Wednesday, April 9, 2014

TCO and ROI Explained

What these metrics mean and why they are important

Key Terms: Total Cost of Ownership (TCO), Return on Investment (ROI)

When CIOs and other like-minded executives consider the financial impact of a new technology investment, they overwhelmingly look to two metrics: total cost of ownership (TCO) and return on investment (ROI). Although these two terms are sometimes thrown together, they are actually measures of two very different things and which metric is preferable depends on the parameters of your decision. 

First of all, let’s clear up the definition of these terms. 

TCO or total cost of ownership is a measure of cost. This includes the capital cost to purchase equipment, deploy it, configure it or integrate it with other systems, and the operational costs (sometimes referred to as the run-rate) to operate and administer the equipment over a given period of time. Time is a key component of TCO, as most operating costs are ongoing; therefore, the longer the timeframe, the higher the TCO. If you think of a car as a metaphor for an IT investment, the TCO for your vehicle would certainly consider the price you paid for the car at the dealership, but it would also include the ongoing costs of ownership, like insurance, gas, and maintenance for as long as you owned the car. In the IT world, these ongoing operational costs can sometimes far outweigh the initial capital cost of a technology solution. 

Return on investment is a measure of benefit from a capital investment. ROI is depicted as a percentage. ROI looks at the total capital cost of an investment and calculates the value returned by that investment over a given time period. Time is a key component in calculating ROI in two ways. Like TCO, an ROI result will change over time as ongoing benefits (like a reduction in operating costs) continue to accrue. The timing of investment is also critical to an accurate ROI calculation. In most scenarios where ROI is an effective metric, an upfront capital investment is offset by some kind of ongoing operational benefit to create a positive cash flow. To generate a positive ROI, the positive cash flow generated by the benefits of that investment must outweigh the initial cost of the investment.

To calculate ROI, you need to model the outbound cash flows (costs) and inbound cash flows (benefits) associated with a particular investment. Any accurate ROI calculation should consider all costs associated with an investment, therefore, an ROI analysis must start with the TCO of the proposed solution. You must also model benefits of the investment which you will weigh against the cost. These benefits can be savings over an existing cost, additional profit generated from new revenue streams enabled by the technology, or any other benefit that can be quantified as currency. 

So, which metric is better? The answer is different depending on your customer’s decision point.

TCO is a useful metric for comparing a proposed solution to the TCO of another similar solution. It is especially useful it comparisons of competitive solutions that may provide similar functionality to the business, but in different ways. Considering the capabilities offered by two competing technologies to be equal, a lower TCO is a better TCO. TCO is a useful metric for the IT buyer who is asking, “Which new technology should I invest in?”

ROI is often used to compare a proposed IT investment against an existing solution. In this type of scenario, the proposed technology generally promises to deliver the same functionality as the existing environment, but in a more efficient manner or with lower overhead costs.  ROI can also be used, however, to demonstrate the benefit of new business capabilities that are not supported by the existing technology. ROI is a useful metric for an IT buyer who is asking “Should I invest in a new technology at all?”

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