Slide 1 of 24 Title: IS Investment Why Finance Matters? Productivity and the Productivity Paradox IS Investment Evaluation Tools/Techniques –Traditional.

Slide 1 of 24

Title: IS Investment

• Why Finance Matters?• Productivity and the Productivity Paradox• IS Investment• Evaluation Tools/Techniques

– Traditional (tangibles)– Modern (intangibles)– Modern (tangibles)

• Cases

IS INVESTMENT

Slide 2 of 24

“The past forty years has seen dramatic advances in the technology of information processing and its widespread adoption bears testimony to the advent of the ‘information society’. However, the economic implications of this transition remain to some degree obscure, since there is little evidence that the new technology has led to clear improvements in productive efficiency.”

Geoffrey M. Brooke

Slide 3 of 24

Why IT Gets no Respect(Forbes et al., 2005)

• COMPANIES ARE MAKING THE SAME MISTAKES OVER AND OVER AGAIN– A full 1/3 of the IT money was essentially wasted– More than one half of projects either fail or experience

major cost overruns– Only 10% were on time and on budget– More than 1/3 of the attempts to implement major software

packages fail– 71% cannot say whether IT is delivering value for

money(VFM)– 38% say IT is “… only moderately well in alignment with

business objectives…”

Slide 4 of 24

Why Finance Matters?

• Company’s need real assets• Some assets are tangible – plant, machinery etc.• Some assets are intangible – expertise, trademarks, patents• All need to be paid for!

• Two major financial questions– How much should we invest and what specific assets

should we invest in?– How to raise cash for the investment – loans, shares etc.

• Our focus is on the first question – IS investment decisions

Slide 5 of 24

• Over the last 50 years, organizations have invested trillions of dollars in information technology.

– Total worldwide annual spending on IT in 2005 was three trillion dollars,

– Yet it is very hard to demonstrate that IT investments really have increased outputs or wages or profitability.

• The discrepancy between measures of investment in information technology and measures of output at the national level is described as the Productivity Paradox.

Productivity Paradox !

Slide 6 of 24

80%

40%

0%

$100 $1,000 $10,000 $100,000

IT Spending per Employee

Ret

urn

on E

quit

y

Tyson Foods

Philip Morris

Quaker Oats

Pepsico

Dole Food SuperValu

H.J. Heinz

Coca-Cola

Information Economics, Paul Strassman

Case: IT versus Profitability

Slide 7 of 24

IS INVESTMENT

• The head of IT in AT&T (2003) stated that

“the area of measurement is the biggest single failure of information systems while it is the single biggest

issue in front of our board of directors”

• Peter Drucker

– “If you can’t measure it, you can’t manage it “

Slide 8 of 24

A number of measurement problem areas have been identified:

• Inappropriate measures

• Budgeting practices concealing full cost

• Undersanding human and organisational costs

• Understanding knock-on costs

• Overstating costs

• Neglecting ‘intangible’ benefits

• Not fully investigating risk

• Failure to devote evaluation time and effort to major capital assets and failure to take into account time-scales for likely benefits

2 Approaches – Justification and Evaluation

Slide 9 of 24

IT/IS COSTS

• Hardware• Software• Installation• Environmental• Running/Expense• Maintenance

• Security• Networking• Training• Wider Organisational• Compliance/Regulatory

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Example of an ITJustification Framework

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EVALUATION TOOLS/TECHNIQUES

• The traditional approach to evaluating IT investment concentrated on the tangibles and was focused on financial techniques

• However, information, which, is at the core of most intangible assets has become a valuable commodity, which requires measure in order to enable a company to gain a true reflection of the value of their investments and the subsequent derived outcomes

Slide 12 of 24

Traditional IS Evaluation Tools/Techniques (Tangibles)

• Cost Benefit Analysis (CBA)

• Return on Investment (ROI)

• Internal Rate of Return (IRR)

• Net Present Value (NPV)

• Discounted CashFlow (DCF)

• Payback Period

• *See notes for more details

Slide 13 of 24

Tangible Tools

Tangible Tool Purpose Ratio

Return on Investment Evaluate a no of projects annual net income

project investment

Net Present Value Use discount rate based on cost of capital to establish present value of project

NPV =

Present Value of Benefit

Present Value of Investment

Internal Rate of Return Base on NPV

Uses interest rate to cause npv to equal 0

Discount rate at which

Cash receipts = cash expenditure

Discounted Cash Flow Considers time-dependant nature of money value

Payback Period Amount of time for cash inflows to equal project investment

Payback(in time) = Investment

Average Annual Benefit

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Benefits: Intangible

Synergy with other projects

Expanded long-term opportunities

Strategic positioning

Job enrichment

Recording of knowledge

Costs: Ongoing

Operating personnelCommunication lines

Hardware maintenance

Software upgrades

Office space and utilities

Benefits: Quantifiable

Improved decision speed

Improved decision quality

Automation of tasks

Ability to perform new tasks

Costs: One Time

Software expert system purchase

Software development

Other software purchase

Hardware platform lease or purchase

Costs/Benefits

Slide 15 of 24

• An area where it is necessary to define and measure IT benefits and costs. – Car Assembly, robots– Warehousing, bar-coding– Wine Production

• Capital investment decision. Such decisions can be analyzed by a cost-benefit analysis

• Car Example with Robots• Benefits labour cost savings over

usable life of the robots

Costs are the capital investment and

the operating and maintenance costs

Evaluation: Automation Investments

Slide 16 of 24

Modern Evaluation Tools/Techniques (Intangibles)

• Information Economics• Performance Metrics• Benchmarking • Return on Management• Risk Analysis• Opinion Modelling

• *see notes for more details

Slide 17 of 24

Information Economics is another method of evaluating IT that focuses on key organizational objectives.

It incorporates the technique of scoring methodologies, which are used in many evaluation situations.

Scoring methodology is used by analysts to first identify all the key performance issues and assign a weight to each one.

Organizational objectives are used to determine which factors to include, and what weights to assign in the scoring methodology.

This approach can incorporate both tangible and intangible benefits.

This flexible approach can be carried out by software packages such as Expert Choice (expertchoice.com).

Information Economics

Slide 18 of 24

Information Economics

Return on Investment (ROI) =

Traditional cost-benefit analysis (CBA)

+ Value Linking

+ Value Acceleration

+ Value Restructuring

+ Innovation Evaluation

Slide 19 of 24

Information Economics – Value Assessment Factors

• Business Domain– Strategic Match +– Competitive Advantage +– Management Information +– Competitive Response +– Organisational/Project Risk -

• IT Domain– Strategic IS Architecture +– Definitional Uncertainty -– Technical Uncertainty -– IS Infrastructure Risk -

Slide 20 of 24

Performance Measurement Example

PROCESS STRATEGIC GOAL

CSF MEASUREMENT

Software Procurement

Reduce cost Negotiate Pricing Percent discount/user

Slide 21 of 24

Some Current IT Performance Metric Examples

• Development– No. of modifications to software package– No. of changes to design– % development cost– Ratio of contractors to employees

• Data Center– No of users requesting access to tools– No. of errors reported– No. of user queries stored– No. of Service outages

• Network– Network response time– Mean time to repair (MTTR)– Network availability percent– Cost per LAN port

Slide 22 of 24

• One approach to evaluating infrastructure is to focus on objective measures of performance known as benchmarks.

• Benchmarks come in two forms:

– Metric benchmarks provide numeric measures of performance. IT expenses as percent of total revenues. Percent of “downtime” (when the computer is not available). CPU usage (as percent of total capacity). Percentage of IS projects completed on-time and within budget

– Best-practice benchmarks emphasize how information system activities are actually performed rather than numeric measures of performance.

Evaluating IT - Benchmarking

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• Costmark is a benchmarking tool to assist in managing SAP R/3-related environments. – It provides a snapshot of various costs related to personnel,

hardware, software licenses, maintenance, help-desk functions, and telecommunications.

• Some examples of reports generated by Costmark:– Distribution of cost of operations across different user

groups.– Total cost of operations across different user groups and

across different departments.– Comparison of various costs with average costs obtained

across all SAP-R/3 installations (i.e., industry average).

Benchmarking Tool

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Return on Management

• A measure of performance based on the added value to an organisation provided by management

• Return-on-Management = Management Value-added

Management Costs

Slide 25 of 24

Risk Analysis

• Game Theory

• Simulation/modelling Techniques

• Sensitivity Analysis/Structured Scenarios

• Probability of Attainment

• Bayesian Analysis

Slide 26 of 24

Opinion Modelling

• Interviews

• Questionnaires

• Direction of Perception methods

• Opinion Surveys

Slide 27 of 24

Modern IT Evaluation Costing Approaches

• Total Cost of Ownership

• Chargeback

Slide 28 of 24

• An interesting approach for evaluating the value of IT is the total cost of ownership (TCO). – TCO is a formula for calculating the cost of owning and

operating a PC. – The cost includes hardware, technical support,

maintenance, software upgrades, and help-desk and peer support.

– By identifying such costs, organizations get more accurate cost-benefit analyses and also reduce the TCO.

– It is possible to reduce TCO of workstations in networked environments by as much as 26 percent by adopting best practices in workstation management (Kirwin et al., 1997).

Evaluating IT - TCO

Slide 29 of 24

• Ideally IT accounting systems will effectively deal with two issues: – Provide an accurate

measure of total IT costs for management control purposes.

– Charge users for shared (usually infrastructure) IT investments and services in a manner that contributes to the achievement of organization goals.

• These are two very challenging goals for any accounting system. The complexities and rapid

pace of change make them even more difficult to achieve in the context of IT.

In the early days of computing it was much easier to identify costs. Nowadays a large proportion of the costs are in “hidden,” indirect costs that are often overlooked.

IT Accounting Systems

Slide 30 of 24

• Chargeback is an alternative IT accounting method which distributes all costs of IT to users as accurately as possible, based on actual costs and usage levels. Although accurate allocation

sounds desirable in principle, it can create problems in practice.The most accurate measures of use may reflect technological factors that are totally incomprehensible to the user.

• Behavior-oriented chargeback is another IT accounting alternative. The primary objective of this system is influencing users’ behavior. It is possible to encourage

(or discourage) usage of certain IT resources by assigning lower (or higher) costs. Although more difficult to develop, it recognizes the importance of IT to the success of the organization.

Chargeback