Chapter 7 Business Case Accounting Management of Computer System Performance.

Chapter 7Business Case Accounting

Management of Computer System

Performance

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Agenda Chapter 7

Objective:

Students should be able: to explain the processes of IT Business case accounting.

IT Business Case Accounting

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Business Case Accounting Concepts

Concept Review:The following accounting and financial

concepts apply to a Business Case Analysis (BCA).

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Financial Concepts Reviewed

Future value (FV) - refers to the amount of money to which an investment will grow over a finite period of time at a given interest rate. Future value is the cash value of an investment at a particular time in the future dependent on interest or other methods of return.

Present Value (PV) - The current value of one or more future cash payments, discounted at some appropriate interest rate.

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Net Present Value (NPV) - The present value of an investment's future net cash flows minus the initial investment. If positive, the investment should be made (unless an even better investment exists), otherwise it should not.

Cash Flow - A measure of a company's financial health. Equals cash receipts minus cash payments over a given period of time; or equivalently, net profit plus amounts charged off for depreciation, depletion, and amortization.

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Rate of Return - The annual return on an investment, expressed as a percentage of the total amount invested.

Internal Rate of Return (IRR) - The rate of return that would make the present value of future cash flows plus the final market value of an investment or business opportunity equal the current market price of the investment or opportunity.

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The following are a series of Financial Concepts that are commonly used in Business Case Accounting.

They are used to measure financial viability and are applied the same to all capital investment opportunities. Hurdle Rate - The required rate of return in a

discounted cash flow analysis, above which an investment makes sense and below which it does not. Also called the required rate of return.

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Discounted Cash Flow - is what someone is willing to pay today in order to receive the anticipated cash flow in future years. A method of evaluating an investment by estimating future cash flows and taking into consideration the time value of money.

If you wanted $1000 income in the future (say 5 years), what would you be willing to invest today?

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Hidden Costs – These are ancillary or indirect costs that are associated with direct IT costs. These may include BPR activities and can be substantial.

Opportunity Costs – relates to those potential benefits a company may enjoy should the funds that are to be applied to the subject IT project are spent elsewhere.

Note: as IT costs often constitute 40-60% of a firms capital budget, opportunity costs will continue to weigh in heavily on executive decision making. As an IT professional, be prepared to face this challenge.

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Marginal Costs – when a BCA is conducted, only stripped costs and revenues are measured. This means only variable direct costs are

calculated excluding overhead and other cost factor multipliers.

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Time Value of Money – The concept that money today is worth more than it would be tomorrow considering the premise of opportunity costs. The money in hand now could be reinvested

and earn higher or greater revenues in the future over the promise of this same amount of money in the future. The cost of any decision includes the cost of the best forgone opportunity.

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Economic Life or Horizon – The life expectancy for a project. (Servers will become obsolete in 3-5 years. Therefore the Economic Life of a server will not exceed 5 years).

Terminal Value – The value of the material if it were sold for scrap at the end of the economic life.

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The performance of a Business Case Accounting profile must use several of these tools. The analysis is complex and involved. Failure to do the analysis properly means an

increased chance of failure of the project. Within each of these formulas, there are

numerous variables that need to be defined.

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Sources of Cost Estimates

Estimated costs require data collection. This is done Through estimating (quotes by vendors/ staff) or Through the use of actual costs accumulated from

previous jobs that are the same or similar.. Costs are usually divided into two elements. Direct

and Indirect. Specific allocations are a function of Accounting Practices and may differ. Direct Costs-Labor, Materials, Facilities, Services and

Supervision Indirect Costs-Administration, Fringe, G&A, Sr.

Management. Etc.

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Importance of Cost Estimates

Estimates are created using the following three variables. Effort of Labor and material - This ensures that

appropriate resources are provided to the project. Time - Establishes an expectation to allow team members

to budget their time. This is also used to calculate cost elements such as cost of capital and carrying costs.

Cost - Enables benefits to be weighed against costs. This is used as one of the key components of project valuation.

Substantiation should be provided for each of these elements.

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When performing IT Business Case Analysis, it is important that you understand the methodologies used in providing the estimates.

To reiterate, they must be based on either actual history costs or quotations.

If they are based on quotations, it is imperative that the underlying methodology that was used is identified and understood.

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A consisting estimating methodology should be expected.

This is usually available from the Program Management or estimating offices of your organization.

If you are compiling estimates, they should be compiled consistently using the same basis of approach.

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This applies from task to task or from project to project.

A consistent approach will generate data that can be compared with out fear that an inappropriate approach to estimating was used. This will skew any comparison of the data.

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Effort Estimating (Costs) Highlights

Use the following techniques: Experience (or actuals).

The time it took you to do it last time Activity or deliverable - Discrete Function point – effort is compiled

PERT Estimating Provide three estimates:

a = optimistic effort (time)m= most likely effort (time)b = pessimistic effort (time)

Expected: te = (a + 4m + b)/6 Standard deviation: se = (b - a)/6

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Time Estimates

You must answer the question: “How much time will it take to complete the task.” Consider whether activities can be divided among

several people. Time estimates are a function of effort (or labor)

estimates. Do not assume that just because you assign more

engineers to perform the task, that it will get done quicker.

Factors Labor, Equipment and material, Facilities

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Time Estimating Issues

Supportive data in the form of time and cost standards.

Reasonability based on experience Definition of resource requirements for each

activity Influencing factors other than time and cost Contingency plan estimates

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Material Estimates

You must answer the question: “How much does it cost for the material needed for the task.” Consider sources of supply, price and delivery

schedule. Consider the Time Value of Money principal.

IT hardware costs have historically fallen over time. Factors

Labor may be required to install or use the specified hardware or software.

Include labor estimates to install the procured items. Include shipping costs, storage, handling, etc.

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Material Cost Estimates Issues

Are the quotes reasonable and were multiple sources sought? Just because a vendor says they are your friend,

remember who pays their commission and how they earn that commission.

Is the company able to deliver the material? Are they financially sound and reliable.

Are the items being purchased complete? Do you need rails for the server to fit in the rack? Is

there is a special software package required for mirroring? etc.

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Documenting Cost Estimates

Irrespective of the estimate type (labor, schedule or material), it should be documented.

Documented estimates should reflect; Specifics of the estimate. Who prepared the estimate. Who reviewed the estimate. Where the information was obtained. If comparative data is used, information justifying the

validity of the comparison. The period of validity of the estimate.

This is a function of the material price quotes.

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Quotations –The Basis of Estimate

The Basis of Estimate or BOE is an extremely useful tool in quantifying and understanding the quotation.

The BOE is a written document. It indicates the estimated effort to perform a task.

It takes a specific WBS element and treats it as a task. All sub or component tasks the also identified. For each of these elements, specific labor and material

requirements are identified and put into writing on the form.

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For each labor element, specific skills are identified. Ex.: The task is to install and configure a new Firewall. Labor would

include: 1 Network Technician to rack the device, hook up power and

network cables. = 1 hour 1 Firewall engineer to install the standard firewall rule set and set up

the base configuration. = .25 hours 1 Firewall engineer to optimize the firewall rule set based on

incomplete directions for the S/W and H/W engineers. This include the initial setup and 6 subsequent changes. = 3 hours

Hardware would include: 1 Nokia 660 Firewall with RAM kit, patch cable and Power cord 1 Checkpoint License with 25 IP addresses.

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This document is then completed and signed off by the individual who prepared the estimate and their boss. This commits that individual that the work can be done in

the amount of time identified. It also assumes that they didn’t pad the heck out of it to

start with but that’s another issue. The BOE is then provided to the estimating group

for pricing. Always try to get a third party to do your pricing. It

avoids political issues in the future if you do and make a mistake.

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Compiling Cost BOEs

All of the BOEs should be Compiled and recorded by WBS Each should be priced as discrete elements. Prices should be rolled up and totaled. At this point all quantifiable costs have been identified

and totaled.

The cost or INVESTMENT of the Project is now known within a reasonable certainty if adequate estimating processes and procedures were followed.

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Estimating Benefits

Estimating Benefits presents several challenges. In a Displacement Model, the costs being replaced, are

known. They are real and can easily be quantified.

If the system will replace 10 workers in the Paint booth at $18.00, then you will save $180 a day in direct costs.

Indirect costs would include, Fringe, G&A, benefits, etc.

These costs become savings or benefits to the corporation.

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Estimating Benefits

In a Cost Avoidance Model, the costs being avoided, can usually be estimated with a high degree of certainty.

If a system is being deployed to avoid hiring additional staff, then the cost of the staff can also be estimated with a good confidence level.

There is additional risk with this model in that the costs are probably accurate, but there is no quantifiable data on which to base the estimate.

As with the displacement model, these costs also become savings or benefits to the corporation.

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Estimating Benefits

The most difficult benefit to accurately estimate is those resulting from an IT Investment that is either a new solution or product unto itself. Examples of this are a “.com”, a B2B or B2C portal type

of solution.

The problems, except for those that have done exactly the same thing previously, are as follows: If a similar solution has been deployed by another

company, they won’t tell you how they made it work and how many benefits that are receiving, much less quantify it. You don’t really know what will happen.

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Estimating Benefits

All ROI modeling for this type of work is kept highly confidential by the companies that have made it work.

The markets are evolving and not really mature as compared to other markets with long histories. For a $1M in ads to run during the Super bowl, your

product should generate “x” dollars in sales based on historical data. For $1M in advertising on Yahoo or AOL, the amount of money you will generate can be estimated but there is little long term quantifiable data on the expected returns of the investment.

The benefits from a B2B portal can also be estimated but quantifiable data is elusive.

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Estimating Benefits Use data from similar sources or projects.

It may be appropriate to retain some consultants who have done this type of project before.

Consultants can often provide guidance that would not be obtainable elsewhere.

Be cautious in the selection process. They may not be as good as they say that they are.

Quantify as much as possible. Support it with extensive market research. Ask for justification of each estimate. Use a reasonableness test. Does it make sense.

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Estimating Benefits

Backup estimates. The company that was going to sell $65,000 worth of

Hot Wheels a month was just plain wrong. It isn’t going to happen.

Question all the estimates that you receive.

Use benefit numbers that are very conservative. If you are wrong and things are better, great. If they

are worse, you’ll know sooner.

Make sure that the benefits projected identify any associated costs that would offset the benefits.

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Estimating Benefits

Each solution and the firms that is deploying it at any specific time will receive different benefits.

Be as complete as you can in your analysis. Apply financial principles to the benefits

estimates as you would to the cost estimates. Both change over time. Look outside the solution that is being estimated. Risk

may be external to the solution. Regulations, conflicts and changing demographics

all impact costs and benefits. Consider everything that affects the company in your analysis.

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Estimating Benefits

Estimating intangible benefits, uses one of two approaches. Approach One: Negotiation with the operating

units to assess the value of the intangible. This is usually done by asking what is the value to

the benefit to stakeholders. Answers will vary but ask enough and a common value can be obtained.

Approach Two is Imputation. This is the practice of 'filling in' missing data with

plausible values and applying a test of the value.

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Estimating Benefits In estimating intangible benefits, consider

that the very nature of this type of benefit. Through real, it is difficult to apply quantifiable

values to it. The values applied can all ways be questioned

and challenged. Realizing these difficulties, many firms as

part of their estimating methodology, consciously choose to exclude intangible benefit valuations from their calculations.

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Business Case Accounting Methodologies

Use Discounted Cash Flow (DCF) analysis techniques to determine the viability of the project. This method evaluates an investment by

estimating future cash flows and takes into consideration the time value of money.

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Business Case Accounting Methodologies

The specific DCF calculation methodology is found in the downloadable pdf file from the International Valuation Standards Committee. DCF relies on explicit assumptions regarding

the income potential of the Investment (which was quantified by the BOE process).

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Business Case Accounting

The Ex-Ante valuation of projects using a BCA approach requires the preparation of balance sheets.

The goal is to project costs over time and income streams over a like period. The Cost displacement approach considers the cost of the

investment as compared to the other costs saved (benefit) by the implementation of the system. Usually uses a simple payback (ROI) calculation.

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The cost displacement model is straight forward. The IT system replaces some other existing function,

service or resources and its associated cost. The trick is to make sure that your analysis includes all

costs of the IT systems and all of its on going costs. Resources to be replaced would include manual

operations. An example would include robotic sprayers replacing

humans in the paint booths. The benefits of the robotics must offset the cost of the

labor. This is both a quality and a cost issue.

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The second approach is to use a cost avoidance approach. Takes the approach that the cost of the system is required

to avoid incurring other costs. A regulatory mandate may require additional functions to

be performed. The introduction of an IT system avoids manual costs.

An Example would include an on-line portal that allows clients to input their data, eliminating the need for individuals to perform data collection.

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Decision Analysis should be based on the best information possible. The assumption is that the better the underlying

information, the better the ability of management to use this information to make a decision.

This requires accurate, quantitative data that is confirmable and viable.

This requires a consistent methodology in estimating both the costs and the returns, or benefits, on any investment.

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Business Case Accounting Ex-Post analysis is simple in concept but may be

more challenging in execution. It involves the identification of costs and benefits of a

project after the project is complete or at a minimum, well underway.

It is used for validation of Ex-Ante estimates as well as work in process costing.

First and foremost, the underlying premise of this estimating approach requires the timely collection of data when the work is performed or within a reasonable period thereafter.

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Business Case Accounting Real time or close to real time accounting

is required because of the answer to this simple test. Three weeks ago, what were you doing

between the hours of 10:30 AM and 11:45 AM and how much did your employer pay you to do that amount of work?

If you can’t answer this with close to 100% accuracy, then if you need this data for estimating purposes, you need to collect it in real time (Same Day) if at all possible.

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Business Case AccountingExecutive Use

Select a model Select a period of time for comparison purposes

(Project/Product Lifecycle or period of expected return)

Identify and quantify project costs for that period. Identify and quantify the project benefits for that

period. Compare the two and determine which is greater. Consider intangibles and make a decision. Commit and move forward.

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Summary

Address estimates discretely and consistently.

Across a corporation, a consistent approach to estimating is required.

If all capital intensive projects are to be compared, then the value of each must be comparable.

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References –Sites Accessed Time Value of Money: http://www.econedlink.org/lessons/index.cfm?

lesson=EM37 Future Value: http://www.econedlink.org/lessons/index.cfm?lesson=EM37 Valuation Technique 3: Discounted Cash Flow:

http://www.businesstown.com/valuing/technique3.asp Discounted Cash Flow and other similar terms:

http://www.investorwords.com/cgi-bin/getword.cgi?1476 SDLC Models:

http://www.cis.ohio-state.edu/~lohse/CIS516/SlidesInHTML/OtherMethods.ppt Cost Estimating: http://www.jsc.nasa.gov/bu2/resources.html

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Homework

Chapter 7 Business Case Accounting Management of Computer System Performance.

Documents

Transcript of Chapter 7 Business Case Accounting Management of Computer System Performance.