Many of us hear the terms TCO (Total Cost of Ownership) and ROI (Return on Investment) quite frequently in the context of IT Investments. However, the sad part is that most of the times they are used to refer to the "value" of an IT project or an asset. These are clearly two distinct metrics that communicate very different messages. In layman terms TCO refers to the total cost of owning and maintaining an IT asset and/or service. The word to keep in mind is "cost". Hence it is a "cost metric" measured in monetary terms. It no way refers to the value generated or the potential value that can be generated by the asset and/or the service. ROI on the other hand is return on an investment. It is the "value" created by investing capital on an IT asset. Hence it is a "value metric" measured as a ratio.
Let us now get a little technical about these terms by decomposing these metrics into their respective components.
Mathematically speaking...
ROI = Net Savings / Investment Amount
Example: A company invests $2M on a new Data Warehousing project. This amount includes purchasing software, hardware and consulting. This project replaces a manual data analysis process which involves 5 FTE (Full Time Employees) worth of work, each drawing an average annual salary of $80,000. There is an annual cost of $50,000 on software and hardware licenses for the new Data Warehouse. We assume that no new FTEs are hired to maintain this and would require only 1FTE to maintain.
ROI (year 1) = ( Current Cost - New Cost) / Investment Amount
= (400,000 - 2,050,000)/(2,050,000) = -80.5%
Hence, this is a bad investment...really?
ROI (year 2) = (400,000 - 130,000) / 2,050,000 = 13.2% (now we are in business...)
ROI (year 3) = same as year 2...
Alternate way
If we consider the depreciation on the $2M capital expenditure on a 5 year straight-line basis, we get an annual depreciation of 400,000 for 5 years.
ROI (year 1) = ( Current Cost - New Cost) / Investment Amount
= (400,000 - (400,000 + 130,000)) / 400,000 = -32.5%
ROI (year 2) = (400,000 - (400,000 + 130,000)) / 400,000 = -32.5%
This is truly a bad investment. Wait...we are using an accounting principle to measure ROI for every year. So what happens when this investment is fully depreciated (assuming no salvage value)
ROI (year 6 ) = (400,000 - 130,000)/0 = ERROR
Yet another way
Year 1 Net Savings = 400,000 - 2,050,000 = -1,650,000
Year 2 Net Savings = 400,000 - 130,000 = 270,000
Year 3 Net Savings = 400,000 - 130,000 = 270,000
Year 4, Year 5 same as Year 3
Considering an IRR (Internal Rate of Return i.e. the return on investment rate at which the Net Present Value of an investment is 0) for this investment, a 5 year value is -15% and it becomes positive in only the eighth year 4% - which is a very low return. In other words this project has a very low return to the extent that it becomes positive only in the eighth year. Hence not a financially high-return project at all.
Conclusion:
- Use IRR instead of the ROI formula to determine the value of the return since it takes into consideration the Net Present Value (NPV) of the savings.
- Compare the IRR to the company's Cost of Capital (WACC) to determine whether the IRR is greater than that. This is a good metric to ascertain what IRR is good for the project.
- Try and avoid the first 2 methods as one is inaccurate and the other uses an accounting principle (which should be used for book-keeping not valuation purposes)
Now to TCO...
Total Cost of Ownership (TCO)
A very common term used by technologists mostly senior leadership types...Some tend to overdo it whereas some try to equate ROI with TCO - again a Value Metric with a Cost metric. Though there is a subtle connection. TCO is used to compute ROI - but not the other way around.
Remember the equation: ROI = Net Savings / Investment Amount
The Net Savings is represented as Investment - Cost (TCO). Here we equate cost to TCO when we are calculating a multi-year ROI. However, as I pointed out earlier, IRR is perhaps the best way to compute the returns from an IT Capital Investment. In the calculation of the IRR the cost component is the Current TCO - Future-state TCO. Hence please use TCO here.
How do we define TCO? As mentioned earlier TCO is the total cost of owning and maintaining an IT asset and/or service over its "useful" lifetime or till it is "refreshed". Yes IT Assets do have a "life". This is an Economics concept in this context rather than a financial one. To that extent, it simply means the IT asset must be replaced when the returns from it are diminishing. How do we measure that? An easy way to get a better control on that is the time when the cost of maintaining the asset increases instead of decreases. That is the point when it should have been already refreshed/replaced. Hence, the economics perspective lends an easier way to understand it.
From a finance perspective, TCO contains the CAPEX and the OPEX associated to that IT asset across its "useful" lifetime aka. till it is fully depreciated. We need to draw a very careful set of rules here...
- The IT asset has a life
- There is CAPEX needed to procure the IT asset (may not be true for leased assets - but are counted under OPEX)
- The IT asset has an associated OPEX
- The existence of the IT asset may lead to procurement of other IT assets to maintain it which otherwise would not have to be procured or maintained. These form part of the IT asset's TCO
It is important to capture all the assets that are linked to this single asset. From an economics point of view, all "complementary goods" associated with this asset need to be accounted for in order to accurately compute the TCO.
To summarize, the ROI is the net yield from am IT investment whereas the TCO is the total cost of procuring and maintaining it that must be used to compute the ROI (IRR).
Hence ROI (IRR) = f(TCO) or ROI(IRR) depends on the TCO and not vice-versa
...makes sense?
