In Part I – ECM Project Costs and Benefits (April 12th 2010), I talked about the different types of costs and benefits – and which of those costs and benefits were applicable in evaluating an ECM project. This is a continuation of that article – and hopefully the information provided will be of benefit when trying to get your ECM project funded.
When a company decides to undertake your ECM project, they’re consciously deciding not to fund some other project, not to offer their employee’s a larger raise, not to return the money to their shareholders or not to invest in a new business venture or launch a new marketing campaign. Instead they’re trusting that the ECM project under your project management direction will provide more value to the company then these or other investment options.
Today – we’re going to talk about how an organization makes that choice and how they analyze various investment options and arrive at a decision on which projects to fund, which to reject, and which to defer. To begin the conversation we need to understand the common types of evaluation measures such as NPV, ROI, IRR, payback period, etc.
Any elective project undertaken should provide greater benefits than the costs associated with implementing the project. If such isn’t the case, then other factors are at play, such as the project is not elective, but required to meet legal requirements or new business needs. In 2002, the Sarbanes-Oxley Act provided a legal mandate for many companies to invest in content management solutions thus bypassing the cost-benefit scrutiny we’re discussing here.
There are a number of underlying assumptions in play behind the various evaluation measures:
- Companies are risk averse – and other things being equal will choose to fund a project viewed as ‘less’ risky.
- The future is uncertain, and no one can accurately predict how new requirements or technology will affect today’s business.
- Because of inflationary pressures and personal preferences- we will normally view having a dollar today as being better than having a dollar tomorrow.
There are strengths and weaknesses associated with each of the common measures of a projects value. We’ll talk about some of those differences. I like tools – and my wife is pretty much sure that I have every tool known to man (which isn’t the case). When discussing a new tool purchase with her - she applies a fairly unique methodology that I call COG where she evaluates 3 criteria:
- How much does the tool cost?
- How long does it last?
- How many days a year will I use the tool?
A few months ago I ‘needed’ a new pressure washer (cost $300, minimum lifespan of 3 years, and a use rate of twice per year – as moss grows fast in Seattle). The purchase was approved easily because the daily use rate of the pressure washer of $50 was less than the corresponding COG (cost of golf) for that day. Any tool purchase generally gets approved if the cost involved in using the tool stops me from spending the day on the golf course. As an added non-measurable benefit – the driveway and sidewalks are now moss free.
Excluding the COG measure - normal measures of evaluating a project or purchase such as NPV, ROI, IRR, payback period, and discounted payback period will summarize the cash flows from your project into a single number. The thought is that by comparing these numbers for various projects or investment alternatives - you can make a more informed decision on which projects to undertake.
Your ECM project will generate a set of cash flows. Typically for an ECM project the cash will be flowing out (negative cash flow) as you invest in hardware, software, installation, configuration, etc. At some point in time the cash flows will become positive as your project realizes benefits from your ECM implementation. In Part I – we talked about these benefits, and which costs/benefits could be applied to our measure of choice.
Let’s now take a more in depth look at the measurements most in use.
Payback Period
This is a pretty common way to value a project. The simplest way is to lay out a timeline (generally by month), and total for each month the net benefits received in that month. When you reach the month on the timeline where the sum of all the benefits exceeds the upfront costs – then you have found the payback period. In times of uncertainty, most organizations might restrict projects to those with paybacks of less than 1 year. Remember our assumptions about uncertainty and risk? In general a project with a shorter payback period is assumed to be less risky. Projects with longer payback periods are more likely to incur scope change, cost overruns, delays, etc. One of the negatives in using payback period is there is no way to evaluate longer term – more strategic projects as the measure focuses your team on projects with quick paybacks. I would hope that your company considers an ECM implementation to be a strategic project! On a personal note – I’d like to hear from any organization that realized a payback of less than 1 year on an ECM implementation.
Discounted Payback Period
Remember our assumption that people prefer a dollar today over a dollor tomorrow? With a discounted payback period, you make the same calculations as in the payback period, but the future benefits of your project are discounted each period. This rate of discount is sometimes called the hurdle rate. This rate usually includes two components:
1) the return on a non-risky investment option such as putting your money into a savings account. If you can get a 3% return on your money by leaving it in a savings account – then at a minimum you would want your ECM project to return 3%. If your project doesn’t return 3% then you would better off leaving your money in the bank.
2) some discount factor to accomodate risk/uncertainty. This might be an additional 5-10%
If your company is focused on projects with a short payback period of a year - then the discounted payback period won’t be significantly different than the payback period value.
ROI – Return on Investment
If you invest $1 on your ECM project today, and end up with future benefits of $2.50 you will have a calculated return on investment of 150%. ROI is simply the ratio of net benefits to costs (net benefits divided by costs or in our case $2.50 – $1.00 divided by $1.00) expressed as a percentage. The higher the number the better the investment or the better the return on your ECM project.
In the real world you will most likely have to discount your future benefits by some discount percentage for the same reasons we have previously discussed ($1 in the future isn’t worth as much as $1 today, the future is uncertain, unknown risks might arise, etc.)
The other important question that will arise is how far in the future you can use to calculate benefits? You could reasonably expect to see benefits from your ECM project many years into the future, but you may be restricted to only using 3-5 years in your ROI calculation. Unfortunately this will undervalue the true benefits of your ECM project when compared to a project where 100% of the benefits are realized during the evaluation period.
NPV – Net Present Value
NPV measures a project and tells you how much that project is worth to you in today’s dollars. The calculation restates all future benefits into today’s or ‘present’ value. Let’s look at a simple project:
Today: We spent $100 on the ECM project
Year 1: Because of implementation timing we only saw benefits the latter part of the year, – let’s say $10
Year 2: rollout to remainder of organization at beginning of year 2 - let’s say benefits of $50 realized
Year 3,4,5 - full year of extended benefits of $60 per year
We’re going to simplify the calculation by assuming that all benefits are realized at year-end – and not throughout the year as is really the case. Also we’ll use a discount rate of 10%
NPV = Year 1 net benefits discounted by 10% + Year 2 benefits discounted by 10% compounded for 2 years + Year 3 benefits discounted by 10% compounded for 3 years, etc, or
NPV = -100 + 9.09 (year 1) + 41.32 (year 2) + 45.07 (year 3) + $40.98 (year 4) + 37.26 (year 5)
NPV = $73.72
Note how the exact same benefits in years 3,4 and 5 are worth corresponding less when expressed in present (today’s) value. The nice thing about NPV is that it provides a way of measuring total impact to a company. Two projects with exactly the same ROI might have vastly different NPVs. One of the strenghts of NPV is that it gives an indication of the ‘size’ of the project’s value to an organization.
IRR – Internal Rate of Return
One of the things that I don’t like about most measures discussed above is that they utilize some ‘artificial’ discount or hurdle rate set by company policy. The IRR eliminates this somewhat arbitrary number and instead provides the actual rate of return on your project’s investment. Essentially, the IRR is the interest rate that your project will return to your company if they invested in your ECM project. Excel or most business calculators can make this calculation – simply providing you with what kind of return you would get if you invested $X today and received $Y in the future. Since the IRR is essentially a return on your investment – you can easily compare this number against any other project or non-project investment options. (On a side note, if you used the IRR as your discount rate in the NPV calculation – you would end up with a NPV equal to zero.) The problems with using IRR is that IRR doesn’t give any idea about how large an investment is being made, or of how quickly the payback is realized.
There is no perfect measure to use in evaluating or comparing your ECM project with other potential projects – but I hope that you now have the ability to use multiple measures, and to be able to understand the differences, strengths and weaknesses involved in each. Good luck!
Steve Kissinger
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