Cost Justification Techniques Richard T Christoph INFS 780

Cost Justification Techniques Richard T. Christoph INFS 780

Building the Business Case n Firms (and people) need to justify their actions n n n We want to pick the best alternative There is usually risk and uncertainty Costs and benefits can be hard to identify n Especially true in Information Technology

The Business Case n A Business Case is a method of building a reliable justification for a specific action n n Look at costs, benefits, risk, and time. The Business case pulls these together to allow accurate comparison of various projects or options

Project Costs-different types! n Tangible Costs (also called “Hard” costs) n n These are costs we can “see, feel and touch”. We can measure these costs accurately n Examples: Purchase cost of computer, power usage, software purchase costs, wages, etc.

Project Costs- different types! n Intangible Costs (also called “Soft” costs) n n These are costs we cannot “see, feel and touch”. Usually cannot measure these costs accurately n Examples: Productivity gains from computer use, Sales gains from better customer support software, etc.

Tangible Displaced Cost n Displaced costs are costs you pay now, but will not have to with the new project. n These are current costs that are “displaced” by the new system. n n n Most certain savings possible. I can accurately measure the costs, AND, I am paying them now! Example: If you are renting a house now and want to purchase a house, the rent you are paying is a displaced cost.

Tangible Avoidable Cost n Avoidable costs are costs you DO NOT pay now, but will have to if you do not go forward with the new project. n These are costs you will need to pay in the future that are “avoided” by the new system. n n n Less certain than the displaced costs; I can accurately measure the costs, BUT, I am NOT paying them now! Example: If you want a new car. Your current car will need an engine repair in the future. This potential repair cost is avoidable IF you buy the new car.

Intangible Displaced Cost n Displaced costs are costs you pay now, but are not easily measured. n These are current costs that are “displaced” by the new system. n n n Hard to measure benefits possible. I am paying them now – but how much are they? Example: Student registration causes frustration – new system may displace this frustration – but HOW MUCH IS IT WORTH?

Intangible Avoidable Cost n Costs or benefits that you DO NOT have now, but will have to if you go forward with the new project. n These are often large benefits you may gain in the future with the new system. n n n Often strategic in nature, uncertain; I can not accurately measure these benefits Example: SABRE (the on-line travel reservation system) experienced huge strategic benefits from competitive advantage. These easily were the largest benefits, but impossible to measure accurately beforehand.

Cost Justification-summary MEASURABLE Low High 1 2 Displaced, intangible Avoidable, intangible function 3 Displaced, tangible function High 4 Avoidable, tangible function CERTAINTY Low

Cost Justification n Easiest to measure in Quadrant 3 n n Ideally, justify your project here If justification here is hard to do, be very careful! n n Probably will end up with a losing project Biggest risk/return in Quadrant 2 n n Hard to assign benefits to a specific project Can provide competitive advantage

Total Cost of Ownership n TCO = the total cost of buying, using, maintaining, and dumping something n n Will always be higher than purchase price – TCO for computing equipment=3 to 10 times purchase cost Captures costs – not benefits n Build different scenarios to handle risk (best case, worst case, expected case)

Return on Investment n n ROI = gain from project / cost of project Can compare ROI of a new computer with a delivery truck n n n Makes comparisons easy, but hard to figure benefits Be sure that all projects calculate cost the same (TCO or just purchase cost) Consider WHEN returns come (discount future cash flows)

Cost/Benefit analysis n n Show all costs (tangible & intangible) and benefits Displays costs & benefits over time as they are expected to occur Best ones use a discounted cash flow for future earnings & costs See http: //solutionmatrix. com/ for more detail on justification.

Mr. or Ms. – CIO: Don’t Forget n Most managers are poor listeners. n You are often the worst. They “know” the technology and tend to look down on those who do not. n Carr states IT often adds little to the bottom line n How do we add value to the firm?

CIO’s – We don’t Trust ‘em n CIOs have credibility problems n n n Projects run late and always over budget Can you imagine if other parts of the firm did this? Manage the today function well n n If pizza parlors had the service ratings of IT shops, they would be out of business. FINISH the small stuff quickly, Answer questions

How should IT Pros Justify? n Avoid credibility issues by being very complete n n n Do a complete Cost/Benefit analysis Include and identify which quadrant benefits come from Show an ROI that makes sense Use discounted cash flow If you can’t justify it – why do it?

Consider the “waves” of Information Technology n Wave 1: Reduction of cost n clerical and administrative reductions (TPS) n n Wave 2: Leverage investment n n No advantage here MRP, inventory control. Based on ROI NOTE: both 1 and 2 depend on cost reductions or displaced costs. n n Little if any proprietary advantage available here These are infrastructural issues

Benefits, con’t n Wave 3: Enhancing products-provide value n n Wave 4: Exec. Decision support n n n Managers seek real-time decisions Wave 5: Reaching the consumer n n Customer support lines with Dbase lookup Home banking, brokerage, e-commerce These three increasingly move to the intangible section of cost justification Note these are moving into infrastructural

It Functions Added Value Business Requirements Identification Information Architecture System Development Cost C’tnrl Operations IT Knowledge Business Knowledge

What is a mother to do? n Increasingly, traditional IT functions are being displaced n n n Outsourcing of operations & knowledgeable users reduce IT function Conventional wisdom suggests that as we move up the IT functions, they become more specialized and a possible source of competitive advantage What does Carr say?