by T. Mayor

Traditional Financial Methods For Calculating IT Value: Economic Value Added, TCO, Total Economic Impact, Rapid Economic Justification

Jul 15, 20027 mins
IT Leadership

Economic Value Added (EVA)

“Net profit minus the rent.”

Nuts and Bolts: As a metric, EVA equals net operating profit minus appropriate capital charges. Simply put, when managers employ capital, they have to pay for it, explains Gregory Milano, partner and management committee member in the EVA consulting practice of North America at Stern Stewart & Co., the New York City-based developer and promoter of EVA. By assessing a charge for the use of capital, EVA encourages managers to monitor assets as well as income, and keeps them aware of the trade-offs between the two, Milano says. If you’re evaluating a new ERP system, for example, EVA requires that you factor in all investments, including initial cash outlays, maintenance, and internal and external training costs, and take those as a charge against anticipated benefits, which might be increased revenue or reduced costs.

Using EVA as a yardstick to assess the performance of individual departments, including IT, on a monthly, quarterly and yearly basis can help with decisions on new projects. Conflicting and confusing goals (like revenue growth, market share or cash flow) are replaced with a single financial measure for all activities.

BancorpSouth has had success in eliminating multiple goals. “In the past, we looked internally at growth goals, efficiency ratios, pricing margins, market share and of course, on the external side, earnings per share, but there were no capital considerations. People would make decisions to get growth volume and wind up losing their shirt,” says Will Newcomer, senior vice president of MIS at BancorpSouth, a six-state bank headquartered in Tupelo, Miss. By putting Hyperion Solutions’ EVA calculation tool on each branch manager’s desk, BancorpSouth can tell branches that they need to hit income goals and make back the cost of their capital?but still give them the autonomy to do it their way.

Word of Mouth: EVA is a good way to gauge the top-level impact of IT, says Alinean’s Pisello, but it’s difficult for many IT organizations to connect that high-end view with something like the purchase of a new server without using intermediate measures. BancorpSouth may be in the minority by using EVA as a full-blown valuation framework. Other companies feel more comfortable using it as a single metric that plugs into another valuation methodology.

Time and Money: As little as three or four months for small companies with clear financial data; a few years for full implementation in large, complex companies. Cost is commensurate with the size of the company and project, says Milano.

Total Cost of Ownership (TCO)

“If you’re already too cost-focused, TCO will just dig you in deeper.”

Nuts and Bolts: TCO is an efficiency measure best used for helping service-oriented departments like IT squeeze better price and performance ratios out of key business processes such as operations, disaster recovery, change management and tech support.

Responding to a client query in 1986, Gartner’s Bill Kirwin and others set out to calculate the ongoing costs of procuring, administration, setup, moves/adds/changes, tech support, maintenance, peer support, downtime and other hidden costs of owning a PC. “We said, Let’s take a holistic view of costs across enterprise boundaries and over time,” says Kirwin, now vice president and research director at Gartner in Stamford, Conn. “When we added it all up, it was pretty surprising. Nobody believed the numbers at first, not even internally at Gartner.”

They do now. TCO has become a way of life for many technology managers who like its dispassionate analysis of new products and upgrades. Hardware manufacturers can increase sales by building TCO-reducing features into their products that reduce maintenance and support costs.

Word of Mouth: TCO does an excellent job of providing a current cost benchmark, and it works well for analyzing a narrow function or series of functions. When combined with best practices benchmarks, it can make a good framework for assessing and controlling IT spending. TCO does not assess risk or provide a way to align technology with strategic and competitive business goals.

Even Gartner, which developed TCO, acknowledges it isn’t a silver bullet, but rather an efficiency metric that works well when plugged into the financial perspective of a Balanced Scorecard or other qualitative methodologies. Gartner is working on a broader version of the methodology called Total Value of Opportunity (TVO) that has a greater emphasis on investment performance.

Time and Money: Between eight and 16 weeks; anywhere from $30,000 to $50,000 on the low end.

Total Economic Impact (TEI)

“It’s better to build layers on top of an organization’s existing toolkit than to drop in something brand new.”

Nuts and Bolts: Total Economic Impact is a decision-support methodology designed to accommodate risk and something Giga Information Group Research Fellow Chip Gliedman calls “flexibility”?deferred or potential benefits often left out of straight cost-benefit analyses.

In analyzing expenditures, IT managers assess three key areas?cost, benefit and flexibility?and determine risk for each. Cost analysis takes a TCO-like approach in considering ongoing costs in addition to capital expenditures. This tends to be an internal IT measure. Benefit assessments look at the project’s business value and strategic contribution outside of IT.

TEI calculates flexibility using a futures-options methodology, such as Real Options Valuation or the Black-Scholes model, both of which attempt to value options to be exercised later. For IT investments, risk considerations include the availability and stability of vendors, products, architecture, corporate culture, and size and timing of the project.

It doesn’t matter which calculations a company uses, provided it is analyzing all three categories and assessing risk for each, says Gliedman. “It’s better to build layers on top of an organization than to drop in something brand new,” he says.

Word of Mouth: TEI works best when analyzing two distinct scenarios (build versus buy or Oracle versus Sybase), particularly when those two choices involve infrastructure or other enterprisewide projects whose benefits are notoriously hard to pin down. Some measurement experts, including Technology Decision Modeling’s Don Hinds, aren’t thrilled with the subjective, nonstatistical nature of TEI’s risk-assessment component.

Time and Money: Five days to two months; $20,000 to $30,000 on the high end.

Rapid Economic Justification (REJ)

“Truth and beauty of the numbers.”

Nuts and Bolts: Like TEI, Microsoft’s Rapid Economic Justification seeks to flesh out TCO by aligning IT expenditures with business priorities. The five-step process requires IT to: develop a business assessment road map identifying a project’s key stakeholders, critical success factors and key performance indicators; work with stakeholders to identify how technology can influence success factors; perform a cost-benefit equation; profile potential risks representing probability and impact of each; and run standard financial metrics.

Brad Post, group marketing manager for Microsoft’s business value group, swears REJ doesn’t favor Microsoft products. “It’s a church and state division. We’re really after the truth and beauty of the numbers.” To certify REJ as 100 percent neutral, the Microsoft team sends its initial report to Gartner, Giga or KPMG for comment and authentication.

That touch appealed to Angelo Macchia, executive vice president and CIO at Aegis Communications Group. The Irving, Texas, teleservices outsourcer, which has 10 call centers and some 8,000 employees worldwide, was considering a move from Unix/Sun to an all-Microsoft platform. “Gartner did our audit, and they were tough on it,” says Macchia. “They pushed back on comparisons that they thought weren’t fair, and Microsoft went back and revamped some numbers.”

Word of Mouth: REJ is best suited for managing single projects rather than an entire project portfolio. Analysts and users like REJ’s business assessment phase, its TCO-like baseline and its inclusion of risk analysis, although that analysis is subjective. If the winds are blowing fair from Redmond, you could get the whole valuation for free, as Aegis did. However, despite the “rapid” in its name, the REJ process can be slow. Also, some organizations won’t trust any vendor-sponsored findings.

Time and Money: Between 12 and 20 weeks; $20,000 to $80,000.