Gaining the support of senior management for spending on data quality is an essential but sometimes difficult task. Almost all well run companies use some form of capital budgeting for their investment decisions. Thus, a sound financial justification for data quality projects is the key to building a compelling case for spending on data quality. However, the financial benefits of data quality improvements can be difficult to measure. Nonetheless, if your proposal is factual and backed up by hard data, it stands a far better chance of getting approved. A proposal based on facts will be perceived as less risky and its projected returns will be considered to have a higher probability. The greater the projected financial return of a data quality project is; the greater is the likelihood that it will be approved.
If you are considering spending on an upstream data quality tool and are currently spending on downstream data quality solutions, your task can be considerably easier than for a de novo project. If you already have a downstream data quality system, you likely have data on how much employee time is required to cleanse your data bases or if you are using an outside service you have received invoices that document the cost of that data quality effort. Upstream data quality tools will eliminate much of the downstream costs. Thus, making an estimate of the amount of benefit provided by upstream data quality tools can be relatively easy and will be based on hard facts not supposition. You can use Ikhana’s ROI calculator to create a quick return on investment (ROI) for your data quality needs.
Return on investment is a quick, but somewhat crude, measurement of the financial worthiness of a project. It is simply the benefits gained from an expenditure minus the expenditure with that difference divided by the expenditure. In the above case, the ROI is the cost savings from an upstream data quality tool less the cost of the tool and that difference divided by the cost of the tool.
Another simple financial analysis that can be used is the payback period . A payback period is the amount of time it takes for an investment to pay for itself. If an investment has a payback period of as little as a few months, it will be very attractive to company management for a couple of reasons. One reason is that the internal rate of return (IRR) (more about this later) will probably be very high because the investment is recouped so quickly. Another reason is that, because the investment is recouped quickly, the risk is less. The more time that passes after an investment is made before the returns pay for it, the more time there is for something to go wrong. If an investment pays for itself immediately, it is a “no brainer” to make the investment. The IRR of the investment is almost infinite. There are some who argue that the payback period is an essential metric for evaluating IT projects.
The IRR and net present value (NPV) are perhaps the most common and most trusted capital budgeting tools. For projects that require multiple periods to implement or multiple periods to recoup the initial investment, the IRR and NPV are the most appropriate analytical tools. The reason for this is the concept of the time value of money. Basically, the notion of the time value of money is that a dollar today is worth more than a dollar a year (or any period of time) from now. The rate at which the value declines over time is known as the discount rate. For a company the appropriate discount rate is the company’s weighted average cost of capital (WACC). Many companies add a risk premium to the WACC to arrive at their discount rate.
To calculate the NPV of an investment proposal the future benefits from the investment are discounted back to today using the company’s discount rate (WACC). Then, when the investment costs are subtracted from the discounted benefits the result is the NPV. If the NPV is positive, it indicates that the project could be a good investment and should result in an increase in the value of the enterprise because the future benefits exceed the costs of the project even when discounted at the company’s cost of capital.
The IRR gives financial analysts another metric to judge the merits of an investment. The IRR uses the same concepts as NPV. However, the IRR is itself a discount rate. It is the rate that when used to discount the future cash flows of an investment will result in a discounted value equal to the cost of the investment. It is the return on the investment over time. (No wonder they call it the internal rate of return.) If the IRR of an investment is greater than a company’s WACC, the investment will have a positive NPV. The greater the spread of the IRR over the WACC, the more attractive the potential investment will be.
This is a very cursory overview of financial analysis for capital budgeting decisions. Please refer to the hyperlinks for more detailed explanations.
In a future blog we will discuss how you can estimate the benefits of a data quality initiative.
