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AACS3035 MANAGING INFORMATION SYSTEMS CHAPTER 4

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Chapter 4 Costs & Benefits

After reading this chapter, you will be able to: •Describe different types of costs and benefits •Evaluate models for assessing the business value of ISs.

• Obviously, the justification for an IT investment is that it will increase income, either

through cost savings or by increased revenues. • Thus, determination on costs & benefits of an investment is essential, and can be

determined by using cost/benefit analysis. • 3 steps process:

To estimate the anticipated development and operation costs. To estimate the anticipated financial benefits Calculate the detail estimates of costs and benefits

4.1 Cost categories • Development Costs – those costs that are incurred during the process of development • Development costs categories:

Salaries and wages Equipment and installation Software and licenses Consulting fees and payments to third parties Training Facilities Utilities and tools Support staff Travel and miscellaneous

• Operational Costs – those costs that are incurred after the outcome is put into

production. • Once the new product is up and running, normal operating costs are incurred

every year. • Generally it included only the costs that are directly related to the new system

and its maintenance. • Operation costs categories:

Connectivity Equipment for maintenance Costs to upgrade software licenses Computer operations Programming support Training and ongoing assistance (the help desk) Supplies


4.2 Benefits (Tangible and Intangible) A. Tangible benefits • Benefits that can be quantified and assigned a monetary value. • Benefits usually come from two major sources, decreased costs or increased revenues. • Cost savings or decreases in expenses come from increased inefficiency in company

operations. • Specific areas that reduced costs include the following:

Reducing staff by automating manual functions or increase efficiency Maintaining constant staff with increasing volumes of work Decreasing operating expenses such as shipping charges for “emergency shipments” Reducing error rates through automated editing or validating Achieving quicker processing and turnaround of documents or transactions Capturing lost discounts on money management Reducing bad accounts or bad credit losses Reducing inventory or merchandise losses through tighter controls Collecting receivables (account receivables) rapidly Reducing cost of goods through volume discounts and purchases Reducing paperwork cost by implementing electronic data interchange and other

automation • There are no “standard” benefits; different project has different anticipated benefits B. Intangible benefits • Benefits that are not easily quantified • It includes more efficient customer service or enhanced decision making • It cannot be immediately quantified but may lead to quantifiable gains in the long run • Examples of intangible benefits:

Increased levels of service (in way that cannot be measured) Increased customer satisfaction (not measurable) Need to develop in-house expertise (such as with a pilot program with new

technology)



4.3 Traditional Capital Budgeting Models • Capital budgeting models are one of the several techniques used to measure the value of

investing in long-term capital investment projects. • The process of analyzing and selecting various proposals for capital expenditures is

called capital budgeting. • The objectives of firms invest in capital projects are:

To expand production to meet anticipated demand To modernize production equipment to reduce costs

• Information systems are considered as long-term capital investment projects. • Organizations use several different methods to determine which investment is best. A. Payback method • A measure of time required to pay back the initial investment on a project. • It is a popular method because of its simplicity and power as an initial screening

method. • It is computed as:

Original Investment Number of years to pay back =

Annual net cash inflow Payback Period: What It Looks Like

Server consolidation ATM installation

Investment: $1 million

Investment: $1 million

Year Savings

1 $333,333 $250,000

2 $333,333 $250,000

3 $333,333 $250,000

4 $250,000

5 $250,000

Total $1 million $1.25 million

Payback period 3 years 4 years

Table 4.1 An example of payback period



A payback calculation answers the question: How long will it take to get my money back? But it doesn’t tell you much about the investment after the break-even point. In this example, a bank can spend $1 million on server consolidation and recoup its costs in three years. Or the bank could spend the same amount on ATMs and recoup its costs in four years. The server project is the payback winner, but the ATM project saves $250,000 per year indefinitely. • Advantages

It's easy to compute and easy to 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.

B. Return on Investment (ROI) • The objective of ROI is to calculate a percentage return (like an interest rate), so that the

costs and the benefits are exactly equal over the specified time period. • First, calculate the average net benefit with the formula as:

(Total benefits – Total Costs – Depreciation)

Net Benefit =

Useful life • Then, net benefit is divided by the total investment.

Net Benefit ROI = Total initial investment • Company makes capital investments to earn a satisfactory rate of return.



C. Net Present Value (NPV) • Money that has been promised to receive three, four and five years from now is not

worth as much as money received today. • Money received in the future has to be discounted by some appropriate percentage rate,

usually the prevailing interest rate. • Present value is the value in current dollars of a payment or stream of payments to be

received in the future. • It can be calculated by using the following formula:

PV = FV *

1

Where,

(1 + i) n

PV = Present Value FV = Future Value i = Interest Rate n = Number of years in the future number of years • Present Value = amount receive in future / (1 + discount interest rate) • 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 • Net present value 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 = Present value of expected cash flows – Initial investment cost • Eg. If the present value of the stream of benefits is RM 3,734,629, and the cost (in

today’s dollars) 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 more than

RM2 million. • This is a fairly good rate of return on an investment. Page 5 of 10 ocp/mis/s2/0708


Net Present Value: What It Looks Like

ATM installation Server consolidation

Year Discount factor (at

10%) Cash flow Present value

of cash flow Cash flow Present value of cash flow

0 1.000 -$1 million -$1 million -$1 million -$1 million

1 0.909 +$500,000 +$454,500 +$1 million +$909,000

2 0.826 +$500,000 +$413,000 +$750,000 +$619,500

3 0.751 +$500,000 +$375,500 +$500,000 +$375,500

4 0.683 +$500,000 +$341,500

5 0.621 +$500,000 +$310,500

Total +$1.5 million +$895,000 +$1.25

million +$904,000

NPV considers the time value of money. In this example, we compare two $1 million projects with a minimum desired rate of return of 10%. On the basis of simple cash flow, the ATM installation looks better because it generates $250,000 more over the life of the investment. But when the time value of money is considered, the server consolidation project looks slightly better, with an NPV higher by $9,000, because the returns occur earlier in the project’s life. Table 4.2 An example of net present value • Advantages

By considering the time value of money, it allows consideration of such things as cost of capital, interest rates and investment opportunity costs. It's especially appropriate for long-term projects.



D. Internal Rate of Return (IRR) • Refer as “Go/No-Go Investment threshold” • It is a variation of the net present value method. • It takes into account the time value of money. • IRR is also defined as profit that an investment is expected to earn. • It is the discount (interest) rate that will equate the present value of the project’s future

cash flows to the initial cost of the project.

Internal Rate of Return: What It Looks Like

Discount rate: 10% Discount rate: 15% Discount rate: 20%

Year Cash flow Factor Amount Factor Amount Factor Amount

0 -$1 million 1.000 -$1 million 1.000 -$1 million 1.000 -$1 million

1 +$300,000 0.909 $273,000 0.870 $261,000 0.833 $250,000

2 +$300,000 0.826 $248,000 0.756 $227,000 0.694 $208,000

3 +$300,000 0.751 $225,000 0.658 $197,000 0.579 $174,000

4 +$300,000 0.683 $205,000 0.572 $172,000 0.482 $145,000

5 +$300,000 0.621 $186,000 0.497 $149,000 0.402 $121,000

Total +$500,000 NPV = +$137,000 NPV = +$6,000 NPV = -$102,000

IRR = slightly more than 15%

IRR is often used as a hurdle rate, a sort of go/no-go investment threshold. In this example, there is an initial investment of $1 million, with a net (undiscounted) return of $500,000. The NPV of the $1 million outlay depends on the discount rate, or cost of capital, used to evaluate the investment. The NPV is zero at the IRR, here a fraction of a percentage point above 15%.

Table 4.3 An example of internal rate of return • Advantages

It provides a simple hurdle rate for investment decision-making It's the method favoured by many accountants and finance people.



4.4 Limitations of Traditional Models Payback Method It doesn't measure profitability It does not take into account the time value of money and ignores financial performance

after the break-even period. For instance, a dollar saved today is worth more to us than a dollar saved ten years from

now, since today’s dollar could be drawing interest in a bank for us for ten years. Payback analysis does not consider any benefits of the system that are accrued after the

payback period. For instance, an alternate solution might produce the greatest benefits at the lowest cost

a year after the payback period has ended, a fact that is ignored by payback analysis. ROI 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. It does not consider the time value of money. (In order to evaluate this time factor, NPV

is recommended). NPV Ranking investments by NPV doesn't compare absolute levels of investment. NPV looks at cash flows, not at profits and losses the way accounting systems do. NPV is highly sensitive to the discount percentage, and that can be tricky to determine.

IRR It's not as easy to understand as some measures and not as easy to compute (even Excel

uses approximations). Irregularity computational can produce misleading results, particularly with regard to

reinvestments.



4.5 Other Methods of Evaluation • When the firm has several alternative investments from which to select, it can employ

portfolio analysis and scoring models. • It can apply real options pricing models to IT investments that are highly uncertain • It can also use a knowledge value-added approach to measure the benefits of changes to

business process. Portfolio Analysis • The portfolio can be described as having a certain profile of risk and benefit to the firm.

Project Risk Low High

Cautiously Examine

Routine Projects

Avoid

Identify and

Develop

High

Potential Benefits to

organization Low

Figure 4.1 A system portfolio • There is no perfect profile for all organizations. • 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 industries should concentrate on high-

benefit, low-risk projects. • Portfolio analysis can be used to select alternatives after determined the overall direction

of systems development. • Usually, it focusing on systems of high-benefit and low-risk; these promise early returns

and low risks. • ↑ benefit, ↑ risk systems should be examined. • ↓ benefit, ↑ risk systems should be avoided. • ↓ benefit, ↓ risk should be re-examined for the possibility of rebuilding and replacing

them with more desirable systems having higher benefits. Page 9 of 10 ocp/mis/s2/0708


Scoring Models • Is a quick method for deciding among alternative systems based on a system of ratings

for selected objectives. • It gives alternative systems a single score based on the extent to which they meet

selected objectives. (Matlin, 1989; Buss, 1983) • It helps to bring about agreement among participants concerning the rank of the criteria. • Scoring model consists of criteria, weights and scale. • Criteria - the result of lengthy discussion among the decision-making group. • The outcome of scoring model is not the score, but the agreement on the criteria used to

judge the system. (Ginzberg, 1979; Nolan 1982) • Weights – decision makers attach to the decision criterion. • Scale – Usually, use 1-to-5 scale (lowest to highest) to express the judgments of

participants on the relative merits of each system. • It requires experts who understand the issues and the technology. • Scoring models are used most commonly to confirm, to rationalize and the support

decisions, rather than as the final judgers of system selection.

Criterion Weight AS/400 UNIX Windows XP

Percentage of user needs met

0.40 2 0.8 3 1.2 4 1.6

Costs of initial purchase 0.20 1 0.2 3 0.6 4 0.8 Financing 0.10 1 0.1 3 0.3 4 0.4 Ease of maintenance 0.10 2 0.2 3 0.3 4 0.4 Chances of success 0.20 3 0.6 4 0.8 4 0.8 Final score 1.9 3.2 4.0

Scale: 1 = low; 5 = high Table 4.4 Scoring Model used to choose among alternative office system


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