Saturday, December 27, 2003

Escaping the ROI trap

A strong ROI is the key to getting management approval for new systems, right? Not always. With the weak economy over the past two years, I've observed a trend in which, many times, executives refuse to approve new system investments no matter how compelling the business case is. I call this the "ROI trap."

What it is
The ROI trap works like this. The user sees a pressing need for a new system and submits a funding request. Executive management reviews the request, agrees that a new system is desirable, but indicates that no funds will be granted without a clear and compelling business case. So the user launches a significant effort to gather data on the projected benefits as well as the expected costs. The user may also enlist the help of an outside consultant and the software vendor, who are all-too-happy to provide an ROI template and participate in the effort to gather data. To avoid surprises, the team interviews executive management to determine reasonable assumptions. The team finally puts together what they think is a compelling business case and makes the presentation to executive management only to see the project shot down, put on hold, or worse--directed to "gather more data."

Why executives don't believe ROI calculations
I've theorized that the ROI trap has to do with the nature of uncertainty surrounding most ROI calculations: that is, the benefits are uncertain, but the costs are absolutely certain. In other words, the decision maker isn't sure of the benefits, but he is quite sure of the costs. So the executive, deep down, doesn't trust the ROI, no matter how compelling it is. In the face of uncertainty, the safe decision is to say no--or, if the decision maker is timid, to ask for more data.

Recently, I've been reading Judgment in Managerial Decision Making by Max Bazerman (2002, John Wiley & Sons), which explains common biases in how managers make decisions. Bazerman's research indicates that people are "naturally risk-averse concerning gains and positively framed questions" and "risk-seeking concerning losses and negatively framed questions." Read that part in italics again, and think about it, because it is the key to understanding the ROI trap.

Bazerman references a study in 1981 where participants were asked to make two decisions. The first decision was between:
  (a) a sure gain of $240, and
  (b) a 25% chance to gain $1000 and a 75% chance to gain nothing.

Result: 84% of the participants chose (a)--the small sure gain rather than the potentially larger gain.

The second decision was between:
  (c) a sure loss of $750, and
  (d) a 75% chance to lose $1000 and a 25% chance to lose nothing.

Result: 87% of the participants chose (d)--the potentially larger loss rather than the smaller guaranteed loss.

Bazerman's research, in plain English, means this: when looking at benefits, people would rather choose a small benefit that is guaranteed rather than a larger benefit that is uncertain. On the other hand, when looking at costs, people would rather choose a greater loss that might NOT happen than a smaller loss that is guaranteed.

Bazerman points out that this is why insurance payments are called "premiums" instead of "guaranteed losses." Think about it. When you buy health insurance you are choosing a small guaranteed loss (the premium) over a great uncertain loss (a large medical bill). But if the premium were designated as a "guaranteed loss," there would probably be a lot less insurance sold, or people would choose higher deductibles (i.e. smaller guaranteed losses.)

In other words, when considering benefits, people generally like to "take the sure bet." But when considering costs, people generally like to say, "I'll take my chances."

Now think about how most new system investments are presented to management. They are presented in terms of guaranteed costs and uncertain benefits, exactly the opposite of what the decision maker finds most appealing. How much more attractive the business case would be if it could be presented with the costs as an "insurance premium" against possible great losses and, at the same time, with some element of "guaranteed benefits."

If Bazerman is correct, then the ROI trap is a threat to many investment decisions. But I suspect that the cash-constrained environment that many businesses have been operating in over the past few years has made the ROI trap more deadly.

How to escape the ROI trap
When you suspect that your new system request is threatened by the ROI trap, I would suggest the following:
  1. Emphasize problems with the current situation and the risks of doing nothing. Frame the business case to highlight the problems, including the worst-case scenario, of staying with the existing system, e.g. loss of vendor support, regulatory non-compliance, inability to meet the needs of the business, need to hire additional headcount, or loss of competitive position. If there are any disaster recovery or business continuity concerns, play those to the hilt. When you're facing the ROI trap, the most likely outcome is "no decision." So, build the case for action first. Otherwise, the rest of the business case will fall on deaf ears.

  2. Structure the deal to reduce fixed costs, especially up-front costs. See if you can move the deal to a subscription model, where many of the upfront software license and implementation costs are amortized over a three or five year period. Where this is not possible, a financing or leasing arrangement can have the same effect. Frame the remaining fixed costs as an "insurance premium" against the problems of the existing system, not as a cost to get future benefits.

  3. Build the ROI around the firm tangible benefits. Even better, show those tangible benefits as a discount against the fixed "insurance premium." For example, show the benefit of not having to pay license fees or maintenance on the existing system--a benefit that is indisputable.

  4. List intangible or soft benefits, such as "improved management decision making," as a secondary category. Let the decision maker himself pull any of those soft benefits back into the primary rationale for the decision. When the ROI trap is threatening, it is better to be criticized for being too conservative than too aggressive.
These tips are no guarantee that the new system will be funded, but they should lessen the chance of your falling into the ROI trap.

Update: Read Part 2 for more on this subject.

No comments: