July 31, 2019

TCO vs ROI: Which is Best for Making Investment Decisions?

Image of business people discussing financial metrics like whether to use TCO vs ROI.
Image by rawpixel from Pixabay

Financial metrics, like total cost of ownership (TCO) and return on investment (ROI), are fundamental to making asset and technology investment decisions. This is true whether you’re the CIO of a large corporation, an entrepreneur at a start-up, or even the seller of a desired solution. When you propose an investment, you’re typically fighting for budget. You need an objective way to demonstrate the value of the proposed purchase. But what can you learn from TCO vs ROI and which metric will help the most?

TCO and ROI both offer insight into an investment, but from different points of view. Before diving in to any analysis, take a moment to consider your goals. Is the purpose of this investment to reduce costs, drive business value, or some combination? Once you answer this question, the answer to, “Which metric is best,” will become more clear. Now let’s take a deep look at these metrics, beginning with definitions.

What is Total Cost of Ownership (TCO)?

Total Cost of Ownership (TCO) is defined by its name; the total cost of owning (or using) an asset or technology over its entire life cycle. Therefore, a TCO analysis examines every expense involved in making an investment. This includes the expense of obtaining the product or service (acquisition costs), deploying the asset for functional use (implementation costs), using the asset, and maintaining the asset or technology over its lifetime.

The Total Cost of Ownership Formula

The total cost of ownership (TCO) formula: TCO=Investment Costs+Operating Costs+Maintenance Costs-Residual Value.

When performing a TCO analysis, the time duration needs to be carefully considered. For example, if you’re comparing a car lease to a car purchase, you will get a very different answer if you only carry your analysis out to the duration of the lease (e.g., three years) versus the assumed useful life of the purchased car (e.g., ten years).

Businesses typically look at asset life in two ways, depreciable life and economic life (aka useful life). Depreciable life is the period of time the investment will appear on your balance sheet and add (be depreciated) to your operating expenses. Economic life is the period of time during which you expect to use an asset. We typically recommend looking at the latter; what is the TCO over the useful life of the given technology or asset?

Let’s look at a TCO example.

Total Cost of Ownership Example

Your company has already moved a couple of key applications to the cloud and you think there might be a value to moving one of your department’s applications too. Does it make financial sense? Should you invest in moving that application to the cloud? Or, do you finally upgrade your existing on-premises (or on-prem) application to ensure ongoing vendor support?

Costs components will vary dramatically depending on the type of investment. When evaluating an enterprise software investment (on-prem or in the cloud) here are some of the costs you might include:

  • Initial costs
    • Purchase price of the software license or subscription cost of the service
    • Cost of hardware or hosting
    • Cost to deploy, implement, integrate, and secure the software
    • User training
  • Operating costs
    • Internal labor costs to manage the software and support the users
    • Bandwidth
    • Floor space, power & cooling for on-premises
  • Maintenance costs
    • Annual vendor maintenance, support, and/or assurance costs
    • Planned and unplanned downtime
  • Residual value
    • Typically, zero for the software, but you might be able to sell the on-prem hardware

For this comparative analysis, you project a useful life of 5 years for the on-premises upgrade. So, you set 5 years as your time duration and discover the following costs.

Five-Year TCO of Cloud vs On-Premises

Total cost of ownership (TCO) example showing the five-year TCO of cloud vs on-premises.

As you can see, even though the upfront costs are lower, moving the application to the cloud doesn’t necessarily allow you to reduce TCO. It eliminates the on-premises costs but replaces them with an annual subscription. So, even though the initial investment is higher, the on-prem TCO over five years appears to be a better choice with a total cost $65,000 lower than moving to the cloud.

The best part of using a TCO analysis is that it forces you to think beyond the purchase price. Unlike ROI, TCO allows you to more easily make a side-by-side comparison (like the one above) between two options. New vs upgrade or buy vs build, for example.

The biggest problem with TCO vs ROI is it doesn’t take business value into consideration. There are often quantifiable benefits that can offset the cost of a business asset or technology investment. But a total cost of ownership analysis, in practice, typically lives up to its name by only providing direct lifetime cost information.

Let’s compare this to using ROI to analyze the same project.

What is Return on Investment (ROI)?

Return on Investment (ROI) is a percentage that represents the net value received (benefits minus costs) from an investment over a given period of time. The ROI formula is easy to remember. This is because the ROI calculation is visually literal: ROI = total benefits minus total costs (return) divided by (on) the total costs (investment).

How to Calculate ROI

The return on investment (ROI) formula: ROI=Total Benefits-Total Costs/Total Costs.

Similar to TCO, an ROI analysis will typically consider the useful life of the asset or technology.

Return on Investment Example

In the example for TCO, we compared the total cost of moving to a cloud solution versus upgrading an existing on-premises application. Are there business benefits, beyond direct costs, that we can forecast if we move the application to the cloud?

The TCO analysis showed $2,025,000 in on-premises costs that would go away with a move to the cloud. Unfortunately, the cloud costs more over the same five years. But you recall that your company justified a move to the cloud for the other applications based on business value, including user efficiency and faster time to market. You also know that your company’s key initiative is Project Mercury, which heavily emphasizes employee productivity and faster time to market on revenue projects.

So, you roll up your sleeves and meet with the various departments that use the current application. You identify $500K in business user productivity, $100K in cost avoidance by extending infrastructure life, and $600K in accelerated margin through faster time to market of two revenue projects. That results in incremental business value of $1.2M for the cloud solution.

Five-Year Benefits of Moving to the Cloud

Return on investment (ROI) example showing the five-year benefits of moving to the cloud.

Using the ROI formula, we can now assess the value of moving to the cloud. ROI is the total benefits minus total costs (net benefits) divided by total costs. In this case:

ROI = ($3,225,000 – $2,090,000) / $2,090,000 = 54.3%

So, while the TCO calculation originally made the “forced” on-premises upgrade appear more favorable, performing an ROI analysis would challenge that conclusion. In this case, when we account for the business benefits, the result suggests that moving to the cloud may be the better choice.

Which Metric is Better Between TCO and ROI?

When deciding whether to use TCO vs ROI, it helps to go back to the basics.

If you recall, TCO focuses on the total cost of the asset or technology over its useful life. While, ROI goes beyond cost by adding in the anticipated business benefits so you can calculate your total return. Both metrics offer insight into a proposed investment, but they answer different questions. You need to revisit your investment goals to make an informed decision. TCO would support a cost-centric mandate, whereas ROI would support a long-term value pursuit.

In the move to cloud example, Project Mercury had a focus on employee productivity and faster time to market. While labor is a cost and, thus, could be a component of TCO, productivity and time to market are also business benefits. So, in this case, ROI is the better approach for cost justification.

When the criteria are less clear consider the following when evaluating multiple investment options:

  • If the value returned is the same for all offers, then TCO may be more telling.
  • If, however, the value returned is significantly different between your given choices, then ROI would be more informative.

In my experience, a true cost justification exercise will commonly incorporate TCO and ROI along with the net present value (NPV) metric over the same period of time. It will also include the payback period (time from the investment to break-even) to provide additional insight.

If you would like to understand more about NPV and how it can show the cost-effectiveness of a given investment, check out our article titled “ROI vs NPV: What Are They and What Do They Mean?

TCO vs ROI: Why Does it Matter in Technology Sales?

If you’re the buyer, the utility of these metrics is clear. You need to make the best financial decision for your business. The TCO and ROI metrics allow you to examine the costs and benefits of the proposed investment so you can make the best choice. Understanding your company’s goals certainly helps.

If you’re the seller, it’s in your best interest to understand how your customers make decisions and to provide them with the resources they need to build a business case. Ideally, you would be able to calculate these metrics and explain how one might use TCO vs ROI to evaluate your solution when compared to the competition.

At Technology Finance Partners, we’re often pulled in as a 3rd party resource. We deliver ROI Analysis Services by working with the buyer and seller to evaluate the financial impact of proposed solutions. Technology providers that offer this service to their customers differentiate themselves by being more of a trusted advisor. The transparency of understanding the TCO of the proposed solution and how it delivers business value and ROI helps the customer to make a more informed decision which ultimately strengthens the long-term partnership.