By Larry Melillo

As they must do with any major investment, finance and technology leaders must develop a return-on-investment (ROI) model to justify software purchases. In many cases, organizations find it difficult to identify the indirect benefits and costs associated with software implementation.

A number of factors may make it difficult for an organization to develop an enterprise software ROI model:

• Type of software   A different ROI approach should be developed depending on the type of software you plan to deploy.
• Hidden benefits   Technology benefits are often hard to identify and may depend on how the software will be used. For example, one company may implement reporting software to provide financial reports, and another company may deploy the same reporting technology to analyze customer data. Although the companies use the same technology, the benefits for each organization's software deployment would be markedly different.
• Hidden costs   Many costs associated with technology implementation are hidden. Furthermore, these hidden costs can occur over the useful life of the technology and might include expenditures such as support, maintenance, and training.

This article provides a framework you can use to capture key benefits and costs when developing a complete enterprise software ROI model. Including such a model within a well-rounded business case can help managers determine whether it is worthwhile to proceed with a new software investment.

Types of enterprise software

When creating a software ROI model, your first step should be to identify the type of software investment. Software investments can be grouped into two broad categories:

• Application software supports a specific business process or a set of interlinked processes. Examples include financial programs such as General Ledger from SAP or operational programs that cover plant floor operations, sales force automation, or supply chain management.
• Infrastructure software supports a business application. Types of infrastructure software include middleware (software that interacts across hardware and network environments), messaging (e-mail and collaboration software), and storage, security, and network management tools. None of these tools by themselves provides a unique business value. When they are combined, however, these tools provide the infrastructure that supports the software programs that run a business.

Software benefits

After you've identified the type of software you want to deploy, the next step is to determine the benefits that your organization will derive from implementing the software. Benefits can be classified in two ways:

• Hard benefits result in a tangible cash benefit. Strong ROI models typically derive the majority of their benefits from hard dollar savings.
• Soft benefits are not easily quantifiable in hard dollar terms. Although they don't provide a cash benefit, soft benefits are important because they quantify other factors that may be important when evaluating whether to proceed with the investment.

Benefits differ based on the type of software deployed. The following table provides a guide for classifying benefits when creating a software ROI model.

The following example illustrates how to identify the benefits of a software investment. A retailer who is deciding whether to deploy a merchandise management software program to assist with inventory management and stocked merchandise levels could group the benefits as follows:

• Reduced head count   Improvements in process efficiencies result in a mandate for 25% reduction in staff, which leads to layoffs. (More optimistically, the displaced workers could be retrained to perform more valuable jobs within the organization.)
• Reduced errors   Fewer defects associated with the new process lead to less time restocking misallocated items, which reduces shipping costs.
• Increased revenues   Improved merchandise management ensures that desired items are in stock, which improves sales per square foot.
• Productivity savings   Employees no longer waste time searching through manual product binders. Instead they spend only half that time by efficiently accessing product data by using the new software program.
• Improved customer satisfaction   As measured by an external customer satisfaction survey, the ratings of stores have improved from "okay" to "great" in terms of stocking the merchandise that customers want.
• Improved information   Retail buyers can monitor fast-selling items at particular stores, which allows the buyers to quickly order new stock so that they can grab additional market share for their companies.

Costs of enterprise software deployment

No ROI model would be complete without a realistic understanding of the costs of your investment. Whether you use application or infrastructure software, the costs of implementation can be separated into the following cost buckets:

• Vendor license or development costs   These are the costs of owning software code, whether the software program is purchased from a vendor or developed in-house by using internal or consulting resources. These costs are often the largest expenses incurred for any software investment.
• Vendor maintenance   If you purchase software from a vendor, maintenance costs often are incurred throughout the useful life of the software. These costs also provide for future acquisitions of software patches and upgrades. Maintenance costs are usually calculated as a percentage of the initial license cost.
• Implementation services   Implementation services costs include the professional services costs associated with deploying packaged vendor software. Examples of such services include the costs of consultants, who typically charge for their time on an hourly rate for software implementation. Depending on the complexity of the software, these costs can come near to, or even exceed, the cost of the software.
• Future-year services   Future-year services include costs associated with adding future functionality to software that was developed in-house or purchased externally. Such functionality could include creating custom code, adding new modules, or integrating another software program.
• Hardware   These costs include expenditures associated with servers, network equipment, PC upgrades, and other physical infrastructures that are required to deploy and maintain the software.
• Systems management   A number of these direct and indirect costs are associated with applying the necessary infrastructure to make application software work. Examples include security, storage, integration, messaging, and problem management (help desk).
• Training   These costs include software training for end users, technical administrators, and help desk employees.

When taken together, these costs are often referred to as the total cost of ownership (TCO), because they represent all of the short-term and long-term costs associated with implementing any software program.

ROI model principles

After you've identified the benefits and costs of your software investment, you're ready to build the ROI model. Keep in mind these principles when developing your model:

• Useful life of software   Consider the useful life of a software program when determining its costs and benefits. For the company-wide deployment of a multimillion-dollar enterprise resource program, a useful life of eight years or more is possible. For the department-wide deployment of a less costly program, such as a small database for storing customer data, a useful life of only three years is possible. The key is to match the benefits and costs of the software to the time in which it is expected to function.
• Depreciation   Although the actual life of your software program might last more than five years, for tax purposes most technology investments depreciate within three to five years.
• Cost of capital   A hurdle rate above the organization's cost of capital should be used in any net present value (NPV) or payback analysis. The hurdle rate is defined as the rate of return required by shareholders to ensure that their investments are well spent. NPV analysis is a common financial technique used to determine whether the hurdle rate is being met.
• Quantification of risk   The risks associated with deploying software or obtaining its benefits should be noted within your ROI model. The probability of achieving the software's benefits should be adjusted accordingly within the model.
• Balanced presentation   The ROI model should be presented as the financial component of your business case. Balance this financial component with your organization's strategic goals and other significant qualitative factors. If a company's competitive advantage lies with providing superior customer service, any technology that can demonstrate improvement in the company's customer satisfaction ratings may be a worthy investment, regardless of the ROI results.

Organizations need to quantify and model benefits and costs when justifying any major software purchase. By applying the principles outlined in this article, finance and technology leaders should be able to develop a complete enterprise software ROI model that contributes to a winning business case for software investments.

About the author   Larry Melillo is a manager at KPMG's CFO Advisory Services. CFO Advisory Services professionals help organizations implement strategies and process changes that drive a more value-added finance function.