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Strategic Case For IT Investment
Strategic Case For IT Investment
1
Learning Objectives
Describe different types of costs and benefits.
List and explain the advantages and
disadvantages of different financial models that
used to measure the value of investing an IS
projects.
Evaluate different alternate models for
understanding the business value of information
systems projects.
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Cost & Benefits
The worth of a project from financial perspective
essentially involved comparison between the
costs that you spend and the benefits that you
gain thereafter.
Using the cost/benefit analysis to determine cost
and benefits of an investment.
3 steps involved in the cost/benefit analysis:
Estimate the anticipated development and
operation costs.
Estimate the anticipated financial benefits.
Calculate & compare the detail estimates of costs
and benefits.
3
Cost Categories
Development costs – the costs that incurred
during development process.
Operational costs – the costs that incurred after
the IS/outcome put into production.
4
Development Costs
– those costs that are incurred during the process of
development
E.g.:
Salaries and wages
Equipment and installation
Software and licenses
Consulting fees and payments to third parties
Training
Facilities
Utilities and tools
Support staff
Travel & miscellaneous
Etc….
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Operational Costs
– Those costs that are incurred after the
IS/outcome is put into production.
Once the new product is up and running,
normal operating costs are incurred every year.
E.g.:
Connectivity
Equipment for maintenance
Costs to upgrade software licenses /software license renewal
fee
Computer operations
Programming support
Training and ongoing assistance (the help desk)
Supplies
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Benefit Classifications
Tangible benefits easy to quantify & assigned a
monetary value.
Intangible benefits hard to quantify
immediately & hard to assign a monetary value
but may lead to quantifiable gains in the long run.
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Tangible benefits
Examples of tangible benefits:-
workforce by automating manual functions
operating expenses (e.g. shipping charges for “emergency
shipments”)
error % (automated editing or validating)
Achieving quicker processing & turnaround of documents /
transactions
bad accounts or bad credit losses
inventory cost or merchandise losses
cost of goods through volume discount from bulk purchase
paperwork cost
computer/facilities expenses
Etc….
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Intangible benefits
Benefits that are not easily quantified & hard to assign a
monetary value.
It includes more efficient customer service or enhanced
decision making.
Examples of intangible benefits:
Increased levels of service (in way that cannot be measured)
Increased customer satisfaction (not measurable)
Improved company image
Improve resource control
Improve organizational planning
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Traditional Capital Budgeting Model
Capital Budgeting - Process of analyzing, and
selecting various proposals for capital expenditures.
Used to measure the value of long-term capital
investment projects.
The following capital budgeting models are used to
determine best investment return projects:
Payback method
Return on Investment (ROI)
Net Present Value (NPV)
Internal Rate of Return (IRR)
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Payback Method
Measure time required to pay back the initial
investment of a project. (How long it takes to recover
system cost.)
Time (intersection point) on which cumulative benefit =
cumulative cost.
Computed as:
(For equal fund flow case)
Original Investment (initial cost)
Number of years to pay back =
Annual Net Cash Inflow (annual return)
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Payback Method Project A:
Project B:
Example Server
ATM installation
consolidation
Investment: $1 Investment: $1
million million
Year Savings
1 $333,333 $250,000
2 $333,333 $250,000
Table 3.1
An
3 $333,333 $250,000
example of
payback
period
4 $250,000
5 $250,000
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Payback Analysis Calculation
For unequal fund flow case,
Example 1-Project A
Project A:
YEAR COSTS CUMULATIVE BENEFITS CUMULATIVE
COSTS BENEFITS
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Payback Analysis Calculation
• The payback period is approximately 4.2 years
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Payback Analysis Calculation
For unequal fund flow case,
Example 1-Project B
Project B:
YEAR COSTS CUMULATIVE BENEFITS CUMULATIVE
COSTS BENEFITS
0 80,000 80,000 - - X
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Payback Analysis Calculation
•The payback period is approximately 4.6 years
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Payback Method (Cont.)
Advantages:
Easy to compute and understand.
Good for high-risk projects in which the useful life of a
project is difficult to determine.
It matters less how long after year to pay back the system
lasts.
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Payback Method (Cont.)
Disadvantages:
Ignores time value of money.
For instance, a dollar saved today is worth more to us than
a dollar saved ten years from now, as today’s one dollar
could be drawing interest in a bank for us for ten year time.
E.g. You have two payment options:
A. Receive $10,000 now
OR
B. Receive $10,000 in three years
Which option would you choose?
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Payback Method (Cont.)
-To illustrate the time value of money, let’s look at the
following timeline:
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Payback Method (Cont.)
Disadvantages:
Does not take into account the overall profitability of
the project.
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Return on Investment (ROI)
The objective of ROI is to calculate a percentage return
based on capital invested, by comparing net benefits
(the return) received from a project to total initial
investment costs of the project.
Computed as:
Net Benefits
ROI = X 100 (%)
Total Initial Investment
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Return on Investment (Cont.)
Advantages:
Can be obtained easily
Easy to calculate and understand
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Return on Investment (Cont.)
Disadvantages:
Two projects with the same ROI might not be equally
desirable if the benefits of one project occur
significantly earlier than the benefits of the other
project.
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Return on Investment (Cont.)
Disadvantages:
Ignore time value of money.
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Net Present Value (NPV) Analysis
Is a technique of evaluating capital investment
using discounting arithmetic to determine
whether or not they will provide a satisfactory
return.
Computed as: PVF (present value factor)
1
PV = FV x ( 1+i )n
PV = Present Value
FV = Future Value
i = Discount Rate/interest rate
n = Number of years in the future
PV = 100 x 1
= 38.55
( 1+0.10)10
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Net Present Value (Cont.)
Thus, the present value of RM1 one year from now at 8%
is: -
PV = 1 * 1 / (1 + 0.08)1 = RM 0.926
Similarly, the present value of RM10 five years from now
at 12% is: -
PV = 10 * 1 / (1 + 0.12)5 = RM 5.674
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Net Present Value (Cont.)
Net present value (NPV) is the amount of money an
investment is worth, taking into account its cost,
earnings and the time value of money.
The formula is:
NPV = PV of expected cash flows – Initial investment cost
or
NPV = total present value of the benefits - total present value of the costs
E.g. If the present value of stream of benefits is RM
3,734,629, and the total present value of costs is RM
1,733,100, giving a net present value of RM 2,001,529.
In order words, for a RM1.7 million investment
today, the firm will receive net return more than
RM2 million (in today’s dollar).
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Project A: Project B:
NPV Example ATM installation Server consolidation
+$1.5 +$1.25
Total +$895,000 +$904,000
million million
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NPV Example: Conclusion
Based on PV analysis, is Project A or Project B
preferable?
PV analysis -->
Project with higher NPV (larger return) is preferable.
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Net Present Value (Cont.)
Advantages:
Considers time value of money. It allows consideration
of such things as cost of capital (The required return
necessary to make a capital budgeting project, such as
building a new factory, worthwhile.) , interest rates and
investment opportunity costs (The cost of an alternative that
must be give up in order to pursue a certain action.)
Considers the earnings over the entire life of the
project.
Simple criteria for accept or reject a project. It is
especially appropriate for long-term projects.
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Net Present
Disadvantages:
Value (Cont.)
Sensitivity to discount rates, and that can be tricky to
determine.
Ranking investments by NPV doesn't compare
absolute levels of investment.
-E.g. this method may be misleading in comparing the
projects of unequal lives. (5 yrs project and 10 years project
involved different levels of risks…)
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Internal Rate of Return (IRR)
Refer as “Go/No-Go Investment threshold”
It is the discount (interest) rate that will equate the
present value (PV) of the project’s future cash flows to
the initial cost (I) of the project.
That is, at IRR, initial cost of the project= present value
of the project’s future cash flow (PV of cash inflow-PV of
cash outflow)
In other words, IRR is the discount rate that generates a
zero net present value for a series of future cash flows.
at IRR rate, net PV = O
The higher a project's internal rate of return, the more
desirable it is to undertake the project.
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IRR Example
Discount rate: 10% Discount rate: 15% Discount rate: 20%
0 -$1 million 1.000 -$1 million 1.000 -$1 million 1.000 -$1 million
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Internal Rate of Return (Cont.)
Advantages:
Considers time value of money.
It's the method favored by many accountants and
finance people.
take into account all those factors like cost of capital,
interest rate, investment opportunity costs
Earnings over the entire life of the project are
considered.
All cash flows within the life of the project are
considered.
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Internal Rate of Return (Cont.)
Advantages:
Effective for comparing projects of different life
periods with different timings of cash in flows.
E.g. √
Project A Project B
Year Cash flow Year Cash flow
0 -$1 million 0 -$1 million
1 +$300,000 1 +$700,000
2 +$300,000 2 +$500,000
3 +$300,000 3 +$100,000
4 +$600,000 4 +$100,000
5 +$100,000
Total +$500,000 Total +$500,000
IRR=12% IRR=13%
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Internal Rate of Return (Cont.)
Disadvantages:
This method is tedious and difficult to calculate.
(Even Excel uses approximations answer is not as
100% true/accurate)
E.g. excel (IRR) =28.75%
specific IRR calculator (IRR)= 28.649282902479%
This method is based on top of the assumption that
the earnings are reinvested at the IRR rate which is
not always true.
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Limitations of Financial Models
Cost and Benefits factoring does not account for the risks in
assessing the final outcome.
It tends to overlook or ignore the social and organizational
dimensions of information systems that may affect the true costs
and benefits of the investment.
E.g. -Too focus on tangible cost until ignore intangible cost. (Many
companies’ information systems investment decision do not
adequately consider costs from organizational disruptions created
by a new system, such as the cost to train end users & customer
turnover cost as can’t carry on business as usual during system
development
-overlooked on certain tangible benefit area. (too optimistic on
estimating overall anticipated net return)
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Limitations of Financial Model
E.g.
-do not consider the impact that users’ learning curves for a
new system have on productivity
-do not consider time needed to convert from the use of old
system to new system (not consider the time managers
need to spend overseeing the new system related changes)
-Technology changes rapidly –especially during the course of
the project, causing cost estimates vary greatly.
- overlooked on certain intangible benefit area
-cost and benefits do not occur in the same time frame
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Other Methods of Evaluation
2 alternative methods (Non financial and strategic
considerations) to evaluate the worth of the IS
investment:
Portfolio Analysis
Scoring Model
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A) Portfolio Analysis
A measure of comparing and evaluating a certain
profile of risk and benefit to the firm.
Project Risk
High Low
Potential
Cautiously Examine Identify and Develop
Benefits to High
organization Low Avoid Routine Projects
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Portfolio Analysis
Each information system project carries its own set of risks
and benefits.
Use Portfolio Analysis examine portfolio of projects
in terms of potential benefits and likely risks.
Information intensive industries should have a few
high-risk, high-benefit projects to ensure that they are
staying current with technology.
Organizations in non-information intensive should
concentrate on high-benefit, low-risk projects.
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Portfolio Analysis
Under portfolio analysis,
High Benefit, Low Risk systems should be identify &
develop.
High Benefit, High Risk systems should be examined.
Low Benefit, High Risk systems should be avoided
Low Benefit, Low Risk systems should be reevaluated
for possible changes in order to make them a high
benefit systems.
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Portfolio Analysis Exercise:
Manor Way Tools
Manor Way Tools began life as a small steel company at
year 1998. It was one of the first companies to put carbon
into regular iron to create steel. It was strong and
flexible. Their first products were fish hooks which were
made from the flexible wire that they were able to
produce.
Over the years the product portfolio grew to include
anything that their operation could turn its hand to
such as javelins and railings. Today they focus their
operations on the manufacture of tools for the
professional, production, and the enthusiastic amateur.
Core products include handsaws, drill bits, screwdriver,
bow saws etc
The tool trade is very complex and competitive. Manor
Way's main competitor is Oliver Tools. They are the
market leader in many similar areas of the market.
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Portfolio Analysis Exercise:
Oliver is the market leader in handsaws with 70% of the market.
Manor Way has only 10%. As Manor Way are just new to the field of
producing handsaw and because of the budget constraints, they are
still manually producing the handsaw and therefore the numbers of
handsaws produced per day is rather limited. Handsaws usage in
house building are reducing from time to time and nowadays many
amateurs use power tools. However it is still quite profitable.
Manor way still make a range of barbed fish hooks which are now
banned in some markets. Nevertheless, the profit earned from
selling such barbed fish hooks is little compare to other products
and the monthly sales is not stable as well.
Both Oliver and Manor Way have invested heavily in gardening tools
and expect sales to increase in the future since people have more
leisure time and a larger disposable income. The profit earning from
selling such gardening tools is high and attractive. Manor Way has
10% of the new market, and Oliver has 15%.
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Portfolio Analysis Exercise:
Manor Way has a high share in the new market for sandpaper
replacement products. Their Wayplate is a popular steel
sandpaper replacement for which they have sole rights. They
have 25% of this growing market. Profit earning from selling
Wayplate is not as high as selling gardening tools but still been
highly observed and recommended by the Manor Way
management for its anticipated bright future sales.
54
Scoring Models
Quick Method for deciding among alternative
systems based on a system of ratings for selected
objectives (criteria).
It gives alternative systems a single score based
on the extent to which they meet selected
objectives (criteria).
It helps to bring about agreement among
participants concerning the rank of the criteria.
Scoring model consists of criteria, weights and
scale.
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Scoring Models
Criteria - the result of lengthy discussion among the decision-making
group.
“factor” , “issue” to take into account when decide the worthiness of
a project/investment.
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Scoring Models
Scale – Usually, use 1-to-5 scale/score (lowest to highest) to express the
judgments of participants on the relative merits of each system
(criteria/objective).
A range of value for measuring /grading purpose.
E.g. 1-10(worst-best)
Scale Meaning
3 Fully satisfies
2 Substantially satisfies
1 Partly satisfies
0 Does not satisfy
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Scoring Model
Steps in setting up a scoring model:
1. Identify criteria important to the project selection process.
2. Assign weights to each criterion.
3. Assign scales to each criterion for each project.
4. Multiply the scales by the weights to get the total weighted
scores.
Under scoring model, criteria are weighted and assigned score accordingly,
the final score will determine the likely choice for the new system.
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Scoring model example:
Criterion Weight score AS/400 score UNIX score Window
(weighte (weighte s XP
d score) d score) (weighte
d score)
Percentage of user 0.40 2 0.8 3 1.2 4 1.6
needs met
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Scale range : 0 – 5 ; 0---do not satisfy, 5---fully satisfy
ERP System A ERP System B
ERP System A ERP System B
Function Weight Weighted Weighted
%(scale) % (scale)
Score Score
3.0 Warehousing
3.1 Receiving 2 3 3
3.2 Picking/packing 3 2 2
3.3 Shipping 4 1 2
Total Warehousing
Grand Total 62
Scoring Model: In-Class Exercise
1. You are think about a new computer for your own needs
(general, gaming, desktop replacement, travel)
2. Evaluate 4 possible proposed solutions for your personal
needs
3. Go to Dell web site OR any other website (e.g.
http://computers.toptenreviews.com ,
http://www.pcmag.com )
4. Select 10 most important computer specs = criteria for you
5. Assign numeric weights for each designated criterion
6. Assign numeric scores (range 1 – 10) to each criterion for
each option/alternative
7. Calculate totals by multiplying the scores by the weights
and get the total weighted scores
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Solution
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