Internal Rate Of Return (IRR): Why IT Managers Should Know How To Use It

by drjim on November 29, 2012

The Internal Rate Of Return (IRR) is a very important percentage…

The Internal Rate Of Return (IRR) is a very important percentage…
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As an IT manager you will eventually be responsible for convincing your company to fund an IT project that your IT dream team wants to work on. Sure, from a technology point-of-view this may be a necessary project to do; however, the leadership in your company who control the funding probably don’t really care about that – they want to know how much money the company is going to make if you do this project.

What Is The Internal Rate Of Return (IRR)?

The question that the rest of the company is going to be asking you about the IT project that you are requesting funding for will be “…is this the best thing for us to be spending our limited funds on?” It’s a good question and you had better have a good answer for it.

It turns out that there is a standard way of talking about the value of a project. The Internal Rate Of Return (IRR) is a time-value tool that allows IT managers to make a decision as to if a proposed IT project is a good idea or not. If you are faced with having to choose between multiple possible IT projects, then IRR can help you to pick the one that will deliver the best benefits for the company.

In formal business-speak, the IRR is defined as being the discount rate at which the Net Present Value (NPV) of an investment equals zero. This is just a fancy way of answering the question “How much money will this project generate for the company over time?”

Yes, you could calculate this by hand, but it would take quite some time. Instead, this is the type of calculation that you need to do using either a fancy calculator or, even better, a spreadsheet. The % that you’ll get is the return on every dollar that the company chooses to invest into the project.

What Is The Hurdle Rate?

Making a positive return on every dollar that it invests into your IT project sounds wonderful for the company, doesn’t it? However, that’s not going to be enough to get your project funded. For you see, the company has a lot of other things that it can do with its money and they too will generate a return on every dollar that they invest in it. Where should they spend their money?

It turns out that there is a simple way to determine if the IRR value associated with your project is good enough to cause it to be funded. Every company has a value that they called the hurdle rate. This is a percentage that is the minimum rate of return that all investments that the company makes must achieve.

The thinking behind this is pretty simple. In the worst case, the company could take all of its investment money and stick it in a bank savings account. If they did this, then they would be guaranteed to earn a certain amount of money at the end of a period of time. You want them to invest in your project. That means that you’ve got to be able to show that your project is going to be able to generate enough money to cover what the company would earn if they just put their money in the bank along with extra money to compensate the company for the risk that they’ll be taking by investing in your risky project.

What Does All Of This Mean For You?

Nobody ever said that being an IT manager was going to be an easy job! You are going to be called on to present IT projects for funding approval to your company’s management. When you do this, you need to be ready to talk about the project using the terms that the rest of the company uses.

Internal Rate Of Return (IRR) is one such term. The IRR is a percentage value that tells the rest of the company how much money an investment in your project would generate. Knowing this value, decisions can be made between multiple different ways to spend the company’s money.

Even if you don’t anticipate that you’ll be asked to provide an IRR during a request for project funding, it might still be a good idea to calculate it. During heated funding discussions, it’s always a good idea to have standardized values available to add credibility to your request during the discussion. Good luck!

– Dr. Jim Anderson
Blue Elephant Consulting –
Your Source For Real World IT Management Skills™

Question For You: How many percentage points above your company’s hurdle rate do you think an IT project has to be in order to have any hope of getting funded?

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What We’ll Be Talking About Next Time

What makes an IT manager successful? In a word it’s communication. The IT managers who are able to successfully reach out and talk with the rest of the business using terms that they use every day are the ones who will be able to get more things done with their IT dream team and get them done quicker. In order for you to be considered to be a successful IT manager, you are going to have to boost your vocabulary by learning and understanding what the following three financial terms mean.

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