Economic Analysis of Alternative Solutions IT Acquisition
Economic Analysis of Alternative Solutions IT Acquisition Template 7
Introduction Economic analysis is a management tool that assist in determining, analyzing, and documenting the financial costs and financial benefits of alternatives. The product of the economic analysis of an IT acquisition alternative solution is a projection of the risk-adjusted financial return on investment (ROI) and the net present value (NPV) of the investment. The material below discusses the concepts underlying economic analysis. At the end, it provides a link to an economic analysis worksheet that applies the concepts and generates risk-adjusted ROI and NPV figures for an IT acquisition alternative or a proposal.
NPV Versus ROI Comparisons of the ROI and NPV of the competing alternative solutions will identify the alternative that is most advantageous from a financial standpoint. Both ROI and NPV are used in making the comparisons because they have different meanings and both provide valuable information for the decision makers. ROI is a ratio that compares two quantities, such as investing $3 million and receiving $5 million in return in terms of current dollars over a five-year period. This is an ROI of 67% (i.e., net gain divided by the cost, or $2 divided by $3, where both the net gain and the cost are in today’s dollars). NPV, on the other hand, is a figure that depicts the present value of the projected future stream of benefits and costs. It can determine, for example, that the value of an IT investment over, say, the next five years is, in terms of today’s dollars, $2 million more than its $3 million cost. In other words, the $3 million investment is expected to produce an NPV (net gain) of $2 million in terms of today’s dollars. Which is better, an ROI of 67% or a NPV of $2 million? With the example given here, there is no difference. But there is usually a difference. For example, it is possible to get a 67% return on a $100 project, so telling us that the return will be 67% does not give us enough information. Similarly, the NPV figure of $2 million does not by itself tell us the rate of return we can expect on the dollars invested. We need both the ROI and the NPV to get a proper financial picture. When the ROI and NPV are computed using the same set of data, we will know both the rate of return as well as the total amount of net gain that will be produced in terms of today’s dollars.
Providing Data for the Economic Analysis Generally, when an alternative solution is identified, its benefits, costs, and risks are documented in some detail. The cost information as well as insights on risks can be generated through the preparation of a work breakdown structure for each alternative solution. The economic analysis, using information from the WBS and its financial documentation for each alternative solution, can be used to identify the solution expected to generate the best financial return.
Risk Data and Risk Adjustments The ROI and NPV generated by the economic analysis need to be “risk-adjusted” to take into account the probability that not all of the financial benefits may be realized. Template 6 enabled you to perform a risk analysis of the alternative solutions. Now the question is how will the risks identified for an alternative solution (taking into account the planned risk mitigation) likely to affect the benefits expected from implementing that alternative solution. In general, the effect of risk on the expected benefits is a matter of informed judgement. Template 7 takes the form of an economic analysis worksheet that you can download, as provided in the week 5 content area. A separate Economic Analysis is prepared for each alternative solution. In making entries in a worksheet, decisions need to be made on how each type of expected financial benefit will be affected by risk in each year of the projected life cycle. These risk-estimate inputs enable the Worksheet to calculate risk-adjusted benefits over the life cycle of the project.
Benefits and Costs Data Benefits Data Template 2 summarized the new capabilities or functionalities that any solution to the problem must satisfy. These are important benefits of a satisfactory alternative solution. Each alternative solution must satisfy these requirements but each alternative solution may have other benefits beyond those new capabilities or functionalities. These benefits need to be identified and quantified in financial terms. The financial benefits data can then be entered into the Economic Analysis Worksheet for the life cycle of the IT system. Cost Data The Economic Analysis Worksheet also require cost data for the life off the IT system. You will use the cost information generated in the preparation of the work breakdown structures (Template 5). There are a number of approaches to improving the reliability and validity of cost estimates and projections, but they are beyond the scope of your present course and this activity. Estimating and projecting cost is often one of the weakest aspects of IT acquisition planning. Sometimes in the zeal to get a proposal approved, costs are minimized, overlooked, or hidden in biased and faulty assumptions. Sometimes it is simply a lack of knowhow. Organizations that implement a professional approach to estimating and projecting cost benefit in many ways, not the least of which is more effective project management.
Selecting a Common Life Cycle Period The same number of life cycle years should be used for each of your alternative solutions when making entries in the Economic Analysis Worksheets. If a life cycle of three years is used for one alternative solution, a three-year life cycle must also be used for the other alternative solution. The same number of years for the life cycle is used for every alternative solution so they have a common period over which results can be compared. Usually, this means using the number of years equivalent to the alternative with the shortest life cycle (often three or four years). However, the selection of the life
cycle period to use must be done with good judgement because alternatives often have different years when they have their peak payoffs. For example, if one alternative has a 3-year life cycle with its peak payoff in years 2 and 3, and a second alternative has a 4-year life cycle with its peak payoff in years 3 and 4, some will argue that it would not be fair to use a 3-year period to make a comparison. Could a 4-year or 5-year life cycle period be used for both alternatives? The answer is yes, but then it will be necessary to provide 4 or 5 years of data for each of the alternatives. A decision will need to be made to select the number of years that provides the best comparison, whether it is 3, 4, or 5 years. Where does one get the data for years 4 and 5 when one of the alternatives has, say, a 3-year life cycle? One approach is to continue the shorter-life alternative past its operational “Obsolescence” date by using the year 3 data for year 4 and, if needed, for year 5, with some adjustments if needed. The adjustments can include any added cost and or changes in the benefits that are likely to occur in years 4 and 5. The important point is that the comparisons of the alternative solutions need to be made over the same period of time.
Economic Analysis Workbook You can download the Economic Analysis Workbook (Template 7) from the list of resources. The Workbook contains five worksheets. Worksheets 1, 2, and 3 contain examples of data that were entered for two alternative solutions. Worksheets 4 and 5 explain how the data were generated for the alternative solution presented in worksheet 2. You may find this helpful in developing or confirming the data that you should enter for your two alternative solutions. If you had difficulty determining the costs for your work breakdown structures, the explanations in worksheet 5 should be especially helpful. After you have studied the examples provided on worksheets 2 and 3, you can replace the sample data with the data for your own two alternative solutions. The worksheets will calculate automatically, as will the comparison information on worksheet 1. In other words, the chart and tables on worksheet 1 will now compare your two alternative solutions based on the information you entered. The cells of the worksheets are “locked” except for those you need to use to enter your data. The locked cells contain the formulas for calculating the worksheets and this is a way of protecting them from accidental modification. If no entries are made for a specific year in the worksheet, that year is ignored. The instructions in worksheets 4 and 5 explain this. The Workbook also explains that all costs and benefits are entered in terms of today’s dollars. If an alternative solution will increase maintenance costs by, say, $500 per year for the next three years, that is the figure you enter. On the other hand, if the maintenance costs will increase by 10% per year over the next three years, you enter $500 for the first year, $550 for the second year, and $605 for the third year. The worksheet takes care of all calculations, including adjustments for the time value of money for these and other entries.
You must also enter the benefits that an alternative solution is expected to generate and the probability that each type of benefit will actually be received. For example, if an alternative solution is expected to add $100,000 per year in improved productivity, you would enter the $100,000 and also the percentage of the $100,000 expected to be actually achieved each year. It could be 70% in the first year after the project ends and 95% in the subsequent years. You would enter the 70% and the 95% figures in your worksheet. You need to determine and assign the probability figures (the percentages) based on the risk analysis you did for each alternative solution. These probabilities are necessary so the worksheet can produce a risk-adjusted, discounted (by the time value of money) ROI and NPV for your alternative solution. As you may recognize, the worksheets use a relatively simple and practical way of adjusting for risk. There are more sophisticated ways, including the use of Monte Carlo simulations based on probability distributions (such as the triangular distribution). If you wish, you can do research to obtain more information about probability distributions and Monte Carlo simulations.
Downloading the Workbook When you download the Economic Analysis Workbook, take a little time at first to read the instructions and study the examples. Then it is usually a good idea to enter zeros in all the data cells before you start entering your own data into a worksheet. This will erase the example in the worksheet and you will know that all the data entries are your own. NOTE: Each page of the Workbook is designed so that it will print on one Word Document page. Do not change these settings, since some instructors print each Workbook for grading. The results of the Economic Analysis of the two best alternative solutions serve as input to the Template 8 analysis, which determines which of the two is the most advantageous solution.