of a future expenditure? Present management with the actual cost of the purchase by using financial tools like Payback analysis, Total cost of ownership, or Return on Investment.

The payback method is a great way of analyzing multiple projects. It simply shows you how long it will take to earn your initial investment back. As a general rule the shorter the payback period the better. Payback analysis is simple to learn and great for small projects. However, it does have its faults. It does not account for it does not account for the time value of money, risk, financing or other important considerations, such as the opportunity cost. Even with these limitations it is still a good tool to use in determining the value of a project.

Total cost of ownership, TCO is more complex than Payback analysis and takes more effort to complete for large projects. However, the TCO provides the total cost of an IT expenditure; everything from hardware, software, outside services, and all internal costs. TCO is calculated by adding all of the costs associated with a given purchase over its expected life time. It is not uncommon that a project with a low initial cost may be become too expensive when all costs are considered. Good TCO analysis brings out the hidden or non-obvious ownership costs that might otherwise be overlooked in making purchase decisions or planning budgets.

Return on Investment ROI is the performance measurement used to evaluate the efficiency of an investment or to compare the efficiency of a number of different investments. To calculate ROI, the return of an investment is divided by the cost of the investment. At one time, ROI was the most common analyzing tool, however it status to both TCO and Payback Analysis.

An ROI calculation quantifies both the costs and the expected benefits of a specific project over a specific timeframe. TCO includes just total costs of the project. While Payback only shows the amount of time you will get your initial investment back. The question is which tool is better for analyzing you project. There is no, “one size fits all” solution. All three of these options are valuable tools when analyzing your project.

By: Brandon Johnson

Works Cited

Business Reengineering, Information Systems Planning and Acquisition, http://www.umsl.edu/~joshik/msis480/chapt13.htm

Business process reengineering, http://en.wikipedia.org/w/index.php?title=Business_process_reengineering&oldid=411743998

Return On Investment, http://www.investopedia.com/terms/r/returnoninvestment.asp

Getting a Grip on TCO and ROI, http://itmanagement.earthweb.com/columns/bizalign/article.php/3076031/Getting-a-Grip-on-TCO-and-ROI.htm

Rate of return, http://en.wikipedia.org/w/index.php?title=Rate_of_return&oldid=410674458

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