Cost of ownership, ROI, and cost/benefit analysis: What´s the difference?
Cost of Ownership, Return on Investment, and Cost/Benefit analysis are all special kinds of business case analyses. Each term implies a slightly different approach to the general business case question: “What are the likely financial and other business consequences if we take this or that action (or decision)?”
Whether developing your own case or evaluating someone else's, remember that none of these terms has a single precise or universally agreed definition—unless your organization has established standards for these terms. Therefore, it is important to document and communicate which cost (and/or benefit) line items are included and which are not, the time period covered, and major assumptions used in calculating financial metrics. Here are some of the important characteristics of each approach.
• Cost of Ownership / Total Cost of Ownership (TCO)
• Return on Investment (ROI)
• Cost Benefit Analysis (CBA)
Cost of Ownership / Total Cost of Ownership (TCO)
Cost of Ownership (sometimes called “Total Cost of Ownership”, or (TCO) usually means:
The total cost of acquiring, installing, using, maintaining, changing, and getting rid of something across an extended period of time (most or all of its useful life).
Cost of ownership figures are often developed for computer systems, medical test equipment, and a wide range of other expensive capital items. Note especially the following:
- Cost of ownership is always more than purchase price, sometimes many times more. Total five year cost of ownership for computing equipment, for example, can be 3 to 10 times the original purchase price.
- Naming the cost of ownership subject does not fix the boundaries for the cost of ownership analysis. You must still decide and communicate which costs belong in the analysis and why. IT costs of ownership comparisons from publishing analysts tend to have a rather narrow scope, focusing on purchase price, maintenance, and very direct operational costs (here the emphasis is on “Apples-to-Apples” comparability). IT cost of ownership analyses from sales people, consultants, or managers for specific settings tend to have a broader scope, aiming at the “Total” or “Comprehensive” cost of ownership (here the emphasis is on completeness and predictive accuracy for this setting).
- A cost of ownership estimate can be the “Cost” side of a cost/benefit analysis, but cost figures alone does not capture “benefits” except in a very limited way. If the costs of ownership figures for different alternative actions are compared (perhaps a “business as usual” scenario and a “change” scenario), one scenario may show cost savings or avoided costs relative to the other.
- Cost of ownership does not capture financial benefits that come from such things as increased revenues, increased business volume, improved competitiveness, and many other factors. This limits the value of a “pure cost of ownership” business case in two important ways:
- Cost of ownership analysis alone usually cannot provide the basis for estimating "Return on Investment" or financial metrics such as IRR or payback period, unless cost savings are counted as "returns." .
- Cost of ownership alone is a sufficient decision criterion only when all possible actions differ only with respect to cost, but otherwise should have the same positive impact on operations or business performance.
- Cost of ownership results are usually presented as cost totals rather than incremental costs that go with an action. As such, cost figures have clear, easily interpreted meaning for budgets.
For more on Total Cost of Ownership, click here.
[ Page Top ] [ FAQs ] [ Business Case Books & Tools ] [ Home ]
Return on Investment (ROI)
The term Return on Investment (ROI) is commonly used in different ways.
When investment counselors perform financial statement analysis, the strict meaning of Return on Investment (ROI) is Return on Invested Capital, a measure of company performance: The company’s total capital is divided into the company’s income (before interest, taxes, or dividends are subtracted). Alternatively, ROI is sometimes equated with Return on Assets: a company's income for a period divided by the value of assets used to produce that income.
In the business case, or when comparing one potential investment with another, the term ROI applies to cash flow analysis, not financial statement analysis. In this case, most business people use “ROI” simply to mean the “Return” (incremental gain) from an action, divided by the cost of that action. In this sense, an investment that costs $100 and pays back $150 after a short period of time has a 50% ROI. When ROI is requested, it is prudent ask specifically how that is to be calculated. Understand clearly, that is, how both the “return” and the “investment” are derived and what time period is covered.
Three ways to maximize ROI are suggested by the figure above: Minimize costs, maximize returns, and accelerate the returns. A relatively small improvement in all three may have a major impact on overall ROI.
ROI is an appealing concept because its meaning seems self-evident and easily understood. Many factors can complicate its calculation or interpretation, however, and for that reason many business people do not attempt to present ROI as a quantitative result, but focus instead on financial metrics such as Net cash flow, DCF, IRR, and payback period (see "What's the best way to summarize a business case?")
Problems with ROI include the difficulty of finding a truly appropriate investment cost figure (this may call for arbitrary cost allocation judgments or the addition of “opportunity costs,” for instance). Other problems with ROI come from the passage of time. Investment costs typically come early, while returns may come years later. Thus, the time value of money (discounting) may need to enter the ROI equation; and, it may be especially difficult to match specific returns with specific costs. In brief, the simple ROI concept is probably appropriate only when both "Investment cost" and "Return" come over a short time period, are clearly tied to each other, and can be derived simply and unambiguously.
For more on return on investment, click here.
[ Page Top ] [ FAQs ] [ Business Case Books & Tools ] [ Home ]
Cost Benefit Analysis (CBA)
Cost/Benefit (C/B) analysis is used, widely, for planning, decision support, program evaluation, proposal evaluation, and other purposes, in organizations of all kinds, even though the term itself has no precise definition beyond the implication that both positive and negative impacts are going to be summarized and weighed against each other. Some key points to remember about C/B analysis include the following:
- A good cost/benefit analysis for a major acquisition or action will include a time dimension and other characteristics of a good business case (See “What’s a business case?”). In order to evaluate a C/B analysis properly, your audience needs to see the timing of expected inflows and outflows as well as the cost and benefit models that determine what is included in the case and what is not.
- A cost/benefit analysis will on the one hand attempt to quantify every benefit and cost for inclusion in the financial analysis, even the so-called intangible or “soft” costs and benefits. On the other hand, it will not omit discussion of important non-quantified benefits and costs. The reason it is important to quantify everything possible is this: If no financial value is assigned to an agreed cost or benefit, that impact contributes exactly nothing to the financial analysis. Is this really appropriate? Often it is not. A company may invest in technology in order to improve its “professional image,” improve customer satisfaction, or create a “more professional work environment.” But how much monetary value should be credited to these benefits? They will be valued at 0 if an acceptable valuation is not agreed.
- Cost/benefit analyses usually represent incremental costs and benefits (only financial changes due specifically to the action or proposal in view). This is because C/B analysis is usually undertaken for decision support purposes. The objective, after all, is to understand the net effect of a decision. A very easy mistake for C/B analysts to make, however, is to mix incremental C/B data with total C/B data in the same analysis.
- The most useful financial results in a C/B analysis appear in a time-based cash flow summary. This is the basis for calculating standard financial metrics such as net cash flow, DCF, IRR, and Payback Period. If the cash flow statement also shows individual cost and benefit line items, it can serve as an effective tool for risk management and for optimizing returns (see “What’s the best way to summarize a business case?").
[ Page Top ] [ FAQs ] [ Business Case Books & Tools ] [ Home ]
We recommend that you review and expand your Business Case skills with one of the New Solution Matrix Books on the Business Case!
Learn from the trusted authority, the world's most frequently cited business case book. Clear, concise, and practical. Everything you need to know for building your business case, complete with ROI and other financial metrics. Click here to read more and order online...
Learn how to calculate the ROI of so-called "soft" benefits and find out how to cut your Business Case preparation time in half! |
Business Case Essentials, 3rd edition
[ Pacioli ]
What do financial metrics say about business case results? >>
© Copyright Solution Matrix Ltd. 2004 - 2010
