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Understanding the Business Value of IS

(supplement to Ch. 14)

Kat Schwaig

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Investing in Systems

Investment in Systems May be Due to– Need for strong infrastructure to provide

strategic life to the firm– Survival– Government Regulations– Ongoing operations

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Decision Process of Investing in Information Systems Level I Business Decision (Go/No Go)

– Status Quo or Manual Solution vs. Build and or Buy (Buy #1 or Buy #2 or Buy #3)

– cost-benefit analysis & risk analysis

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Level 1 Business Decision

(Go/No Go)– Cost-benefit analysis = comparison of expected

costs to expected benefits to determine if a computerized solution--irrespective of build/buy or particular vendor decisions--makes sense. Spreadsheets are often used as computerized tools for this analysis!!!

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Costs & Benefits

Costs– Hardware– Telecommunications– Software– Services– Personnel

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Costs & Benefits

Benefits– Tangible (i.e. cost savings):

• increased productivity; lower operational costs; reduced work force; lower computer expenses; lower clerical & professional costs; reduced rate of growth in expenses; reduced facility costs

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Cost & Benefits

Benefits– Intangible

• improved asset utilization; improved resource control; improved organizational planning; increased organizational flexibility; more timely information; more information; increased organizational learning; legal requirements attained; enhanced employee goodwill; increased job satisfaction; improved decision making; improved operations; higher client satisfaction; better corporate image

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Level I Business Decision

(Go/NoGo)– Risk Analysis - analysis of the uncertainties in

going ahead or not going ahead with a change• Risks included general factors such as the level of

experience of the IS dept. in this type of system, the fit with the organizational culture, & the stability of the technology to deliver as required.

• They also include specific factors such as those in the level II business decisions

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Level II Business Decision

Build/Buy– If a software investment is involved, then…

comparative software cost-benefit analysis• compare the financials on a decision to insource

versus a decision to outsource• “Buy” estimates, which may be assembled by

systems integration managers from vendor responses to an RFI (request for information), are highly preliminary

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Level II Business Decision

Build/Buy– Financial argument

• The argument is whether a choice to build or buy results in a greater production cost advantage. This is the “economies of scale” issue in the outsourcing decision

– Non-Financial argument• The argument is whether a choice to build or buy

makes sense in the light of the other major questions related to outsourcing, (core competency, expertise)

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Level II Business Decision

Build/Buy– “Build” risks refer to the uncertainty that the in-house

project will be completed to the user’s satisfaction and that the estimated timelines and costs are reasonably accurate

– “Buy” risks in this situation refer to the uncertainties that the vendor software is real (not vaporware), that it will perform as advertised, that the vendor will not go out of business during the period that the software is in use, etc..

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Level I & II Business Decision

Go/No Go and Build/Buy– In situations when an already existing system is

being replaced, benefits include the expenses that will be avoided by scrapping the old system plus the additional benefits realized by integrating a wholly new system.

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Managing the Business Decision to Invest in Information Systems Analytical Tools Commonly Used

– Payback Method– Accounting Rate of Return– Cost-benefit Ratio– Net Present Value (NPV)– Profitability Index– Internal Rate of Return

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Capital Budgeting Models

Why do firm’s invest in capital projects?– Expand production to meet demand– Modernize production equipment to reduce cost– Noneconomic reasons

• Install pollution control equipment

• Convert to human resource database to meet government regulations

• Satisfy public demands

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Cash Flows

All capital budgeting models rely on measures of cash flows into and out of firms

Outflows– Immediate outflows: cost due to purchase of

equipment, labor, etc– Additional outflows: maintenance, updates

Inflows– Increased sales of more products– Reduction in cost of production and operations

Difference between cash outflows and inflows is used for calculating financial worth of an investment.

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Payback Method

A measure of the time required to payback the initial investment on a project

1st Year investment

Annual net cash flows

Payback

=

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Accounting Rate of Return

Calculation of the rate of return from an investment by adjusting cash inflows produced by the investment for depreciation. Approximates the accounting income earned by the investment.

ROI =Net Benefit

Total Initial Investmentwhere

Net Benefit =

Total Benefits - Total Cost - Depreciation

Useful Life

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Cost-Benefit Ratio

A method for calculating the returns from a capital expenditure. Ex. A cost/benefit ratio of 1.42 indicates that benefits are 1.42 times greater than cost.

Cost -Benefit = Total Benefits

Total Costs

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Net Present Value (NPV)

Amount of money an investment is worth, taking into account its cost, earnings and the time value of money– compare the cost of the investment (cash outflow in

year 0) with net cash inflows. Any dollars received in the future must be discounted by some appropriate % rate (prevailing interest rate or cost of capital)

NPV = PV of expected cash flows - Initial Investment Cost

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Profitability Index

Used to compare the profitability of alternative investments

Profitability Index =

PV of Cash Inflows

Investment

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Internal Rate of Return

Rate of return or profit an investment is expected to earn; the discount (interest) rate that will equate to PV of the project’s future cash flows to the initial cost of the project.– i.e. that rate which will result in PV - 1st year

investment = 0– variation of NPV– considers the time value of money

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Limitations of Financial Models

Used to – A) Justify new systems, B)explain old systems

post hoc, C) develop quantitative support for a political position

Financial models Assume:– All relevant alternatives have been examined– Costs and benefits are known– Costs and benefits can be expressed in a

common metric ($)

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Limitation of Financial Models as Applied to Information Systems

May not express the risks and uncertainty of their cost and benefit estimates

Cost and Benefits do not occur in the same time frame Inflation may affect costs and benefits differently Technology can change during the course of the project causing

estimates to vary greatly Intangible benefits are difficult to quantify Financial models have an application bias: transaction and clerical

systems that displace labor and save space always produce more measurable tangible benefits than MIS, DSS, GDSS

Models are usually dealing with PPE with life up to 25 years. IS much shorter and require significant investment to redesign. Payback must be shorter; rates of return higher

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Level III Business Decision

Buy #1 vs. Buy #2 vs. Buy 3 (S.I. alternatives)– RFP process or small $ investment data gathering

• see lecture on RFPs and small $ investment decisions

– Comparative S.I. alternatives (detailed) analysis• thorough analysis of systems integration proposals and

responses to RFPs ( see lectures on RFPs)

– risk analysis

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Level III Business Decision (S.I. Alternatives) Buy#1 vs. Buy #2 vs. Buy #3 - Risk

Analysis– similar to that of business level II except that the

vendor’s bids are more precise– to include risk factors in the overall assessment,

a single index value for all risks taken together should be created

– this risk index value can then be considered in a scoring model

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Level III Business Decision

The result?– Vendor bids rejected and some accepted.– What was an inquiry project is now a systems

project. – preparation of contract– negotiation of contract– signing/awarding of contract