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Why TCO is not the best way to evaluate IT investments

Why TCO is not the best way to evaluate IT investments

Measuring enterprise technology purchases in terms of investment ratios to operational revenues is not very sound

For nearly 20 years, IT has attempted to qualify and quantify the cost and value of technology investments.

But IT spending follows different paths depending on the objective and it’s very important to distinguish what the word ‘investment’ means and how it is analysed.

In finance, investment will either overtly or implicitly mean a return, or a yield, such that any money invested will produce an income over the term of the investment and return on capital.

This is how technology investments with new products and public share offerings are valued and analysed. Technology investors in Cisco or a new startup, for example, will determine an investment on the basis of returns.

Enterprise technologies such as ERP applications, infrastructure, desktops and so forth, are applied to large capital investment programs that may or may not produce a direct return.

Obviously these investments produce an indirect return by enabling an organisation to function and allowing divisions of the business to fulfil their jobs.

But, generally, no direct income is derived from enterprise technology investments. Also, they are a depreciated asset, which will not produce a capital return either.

Measuring enterprise technology purchases in terms of investment ratios to operational revenues is not very sound and makes the definition of investment opaque.

These terms, which may be applied and measured accurately, acknowledge that technology is a cost, not necessarily a yield-producing investment.

This distinction in investment is very important because it leads to the dominant analytical techniques for evaluating enterprise technology investments.

Enterprise IT investments are typically assessed from the time of acquisition through to all the additional components of its operational costs and decommissioning. The overview of its total cost of ownership may endure for several years.

This methodology has one clear advantage in that it shows how much an investment will cost, and it can be used to compare different but comparable products. In addition, benchmark costs from similar organisations and technologies are used to empirically validate expenditure in comparative terms.

The value of this procedure is to gain a perspective over the life of an investment and to assess expenditure relative to others.

It’s like buying and using a car for several years. The car does not produce a yield, it enables mobility. Its costs per annum can be assessed relative to other cars in the same category, thus a buyer can evaluate relative value in terms of cost, comfort, efficiency, and status.

The expense of the car is an investment in the sense that it is a substantial sum to purchase and operate the vehicle, not that the car produces a yield over its use period.

There is one more major and critical difference between enterprise technology investments and financial investments. That is time, or the ‘time value of money’ which is the principle that the purchasing power of money varies over time.

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This idea is central to financial investments and the valuation of anything from individual assets, share prices, superannuation and dividends.

The time value of money is completely absent when it comes to doing financial analysis of enterprise technology investments. All costs, whether in a classic total cost of ownership and/or benchmarking analysis, are assumed to be at present value.

The investment analysis, which analyses ratios of IT investments to business revenues, is also achieved implicitly at present value. This occurs even though revenues will be earned over several years, not the same year as the technology investment.

The reason why this is important is that money is worth more now than in the future.

This is true for enterprise technology investments even if they do not hinge on the same metrics of return or use of capital over time that a financial investment would make.

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Negotiating the payment timing for a technology asset alone can quickly turn an inefficient investment into an efficient proposition when ‘time value of money’ is integrated into the analysis.

The benefit of net present value

Discounted cash flow analysis is the method by which to derive the net present value of an investment. In many respects, it is a powerful method to value your IT assets. Using this method, future cash flows are forecasted and discounted to provide their present values.

This method is beneficial because it accounts for the time value of money, and does not depend on other data sources in order to compute outputs. It provides a more realistic evaluation of the value of technology and the efficient use of capital over time.

Ultimately, you need to ask yourself the following questions when you are analysing the value of your technology investments.

  • Which methodologies should be applied given our current requirements? Total cost of ownership or benchmarking or both?
  • Which methodologies are used by our finance department and which are preferred for certain functions?

It’s possible to be more precise in the way that you evaluate the cost of technology equipment over time. Implementing better analytical methods is necessary if you are to make good technology investment decisions.

Guy Cranswick is an advisor at research firm IBRS.

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Tags enterprise resource planningciscoERPdesktopapplicationsTCOIBRSbusiness analyticsbenchmarkingtechnology investmenttotal cost of ownership (TCO)Total cost of ownershipGuy Cranswickdiscounted cash flow analysisfinancial analysisnet present value

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