Information Technology Investments: Value and Risk

1
Information Technology Investments Value and Risk

• John Bentley
• BCO6653 - 2005
• Stephen Paull
• Stephen Burgess

2
The Need to Monitor IT Expenditure

• Corporate responsibility
• Legal responsibility
• Form of Control
• Assists planning
• Regular expenses
• Planned projects/ upgrades
• Explanations for unexpected happenings

3
Methods for Funding IT Depts

• Chargeback
• Allocation
• Corporate Budget

4
Chargeback

• IT costs are recovered by charging individuals,
  departments, or business units
• Rates for usage are calculated based on the
  actual cost to the IT group to run the system and
  billed out on a regular basis
• They are popular because they are viewed as the
  most equitable way to recover IT costs
• However, creating and managing a chargeback
  system is a costly endeavor

Source Pearlson Saunders web site
5
Allocation

• Recovers costs based on something other than
  usage, such as revenues, log-in accounts, or
  number of employees
• Its primary advantage is that it is simpler to
  implement and apply
• The major problem is deciding the basis for
  charging out the costs

Source Pearlson Saunders web site
6
Corporate Budget

• Here the costs fall to the corporate Profit
  Loss, rather than levying charges on specific
  users or business units
• In this case there is no requirement to calculate
  prices of the IT systems and hence no financial
  concern raised monthly by the business managers
• However, there are drawbacks, as shown in the
  next slide

Source Pearlson Saunders web site
7
Options for Funding the IS Area
Source Pearlson Saunders web site
8
Types of IT Expenditure

• New IT Infrastructure
• Hardware Networks
• Major Software installations and upgrades
• Maintenance costs
• Hardware Software
• User Support
• Business projects incorporating IT

9
IT Infrastructure Major Software

• Difficult to isolate for cost/ benefit
• The business is usually reliant on these for
  basic business functions
• Estimates need to be made of
• Cost ( and resources eg personnel)
• Time
• Usually budgeted for over a period of years (eg
  1-3)
• Success?
• Matching to budgeted cost, time and expected
  functionality
• User acceptance and use
• Measurable improvements such as faster
  decisions, increased business functionality

10
Maintenance Costs User Support

• Keeping systems operational
• Regular budget item
• Maintenance programming, servicing equipment,
  network connection maintenance, help desk
  operation
• Success?
• Usually judged against budgeted costs and number
  of internal complaints!
• Explanations requested for cost overruns

11
Business Projects with IT

• Often proposed external to IT department
• Project costs often incorporate other departments
• Eg advertising expenses for a new initiative
  (Fly Buys)
• Success
• Increased custom, lower costs, ..
• Is reliant on other aspects of the project as
  well (eg success of advertising campaign)
• IT part of the project can still be separately
  budgeted and evaluated according to cost, time
  and functionality

12
Total Cost of Ownership (TCO)

• TCO is fast becoming the industry standard
• It looks beyond initial capital investments to
  include costs associated with technical support,
  administration, and training.
• This technique estimates annual costs per user
  for each potential infrastructure choice these
  costs are then totaled (life-cycle cost).
• Careful estimates of TCO provide the best
  investment numbers to compare with financial
  return numbers when analyzing the net returns on
  various IT options

Source Pearlson Saunders web site
13
TCO as a Management Tool

• TCO also can help managers understand how
  infrastructure costs break down
• It provides the fullest picture of where managers
  spend their IT dollars as TCO results can be
  evaluated over time against industry standards
• Even without comparison data, the numbers that
  emerge from TCO studies assist in decisions about
  budgeting, resource allocation, and
  organizational structure

Source Pearlson Saunders web site
14
Risk Assessment

• Any proposed project (IT or otherwise) is going
  to have an element of the unknown (risk)
  associated with it.
• Businesses generally use one or more techniques
  to balance the potential risk against the
  potential costs
• Some of these are quite simple, some quite
  complicated

15
Cost/Benefit

• Payback
• Time Value of Money
• DCF analysis
• Internal Rate of Return (IRR)
• Weighted average
• Combinations
• Balanced Scorecard

16
Payback
Time taken to pay back the original
investment ? 5 years
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The Time Value of Money

• Works on the principle that a dollar now is worth
  more than a dollar in the future
• Because you can invest the dollar now
• This means that any costs or benefits identified
  in the future need to be discounted into
  todays dollars
• How to choose the rate?
• Opportunity cost
• Best rate achievable if project is not continued
• Industry Best Practice rate
• Business standard rate for projects

18
Discounted Cash Flow (DCF) Analysis
Future costs and Returns are discounted back to
todays amounts In this case, 6 NPVamount/(1r
)n r discount rate (0.06) n number of years
19
Internal Rate of Return (IRR)
Attempts to calculate the return of
an investment by guessing different rates (for
r) until an NPV of 0 is achieved. It keeps
trying new rates and recalculating the NPV Excel
formula IRR(range, guess)
(if you put in a guess you think to be close it
helps with the calculation)
20
Weighted Average

• When you are aware of multiple possible outcomes,
  one alternative is to calculate the expected
  value
• Eg You perceive a 40 of chance of a project
  returning 100,000, 40 chance of 50,000 and a
  20 chance of a 20,000 return.
• Expected return (.4 x 100,000) (.4 x 50,000)
  (.2 x 20,000) 40,000 20,000 4,000
  64,000

21
Combinations

• It is common to use a number of different
  techniques for assessing projects
• Eg payback and DCF analysis
• Sometimes the techniques can be combined
• Eg DCF analysis and weighted-average

22
Identifying Costs and Benefits

• In IT expenditure, it is usually easier to
  identify costs than benefits
• Costs
• Usually can be quantified cost of labour,
  software, hardware, and so forth
• Benefits
• Need to be separated! How can you be sure
  something else hasnt had an effect?
• How do you quantify the benefits such as faster
  information, savings in inventory space and so
  forth?

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So Why Do So Many IT Investments Fail?

• Inadequate risk analysis
• Underestimating cost and time
• Forgotten/unforeseen costs
• Need to sell investment
• Lack of adequate specifications
• Inability to carry out task
• Ineffective (or no) change management

24
Conclusion

• Different types of IT Expenditure
• Regular budget items, business projects
• Success for each type can be assessed in some way
• Assessing risk is an important component of
  evaluating potential IT investments