Everything to know about ROI, TCO, NPV, and Payback

One of the really great things about finance is that there’s nothing new.  Financial metrics have been around since the beginning of time and haven’t changed since. Early cavemen performed rudimentary return on investment (ROI) assessments when they decided to go hunting for food.  This is where the idea of a cost benefit analysis started.  How cold is it outside this cave versus how hungry am I and how long do I need to hunt to gather enough food?  Who knew finance was actually the oldest profession?

Unfortunately, unlike the simple assessments made during the Stone Age, today we get complex words and three letter acronyms that make finance appear more difficult. But in fact, nothing has really changed.  There are two questions we still ask: “Is it worth it? And “How long until I recover my investment?” We answer that with ROI and Payback Period and that’s why those are the two most valuable metrics to use when building a business case, and really the only two you need to know. 

Of course, if finance were just two metrics then finance classes would last an hour and there’d be a lot of unemployed finance professors and consultants. To avoid this potential unemployment crisis, a bunch of less useful metrics were created including NPV, TCO, and IRR to keep students studying and consultants billing.  Let’s demystify these metrics and understand what they are telling us, and, more importantly, what they aren’t telling us.

Return on Investment (ROI) is a metric you already understand, even if you don’t think you do.  It’s the annual return you receive on an investment and it’s the same percentage number a bank tells you when you deposit funds.  If the bank is offering a 5% interest rate, then you intuitively know a deposit of $100 today will return $5 a year from now and you’ll still have your $100 deposit.  

Calculating the ROI of an investment is easy if you know the return.  It’s the total return you expect (in this case, $5) divided by your investment (here it’s $100).  So in this example, 5 divided by 100 = 0.05 or 5%.  That’s all there is to it.  The greater the annual benefit the higher the ROI while the higher the initial investment the lower the ROI. 

At Nucleus, we use a three year time horizon for assessing the ROI of a project.  Our analysts add the net benefits (total benefits less total costs in the year) for each of the three years then divide by 3 for an average annual net benefit number.  That smooths any impact of initial year rollout or deployment costs and provides a more realistic assessment of the projects’ ongoing ROI.

So the calculation for ROI is nothing more than:

                   ((net benefit in year one + net benefit in year two + net benefit in year three) / 3)

          ROI = ———————————————————————————————————–

                                                                    total initial cost

Now you might find people who try to make the ROI calculation more complex by using phrases such a “risk-weighted ROI” or “three-year ROI” instead of “annual ROI.”  These are false calculations used to mislead the buyer rather than provide an accurate assessment.  If you’re not sure, think about the bank.  If your bank doesn’t use the metric, you shouldn’t.

ROI vs Payback Period

Payback Period is nothing more than time needed before you recover your investment.  Let’s go back to our $100 investment, but make the annual return $50 (or a 50% ROI).  If you receive $50 every year, it will take two years to recover your $100 investment, making your Payback Period two years.  So the calculation is total investment ($100) divided by annual return per year ($50) or two years.  Simple.

At Nucleus, we believe Payback Period is the strongest metric you can use when proposing a technology initiative. In the two decades of delivering business cases and working with both sales teams and internal champions, we’ve found it’s easier to “feel” Payback Period than understand ROI.  If you present the business case by stating that you expect the project to “recover its investment within the first 24 months,” it’s easier to grasp than saying the project has a 50% ROI.  Of course, you need to use both metrics, but leading with Payback Period is a good strategy if you want to increase the likelihood that your project will be approved.

Payback Period is also a measure of risk.  The longer a project takes to return its investment the more likely the returns you actually receive will vary from the initial estimates.  Short payback periods make the naturally pessimistic finance types sleep easier at night because they know if the worst happens, after the payback period, at least they’ve recovered their cost.

Here be dragons

You can safely skip the rest of this if you’d like.  There are only two metrics, Payback Period and ROI, and everything else is useless when assessing technology. 

Still reading?  Okay then, we warned you.  

ROI vs Net Present Value (NPV)

Net Present Value (NPV) is the value today of money received at a future date.  You probably already understand that $100 received today is worth more than $100 received a year from now.  That’s because you could put the $100 you receive today in the bank and get a return on that money.  In our earlier example of the bank offering 5% on your $100 deposit, a year from now you’d get another $5 and have $105 total.  So, getting $100 today to put in the bank is worth $5 more to you than $100 a year from now.

With NPV, we can bring the future payment back to today’s money and calculate what the $100 you receive a year from now is worth today at a given interest rate, in this case 5%.  We’ll skip the actual formula and enter the numbers into a financial calculator to calculate an answer of $95.24.  That means $100 a year from now has a “present value” of $95.24 today.  Or, if you put $95.24 into the bank today at 5% interest rate, you’ll get $100 a year from now.

Okay, stick with us now, this gets a bit more complex.  Since you can calculate the present value of the money you receive a year from now, you can also calculate the present value of money received two, three, or more years from now. If you bring all those yearly values back to the present day, you can add them up and calculate the “Net Present Value” for the total project. 

You may have heard people say “what’s the NPV of the project?” Adding the present value of all of the future payments is what they’re talking about.  But is NPV useful for assessing a technology project?  Well, no, not at all.  Let’s look at the bank example.  The bank offering a 5% rate on the $100 investment would return $5 each year, or $15 in the first three years.  If we calculate the present value today of these future $5 payments, we get $4.78 for the year one payment, $4.54 for the year two payment, and $4.32 for the year three payment for a total NVP of these three payments of $13.64, not $15.00.  That’s the present value of the future payments, but when you calculate NPV you also need to include the initial cost.  The math then becomes an initial outflow of $100 with net inflows of $13.64 for an actual NPV of a loss of $86.36.  

Wait, I lost money on this investment?  I thought it has a 5% ROI?  It does, just a negative NPV in the first three years. We’d need to add back the residual value of the project at the end of year three (in this case it would be the $100 deposit), but that’s impossible for a technology project with no residual value.  We could go out further, to say year 10 or 20, but that isn’t realistic and is just trying to fix the underlying problem with the NPV metric. 

NPV is good for calculating the value of money at different periods in time, but adding it up and calculating the “Net” is only useful if the project has a defined beginning and end.  That may be true if you’re a construction company building an office building, but it isn’t true with a technology investment delivering ongoing benefits.

The bottom line is that there’s never a time when NPV can be used to assess a technology initiative.  

ROI vs IRR

Internal Rate of Return (IRR) is not ROI.  If it were ROI it would be called ROI.  It’s not.  Unfortunately IRR has the word “return” in it, so a lot of folks think it must be just as good as ROI.  These people are dangerous.  IRR has nothing to do with the ROI of a project and calculates something completely different.  IRR calculates the interest rate that sets the NPV stream equal to 0.   Clear?

You might occasionally see IRR used as ROI in some technology vendor marketing material.  Why?  The obvious answer is that people don’t know any better, but there’s a more sinister answer that may be in play.  An unscrupulous consultant can influence the IRR with very slight adjustments in the estimates of the benefits or the timeline, essentially creating the IRR you desire.

Let me show you how.  Let’s say I’m considering two projects that each require an initial investment of $100, and over the first ten years generate the same 100% IRR.  Both projects appear equal and since I’m looking at a ten year timeframe, I can certainly make the case that I’m being thorough enough. But what if the first project returned $200 at the end of the first year and only $1 ten years later while the second project returned nothing for the first nine years and $102,000 in year ten?  What?  $102,000 in year 10?  Great!  Clearly the second project is a lot better than the first.  If we average the payments over the ten years and calculate average annual ROI, the first project has an annual ROI of 20% while the second has annual ROI of 10,200%

Confused?  Go back to the bank example. Imagine you and your friend each purchase a 10 year CD with a $100 investment offering a 100% IRR.  Ten years later you walk into the bank and they cheerfully give you $201 plus your initial $100 investment (and a pen) while your friend gets $102,000 plus their initial $100 (and buys you a beer).  That’s why you never see IRR used in the bank.  It’s not an accurate measure of a project’s return.

Still want to be an IRR ninja.  Okay, here’s the trick.  If you extend the timeline and make minor adjustments early on in the payments you can dramatically adjust the IRR.  If we make the first project’s initial payout $300 instead of $200 the IRR increases to 200%, making it appear twice as attractive as the second project, yet it’s still a comparatively poor choice. Technically the issue is with the assumed reinvestment rate and a formula called MIRR adjusts for that but it’s nothing more than an attempt to fix a bad metric.

I’d like to say we never see IRR, but in fact our analysts see it on a regular basis.  In one case we were asked to independently analyze an “ROI” business case generated by a vendor’s business value team to justify the purchase of their solution by a large municipality.  The business case had a glowingly positive IRR, but when we assessed the benefits using a real ROI calculation we found the project would never generate a positive return.  In this case, there was no way around it; the vendor was lying.

There are some very unique cases where IRR can be useful, but it’s rare and we’ve never seen an example with a technology assessment.  The rle is to never use IRR to assess a technology investment.  If you see it, or it’s presented to you instead of ROI, walk (or run) away.  

Okay, still curious about IRR?  Here’s an example of how IRR can be used properly.

Let’s use our construction company example and assume that during the next year you plan to build a building.  You make a detailed plan with the cost of materials and labor and the timings of the payments along with a final sale amount at the end of the project. Now you’ll need to find a construction loan to pay for the project as you build it.  Of course, the bank isn’t going to negotiate with you on how much to give you.  You need enough to build the building and half a building just won’t do it.  What the bank will negotiate on is the interest rate on the construction loan.  Here’s where IRR shines.  IRR calculates the interest rate that sets the NPV equal to 0, thus leaving no money on the proverbial table.  That’s your table by the way.  So, if you negotiate a rate with the bank that’s less than the IRR you calculated there’s extra money on that table for you.  If the rate is higher than the IRR you’re going to need to add your personal money to the table to make the project work.  Cool, right?  

Total Cost of Ownership (TCO) is nothing more than the total cost of, well, ownership. It’s a good number to understand, but it only tells you the cheapest project, not the best.  Of course, the cheapest option is always to do nothing.  Calculating TCO is useful when budgeting for the cost side of a project, but for the most part, ignore TCO as a metric for making a technology decision.

Cost to Benefit Ratio calculates the return for every $1 spent.  It’s a useful metric for helping non-finance people understand the magnitude of an investment, but should be expressed as a 1 to X number rather than a percentage.  Curiously we sometimes see ROI miscalculated as the total benefits over 3 years divided by the total costs. That’s not ROI.  It’s just the benefit to cost ratio.  For the most part it’s not useful in any way.

There are other metrics, and plenty of people talking about opportunity costs or risk factors when assessing technology.   You can safely ignore all of that.  The only two metrics to use are Payback Period and ROI.  They are tried and true, they got early cavemen out hunting, they are taught to every finance professional, and there’s only one way to calculate them correctly.  

Finance isn’t trendy.