IS Business Cases: Cost-Benefit Analyses

4 Feb

A key aspect of any business case is cost analysis of an initiative which includes consideration for both the cost and the payback, be it in monetary or non-monetary terms. For inititiaves of a smaller nature, a cost-benefit analysis can be quite basic and can include projected benefits of an investment by way of:

(a) return on investment (ROI), (b) improved performance – e.g. decreased operating costs, improved quality, etc., or (c) better customer service.

However, for medium and larger-scale initiatives there should be a more extensive amount of detail on costs and financial analysis. One such way of doing this would be to present income and costs under headings: income, production cost, labour cost and capital cost.

Another factor that needs to be distinguished in a business case are the various sources of information. For instance, primary information is researched (e.g. employee feedback) where as secondary information would normally exist within an organisation already (e.g. internal reports). It is necessary for one to think about the balance between the quality of the information (primary = usually better) versus the cost of getting it (secondary = usually cheaper). (1)

Fundamentally, cost-benefit analyses assess the impact and net benefits of the chosen option in achieving the desired outcomes, in comparison with other feasible approaches.  The evaluation should include both tangible and intangible factors as well as quantitative and qualitative factors. The costs and benefits must apply for the lifetime of the proposal as opposed to just the implementation period. The main steps in the process are as follows:

1. List alternative options.

2. Identify costs (including economic, social and environmental) of each option.

3. Identify benefits (including economic, social and environmental) of each option.

4. Assign Euro values to as many costs as possible.

5. Assign Euro values to as many benefits as possible.

6. Determine the cost-benefit ratio for each alternative.

7. Rank acceptable proposals on the basis of their cost-benefit ratio.

8. Consider the ranking as a guide for your recommendation. (3)

A few examples of cost-benefit analysis methods include:

Payback Period (PBP): the amount of time it will take to recoup the total euros invested in a project. Payback occurs when the cumulative discounted benefits and costs are greater than zero. PBP is the most widely used measure for evaluating potential investments and, due to it highlighting the risks inherent in lengthy IT projects, is a crucial metric for evaluating projects in the IT field.

Net Present Value (NPV): aka ‘Discounted Cash Flow’. This converts future values of benefits to their present value equivalent by discounting them at the organisation’s cost of funds. It then relates the present value of the future benefits to the cost required to achieve said benefits. Essentially it is the value today of a future payment discounted at an assumed rate. If the rate is positive a profit will ensue. The higher the NPV the more attractive the investment. (2) Suited to longer-term investments, NPV’s stengths include the fact it takes into account all cash flows, both present and future, as well as the time value of money. (4)

Internal Rate of Return (IRR): Rate of return or profit that an investment is expected to earn taking into account the time value of money. It is the discount / interest rate that will equate the present value of the project’s future cash flows to the project’s initial cost. IRR is referred to as the flip-side of NPV, with it being based on the same principles / math. (2)

As alluded to in my previous blog, a comfortable understanding of these measures along with their benefits and drawbacks are crucial when one is composing a business case for IS investments. My next blog will thus be a continuation in this area, with it comprising analysis of alternative approaches to those detailed above, including ROI, MIRR and ARR. I will also be delving into what other elements need to be included when one is constructing a business case for IS investment. Until then…

(Sources:

(1) http://www.mmu.ac.uk/bit/docs/Cost-Benefit-analysis-toolkit-v2.pdf

(2) Lecture notes via Blackboard / Computerworld, 2003

(3) http://www.lpma.nsw.gov.au/__data/assets/pdf…/1-Business_Case_Info.pdf

(4) http://educ.jmu.edu/~drakepp/principles/module6/advdistable.pdf

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