Return on Investment and Total Cost of Ownership Paper
How do they differ?
Return on Investment (ROI) and Total Cost of Ownership (TCO) play pivotal roles in investment decision making. The two concepts, ROI and TCO, offer valuable insights into project investment decisions. Thus, ROI and TCO are important elements of Enterprise Performance Management (EPM). According to (Dimon, 2013), these two financial metrics, ROI and TCO, provide investment insights from varying schools of thought. While the return on Investment quantifies both costs and benefits associated with a particular project, the total cost of ownership only includes costs. Studies by (Uyar, 2014) posit that the TCO has to be included in the cost side in the ROI equation. In “simple terms,” ROI shows the difference between the cost of a product, service, or something else and the amount of cash it generates in the door (adjusted over a given period).
Dimon (2013) argues that TCO is defined by its name, i.e., the total cost of utilizing technology or an asset over its life cycle. This implies that TCO seeks to examine all expenses associated with investing (s), for example, acquisition costs, implementation costs, and maintenance costs. An example of tech investment is the EPM software/solution/module in today’s business operations. If a company wants to purchase and implement EPM software, the investment decision has to be made in such a way that the company’s TCO will be boosted (Blahova, Palka, & Haghirian, 2017). Thus, an investment whose TCO is the lowest is the best option for a company to invest in to help save resources (time and money). On the side of ROI, all expected benefits are considered in calculating the expected return. While firms seek to maintain TCO at the lowest rates possible, ROI rates have to be maintained high.
The Benefits and Challenges of each of the Concepts
Benefits and Challenges of ROI
The use of ROI brings valuable benefits to an organization. ROI calculation and interpretation is easy; a high/positive ROI indicates that the project benefits are more than its associated costs and vice versa (Dimon, 2013). Second, ROI enhances comparative analysis by enabling the comparison between different projects in terms of asset use and profitability. Third, ROI is a better measure of a project’s profitability. Based on ROI calculation, business managers are in a position to determine the project with the highest profitability and hence invest in it. Also, ROI is vital in measuring the performance of the investment division.
On the other hand, just like any other financial metric, the use of ROI is associated with various drawbacks. While the ROI calculation utilizes expected cash flows and expenses, it does not consider the likelihood of those benefits and costs will match predictions (Dimon, 2013). Also, ROI fails to justify the intangible elements of an investment opportunity. Furthermore, the ROI calculation is linked with certain errors, for example, ignoring cost avoidance, ignoring opportunity cost, overestimating returns or costs, lacks collaboration, forgets about dependences, and ignoring hidden expenses.
Benefits and Challenges of TCO
The utilization of TCO as a financial tool for decision making is associated with various pros. According to (Cokins, 2017), TCO calculation considers all cost elements, for it extends procurement to the entire life cycle within an organization. Also, TCO shows the real purchasing cost instead of pure acquisition cost. Besides, firms use TCO as a tool for evaluation project outsourcing deals. Furthermore, TCO is a powerful negotiation tool used by firms to strike business deals with key suppliers (Uyar, 2014). Again, TCO helps define the buyer’s rational purchasing policy, such as assigning purchase volume, to whom, etc.
On the other hand, the use of TCO comes with several challenges. First, TCO is a complex financial metric and system that is difficult to implement, especially if a firm has multiple purchasing items (Blahova, Palka, & Haghirian, 2017). Second, TCO is a deterministic financial model which over-relies on uncertain data. Also, TCO is a static system, meaning that any internal or external changes that might impact the project outcome, such as the cost of maintenance, cannot be immediately implemented.
TCO Elements to Consider when Measuring ROI for EPM
According to (Dimon, 2013), there are many “total” cost ingredients that managers must consider when developing a company’s ROI for EPM. These elements include:
- Cost to acquire and install the system: When measuring a firm’s ROI for EPM, the costs to acquire and install the system must be considered. For example, hardware costs, software costs, network costs, and more
- Ancillary costs: The ancillary costs linked with the costs of acquiring and installing the EPM system have to be factored in. For example, the system might need an add-on license for a relational database management system.
- Upgrading costs: These include the costs to upgrade and debug any effect the system might bring on the firm’s existing systems.
- Cost of capital.
- Installation and implementation costs.
- Operations, maintenance, and upgrading costs.
- Possible consultation costs are required to re-engineer system processes that are getting automated.
- Costs for temporarily back-filling any headcount which has been supported for the ROI initiative for the EPM
- Labor element: These include the labor elements for all of the above ingredients, for example, staff procurement, trainers, IT staff, consultants, new-hire administrators, and more.
When calculating TCO (Dimon, 2013) posits that both direct and indirect expenses have to be considered. The formula for calculating the total cost of ownership is TCO = I + O + M – R, whereby all the above elements are factored. In ROI calculation (ROI = benefits – costs), the main factors to consider are financial profit, mobility and security, and sales revenue. Thus, firms must consider the anticipated sales growth rate upon the Investment into a particular project, for instance, implementing EPM software.
How can both of the Concepts be integrated into EPM?
The two metrics, TCO and ROI, can be integrated into a firm’s EPM system in various ways. According to (Dimon, 2013), master data and data quality management are the best ways to bring TCO and ROI data relationships together in a meaningful manner. To effectively integrate TCO and ROI into a company’s EPM, the management must report on the current gains, expenditure, and milestones and ensure that any variance is communicated to the stakeholders (Cokins, 2017). With a properly deployed EMP, the organization stands in a better position in doing ROI estimates, assessment, and accountability of all costs associated with a given project. With the aid of operational modeling (such as ABC Costing), strategy maps, scorecards, and ERP, TCO and ROI become thoroughly blend to facilitate both short-term and long-range financial planning of the enterprise. With EPM, analytics and comparisons are easily quantified (Uyar, 2014). This ensures that TCO and ROI are fully integrated into the EPM module, such that the TCO rate is maintained as lowest as possible while the ROI rate is maintained as highest as possible.
References
Blahova, M., Palka, P., & Haghirian, P. (2017). Remastering contemporary enterprise performance management systems. Measuring Business Excellence.
Cokins, G. (2017). Enterprise Performance Management (EPM) and the Digital Revolution. Performance Management, 56(4), 14-17.
Dimon, R. (2013). Enterprise Performance Management Done Right: An Operating System for Your Organization. Hoboken, NJ: Wiley.
Uyar, M. (2014). A research on total cost of ownership and firm profitability. The International Institute for Science, Technology and Education (IISTE), 5(1), 9-14.