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Strategic Technology Consulting

Business White Paper Series

Calculating ROI for Business Intelligence Projects

Author: Contributor: Audience:

Jonathan Wu Mike Fitzgerald This paper is intended for project managers and sponsors who are responsible for building the business case for a Business Intelligence project. December 12, 2000

Date:

Table of Contents

Introduction ............................................................................................................................................ 1 Different Financial Matters .................................................................................................................... 2 Net Present Values (NPV) ................................................................................................................ 2 Internal Rate of Return (IRR) .......................................................................................................... 2 Payback Period ................................................................................................................................. 3 Return on Investment (ROI) ............................................................................................................ 3 How To Estimate the Cost ...................................................................................................................... 4 Performing a ROI Sensitivity Analysis .................................................................................................. 5 Non Financial Considerations ................................................................................................................ 6 Business Intelligence Case Study ........................................................................................................... 7 BI Project Costs ............................................................................................................................... 7 BI Environmental Resource Needs .................................................................................................. 8 BI Projects Initial Costs ................................................................................................................... 8 BI Environment Recurring Costs ..................................................................................................... 9 BI Project/Environment Costs ......................................................................................................... 9 Current Reporting Environment Costs ............................................................................................. 9 Comparison of Information Initiative Costs .................................................................................. 10 Calculation of the NPV .................................................................................................................. 10 Calculation of the IRR ................................................................................................................... 11 Calculation of Payback Period ....................................................................................................... 11 Calculation of the ROI ................................................................................................................... 11 Sensitivity Analysis ........................................................................................................................ 12 Case Study Summary ..................................................................................................................... 12 Summary ............................................................................................................................................... 13 About the Author .................................................................................................................................. 14 About BASE Consulting Group, Inc. ................................................................................................... 15

Introduction

Corporate executives are constantly evaluating the cost versus the benefit of different business decisions. A typical question is: Which option will yield the greatest benefit to the organization? Understanding and quantifying each options costs and benefits is necessary to make an informed decision. When assessing projects, the most commonly accepted financial measure is the calculation of the Return on Investment (ROI). There are two primary reasons why ROI is calculated: Business Case Assessment Increasingly, before the initiative is undertaken, project managers are asked to evaluate the financial benefits of a Business Intelligence (BI) project. The ROI provides a financial measure that quantifies the financial rewards of a BI project. By calculating the ROI, managers can evaluate and prioritize various information technology initiatives within their organization. Post-Project Assessment At the completion of a BI project, project managers can calculate the ROI of the project as a post-project assessment. The purpose of the post-project assessment is to evaluate the original ROI calculation performed in the business case assessment. Were the original ROI and assumptions correct? What factors were identified during the course of implementing the BI project that impacted the original ROI calculation? During the implementation of the BI project, ROI can also be used as a means of promoting the financial benefits to the organization, customers, and partners. How do you assess the financial benefits of a BI project? This white paper addresses the calculation of ROI as well as other non-financial considerations for BI projects.

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The Different Financial Measures

Several financial measures can be applied to a BI project, such as the net present value (NPV), internal rate of return (IRR), payback period, and ROI. While each financial measure focuses on one specific analysis, the ROI calculation combines the features of NPV, IRR, and payback period. In addition, ROI is the commonly accepted financial measure for evaluating the financial benefits of a project. Net Present Value (NPV) The calculation of the discounted projected cash flows of the investment derives the Net Present Value (NPV). The NPV allows you to determine the value of $1 one or more years from the date of the calculation. What would you rather have: $1 today or $1 one year from now? $1 in todays currency is worth $1. However, $1 one year from now is worth less than $1 today because of the time value of money. For example, assuming that the discount rate, or investments yield rate, is 10%, $1 today is worth $1.10 one year from now. However, $1 one year from now is worth $0.91 in todays dollars because the interest earned on the $0.91 over the course of a year at the investments yield rate of 10% would be $0.09. Adding the interest earned during the year, $0.09, to the net present value, $0.91, equals $1 one year from now. The formula for NPV is as follows: NPV = CF1 (1 + r)1 + CF2 (1 + r)2 + CF3 + ... + CFn (1 + r)3 (1 + r)n

Legend CF The net cash flow for each year that the NPV is to be applied. The net cash flow represents the difference between the annual costs of the BI environment and the annual costs of the existing reporting environment. r The discount rate or investment yield rate for the organization at the time the NPV is being calculated. Other options for choosing a discount rate include the cost of capital and the return rate of alternative projects. n The total number of years for which the NPV calculation is to be applied. The calculation is performed for each year being considered. Internal Rate of Return (IRR) The calculation of the Internal Rate of Return (IRR) is similar to the NPV calculation with the exception that the equation is solved for the variable r. The IRR represents the inherent discount rate or investment yield rate produced by the project. For example, you are presented with the option of receiving $0.87 today or $1 dollar at the end of one year from now. The inherent discount rate of the $0.87 today verses the $1 dollar at the end of one year from now is 15% [$0.87 = $1 / (1 + r)]. The formula for IRR is as follows: Initial Investment = CF1 (1 + r)1 + CF2 (1 + r)2 + CF3 + ... + CFn (1 + r)3 (1 + r)n

Legend CF The net cash flow for each year that the IRR calculation is to be applied. The net cash flow represents the difference between the annual costs of the BI environment and the annual costs of the existing reporting environment. r The Internal Rate of Return. n The total number of years for which the IRR calculation is to be applied. The calculation is performed for each year being considered. 2
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The Different Financial Measures

Payback period The payback period calculation determines the number of years that are required for the discounted projected cash flows to equal the initial investment. For example, assuming that the initial investment for a BI project was $1,000,000 and the average annual NPV saving of that BI project was $250,000, then the payback period for the BI project would be 4 years or $1,000,000/$250,000. The payback period formula is as follows: Payback period = Initial Investment (NPV of Savings / Yearsn)

Legend n The total number of years for which the NPV calculation was applied.

Return on Investment (ROI) The ROI calculation evaluates the NPV projected cash flows derived from the savings generated by the BI project divided by the initial investment. With this financial measure, one can assess the benefit of the project over the initial costs. For example, assuming that the total NPV saving of a BI project was $1,500,000 and the initial investment was $1,000,000. The ROI for the BI project would be 150% of the initial investment. The ROI formula is as follows: ROI = NPV of Savings x 100 Initial Investment

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How to estimate the cost

What is the total cost of implementing a BI project? Cost can be classified into one of three categories: hardware, software, and labor. Hardware costs relate to the information system devices that are required by the project such as server system(s), client systems, and network communication. Software costs include the software applications required by the project such as the BI application and the Relational Database Management System (RDBMS) license fees. Labor costs pertain to the use of internal and external resources dedicated to the project. Individuals working on the BI project fill the following roles: project manager, business analyst(s), BI application specialist(s), database administrator, systems administrator, and trainer(s). The total cost of implementing a BI project can be divided into two categories: initial and recurring. Initial costs are those costs an organization incurs for the BI project once. These costs include hardware costs for the project, software license fees, and labor costs to configure and implement the system as well as train users. Recurring costs are those costs an organization incurs for the BI project that will continue to be incurred after the project has been completed. Understanding the total cost of implementation is imperative to stay within the organizations budget. Understanding costs can also help determine the phases of implementing the BI application. An estimate of the cost components of a BI project such as software costs, maintenance or support fees, and average configuration cost can be obtained from external resources such as software vendors/ resellers and professional services firms. The estimated cost of implementing a BI application will be used in the ROI calculation.

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Performing a ROI sensitivity analysis

After applying the organizations financial measurements to the BI project, a sensitivity analysis can be performed. A sensitivity analysis is conducted by numerically creating scenarios for a variety of project outcomes. Each scenario is assigned a probability and the appropriate financial measurement is applied. For a BI project, three outcomes could be (1) a successful BI implementation, (2) a partially successful BI implementation, and (3) a failed BI implementation. A percentage is assigned to each outcome communicating the likelihood that the outcome will occur. If the percentage assigned to a successful outcome is less than 50%, the project should not be undertaken until those factors impacting the success of the project are addressed and resolved. At less than 50%, there is a great chance of an unsuccessful project. Applying the sensitivity analysis to ROI can help executives evaluate the risk and potential gain or loss associated with the BI project. In the example below, a probability percentage has been assigned to each potential outcome.

Outcomes Successful Partially successful Failure Total

% Probability 60% 30% 10% 100%

The total probability percentages must equal 100%. Other sensitivity analyses can be performed that focus on changes in recurring savings, recurring costs, discount rate and initial costs. For purposes of this white paper, the focus of sensitivity analysis is on potential outcomes.

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Non-financial considerations

While the ROI calculation is one measure to evaluate a BI project, there are other non-financial considerations that should also be addressed. These non-financial considerations, or qualitative analysis, may include improved information dissemination, improved information access, and propagation of knowledge about the organization through training and the use of the BI application. Striking a balance between the financial measurement and the qualitative analysis is crucial in both winning support and in the ultimate success of a BI project.

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Business Intelligence case study

Now that the different financial measures for a BI project have been defined, lets apply them so that you will have a better understanding of how to calculate and interpret the results. Management of Profitable Corporation is interested in implementing a BI solution. However, the project sponsor has several information technology initiatives for which she is responsible and wants to better understand the value of undertaking a BI project this year. Profitable Corporations current reporting environment is working adequately, but it requires an average of 1,000 people hours per month to support a user community of 1,200 individuals. As the project manager, you have been requested by the project sponsor to quantify the costs and the benefits of the BI project as well as to recommend whether or not to proceed with the project. The following assumptions have been incorporated into this case study: 1. The number of work hours per year per individual is 2,000. 2. Profitables investment yield rate is 9%. 3. With the rapid advancements in technology, a 3-year time horizon is used for the ROI calculation. 4. The duration of the project is less than 1 year. BI Project Costs When the business case was assembled, the following costs were identified for the BI project: Cost Type / Description Hardware: 1. One Sun Enterprise 4500 server with 4 processors to host the Business Objects WebIntelligence application Software: 1. Business Objects WebIntelligence (e-BI application) Unix server (4 processors) license 2. Business Objects Broadcast Agent for scheduling document execution 3. Business Objects Developer suite (Reporter, Designer and Supervisor modules) for 5 individuals 4. Business Objects software maintenance support level selected is 20% of the initial license fee per year ($262,500 + $16,000 + $20,000 = $298,500) x 20% Labor: 1. External consulting firms proposal to install Business Objects, to develop several subject areas (Universes) and to provide user training. 2. Effective hourly labor rate for combined internal and external resources. Cost

$400,000

$262,500 $16,000 $20,000

$59,700

$850,000 $100

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Business Intelligence case study

BI Environment Resource Needs After Business Objects has been configured and deployed, ongoing support of the BI environment is estimated to require time from the following resources. % of Time 100% 5% 5% 1% 25% 236%

Position BI specialists Database administrator System administrator Network administrator Trainer Total

# 2 1 1 1 1

The total resource percentage of time is 236% or 2.36 full time equivalent (FTE) resources. The costs associated with these individuals are estimated at $472,000, which consists of [2.36 FTE resources x 2,000 hours] in a year x $100 effective hourly labor rate. BI Projects Initial Costs The initial costs of the project have been identified and are summarized as follows: Cost Type / Description Hardware: 1. One Sun Enterprise 4500 server with 4 processors to host the Business Objects WebIntelligence application Software: 1. Business Objects WebIntelligence (e-BI application) Unix server (4 processors) license 2. Business Objects Broadcast Agent for scheduling document execution 3. Business Objects Developer suite (Reporter, Designer and Supervisor modules) for 5 individuals 4. Business Objects software maintenance support level selected is 20% of the initial license fee per year ($262,500 + $16,000 + $20,000 = $298,500) x 20% Labor: 1. External consulting firms proposal to install Business Objects, to develop several subject areas (Universes) and to provide user training. Total Initial Costs Cost

$400,000

$262,500 $16,000 $20,000

$59,700

$850,000 $1,608,200

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Business Intelligence case study

BI Environment Recurring Costs The annual recurring costs of the BI environment have been identified and are summarized as follows: Cost Type / Description Software: 1. Business Objects software maintenance support level is 20% of the initial license fee per year ($262,500 + $16,000 + $20,000 = $298,500) x 20% Labor: 1. Annual maintenance of the BI environment (2.36 full time equivalent individuals x 2,000 hrs/yr x $100/hr) Total Recurring Costs Cost

$59,700

$472,000 $531,700

BI Project/Environment Costs The initial and annual recurring costs of the BI project/environment have been summarized by year for the estimated life of the BI environment as follows: Year 0 Hardware Software Labor Totals $400,000 $358,200 $850,000 $1,608,200 Year 1 $$59,700 $472,000 $531,700 Year 2 $$59,700 $472,000 $531,700 Year 3 $$59,700 $472,000 $531,700

Current Reporting Environment Costs The costs of the current reporting environment have been summarized by year over a comparable period to the BI environment as follows: Year 0 Labor Totals $1,200,000 $1,200,000 Year 1 $1,200,000 $1,200,000 Year 2 $1,200,000 $1,200,000 Year 3 $1,200,000 $1,200,000

The annual labor costs for the current reporting environment of $1,200,000 was derived by the 1,000 average number of hours per month x $100 effective hourly labor rate x 12 months in a year.

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Business Intelligence case study

Comparison of Information Initiative Costs The following is a comparison of the annual recurring costs between the BI environment and the current reporting environment. Year 0 Cost of the BI project/environment Cost of the current reporting environment Net savings $1,608,200 $1,200,000 N/M (1) Year 1 $531,700 $1,200,000 $668,300 Year 2 $531,700 $1,200,000 $668,300 Year 3 $531,700 $1,200,000 $668,300

(1)

Not Meaningful -The comparison of the initial investment of the BI project to the annual costs of the current reporting environment is not appropriate because the BI project will not be available until the end of Year 0. The comparison of the two information initiatives is not meaningful until the new solution is complete. The annual costs of the current reporting environment in the year that the BI project is undertaken is considered a committed expense since the BI environment is not in production and individuals within the organization still need to have access to data and information.

Calculation of the NPV Year 1 Net savings Discounted net savings at 9% $668,300 $613,119 Year 2 $668,300 $562,495 Year 3 $668,300 $516,050 Total $2,004,900 $1,691,664

The NPV formula is $1,691,664 =

$668,300 + (1 + .09)
1

$668,300 (1 + .09)
2

$668,300 (1 + .09)3

The net saving generated by the implementation of the BI environment is $2,004,900. In todays dollars, the NPV of the net savings from the BI project is $1,691,664 which reflects the time value of money over the course of 3 years.

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Business Intelligence case study

Calculation of the IRR Year 1 Net savings Internal rate of return $668,300 Year 2 $668,300 Year 3 $668,300 Total $2,004,900 11.9%

The IRR formula is $1,608,200 =

$668,300 (1 + r)
1

$668,300 (1 + r)
2

$668,300 (1 + r)3

The IRR for the BI project yields a rate of 11.9%, which means that the inherent investment yield rate is better than the investment yield rate used in the NPV calculation of 9%. If the IRR was 9%, it would equal the investment yield rate used in the NPV calculation and there would be no inherent investment yield rate variance from the BI project. Calculation of payback period Total discounted net savings at 9% (see NPV calculation) Number of years in time horizon (assumption) Average total discounted net saving at 9% Initial investment in the BI project Payback period in years $1,691,664 (a) 3 (b) $563,888 (c) = (a) / (b) $1,608,200 (d) 2.85 (d) / (c)

The payback period for the BI project is 2.85 years or 2 years, 10 months and 6 days, which means that the financial benefits will offset the initial investment faster than the planned time horizon of 3 years for the BI environment. If the payback period were 3 years, it would match the planned time horizon for the BI environment. Calculation of the ROI Total discounted net savings at 9% (see NPV calculation) Initial investment in the BI project Return on investment $1,691,664 (a) $1,608,200 (b) 105% [(a)/(b)] x 100

The ROI from the BI project is 105%, which means that the financial benefits of the BI project exceed the initial investment by 5%. If the ROI were 100%, then the benefits would equal the costs of the projecteffectively breaking even.

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Business Intelligence case study

Sensitivity analysis % Probability 60% 30% 10% 100% Gain / (Loss) $1,691,664 $($1,608,200) $83,464 Weighted Outcome $1,014,998 $($160,820) $854,178

Outcomes Successful Partially successful Failure Totals

In the sensitivity analysis, % probabilities were assigned to various outcomes. In addition, the dollar amount in terms of gains or losses were associated with each outcome. By applying the % probability to the gain or loss for each outcome, the total weighted financial outcome of the BI project is derived. Several assumptions were made in this sensitivity analysis such as the % probability of each outcome as well as the financial impact of each outcome. With the outcome being successful, it is assumed that the NPV of saving for the BI project would be realized. Conversely, if the outcome were a failure, the loss would be the initial investment of the BI project. With a partially successful BI project, no financial gain or loss was deemed appropriate. Case Study Summary ROI is 105% Payback period is 2.85 years and faster than the anticipated time horizon The IRR of 11.9% is greater than Profitables investment yield rate of 9% Probability of success is greater than 50% Total weighted outcome is significantly greater than $0 The potential gain to Profitable Corporation from the BI project outweighs the risk of failure. The project manager should recommend proceeding ahead with the BI project to the project sponsor based upon the ROI and sensitivity analysis.

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Summary

The quantitative and qualitative benefits of a BI project need to be evaluated before the project is undertaken. Calculating the ROI on a BI project is one means of measuring the benefits to the organization. However, even more critical to the success of the BI project than the calculated costs, benefits, and ROI, is the extent of buy-in for the project from the executive leadership and the business operations of the organization. Having support for the BI project from senior management as well as user involvement in the configuration of the application(s) is essential to its success. Without the necessary support and involvement, the ROI calculation for the BI project is meaningless.

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Author

Jonathan Wu is a Co-Founder and a Client Advocate of BASE Consulting Group, Inc. He has extensive experience designing, developing, and implementing Business Intelligence and data warehousing solutions. He initiated and has contributed to the development of the Business Intelligence and Data Warehousing Certificate Program at the University of California, Berkeley Extension where he is also a lecturer. In addition to teaching, Jonathan is the Business Intelligence online columnist for DMReview.com and also an author for DataWarehouse.com. He has presented on Business Intelligence and Data Warehousing topics at conferences throughout the United States including the Data Warehousing Institute Annual Leadership, Business Objects International User and Oracle Applications User Group Conferences. Prior to BASE, he was an Advisory Business Services manager at PricewaterhouseCoopers and a Senior Accountant at Ernst & Young. Jonathan is a Certified Public Accountant in the State of California and holds a Bachelor of Science degree in Business Administration from the University of California, Berkeley.

Jonathan Wu Phone: 510-628-3300, extension 224 Email: jwu@baseconsulting.com

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About BASE Consulting Group, Inc.

BASE Consulting Group (www.baseconsulting.com) is a leading provider of business intelligence consulting and professional education services. BASE has headquarters in Oakland, California, with regional offices in Los Angeles and Denver, and serves clients throughout the Western U.S. BASE delivers business intelligence solutions that increase the value of its clients enterprises. These solutions provide easy access to essential information and allow for comprehensive reporting that is complete, accurate, timely, and aligned with business metrics, goals and objectives. BASE helps turn corporate data into useful business information, which can be accessed and shared by business decision makers without regard to technical expertise or experience. In addition to its consulting services, BASE conducts formal education out of its Oakland and Los Angeles offices, as well as custom training at client sites. Courses offered provide hands-on training with software developed by BASE alliance partners. BASE has also developed a comprehensive Business Intelligence and Data Warehousing Certificate program, which is accredited by the University of California, Berkeley Extension. Students completing the program earn academic credit in the College of Engineering and Computer Science. BASE was recognized in 2000 as one of the fastest growing privately-held companies in the United States by Inc magazine.

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Web: www.baseconsulting.com Email: info@baseconsulting.com

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