INFO2010 - L4 Justifying the system Flashcards
Biz IT
Evolution of computing, became subsumed into whole biz function
Prevalence and benefits of IS/IT often taken for granted by biz orgs
Strategy needed for optimising IT investment to maximise the investment
Competitive advantage through IT
- Ability of a biz org to compete with others
- Competitive biz recognises that IS/IT can be used to transform an org’s relation to its customers
- Competitive adv gained by providing superior efficiency, effectiveness and sys sustainability
Justifying the investment
Can be transformative of biz practice
Upper management hv pesimistic attitude so peeps want to see a cost justification for IT investment
Sometimes difficult to do
Justifying the investment
Acquiring IT can require significant resources
Two clear benefits:
- predict what cost will be incurred, quantify them, match them with predicted benefits
- if quantified benefits outweighs quantified costs, acquisition of IT is justified
Capital budgeting
Process of analysing and selecting various proposals for capital expenditure.
CB methods rely on measures of cach flow in and out of org
Main reasons for investing into capital projects
- expand production to meet anticipated demand
- to modernise production equipment ot reduce cost
IS - considered long term capital investment projects
Other reasons for investing into capital projects - non economic
Install pollution control equipment
Meet government regs
satisfy non-market public demands
Capital budgeting models
Payback method Acounting ROI on investment Net Present Value Cost Benefit Ratio Profitability Index Internal Rate of Return
Payback method
Measure of time required to pay back the initial investment of a project
Orig Investment
————————– = No of yrs to payback
Annual net cash flow
Payback method benefits
Simple
Powerful as an initial screening method
Good for high risk projects where useful life is difficult to know
If sys pays for itself in 2 yrs, less important how long it will last
Ignores (this is weakness as well as virtue):
- time value of money
- amount of cash flow after payback period
- disposal value
- profitability of investment
Accounting Rate of Return on Investment
Firms make capital investments to earn a satisfactory rate of return; depends on;
- cost of borrowing money
- historic rates of return expected by the firm
- desired rate of return must equal or exceed the cost of capital in the marketplace
Rate of ROI in practice
ROI ralculates the rate of return from an investment by adjusting the cash inflows produced by the investment for depreciation.
Gives an approximation of the accounting income earned by the project
- ignores time value of money; does not need to be converted into present value
Rate of ROI in practice - how to work it out
(Total benefits-Total Cost-Depreciation)
—————————————— = Net Benefit
Useful life
Net Benefit
——————————— = ROI
Total Initial Investment
Depreciation
Cost of life of equipment usual 20+ years for large plant
ICT much less 10-15 years
ROI - how is it used
Projects ranked in descending order by ROI
Those providing acceptable ROI selected
Can be altered by resource constraints, organisational priorities or politics
ROI Disadvantages
IS projects do not lend themselves to easy quantification and estimation of costs and benefits.
Costs and benefits of such projects are variable, complex, interrelated and difficult to estimate - often preclude a meaningful ROI analysis.
Net Present Value
Value in current £ of a payment or stream of payments to be received in future
£ today worth more than £ in the future
Limitation
- does not provide a measure of profitability
- does not provide a way to rank-order diff pos investments
Present Value
Future payments are discounted
Payment
————————– = Present Value
(1 + Interest)^n
n = year
Net Present Value
Sum of Present Value of expected cash flows minus Initial investment cost = Net Present Value
N payment
Sum ———————- - Initial Cost = NPV
n=1 (1 + interest) ^n
If NPV
- > 0 invest
- = ) undecided
- < 0 reject
Present value
If all cash flows are the same;
1 - (1 + interest)^-n Payment x ------------------------------ = NPV
interest
Net Present Value
To compare the investment (made in today’s £) with future savings or earnings, you need to discount the earnings to their present value and then calculate the NPV of the investment.
NPV is the amount of money and investment is worth, taking into account its cost, earnings and the time value of money.
Cost Benefit Ratio
Simple method to calculate the returns from a capital expenditure which is the ratio of benefits to costs
Total benefits
——————————– = C-B Ratio
Costs
C-B Ratio is used
To rank several projects for comparison
Some orgs establish a minimum C-B Ratio that must be attained by capital projects.
Can also be calculated by using Presnet Values to account for the time value of money.
Profitability index
Projects can be rank-ordered on this index, permitting firms to focus only on the most profitable projects.
Present cash value of inflows
——————————————— = Prof indx
Investment
Internal rate of return
Variation on the net present value method
- takes into account the time value of money
- IRR defined as the rate of return or profit that an investment is expected to earn
IRR is the discount (interest) rate that will equate the present value of the project’s future cash flows to the initial cost.
Value of R (discount rate) is such that
Present Value - Initial cost = 0
Summary
Investment in IT Sys different benefits for diff orgs;
- allowing an org just to survive in a global market
- improving the corporate image as a leader in their field
IT should be seen in the context of an overall competitive strategy:
- all change will involve cost
- it costs not to change/stand still
Important benefit of investment in IT relates to the organisation’s market position and the income generated from that position.
