My last post – How much did it cost? – tapped something inside me. Time and again I notice how people in the technology business, indeed, even business in general, are quite capable of using the words of business, management, finance and money without really understanding them. Even people in managerial positions don’t seem to understand the concepts they are advancing.
To complicate matters because digital work often follows different laws even if one does grasp economic concepts they are misapplied. Exhibit 1 is Diseconomies of scale, many of those charged with “managing” software development still assume economies of scale and therefore make things worse not better.
So, thats all by way of saying, here is another blog, indeed perhaps a short series, about economic and financial matters.
One of my bête noire is people talking about Return on Investment but failing to either back it up with numbers or appreciation of how to increase it. There is low hanging fruit here, in most organizations it is quite easy to increase your return on investment simply by writing a value on your work items (user stories, product backlog items, use cases, …) rather than the whole package (project) – see my Estimating business value: Value poker and Dragons Den post.
Low hanging fruit #1: Before you put an effort estimate on any work item write a value estimate first.
Lets talk Cost benefit analysis and Return on Investment, ROI.
ROI is often an idea honoured in the breach rather than reality. Rather than just use the words try and use numbers. While I see teams who put effort estimates on their stories and almost as often hear complaints that teams “cannot estimate accurately” I seldom see value or ROI on a story.
Perhaps the most common way of calculating ROI – at the project level usually – is simply:
ROI = (Benefit – Cost) / Cost
Usually expressed as a percentage, e.g. suppose a piece of work costs $25,000 and generates $35,000 in revenue, a surplus of $10,000. (Notice I’m not calling “profit”, the problems with profit could be the subject of a blog all by itself, technically this might be called “free cashflow” but surplus will do for now.)
ROI = ($35,000 – $25,000) / $25,000 = 40%
If you have a real piece of work which has a 40% return then stop faffing about and do it! In real life opportunities this good are probably too good to be true.
Now three points here. Firstly, if you haven’t done this calculation then simply doing it is better than not doing it. Even a rough calculation is better than none and any calculation will seed discussions.
Low hanging fruit #2: If you don’t have an ROI calculation then do one.
Second, I’ve used dollars here, I could have used pounds sterling, euros, or any other currency. In fact, if you want an indication of whether doing X is more valuable than Y or Z the units don’t matter. And importantly you can mix units.
Look at that calculation again, I could rewrite it as:
ROI = (Revenue / Cost) -1
ROI = ($35,000 / $25,000) – 1 = 0.4 = 40%
Suppose I use value estimation using “business points” rather than dollars:
ROI = (35,000bp / $25,000) – 1 = 0.4 = 40%
Yes I know this is inexact, mixing units isn’t ideal but… it gives a rough guide which is good enough for many purposes, e.g. initial prioritisation.
Low hanging fruit #3: Prioritising using an approximate rule-of-thumb is better than not doing it. Don’t let perfect be an obstacle.
Third, the simplest approach just outlined is better than nothing and its quite usable over the short term near future, e.g. the next two weeks, or even the next six weeks. However once you start looking months out, an especially once you start looking years out you need to think again.
Once you start looking over longer period you need to consider, well: Time.
The fruit aren’t so low hanging from here on…
Specifically you need to consider: inflation (today’s money is worth more than tomorrow, usually) and the “risk free rate”, that is, “how much money could you make just from interest by putting the money into a safe bank account and waiting.” (Economists usually reference US Government bonds as the safest place but I’ll let you decide what you consider safe these days.)
Right now, November 2017, with very low interest rates and almost as low inflation this can seem pointless. And it probably is if you are planning the next couple of months. But if you are thinking a whole year into the future, let alone five or 10 years then it is very very important.
There is a third aspect of time that shouldn’t be ignored either: not all the costs are incurred at once, and not all the revenue occurs at the same time.
A small, $25,000, piece of work may well all happen in the next month but if that $25,000 was part of a bigger $250,000 “project” lasting 10 months then these things start to become important. And if it is part of a $1,000,000, 40 month, 3 year project than the rate of spend, dates of revenue, inflation and risk-free (interest) rate all become important.
Suppose this work will generate $2,000,000 (I’ll keep the numbers simple). The ROI calculation above would give a return of 50% – amazing but definitely wrong!
The simple ROI calculation above assume all the money is spent in one go and all the revenue arrives in one go which is clearly wrong!
What type of deal is it when I ask the bank to borrow $1m today and promise to pay back $2m in three years? – by the way I’m not even considering the risk inherent in doing work here or the cost of delay.
If we are going to put a value, a percent or dollar figure, on that deal one needs to consider time. Which means one needs to have a view on how the figure is arrived at. I know the engineer inside me thinks “there should be a single unambiguous value but it isn’t like that.
There are two commonly used calculations: Net present value (how much is it worth to spend $1m today and get $2m in 40 months time) and Internal Rate of Return (IRR, what is the percentage return on spending $1m today and getting $2m in 3 years?).
I’ll stick with these two calculations but there are others – Microsoft Excel offers IRR, MIRR, XIRR, NPV, XNPV plus PV and NV if you want to get really fancy. And there are others, each one contains its own assumptions and you need to decide which is best for you.
Now, according to Excel, if the safe bank rate is 0.5% (the current Bank of England rate, 0.04% per month) then the return on spending $1m today is only $697,337. (Calculation #1, IRR = 1.79% which seems ridiculous low but right now I can’t see any mistake in my calculation. IRR is an odd formula anyway which can produce two different values at the best of times and goes to show you need to understand what the calculations are.)
Notice, that assume you have $1m, if you need to borrow it and are paying closer to 4% a year then the return is just over $750,000. So actually, where you get the money from changes the rate of return too!
Now, suppose that instead of spending all $1m on day-1 it is spent $25,000 a month for 40 months. So, at the start of month one $25,000 is spent and $975,000 sits in a safe bank account. At the half way point half of the $1m is still resting in a bank account earning interest. It should be unsurprising to learn that the NPV is higher under this scenario. Indeed Excel gives and NPV of $774,00. (Calculation #2)
You can play what-ifs here, suppose all the expenditure occurred in the first 20 months but benefit still didn’t accrue until month 40, then NPV is $750,000.
Things get even more interesting if we change the assumptions about when benefit accrues. Suppose spending runs at $25,000 a month, and after month 20 revenue the product earns $100,000 per month for the remaining 20 months ($2,000,000 in total). Now NPV is just short of $843,000. (Calculation #3).
Take that to the extreme and assume $50,000 is delivered every month … well we can’t! One of the quirks of IRR, or at least the Excel version, is that there must be at least one month when more is spent than earned (negative net cash flow.) Again, one needs to understand the models built into the calculations.
So lets assume in month 1 there is no revenue but in month 40 there is twice as much, $100,000. (This allows me to keep the total net benefit at $2m). Now NPV is $911,897 but curiously IRR is 100% – from suspiciously low to suspiciously high. (Calculation #4)
I have posted Excel spreadsheet online and you can plug in your own numbers – and maybe someone can check my IRR calculation!
I could continue with these modelling assumptions. There are many ways I could extend the model, change the assumptions or otherwise interrogate the model. Notice though, every time I relax an assumption I replace it with another or sometimes several. For example, the revenue patterns above might strike you as unreal and you might change them to ones you think are more realistic, but in doing so you are also making assumptions.
Notice: I haven’t even started on the effects of inflation. Really I should be “deflating” the projected cash flows, i.e. $100,000 earned in month 40 is not $100,000 in future (2021) money which given the effects of inflation is going to be less than $100,000. Again, one would need to take a view on what inflation will be during the next four years. (If we assume US inflation runs at 3% a year between now and 2021 then $100,000 in 2021 prices is only worth $88,850 today – play with one of the inflation calculators on the web.) And if we are deflating future revenue shouldn’t we deflate future costs?
Now notice something else.
I haven’t talked about Agile, Lean, iterations, digital, Scrum, Kanban, continuous delivery or anything else that we normally talk about but isn’t it obvious?
Whatever you call this: delivering something early improves the return.
Nor have I talked about risk, changing requirements, user feedback, market testing or many of the other things that often get talked about. I’ve don’t deny all those benefits but I’ve deliberately kept this in numbers.
That my friends, is the business case for early and iterative delivery.
Read more? Subscribe to my newsletter – free updates on blog post, insights, events and offers.