Software Economics

Introduction to Business Case Analysis

Session 1

Who am I?

August 22, 2013

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•  Sweden

•  PhD Student in Computer Science (Business Process

Management)

•  Masters in Business Administration

•  Worked with development at Handelsbanken

•  Worked with Business Cases (> 10 years)

Who are you?

August 22, 2013

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Please present yourselves (max 1 min per person)

•  Name

•  What is your work experience (where and what do you do)?

•  Any experience with budgets or investment calculations?

•  Have you worked with investments proposals?

•  Have you had experience with sales (selling a product or

service to an existing or potential customer)?

Course Objectives

¤  Know what a Business Case is and being able to do a basic Business Case Analysis

¤  Be able to calculate, use, understand and reason about measures (NPV, ROI, IRR etc.) used for investment calculations.

August 22, 2013

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Structure

¤  Session 1: Basics of Business Case Analysis ¤  What is a business case? ¤  Principles of Business Case Analysis ¤  Benefits ¤  Time Value and NPV ¤  Sangar Case Study

¤  Session 2: Basic Measurements for Business Case Analysis ¤  ROI, IRR, Payback Period ¤  Selver Case Study

¤  Presentation of your Assignments

¤  Session 3: TCO and Funding ¤  Examples of cases ¤  TCO ¤  Funding IT ¤  B&K Case Study

August 22, 2013

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Readings

Look at the course page.

1.  IT Value Chain Management – Maximizing the ROI from IT Investments by Thomas Pisello.

2.  Economics of Information Technology by Hal R. Varian.

August 22, 2013

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Outline of Session 1 (today)

1.  What is a Business Case?

2.  Why is it important?

3.  Some principles of Business Case Analysis

4.  Introduction to basic Business Case Tools

August 22, 2013

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What is a Business Case?

A type of decision-making tool used to determine the

effects a particular decision will have on profitability.

A business case should show how the decision will alter

cash flows over a period of time, and how costs and

revenue will change.

http://www.businessdictionary.com/definition/business-case.html

August 22, 2013

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What is a Business Case?

A business case covers the Information

needed for decision makers to show

that an idea being considered makes

financial sense.

August 22, 2013

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Simple Example

¤  15 minutes, in groups of 5-6 persons.

Scenario: You are the general manager of a software development company. Your company’s profit is decreasing due to ongoing recession.

1.  How can you improve your profit? Give 3 suggestions on how this can be done.

2.  How much would your profit improve with each of the 3 suggestions (make assumptions)?

3.  How much would it cost to implement your suggestions?

August 22, 2013

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¤  Due to lack of financial means and resources, you can only implement one of the suggestions.

¤  Which one will you choose and why?

¤  How would you argue for your case?

August 22, 2013

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Why is Business Case Analysis Important?

1.  It costs money and takes people to make investments (in our setting, IT investments).

2.  There is a limit to the availability of financial and human resources.

3.  Therefore we need to choose wisely what we invest in.

4.  Business Case Analysis gives us the information that will help us make more wise decisions and choices.

5.  Measurements gives us an effective tool to compare different cases against each other.

August 22, 2013

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Business Side of IT

¤  In a survey of 130 senior IT executives found that 80 % say that lack of financial skills makes quantifying IT benefits difficult. (I.T. Staffs Lack Financial Chops For Project Analysis , 03/24/2003, By Eric Chabrow, InformationWeek)

¤  IT people and business people speak “different languages”.

¤  As an IT person, it is VERY beneficial to be able to communicate the benefits of what you are trying to achieve in a non-technical language so business people (decision makers) understand you and your case.

¤  Although not the typical IT metrics they are what business understands. Business side of IT is business.

¤  Business Case is the “medium” to sell the investment.

August 22, 2013

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Business Case Principles

¤  There are quantifiable (tangible) and qualitative (intangible) factors (benefits, gains) associated with investments.

¤  All investments (money) have time value.

¤  There is always an alternative to the investment (at least to do nothing) – Opportunity Cost.

¤  There is always a risk with investments, so we want to be compensated for this risk.

August 22, 2013

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Structure of Benefits

Higher Profitability

Higher Revenues

New Markets

Better Customer

Service

New Products

Lower Costs

Better IT support

Higher Efficiency

August 22, 2013

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Tangible Benefits

Tangible benefits

¤  Easier to measure and more “measurable”

¤  Revenue changes, Profit Margins, Cost Reductions etc.

¤  Can use NPV, ROI etc. to measure and compare.

August 22, 2013

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Benefits over time

August 22, 2013

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Intangible Benefits

Harder to measure (but it is possible), strategic value such as:

¤  Brand Advantage – no direct sales increase or hard to measure but

increased perceived value of corporate brand (sponsoring events)

¤  Strategic Advantage – important for corporate objective (acquisition of

other companies)

¤  Intellectual Capital – increasing access to and knowledge of staff (data

warehouse, business intelligence)

¤  Organizational Advantage – increasing organizational efficiency (instant

messaging, mobile computing)

¤  Risk Avoidance – preventing harmful things (back up solutions, security)

¤  Mandatory – investments that are a must (governmental regulations and

compliance)

August 22, 2013

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Time Value of Money

¤  Money today is worth less (or more) than the same sum of money in the future. Therefore, the value of money is dependent on time. Why?

¤  Inflation: Level of prices of goods and services go up over time. ¤  The value of your money will decrease over time, that is, you

can buy less with the same amount of money as time passes.

¤  Interest rate: The cost of borrowing money / the price you charge to lend money. Increases the value of your money over time. ¤  Real rate

August 22, 2013

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Future Value

Future Value: What is the value of a given sum of money in the future? What does the value depend on?

Future value = present value x (1 x interest rate)number of periods

FV = PV x (1+i)n

i = risk free rate

n = years

August 22, 2013

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Compound Interest

Interest rate is given on both the nominal and the interest rates received.

August 22, 2013

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FV = Future value N = Nominal amount i = annual nominal interest rate (not considering the compounding) n = number of times the interest is compounded per year t = number of years

Example

You have developed a software and will get paid 5 000 EUR. However, due to complications, you will receive the money in 5 years. How much is your money worth in 5 years given that the interest rate is 1%?

Which alternative would you choose?

1.  You get 10 000 EUR now in your pocket or

2.  You get 10 100 EUR one year from now?

August 22, 2013

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Present Value

Present Value: What is the value of a future sum of money today?

Just reverse the future value formula. FV = PV x (1+i)n

PV = FV / (1+i)n

i = risk free rate

n = years

But what do we do when we have several future values spread over several years?

August 22, 2013

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Net Present Value

Same as PV but sum of PV for each year.

August 22, 2013

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NPV formula

August 22, 2013

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•  Net Cash Flow for each year (Cash in – Cash out)

•  i = discount rate

•  N = total number of years

Example

Exercise (20 minutes) in groups of 4-5

Upgrade from XP to Vista or not?

¤  One time investment cost (license, manpower, etc.): ¤  2000 PCs ¤  License is 150 $ per PC (year 0) ¤  Installation: 25 $ per PC (year 0)

¤  Yearly maintenance cost: 50 000$ (starting year 1)

¤  Yearly benefit: 150 000$ (starting year 1)

¤  Years to next upgrade: 4 (next upgrade starts beginning of year 5)

¤  Rate of return: 8%

¤  What is the NPV and is it a good investment?

August 22, 2013

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Solution to example

August 22, 2013

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Interpreting NPV

¤  A positive NPV means the cash inflows are greater than the cash outflows when they are discounted to their present value. The investment adds value, you get more money than you invested.

¤  A negative NPV means that cash inflows are less than the cash outflows when discounted to their present value. The investment results in you having less money.

¤  A NPV at zero means that no value is added or subtracted to your investment.

August 22, 2013

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There is always an alternative

Opportunity Cost

When deciding to invest or not, you always have an alternative to compare with.

If no other investment alternatives, the alternative is to do nothing, no-action, not to invest.

Investing should be compared to at least the alternative of not doing anything.

August 22, 2013

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Baseline versus Upside Scenario

You always have at least two scenarios – to invest or not to.

If you continue business as usual (not to invest), that is your baseline scenario.

If you invest, hopefully you will get a better scenario, the upside scenario.

We are interested in the added value of investing, i.e. what we get more if we invest as compared to not investing (increment).

August 22, 2013

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Introduction to financial terms

¤  Turnover/Revenue ¤  Cost of Revenue/Cost of Goods Sold (COGS)

¤  Gross Profit or Gross Margin ¤  Operating Expenses

¤  Operating Income or Loss

¤  Financial Income and Expenses

¤  Net Profit

August 22, 2013

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Income Statement Example

August 22, 2013

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Income Statement Example

August 22, 2013

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Types of Costs

August 22, 2013

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Income Statements

Search for Income Statements of two different companies.

(in groups of 4-5, 10 minutes)

Answer these questions

¤  In which country do they have their HQ?

¤  In which industry are they operating (airline, hotel,

technology, consulting etc.)

¤ What terms do they use in their income statements?

August 22, 2013

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Example of Set up

August 22, 2013

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Timing of Cash Flows

Initial or Upfront Investment

Annual Revenues or Savings

Year 0 Year 1 Year 2 Year 3 Year n

Possible final value

Possible final cost

Annual Costs

Cash Inflow

Cash Outflow

Summary of Today

¤  What is a business case?

¤  Why do we use business cases?

¤  What are some basic business case principles?

¤  Business Case Tools ¤  What is Future Value?

¤  What is Present Value?

¤  What is NPV (Net Present Value)?

¤  How do we interpret NPV?

August 22, 2013

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Practice

Sangar Business Case - Calculating NPV.

¤  Ill give the background.

¤ What do you need to know in order to calculate the NPV?

¤  I am the business owner you are the consultants, ask me about the numbers.

August 22, 2013

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Next week

¤  We will look at more business case tools

¤  ROI (Return on Investment)

¤  IRR (Internal Rate of Return)

¤  Payback Period

Thank you and see you next week!

August 22, 2013

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