Essentials of Managing IT Finance - Primer for the new CIO

June 1, 2020 Hari Subedi

This blog post was updated on August 29, 2024

It was originally published on June 1, 2020

The role of the Chief Information Officer (CIO) in modern-day businesses is very critical. Today, investment in IT has a direct impact on the empowerment of users, improving productivity and contributing to the overall business goals. However, in most cases, the impact of technology on the bottom line is implicit and not readily demonstrable to the business leaders. In this blog, we discuss the financial challenges that CIOs are most likely to come across and how to best overcome them.

Role of a CIO and key challenges

A CIO is responsible for running an organization’s internal IT operations and managing the entire technology infrastructure.

A CIO is responsible for the following board activities:

Building, operating, and maintaining the IT infrastructure
Ensuring that your technology is aligned with the business goals
Developing strategies to increase efficiency and profitability
Keeping pace with the rapidly changing technology
Managing vendors and suppliers

As their company's top technology manager, the CIO focuses on internal customers, i.e. business units and staff. This necessitates constant collaboration with the business unit managers and an ongoing struggle to meet their technology demands. If organizations had unlimited resources, this wouldn’t be a problem. However, that’s never the case, so a CIO almost always has to manage projects within restrictive budgets.

So, the key challenges for CIOs include:

Demonstrating the value of IT, so that requisite budgets for IT initiatives can be secured, and
Communicating the value of IT initiatives in a language that the business leaders understand.

Let’s take a look at how we can address these challenges.

The Need For Investment In Technology

IT is a strategic investment that requires constant attention. To stay competitive in the market, businesses have to continuously evolve, exploring and investing in new technology. Companies that extensively invest in technology tend to grow into strong strategic positions in the market. There are many examples of this but the most compelling is how the Domino’s pizza chain turned into a tech company.

Given the rapidly changing technology environment and a limited budget, there is only so much technology a business can invest in. Moreover, the CIO is answerable to other stakeholders who may not see the impact of technology as well as the CIO does. So the CIO not only has to seek but also justify the budget required for your IT projects.

With whatever budget CIOs secure, they have to meet the business demands in the following key areas:

IT Operations and Maintenance - deliver IT services, such as desktop support, network & WiFi, communications, IT security, data storage, and servers, etc.
Improvements and Efficiency - reduce business costs, increase operational efficiency, and improve the quality of services
Digital Transformation - integrate digital technology into all areas of business, providing capabilities to improve long-term competitiveness.

Let’s see how this can be achieved…

The Need For Evaluating IT Finance

Although businesses consistently invest in technology, business leaders are increasingly putting these investments under scrutiny. Decision-makers often question whether these investments are truly paying off because they find it difficult to directly link IT spending to key business objectives or financial performance. Consequently, CIOs are often required to justify these investments by demonstrating clear, measurable returns, typically expressed in financial terms.

How To Evaluate Investment In IT Projects

Financial measurements are a common metric used to demonstrate the value of investments in technology initiatives and IT projects.

Here are the common financial measurements used to evaluate projects:

ROI

Return On Investment (ROI) is probably the most common financial metric. As the name suggests, it measures how much return (benefit) your investment brings. It is calculated by dividing the return on an investment by the cost of that investment.

Return on investment is calculated as:

ROI = {(Current value of investment - Cost of Investment) / Cost of Investment} x 100%

The ROI is a popular metric because it is simple to calculate and easy to interpret. A net positive ROI means that the project is worth investing in. In addition, as it returns a percentage value, ROI is easy to compare with other investment options.

Payback period

The payback period is simply the length of time it takes to recover your initial investment. The shorter the payback period, the more desirable the investment. The payback period is calculated by dividing the cost of the investment by the annual cash flow.

The payback has a major problem in that it ignores the time value of money. Therefore, it is generally used only for making quick judgments on investments. Nevertheless, the payback period is still popular because of its simplicity as it helps you to easily determine the number of years it will take you to recover your investment.

Net Present Value (NPV)

The net present value is the difference between the present value of all the future cash flows and the initial investment. From the time value of money, we know that an amount now is worth more than the same amount in the future.

We use this concept to bring all the incoming and outgoing cash flows to their corresponding value in the present. Therefore, you can compare your investment, made today, to the present value of the income you will receive from your investment in the future.

Here’s how you can calculate it:

NPV = (Today’s value of the expected future income) - (Today’s value of the invested money)

A positive NPV will be a profitable investment and hence worth considering.

Internal Rate of Return (IRR)

The internal rate of return is the rate of return at which the net present value (NPV) of all the future cash flows becomes equal to your initial investment. In other words, it is the rate of return that sets the net present value of all cash flows from the investment equal to zero.

Although the actual rate of return from your project will differ from the estimated IRR, it offers a handy measure for comparing different projects. The higher the IRR value, the better the investment option.

When evaluating competing IT projects, the CIO will likely establish a required rate of return (RRR), i.e. a minimum rate of return that is acceptable to the business. Then after calculating the IRR for those different projects, they will choose the one with the highest difference between the IRR and the RRR. This will ensure that they are investing in the best IT project.

Calculating IRR isn’t straightforward. It is determined using a trial and error method. The easiest option is to calculate using the inbuilt formula in Microsoft Excel.

The above financial measurements provide an estimate of the financial impact (return) of your investment over a period of time. These measurements provide a framework using which you can compare different projects and decide which one to invest in. Hence, these will come in handy when making a business case for your IT projects.

Although financial metrics are considered mandatory in order to justify new investments in IT projects, their choice and use are still widely debated.

So how do we communicate the value of IT projects? Let’s see...

What are the problems with these financial measurements?

Evaluating IT investment is a problematic topic. Although many organizations use financial measurements such as ROI, NPV, IRR, etc. as an evaluation method, they are often inadequate for measuring IT investment.

Technology is a difficult investment to evaluate because the income from it is not as clearly defined as with other investments such as a truck or a piece of machinery. Technology in most cases is an enabler that lets you unleash the potential of your staff. The traditional financial measurements do not capture this and other similar intangible benefits.

How to overcome the problems with the financial measurements?

Traditional financial measurements use cash flow for calculating the return on investment. However, as we discussed earlier, most IT projects do not directly produce a cash flow. So, as a workaround, we can use a non-traditional calculation method by considering the savings or quantifying the intangible benefits.

The following are some of the intangible benefits of IT initiatives that can be quantified:

Time savings
Capturing better data for improved reporting and decision-making
Reducing downtime using proactive rather than reactive IT support
Increased level of service
Timely regulatory compliance
Increased efficiency through improved quality-of-life tools

For example, proactive IT support can potentially save you $6,876 per employee per year. How we arrived at this figure can be seen in our blog: How To Calculate Cost Of IT For Your Business.

So if you have 20 employees and your IT support achieves 70% of that saving, you will be saving 70% of 20 x $6,876 = $96,264 annually.

For a 20-employee company, say the cost of IT support is $3,000 per month. So annual cost or investment in IT support = $3,000 x 12 = $36,000

Therefore, for your investment in IT support, the ROI = (96,264 - 36,000) / 36,000 x 100

=> ROI = 167.4%

Now, that’s a very attractive ROI that no business leader can ignore.

You can similarly calculate the other financial metrics to present the business case for your IT projects.

Final thoughts on IT project finance

Although the financial metrics may appear intimidating, many of them are quite simple to calculate and interpret. The only critical thing to remember is that you need to clearly define the benefits and quantify them. The real challenge for the CIO, especially in small businesses, is that they may not readily have access to the data, required for analysis or for identifying historical values. In such cases, you can refer to the industry standards for your respective businesses.

Using these financial measurements, you can not only clearly demonstrate the business value of your IT projects but also communicate this in a language that the business leaders can easily understand. This allows you and your fellow business managers to objectively evaluate investments in various IT projects and make informed decisions.