Net Present Value. Since coming to IT, I have spent much time focused on the topic of business value. This topic has dominated customer presentations and events, CIO forums, internal discussions several blog posts and even a few twitter discussions that I've been having. Whether an IT organization is attempting to justify investment to support a new project or communicating the benefit of an existing one, being able to communicate, demonstrate and deliver the value of those projects is critical.
What I have learned is that there are many different ways to communicate the savings or value created by a project. Matt Beckert, Intel IT finance, and I have spent several hours discussing this topic. Let me provide the cliff notes (simplified version) and why Intel IT is moving to a standard methodology focused on Net Present Value.
Many times you will hear individuals talk about how much they saved by doing something. Example, yesterday I saved 10% by using a coupon buying a coffee at Starbucks. I saved $0.35 on my $3.50 latte. So while I avoided spending $0.35, did I create value for myself â€“ not really.
Value is often a collection of costs that include what I had to spend (my capital outlay), cost avoidance (what I didnâ€™t have to spend), operational cost savings (how my daily costs are affected), additional revenue generated (what I earned), productivity gained (greater output for equal or less input) and several other variables. Intel IT looks at a variety of business value metrics for our project portfolio.
In the terms of IT projects, the business must invest in something to achieve a goal. The collective measure of money spent vs. benefit received is a Net benefit. If I buy 100 t-shirts to sell for a charity and each t shirt costs me $5 and then I sell those t-shirts for $15 each, then the net benefit to my charity of that project is $1,000 (100 x $15 minus 100 x $5).
Expanding on my example further. What if I did not sell those shirts immediately but I held on to them for five years. In this case, my net benefit would still be $1,000 from the project but because of inflation, the value of that earnings is worth less to me than if I sold them immediately. If inflation was 10% per year, then the $1,500 that I earned from sales would [when discounted back with inflation $1,500 / ((1+inflation rate) ^(# years))] would only be worth about $931 in todayâ€™s dollars today. So taking into account the time-value of money, now this t-shirt project was only worth $431 to me in todayâ€™s currency or Present Value.
(Readers Aid. If you anything like me, this topic makes my head spin, Matt helped me build a cheat sheet table that shows the time value of money depending on how long it is held and the annual inflation rate or discount rate applied over that period of time. See the table at the end of this blog.)
It is possible that I could have earned more than $431 by doing another project or by maybe investing my original capital of $500 in the financial market and getting a better ROI (often called the â€śhurdle rateâ€ť for financial planning). With many IT projects affecting a many types of cash flows over different time horizons, it is critically important from a financial perspective to compare apples to apples when looking at projects.
This is why a Net Present Value is so important â€“ it allows business leaders to compare the net value (return on capital) in present value (accounting for time value of money) across many projects, thus prioritizing the most important ones with an eye on the bottom line.
I have to admit, while communicating savings in terms of NPV is a lot more confusing and often less interesting (the numbers are lower than gross undiscounted multiple year savings numbers), it does enable a more level playing field and better articulates the actual impact projects are having on an organization. For example, in the recent data center paper published by Intel IT, our gross benefit is estimated at $1B, while our NPV is estimated at up to $650 Million - depending on when we make the investments and how quickly we realize the benefits. Either way you look at it, you can draw one common conclusion: our eight year Data Center IT strategy is creating a lot of business value for Intel.
Read Mattâ€™s perspective on our Data Center Strategy.
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NPV Table. The net present value of receiving $1,500 cash five (5) years from today assuming a 10% annual rate of inflation is $931.