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Issue No.03 - May/June (2004 vol.21)
pp: 18-22
Published by the IEEE Computer Society
Hakan Erdogmus , National Research Council, Canada
Wolfgang Strigel , Software Productivity Center, Canada




If the software engineering community were to hold a contest to select its most overworked, misused, and abused acronym, it's quite possible the winner wouldn't be AI, RAD, or even OO but the unassuming little term ROI. Ubiquitous and reckless promotion by vendors, consultants, and marketing gurus has diluted the expression return on investment into an umbrella term that can mean anything from profits to competitive advantage to simply "something good." Consequently, the software community looks upon ROI with increasing suspicion as a vague and slippery gimmick used chiefly to make the sales pitch (invariably unsubstantiated) for a particular product or initiative.
On the contrary, ROI analysis aims to achieve clarity in the decision-making process. For example, from a technical perspective, we generally want to increase a software product's quality because fixing existing software takes valuable time away from developing new software. But how much investment in software quality is desirable? When should we invest, and where?
A robust economic and strategic analysis can help answer these questions. If a firm's strategy to achieve competitive advantage is based on higher customer satisfaction and corresponding higher prices, then it can argue for a certain level and type of investment in quality. A competitive strategy based on lower production costs and lower prices might lead to targeting the investment in quality to specific parts of the software product or service. In this way, the value of increasing software quality is framed in terms that senior management can understand and use to make informed decisions. But even technical personnel can benefit from familiarity with this type of analysis. From the new agile development methodologies that explicitly incorporate notions of customer value to the latest asset-based repositories such as product lines, it's clear that the software industry currently views few initiatives from a purely technical perspective.
Learning the Business
It's not the widespread promotion of ROI in the software industry that is misplaced, but the use of a single, narrowly defined concept as a proxy for an entire hierarchy of activities concerned with financial and strategic analysis. These activities fall essentially into four levels, each driving the next:

    Business strategy: Selecting markets in which to participate and formulating strategies for competing in those markets

    Valuation: Analyzing the economic value of projects executed in the pursuit of that business strategy

    Cost-benefit analysis: Translating measured or estimated data into monetary terms (for example, labor costs), forming the basis for valuation

    Metrics: Measuring the parameters (such as programmer time) that form the basis for cost and benefit analysis

Not surprisingly, the software engineering community has done an enormous amount of work in the latter two areas while effectively neglecting the first two. We feel comfortable with gathering and interpreting metrics, which are naturally "close to the code," whereas valuation and competitive strategy seem to belong to the unfamiliar realm of corporate finance. Unfortunately, our educational system neglects to expose software engineers to business fundamentals and doesn't instill a good understanding of the role of technical projects in the context of overall business imperatives. So, we're often not well equipped to elaborate the business case behind our technical vision.
Yet the fundamentals of financial and strategic analysis are within any software engineering professional's grasp. Few disciplines offer better preparation—software engineers can understand and apply abstract concepts, can think clearly and logically, and last but not least, have computational skills. It's ironic that the legions of programmers constructing the financial and strategic analysis tools that businesses around the world use don't apply these same tools to their own products and processes.
Analyzing and Creating Economic Value
It's equally ironic that ROI has acquired the reputation of being a vague and slippery marketing device in the software community, because the definition of ROI used in finance (and in this special issue) is anything but—it's the ratio of net benefits to costs, or
(Benefits — Costs)/Costs.
The ROI calculation organizes a project's costs and benefits ("cash flows" in finance jargon) into a useful profitability measure. But this measure alone doesn't capture two essential ingredients of any serious economic analysis: time and risk. Without the dimension of time, we can't compare the economics of short-lived versus long-lived projects; without accounting for risk, we can't compare a project with its riskier competitor. The rigorous treatment of time and risk brings an analysis firmly into the domain of valuation.
At the heart of modern valuation is the only logical and universally accepted definition of economic value: net present value. NPV analysis levels the playing field for costs and benefits occurring near and far in the future by aligning them all to a single time frame in the present. Is early, one-time delivery preferable to a long-term subscription offering? Should I pour my resources into that one-time, quick-payback project now or invest in a more ambitious program of systematic reuse? Valuation can help make sense of the numbers, giving proper weight to costs and benefits occurring at different points in time.
By explicitly modeling the time value of money, NPV introduces another fundamental concept into valuation. The return generated by money earning interest over time becomes a baseline ROI against which we can compare alternative uses for that money. This opportunity cost of money effectively represents a hurdle that a competing investment opportunity must overcome to be justifiable (otherwise, you might as well put your money in the bank). The opportunity cost of money and its role in creating or destroying economic value is the core principle driving the best management practices available today.
However, time isn't the only factor determining the opportunity cost of money. If a software development project promises the same ROI as money sitting in the bank, then an investor would insist on a discount for taking the additional risk—the higher the perceived risk, the higher the demanded discount. Treating risk in modern valuation goes far beyond the intuitive notions underlying typical project-level risk management programs in the software industry. Valuation explicitly quantifies the level of reward that an investor may demand for taking on risk. Furthermore, it does this while reconciling a project's specific risks with the inevitable, systematic risks that the overall economy thrusts upon it.
Valuation is an important tool for analyzing economic value, but business strategy is the key to creating it. Yet even more so than valuation, most software engineers seem to see business strategy as a riddle wrapped in mystery inside an enigma. Given the careless, overhyped, and even contradictory use of mantras such as "time to market" and "explosive growth" in recent years, the confusion is understandable.
Properly understood and executed, however, business strategy development is a methodical, disciplined exercise based on solid and rational principles. It's thus worthy of study by any software professional—especially given software's highly strategic nature in today's business environment. Analyzing market structure is an essential component of strategy development. Is the average market participant profitable? Are there high barriers to entry? Answering questions such as these can help strategists wisely select markets in which to participate and avoid jumping blindly onto the latest bandwagon. Competitive strategy development in a chosen market isn't a matter of merely "playing to win" but involves making hard choices: Can high market share be pursued profitably at these prices? Is the nature of the service such that we can differentiate our offering and justify higher prices? Will shorter time to market result in a sustainable competitive advantage or just an ephemeral flash in the pan?
The basic principles of market selection and competitive strategy, accessible to any software professional, were violated again and again during the boom years. It's unlikely that the future will be so forgiving.
In This Issue
From 21 submissions, we selected six articles, each addressing one of the top three levels of ROI-related activities—cost-benefit analysis, valuation, or business strategy. We aim to provide, through illustrative examples, a broad perspective on

    • How different kinds of software organizations define and use ROI in different sectors and for different process- and product-related decisions

    • Emerging practical approaches for reasoning about ROI at the top three levels

"Calculating ROI for Software Product Lines" and "Measuring the ROI of Software Process Improvement" focus on cost-benefit analysis. The first develops a business rationale and classic ROI model for migrating a set of software products to a product line, while the latter addresses ROI specifically in the software process improvement domain. The next two articles focus on valuation. "The Incremental Funding Method: Data-Driven Software Development" describes a valuation-based method for release planning in the context of incremental development. "Value Creation and Capture: A Model of the Software Development Process" describes a visual, functional model for analyzing a software development project's value. To illustrate the broad nature of strategic issues pertaining to ROI, we selected two articles of very different flavors. "The ROI of Software Dependability: The iDAVE Model" describes a method for exploring software dependability strategies based on empirical cost and quality models. "Marketplace Issues in Software Planning and Design" gives a high-level overview of marketplace factors and strategies in commercial software development, such as pricing, standards, switching costs, competition, and project structuring.
Although these articles provide concrete ideas of how to reason about ROI in the context of software development, they don't span the whole ROI space. We thus identify additional resources in the related sidebar.
Conclusion
To the practicing software engineer, finance and business strategy might seem to be distant, irrelevant worlds. But ignoring them isn't in our best interest, because they draw closer every day and offer challenges that are as intellectually demanding and satisfying as any in our own field. We hope this special issue raises ROI awareness in the software community.

Hakan Erdogmus is a senior research officer at the National Research Council, Canada. His research interests include software engineering economics, agile software development, and collaborative software development. He received his PhD in telecommunications from INRS, Université du Québec. Contact him at NRC Inst. for Information Technology, Montreal Rd., M-50, Ottawa K1A 0R6, Canada; hakan.erdogmus@nrc-cnrc.gc.ca.

John Favaro is the founder of Consulenza Informatica in Pisa, Italy. His research interests include software reuse, agile methods, and the value-based management of information technology. He received his MS from the University of California, Berkeley. He is a founding member of the International Society for the Advancement of Software Education. Contact him at Consulenza Informatica, Via Gamerra 21, Pisa, Italy; jfavaro@tin.it.

Wolfgang Strigel is the founder and president of Software Productivity Center, a consulting and products company, and of QA Labs, a contract testing company. His interests include collaborative software development, process improvement, project estimation, testing, and software engineering economics. He has an MSc in computer science from McGill University and an MBA from Simon Fraser University. Contact him at strigel@spc.ca.
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