In my previous newsletter I explained why ROI isn’t working in most businesses. Based on comments I received from readers, I want to quickly point out that I don’t believe that the “game players” I mentioned are bad people, in spite of my use of the word “crime” in the article. I believe that everyone falls into that game playing mentality when confronted with a process that requires it. It’s the process that’s at fault—not the people. The people just learn that in order to get a project approved, they have to exaggerate the ROI, and this provides the basis for the problem.
So how do we fix the process? The core of the problem is an inherent bias in figuring ROI, so let’s try to eliminate the bias. Here are some techniques you can use:
1. Have a single group of people who determine the projected ROI for all projects, or who at least review the ROI calculations for projects to make them consistent. Eliminate the advantage that imaginative exaggerators have in doing project proposals.
2. Ensure that ROI proposals include all costs, including all prerequisite projects, infrastructure requirements, and all secondary and tertiary costs. If a project is to be implemented in phases, then include the ROI for each phase as well as the cumulative ROI for all prior phases, and make sure that it’s clear to everyone that a later phase cannot be accomplished without an earlier phase, and therefore cannot be approved without the earlier phases.
3. If a project depends on a prerequisite that is also a prerequisite for other projects, then either (a) break out the costs of the prerequisite that are a specific requirement for this project, and include them in this project’s ROI calculation, or (b) go ahead and approve the prerequisite and take its costs out of the ROI calculations for all of the projects on which it depends.
4. Differentiate in proposals between real dollar savings which affect the bottom line and theoretical savings (e.g., an hour saved per week from each of 200 people) which may be absorbed by the business.
5. Specifically include a section in each proposal on the transition from old system to new: how the transition will occur, how long it will take, what will happen, and how productivity and quality may be impacted during the transition. Factor those productivity and quality costs into the ROI.
6. Include consideration of risk by doing scenario planning in the proposals that require it. Identify the risks in a project, including probabilities of various outcomes. Explicitly identify potential issues, and discuss the steps that will be taken to minimize or eliminate them. Develop multiple ROI calculations based on various likely scenarios, and then build a single composite ROI number based on a probabilistic weighting of the various ROI numbers. For example, if there is a 50% probability of a $100 million savings, a 40% probability of no savings, and a 10% probability of a $50 million loss, then the composite ROI number is $100 x .5 + $0 x .4 – $50 x .1 = $45 million. This may still be a project worth approving, especially if clear steps are taken to minimize the 10% probability of a loss.
7. To the extent possible, go back after each project to determine the actual ROI that resulted from the project. This should be done as part of a generalized project close-out process, which should also discuss things that should be done differently in the next project.
8. Even better, get user commitment for savings before the project starts. For example, if the project is going to eliminate the need for one clerk in each office, then go ahead and reduce the office budgets in advance to reflect the savings. If the project succeeds, then the savings have already been locked in. And now every office has an additional incentive to make the project successful, because they’re already committed to the savings.
I’ve used this last approach successfully in two different companies. In both cases, advance commitment was made to headcount reductions in anticipation of savings from a new system. Because the commitment was made far in advance, the companies were able to meet the headcount reduction goals through normal attrition without any layoffs. And the system ROI was easily achieved because the savings were built into the budget.
The Missing Project Selection Criterion
By using the techniques listed above, you can reduce the bias in ROI estimates. But consistent ROI estimates aren’t enough; an underlying problem with using ROI for project selection is that the project with the best payback isn’t always the best thing for your business. Your business has a strategy for advancing in the marketplace, and the best projects are the ones that help implement that strategy—not necessarily the ones with the highest ROI. Choosing projects based on ROI may contribute to the bottom line in the short-term, but this approach will not position your company for the future.
To improve the project selection process, add another criterion to project selection: strategic alignment. There are a lot of ways to do this; here are a few:
a. Use an ROI multiplier.
For example, if the project is in strong alignment with the strategic direction, multiply the ROI by 1.5 to get an “adjusted ROI”; if the project is in moderate alignment, multiply ROI by 1; if the project goes against strategic direction, then multiply ROI by 1/2 or 1/4. Then rank projects on the resulting adjusted ROI.
b. Use strategic alignment as the primary criterion.
Only consider projects that are in strong or moderate alignment with strategic direction, regardless of their project ROI.
c. Use strategic alignment as a project budget allocation tool.
Set aside a certain amount of the project budget (say, 75%) for projects that are aligned with strategic direction. Then spend up to 25% of your project budget for unaligned projects if their ROI is higher than any aligned project.
You can work out the specifics of how to use strategic alignment in your project selection process; the important thing is that it is taken into consideration in some way in your process.
ROI is probably the best known project ranking tool, but it’s seldom used consistently and correctly. We’re kidding ourselves when we say that we use ROI to rank projects on financial returns. The reality is that calculating project ROI is a game in most companies, and the best game players get their projects approved.
However, you can change the rules of the game to make ROI a better reflection of reality. And you can ensure that your projects are strategic by measuring their alignment with strategic direction. The result will be a better choice of projects for your business, and a higher percentage of successful projects overall.
Note: This post has been combined with another post on ROI from July, 2004, “Why ROI isn’t Working,” and incorporated into Chapter 5 of my book, Boiling the IT Frog. For more information about the book, click here.