Question

Discuss the various models that are commonly used to help measure the value added to a business by information systems.

Answer 1

Various models that are commonly used to help measure the value added to a business by information systems.

Traditional Capital Budgeting Models:

Capital budgeting models are one of several techniques used to measure the value of investing in long-term capital investment projects. The process of analyzing and selecting various proposals for capital expenditures is called capital budgeting. Firms invest in capital projects to expand production to meet anticipated demand or to modernize production equipment to reduce costs. Firms also invest in capital projects for many noneconomic reasons, such as installing pollution control equipment, converting to a human resources database to meet some government regulations, or satisfying nonmarket public demands. Information systems are considered long-term capital investment projects.

Six capital budgeting models are used to evaluate capital projects:

The payback method

The accounting rate of return on investment (ROI)

The net present value

The cost-benefit ratio

The profitability index

The internal rate of return (IRR)

           Chapter 6 introduces the concept of total cost of ownership (TCO), which is designed to identify and measure the components of information technology expenditures beyond the initial cost of purchasing and installing hardware and software. However, TCO analysis provides only part of the information needed to evaluate an information technology investment because it does not typically deal with benefits, cost categories such as complexity costs, and “soft” and strategic factors discussed later in this section.

LIMITATIONS OF FINANCIAL MODELS

Many well-known problems emerge when financial analysis is applied to information systems. Financial models do not express the risks and uncertainty of their own costs and benefits estimates. Costs and benefits do not occur in the same time frame—costs tend to be up-front and tangible, whereas benefits tend to be back loaded and intangible. Inflation may affect costs and benefits differently. Technology—especially information technology—can change during the course of the project, causing estimates to vary greatly. Intangible benefits are difficult to quantify. These factors wreak havoc with financial models.

           The difficulties of measuring intangible benefits give financial models an application bias: Transaction and clerical systems that displace labor and save space always produce more measurable, tangible benefits than management information systems, decision-support systems, and computer-supported collaborative work systems (see Chapters 12 and 13). Traditional approaches to valuing information systems investments tend to assess the profitability of individual systems projects for specific business functions. Theses approaches do not adequately address investments in IT infrastructure, testing new business models, or other enterprise-wide capabilities that could benefit the organization as a whole (Ross and Beath, 2002).

           The traditional focus on the financial and technical aspects of an information system tends to overlook the social and organizational dimensions of information systems that may affect the true costs and benefits of the investment. Many companies’ information systems investment decisions do not adequately consider costs from organizational disruptions created by a new system, such as the cost to train end users, the impact that users’ learning curves for a new system have on productivity, or the time managers need to spend overseeing new system-related changes. Benefits, such as more timely decisions from a new system or enhanced employee learning and expertise, may also be overlooked in a traditional financial analysis (Ryan, Harrison, and Schkade, 2002).

           There is some reason to believe that investment in information technology requires special consideration in financial modeling. Capital budgeting historically concerned itself with manufacturing equipment and other long-term investments, such as electrical generating facilities and telephone networks. These investments had expected lives of more than 1 year and up to 25 years. However, information systems differ from manufacturing systems in that their life expectancy is shorter. The very high rate of technological change in computer-based information systems means that most systems are seriously out of date in 5 to 8 years. The high rate of technological obsolescence in budgeting for systems means that the payback period must be shorter and the rates of return higher than typical capital projects with much longer useful lives. The bottom line with financial models is to use them cautiously and to put the results into a broader context of business analysis.

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Case Example: Capital Budgeting for a New Supply Chain Management System

Let’s look at how financial models would work in a real-world business scenario. Heartland Stores is a general merchandise retail chain operating in eight midwestern states. It has five regional distribution centers, 377 stores, and about 14,000 different products stocked in each store. The company is considering investing in new software and hardware modules to upgrade its existing supply chain management system to help it better manage the purchase and movement of goods from its suppliers to its retail outlets. Too many items in Heartland’s stores are out of stock, even though many of these products are in the company’s distribution center warehouses.

           Management believes that the new system would help Heartland Stores reduce the amount of items that it must stock in inventory, and thus its inventory costs, because it would be able to track precisely the status of orders and the flow of items in and out of its distribution centers. The new system would reduce Heartland’s labor costs because the company would not need so many people to manage inventory or to track shipments of goods from suppliers to distribution centers and from distribution centers to retail outlets. Telecommunications costs would be reduced because customer service representatives and shipping and receiving staff would not have to spend so much time on the telephone tracking shipments and orders. Heartland Stores expects the system to reduce transportation costs by providing information to help it consolidate shipments to retail stores and to create more efficient shipping schedules. If the new system project is approved, implementation would commence in January 2005 and the new system would become operational in early January 2006.

           The solution builds on the existing IT infrastructure at the Heartland Stores but requires the purchase of additional server computers, PCs, database software, and networking technology, along with new supply chain planning and execution software. The solution also calls for new radio-frequency identification technology to track items more easily as they move from suppliers to distribution centers to retail outlets.

           Figure 15-1 shows the estimated costs and benefits of the system. The system had an actual investment cost of $11,467,350 in the first year (year 0) and a total cost over six years of $19,017,350. The estimated benefits total $32,500,000 after six years. Was the investment worthwhile? If so, in what sense? There are financial and nonfinancial answers to these questions. Let us look at the financial models first. They are depicted in Figure 15-2.

FIGURE 15-1 Costs and benefits of the new supply chain management system
This spreadsheet analyzes the basic costs and benefits of implementing supply chain management system enhancements for a midsized midwestern U.S. retailer. The costs for hardware, telecommunications, software, services, and personnel are analyzed over a six-year period.

FIGURE 15-2 Financial models
To determine the financial basis for a project, a series of financial models helps determine the return on invested capital. These calculations include the payback period, the accounting rate of return on investment (ROI), the cost-benefit ratio, the net present value, the profitability index, and the internal rate of return (IRR).

THE PAYBACK METHOD

The payback method is quite simple: It is a measure of the time required to pay back the initial investment of a project. The payback period is computed as follows:

          In the case of Heartland Stores, it will take more than two years to pay back the initial investment. (Because cash flows are uneven, annual cash inflows are summed until they equal the original investment to arrive at this number.) The payback method is a popular method because of its simplicity and power as an initial screening method. It is especially good for high-risk projects in which the useful life of a project is difficult to determine. If a project pays for itself in two years, then it matters less how long after two years the system lasts.

           The weakness of this measure is its virtue: The method ignores the time value of money, the amount of cash flow after the payback period, the disposal value (usually zero with computer systems), and the profitability of the investment.

ACCOUNTING RATE OF RETURN ON INVESTMENT (ROI)

Firms make capital investments to earn a satisfactory rate of return. Determining a satisfactory rate of return depends on the cost of borrowing money, but other factors can enter into the equation. Such factors include the historic rates of return expected by the firm. In the long run, the desired rate of return must equal or exceed the cost of capital in the marketplace. Otherwise, no one will lend the firm money.

           The accounting rate of return on investment (ROI) calculates the rate of return from an investment by adjusting the cash inflows produced by the investment for depreciation. It gives an approximation of the accounting income earned by the project.

           To find the ROI, first calculate the average net benefit. The formula for the average net benefit is as follows:

           This net benefit is divided by the total initial investment to arrive at ROI. The formula is as follows:

           In the case of Heartland Stores, the average rate of return on the investment is 2.93 percent.

           The weakness of ROI is that it can ignore the time value of money. Future savings are simply not worth as much in today’s dollars as are current savings. However, ROI can be modified (and usually is) so that future benefits and costs are calculated in today’s dollars. (The present value function on most spreadsheets can perform this conversion.)

NET PRESENT VALUE

Evaluating a capital project requires that the cost of an investment (a cash outflow usually in year 0) be compared with the net cash inflows that occur many years later. But these two kinds of cash flows are not directly comparable because of the time value of money. Money you have been promised to receive three, four, and five years from now is not worth as much as money received today. Money received in the future has to be discounted by some appropriate percentage rate—usually the prevailing interest rate, or sometimes the cost of capital. Present value is the value in current dollars of a payment or stream of payments to be received in the future. It can be calculated by using the following formula:

           Thus, to compare the investment (made in today’s dollars) with future savings or earnings, you need to discount the earnings to their present value and then calculate the net present value of the investment. The net present value is the amount of money an investment is worth, taking into account its cost, earnings, and the time value of money. The formula for net present value is this:

           In the case of Heartland Stores, the present value of the stream of benefits is $21,625,709, and the cost (in today’s dollars) is $11,467,350, giving a net present value of $10,158,359. In other words, for a $21 million investment today, the firm will receive more than $10 million. This is a fairly good rate of return on an investment.

COST-BENEFIT RATIO

A simple method for calculating the returns from a capital expenditure is to calculate the cost-benefit ratio, which is the ratio of benefits to costs. The formula is

           In the case of Heartland Stores, the cost-benefit ratio is 1.71, meaning that the benefits are 1.71 times greater than the costs. The cost-benefit ratio can be used to rank several projects for comparison. Some firms establish a minimum cost-benefit ratio that must be attained by capital projects. The cost-benefit ratio can, of course, be calculated using present values to account for the time value of money.

PROFITABILITY INDEX

One limitation of net present value is that it provides no measure of profitability. Neither does it provide a way to rank order different possible investments. One simple solution is provided by the profitability index. The profitability index is calculated by dividing the present value of the total cash inflow from an investment by the initial cost of the investment. The result can be used to compare the profitability of alternative investments.

           In the case of Heartland Stores, the profitability index is 1.89. The project returns more than its cost. Projects can be rank ordered on this index, permitting firms to focus on only the most profitable projects.

INTERNAL RATE OF RETURN ( IRR)

Internal rate of return (IRR) is defined as the rate of return or profit that an investment is expected to earn, taking into account the time value of money. IRR is the discount (interest) rate that will equate the present value of the project’s future cash flows to the initial cost of the project (defined here as negative cash flow in year 0 of $11,467,350). In other words, the value of R (discount rate) is such that Present value – Initial cost = 0. In the case of Heartland Stores, the IRR is 33 percent.

RESULTS OF THE CAPITAL BUDGETING ANALYSIS

Using methods that take into account the time value of money, the Heartland Stores project is cash-flow positive over the time period under consideration and returns more benefits than it costs. Against this analysis, you might ask what other investments would be better from an efficiency and effectiveness standpoint. Also, you must ask if all the benefits have been calculated. It may be that this investment is necessary for the survival of the firm, or necessary to provide a level of service demanded by the firm’s clients. What are competitors doing? In other words, there may be other intangible and strategic business factors to consider.

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Strategic Considerations

Other methods of selecting and evaluating information systems investments involve strategic considerations that are not addressed by traditional capital budgeting methods. When the firm has several alternative investments from which to select, it can employ portfolio analysis and scoring models. It can apply real options pricing models to IT investments that are highly uncertain or use a knowledge value-added approach to measure the benefits of changes to business processes. Several of these methods can be used in combination.

PORTFOLIO ANALYSIS

Rather than using capital budgeting, a second way of selecting among alternative projects is to use portfolio analysis. Portfolio analysis helps the firm develop an overall understanding of where it is making information technology investments by inventorying all information systems projects and assets, including infrastructure, outsourcing contracts, and licenses. This portfolio of information systems investments can be described as having a certain profile of risk and benefit to the firm (see Figure 15-3) similar to a financial portfolio.

FIGURE 15-3 A system portfolio
Companies should examine their portfolio of projects in terms of potential benefits and likely risks. Certain kinds of projects should be avoided altogether and others developed rapidly. There is no ideal mix. Companies in different industries have different profiles.

           Each information systems project carries its own set of risks and benefits. (Section 15.2 describes the factors that increase the risks of systems projects.) Firms would try to improve the return on their portfolios of IT assets by balancing the risk and return from their systems investments. Although there is no ideal profile for all firms, information intensive industries (e.g., finance) should have a few high-risk, high-benefit projects to ensure that they stay current with technology. Firms in non-information-intensive industries should focus on high-benefit, low-risk projects.

           Once strategic analyses have determined the overall direction of systems development, the portfolio analysis can be used to select alternatives. Obviously, you can begin by focusing on systems of high benefit and low risk. These promise early returns and low risks. Second, high-benefit, high-risk systems should be examined; low-benefit, high-risk systems should be totally avoided; and low-benefit, low-risk systems should be reexamined for the possibility of rebuilding and replacing them with more desirable systems having higher benefits. By using portfolio analysis, management can determine the optimal mix of investment risk and reward for their firms, balancing riskier high-reward projects with safer lower-reward ones. Firms where portfolio analysis is aligned with business strategy have been found to have a superior return on their IT assets, better alignment of information technology investments with business objectives, and better organization-wide coordination of IT investments (Jeffrey and Leliveld, 2004).

SCORING MODELS

A quick and sometimes compelling method for arriving at a decision on alternative systems is a scoring model. Scoring models give alternative systems a single score based on the extent to which they meet selected objectives. Using Table 15-2 the firm must decide among two alternative enterprise resource planning (ERP) systems. The first column lists the criteria that decision makers will use to evaluate the systems. These criteria are usually the result of lengthy discussions among the decision-making group. Often the most important outcome of a scoring model is not the score but agreement on the criteria used to judge a system. Table 15-2 shows that this particular company attaches the most importance to capabilities for sales order processing, inventory management, and warehousing. The second column in Table 15-2 lists the weights that decision makers attached to the decision criteria. Columns 3 and 5 show the percentage of requirements for each function that each alternative ERP system can provide. Each vendor’s score can be calculated by multiplying the percentage of requirements met for each function by the weight attached to that function. ERP System B has the highest total score.

TABLE 15-2 Example of a Scoring Model for an ERP System

           As with all objective techniques, there are many qualitative judgments involved in using the scoring model. This model requires experts who understand the issues and the technology. It is appropriate to cycle through the scoring model several times, changing the criteria and weights, to see how sensitive the outcome is to reasonable changes in criteria. Scoring models are used most commonly to confirm, to rationalize, and to support decisions, rather than as the final arbiters of system selection. If Heartland Stores had other alternative systems projects from which to select, it could have used the portfolio and scoring models as well as financial models to establish the business value of its systems solution.

REAL OPTIONS PRICING MODELS

Some information systems projects are highly uncertain. Their future revenue streams are unclear and their up-front costs are high. Suppose, for instance, that a firm is considering a $20 million investment to upgrade its information technology infrastructure. If this upgraded infrastructure were available, the organization would have the technology capabilities to respond to future problems and opportunities. Although the costs of this investment can be calculated, not all of the benefits of making this investment can be established in advance. But if the firm waits a few years until the revenue potential becomes more obvious, it might be too late to make the infrastructure investment. In such cases, managers might benefit from using real options pricing models to evaluate information technology investments.

           Real options pricing models (ROPM) use the concept of options valuation borrowed from the financial industry. An option is essentially the right, but not the obligation, to act at some future date. A typical call option, for instance, is a financial option in which a person buys the right (but not the obligation) to purchase an underlying asset (usually a stock) at a fixed price (strike price) on or before a given date.

           For instance, on July 12, 2004, for $4.40 you could purchase the right (a call option) maturing in January 2006 to buy a share of Wal-Mart common stock for $55. If, by the end of January 2006, the price of Wal-Mart stock did not rise above $55, you would not exercise the option, and the value of the option would fall to zero on the strike date. If, however, the price of Wal-Mart common stock rose to, say, $100 per share, you could purchase the stock for the strike price of $55 and retain the profit of $45 per share minus the cost of the option. (Because the option is sold as a 100-share contract, the cost of the contract would be 100 X $4.40 before commissions, or $440, and you would be purchasing and obtaining a profit from 100 shares of Wal-Mart.) The stock option enables the owner to benefit from the upside potential of an opportunity while limiting the downside risk.

           ROPMs value information systems projects similar to stock options, where an initial expenditure on technology creates the right, but not the obligation to obtain the benefits associated with further development and deployment of the technology as long as management has the freedom to cancel, defer, restart, or expand the project. Real options involving investments in capital projects are different from financial options in that they cannot be traded on a market and they differ in value based on the firm in which they are made. Thus, an investment in an enterprise system will have very different real option values in different firms because the ability to derive value from even identical enterprise systems depends on firm factors, for example, prior expertise, skilled labor force, market conditions, and other factors. Nevertheless, several scholars have argued that the real options theory can be useful when considering highly uncertain IT investments, and potentially the same techniques for valuing financial options can be used (Benaroch and Kauffman 2000; Taudes, Feurstein, and Mild, 2000).

           ROPMs offer an approach to thinking about information technology projects that takes into account the value of management learning over time and the value of delaying investment. In real options theory, the value of the IT project (real option) is a function of the value of the underlying IT asset (present value of expected revenues from the IT project), the volatility of the value in the underlying asset, the cost of converting the option investment into the underlying asset (the exercise price), the risk-free interest rate, and the option time to maturity (length of time the project can be deferred).

           The real options model addresses some of the limitations of the discounted cash flow models described earlier, which essentially call for investing in an information technology project only when the discounted cash value of the entire investment is greater than zero. The ROPM enables managers to consider systematically the volatility in the value of IT projects over time, the optimal timing of the investment, and the changing cost of implementation as technology prices or interest rates rise or fall over time.

           This model gives managers the flexibility to stage their IT investment or test the waters with small pilot projects or prototypes to gain more knowledge about the risks of a project before investing in the entire implementation. Briefly, the ROPM places a value on management learning and the use of an unfolding investment technique (investing in chunks) based on learning over time.

           The disadvantages of this model are primarily in estimating all the key variables affecting option value, including anticipated cash flows from the underlying asset and changes in the cost of implementation. Models for determining option value of information technology platforms are being developed (Fichman, 2004; McGrath and MacMillan, 2000). The ROPM can be useful when there is no experience with a technology and its future is highly uncertain.

KNOWLEDGE VALUE-ADDED APPROACH

A different approach to traditional capital budgeting involves focusing on the knowledge input into a business process as a way of determining the costs and benefits of changes in business processes from new information systems. Any program that uses information technology to change business processes requires knowledge input. The value of the knowledge used to produce improved outputs of the new process can be used as a measure of the value added. Knowledge inputs can be measured in terms of learning time to master a new process, and a return on knowledge can be estimated. This method makes certain assumptions that may not be valid in all situations, especially product design and research and development, where processes do not have predetermined outputs (Housel, El Sawy, Zhong, and Rodgers, 2001).