COST BENEFIT ANALYSIS

SYSTEM ANALYSIS

COST / BENEFIT ANALYSIS

INTRODUCTION

Introduction

Data gathering is only one part of systems analysis. The next steps are to examine the data, assess the situation, look at the alternatives, and recommend a candidate system, The costs and benefits of each alternative guide the selection of one alternative over the others.

Each approach has costs and benefits that are compared with those of other approaches before a final recommendation is made. The outcome is a system proposal (also called a project proposal) that summarizes the findings of the analysis and states the recommendations for design.

DATA ANALYSIS

DATA ANALYSIS

• Data analysis is a prerequisite to cost/benefit analysis. System investigation and data gathering lead to an assessment of current findings. Our interest is in determining how efficiently certain steps are performed, how they contribute to achieving the intended goals, and the cost of making improvements.

• For example the safe deposit department was authorized to double its capacity from 4,000 to 8,000 boxes in an effort to meet increased demand. Consequently, the number of employees changed from three to five, with one employee assigned full-time to billing. Analysis of the data collected made it obvious that customers were frequently billed too late, too often, or not at all.

DATA ANALYSIS …

Analysis Current System Facts Objectives (System Design Requirements)

What is done? (processes)

Open customer account Assign safe deposit box Issue keyReceive annual rent

Better customer service Faster information retrieval Quicker notice preparation

How is it done? (processing detail)

•Some 40 boxes opened or closed daily Master card file located too far from customer inquiry station.•Heaviest activity on Fridays and beforeholidays•Too many steps taken with new customers•Delay in billing—all manual Some 80 renewal payment notices prepared daily •Cash received given to head teller atend of each day•Poorly designed application forms •Accounting gets daily summary •Procedure for customer access to boxes is neither documented nor consistent

•Better billing accuracy •Lower processing and operating cost •Improved staff efficiency •More consistent billing procedures to eliminate errors

DATA ANALYSIS …Analysis Current System Facts Objectives (System

Design Requirements) Who does it?

(personnel)•One person handles billing (full-time)•One person handles security•Three persons process customers intoand out of safe deposit area Except for two persons, rest of staff is poorly trained •Communication among staff is adequate

•Better trained personnel •Experience in computer use for other applications

Where is it done? (physical location facility)

•Location allows privacy and security Billing carried out close to customer counter

Allocate quiet space for computer Provide security measure for information access

Assessment of processing

•Time to prepare a renewal notice is 10 minutes•Time to process a customer is 3.5 minutes•15 percent of billing is erroneous in amount, box number, or amount of rent •28 percent of vacant boxes cannot belocated on existing books •Frequent notices regarding "to berenewed" boxes cost $8,000 for mailing•Employee payroll is as high as junior officers in operations area

DATA ANALYSIS …

• The system profile summarizes the operating characteristics of the safe deposit system, such as the volume of work, nature of processes, physical facilities, and personnel. From the analysis, the system design requirements are identified. These features must be incorporated into a candidate system to produce the necessary improvements. The system requirements are:

• Better customer service.• Faster information retrieval.• Quicker notice preparation.• Better billing accuracy.• Lower processing and operating costs.• Improved staff efficiency.• Consistent billing procedure to eliminate errors.

DATA ANALYSIS …

• To achieve these design objectives, several alternatives must be evaluated. The analyst then selects those that are feasible economically, technically, and operationally. The approach may emphasize the introduction of a computerized billing system, replacement of staff, improved billing practices, changes in operating procedures, or a combination of several options.

COST / BENEFIT ANALYSIS

COST / BENEFIT CATAGORIES

• In developing cost estimates for a system, we need to consider several cost elements.

Among them are • Hardware• Personnel• Facility• Operating• Supply costs.


HARDWARE COSTS

Hardware costs relate to the actual purchase or lease of the computer and peripherals (for example, printer, disk drive, tape unit). Determining the actual cost of hardware is generally more difficult when the system is shared by various users than for a dedicated stand-alone system. In some cases, the best way to control for this cost is to treat it as an operating cost.


PERSONNEL COSTS

Personnel costs include staff salaries and benefits (health insurance, vacation time, sick pay, etc.) as well as pay for those involved in developing the system. Costs incurred during the development of a system are one-time costs and are labeled developmental costs. Once the system is installed, the costs of operating and maintaining the system become recurring costs.


FACILITY COSTS

Facility costs are expenses incurred in the preparation of the physical site where the application or the computer will be in operation. This includes wiring, flooring, lighting, and air conditioning. These costs are treated as one-time costs and are incorporated into the overall cost estimate of the candidate system.


OPERATING COSTS

Operating costs include all costs associated with the day-to-day operation of the system; the amount depends on the number of shifts, the nature of the applications, and the category of the operating staff. There are various ways of covering operating costs. One approach is to treat operating costs as overhead. The amount charged is based on computer time, staff time, and volume of the output produced. In any case, some accounting is necessary to determine how operating costs should be handled.


SUPPLY COSTS

Supply costs are variable costs that increase with increased use of paper, ribbons, disks, and the like. They should be estimated and included in the overall cost of the system.

PROCEDURE FOR COST / BENEFIT DETERMINATION

PROCEDURE FOR COST / BENEFIT DETERMINATION

Cost/benefit analysis is a procedure that gives a picture of the various costs, benefits, and rules associated with a system. The determination of costs and benefits entails the following steps:

1. Identify the costs and benefits to a given project.

2. Categorize the various costs and benefits for analysis.

3. Select a method of evaluation.

4. Interpret the results of the analysis.

5. Take action.

COSTS AND BENEFITS IDENTIFICATION

Costs and Benefits Identification

• Certain costs and benefits are more easily identifiable than others. For example, direct costs, such as the price of a hard disk, are easily identified from company invoice payments or canceled checks.

CLASSIFICATION OF COSTS AND BENEFITS

Costs and Benefits Identification

The next step in cost and benefit determination is to categorize costs and benefits.

They may be • tangible or intangible• direct or indirect• fixed or variable.

Let us review each category.

TANGIBLE OR INTANGIBLE COSTS AND BENEFITS

Tangible or Intangible Costs and Benefits

Tangibility refers to the ease with which costs or benefits can be measured. An outlay of cash for a specific item or activity is referred to as a tangible cost. They are usually shown as disbursements on the books. The purchase of hardware or software, personnel training, and employee salaries are examples of tangible costs. They are readily identified and measured.

Costs that are known to exist but whose financial value cannot be accurately measured are referred to as intangible costs. For example, em ployee morale problems caused by a new system or lowered company image is an intangible cost.

Tangible or Intangible Costs and Benefits …

• Benefits are also classified as tangible or intangible. Like costs, they are often difficult to specify accurately. Tangible benefits, such as completing, jobs in fewer hours or producing reports with no errors, are quantifiable. Intangible benefits, such as more satisfied customers or an improved corporate image, are not easily quantified. Both tangible and intangible costs and benefits, however, should be considered in the evaluation process.

DIRECT OR INDIRECT COSTS AND BENEFITS

Direct or Indirect Costs and Benefits• From a cost accounting point of view, costs are

handled differently depending on whether they are direct or indirect.

• Direct costs are those with which a dollar figure can be directly associated in a project. They are applied directly to the operation. For example, the purchase of a box of diskettes for $35 is a direct cost because we can associate the diskettes with the dollars expended.

• Direct benefits also can be specifically attributable to a given project. For example, a new system that can handle 25 percent more transactions per day is a direct benefit.

Direct or Indirect Costs and Benefits …• From a cost accounting point of view, costs are

handled differently depending on whether they are direct or indirect.

• Direct costs are those with which a dollar figure can be directly associated in a project. They are applied directly to the operation. For example, the purchase of a box of diskettes for $35 is a direct cost because we can associate the diskettes with the dollars expended.

• Direct benefits also can be specifically attributable to a given project. For example, a new system that can handle 25 percent more transactions per day is a direct benefit.

Direct or Indirect Costs and Benefits …• Indirect costs are the results of operations that

are not directly associated with a given system or activity. They are often referred to as overhead. A system that reduces overhead realizes a savings. If it increases overhead, it incurs an additional cost. Insurance, maintenance, protection of the computer center, heat, light, and air conditioning are all tangible costs, but it is difficult to determine the proportion of each attributable to a specific activity such as a report. They are overhead and are allocated among users according to a formula.

Direct or Indirect Costs and Benefits …• Indirect benefits are realized as a by-product of

another activity or system. For example, our proposed safe deposit billing system that provides profiles showing vacant boxes by size, location, and price, will help management decide on how much advertising to do for box rental. Information about vacant boxes becomes an indirect benefit of the billing even though it is difficult to specify its value.

FIXED OR VARIABLE COSTS AND BENEFITS

Fixed or Variable Costs and Benefits

• Fixed costs are constant and do not change. Once encountered, they will not recur. Examples are straight-line depreciation of hardware, exempt employee salaries, and insurance.

• variable costs are incurred on a regular (weekly, monthly) basis. They are usually proportional to work volume and continue as long as the system is in operation. For example, the costs of computer forms vary in proportion to the amount of processing or the length of the reports required.

Fixed or Variable Costs and Benefits …

• Fixed benefits are also constant and do not change. An example is a decrease in the number of personnel by 20 percent resulting from the use of a new computer. The benefit of personnel savings may recur every month.

• Variable benefits, on the other hand, are realized on a regular basis. For example, consider a safe deposit tracking system that saves 20 minutes preparing customer notices compared with the manual system. The amount of time saved varies with the number of notices produced.

SAVINGS VERSUS COST ADVANTAGES

Savings versus Cost Advantages

• Savings are realized when there is some kind of cost advantage. So we can say that a true savings reduces or eliminates various costs being incurred.

• The following table is a summary of savings from the use of a new online teller system. In this installation, $131,870 was saved through a reduction in personnel, handling charges, and proof machine rental. After deducting processing charges of $90,990, the net savings from the online system was $40,880.

Savings versus Cost AdvantagesPosition N

Average Annual Pay (includes 25 percent benefits)

Total

Collections teller 1 $12,400 $ 12,400

Savings teller 5 11,610 58,050

Bookkeeper 3 9,940 29,820

Proof operator 1 10,900 10,990

Subtotal 10 $111,170

B. Reduction in handling charges

6,840

C. Reduction in proof machine rental:

Previous units (4 @ $4,500) $18,000

Present units (3 @ $1,380) 4.140

Net savings from rentals 13,860

Total gross savings $131,870

Less processing charges:

Online demand deposit processing

$33,660

Proof of deposit reporting 27,000

Online savings processing 5.100

Teller machine rental 25,230

Total processing charges 90,990

Net savings/year $ 40,880

A. Reduction in personnel and payroll:

EVALUATION METHOD

Evaluation Method

Several evalua tion methods are available, each with pros and cons.

The common methods are:• Net benefit analysis.• Present value analysis.• Net present value.• Payback analysis.• Break-even analysis.• Cash-flow analysis.

NET BENEFIT ANALYSIS

Net Benefit Analysis• Net benefit analysis simply involves subtracting total

costs from total benefits. It is easy to calculate, easy to interpret, and easy to present. The main drawback is that it does not account for the time value of money and does not discount future cash flow.

• The time value of money is extremely important in evaluation processes. If you were faced with an opportunity that generates $3,000 a year, how much would you be willing to invest? Obviously, you'd like to invest less than the $3,000. To earn the same money five years from now, the amount of investment would be even less. What is suggested here is that money has a time value. Today's dollar and tomorrow's dollar are not the same. The time lag accounts for the time value of money.

Net Benefit Analysis …

Year Year Year

Cost/Benefit 0 1 2 Total

Costs $-1,000 $-2,000 $-2,000 $-5,000

Benefits 0 650 4,900 5,550

Net benefits $-1,000 $ -1,350 $-2,900 $ 550

EXAMPLE

The time value of money is usually expressed in the form of interest on the funds invested to realize the future value. Assuming compounded interest, the formula is:

F = Future value of an investment.P = Present value of the investment.i = Interest rate per compounding period.n = Number of years.For example, $3,000 invested in Treasury notes for three years at 10 percent interest would have a value at maturity of:F = $3,000(1 + 0.10)3 = 3,000(1.33) = $3,993

PRESENT VALUE ANALYSIS

Present Value Analysis

• In developing long-term projects, it is often difficult to compare today's costs with the full value of tomorrow's benefits. As we have seen, the time value of money allows for interest rates, inflation and other factors that alter the value of the investment. present value analysis controls for these problems by calculating the costs and benefits of the system in terms of today's value of the investment and then comparing across alternatives.

Present Value Analysis …

• Suppose that $3,000 is to be invested in a microcomputer for our safe deposit tracking system, and the average annual benefit is $1,500 for the four-year life of the system. The investment has to be made today, whereas the benefits are in the future. We compare present values to future values by I considering the time value of money to be invested. The amount that we are willing to invest today is determined by the value of the benefits at the end of a given period (year). The amount is called the present value of the benefit.

• To compute the present value, we take the formula for future value

Present Value Analysis …

• So the present value of $1,500 invested at 10 percent interest at the end of the fourth year is:

NET PRESENT VALUE

Net Present Value• The net present value is equal to discounted benefits

minus discounted costs. Our $3,000 microcomputer investment yields a cumulative benefit of $4,758.51, or a net present gain of $1,758.51. This value is relatively easy to calculate and accounts for the time value of money. The net present value is expressed as a percentage of the investment—in our example:

PAYBACK ANALYSIS

Payback Analysis

• The payback method is a common measure of the relative time value of a project. It determines the time it takes for the accumulated benefits to equal the initial investment. Obviously, the shorter the payback period, the sooner a profit is realized and the more attractive is the investment. The payback method is easy to calculate and allows two or more activities to be ranked. Like the net profit, though, it does not allow for the time value of money.

Payback Analysis …

BREAK-EVEN ANALYSIS

Break-even Analysis

• Break-even is the point where the cost of the candidate system and that of the current one are equal. Unlike the payback method that compares costs and benefits of the candidate system, break even compares the costs of the current and candidate systems. When a candidate system is developed, initial costs usually exceed those of the current system. This is an investment period. When both costs are equal, it is break-even. Beyond that point, the candidate system provides greater benefit (profit) than the old one—a return period.

Break-even Analysis

Break-even AnalysisFigure 8-6 is a break-even chart comparing the costs of the

current and candidate systems. The attributes are processing cost and processing volume. Straight lines are used to show the model's relationships in terms of the variable, fixed, and total costs of the two processing methods and their economic benefits. Intersection B' indicates the point where the total cost of processing 65,000 transactions by the current system is equal to the total cost of using the candidate system. The shaded area beyond that point is the return period. The shaded area AB 'A' is the investment period. Accord ing to the chart, then, it would be more economical to process manually when volume is below 65,000 transactions during a given time period. Processing volume above B' favors the candidate system.

CASH-FLOW ANALYSIS

Cash-Flow Analysis

• Some projects, such as those carried out by computer and word processing services, produce revenues from an investment in computer systems. Cash-flow analysis keeps track of accumulated costs and revenues on a regular basis.

Cash-Flow Analysis …

January

February

March April May June July August September

October November

December

Revenues tram

computer service $22,000

$22,000

$26,000

$27,100

$41,000

$48,000

$59,050

$59,010 $66,450 $ 64,040 $ 69,700 $ 71,040

Operating expenses:Facility preparation

$24,000

$ 9,000

$ 1,400

Hardware lease 7,400 7,400 7,400 $ 7,400

$ 7,400 $ 7,400 $ 7,400

$ 7,400 $ 7,400 $ 7,400 $ 7,400 $ 7,400

Insurance 195 195 195 195 195 195 195 195 195 195 199 195

Salaries 11,100 11,100 11,100 10,600 10,600 10,600 12,010 12,010 12,010 12,010 12,010 12,010

Supplies 3,640 2,700 2,740 3,950 4,600 4,840 4,885 5,110 5,225 5,170 5,360 8,801

Telecommunication

expenses 1,300 1,300 1,300 1,300 1,900 1,900 1,900 1,900 1,900 1,900 1,750 1,750

Travel/entertainment

2,000 1,600 900 800 900 600 400 400 500 500 200 700

User training 1,500 1,500 2,760 2,810 2,850 2,850 2,850 2,910 2,800 2,900 3,100 3,050

Total expenses $51,175

$34,795

$27,805

$27,055

$28,445

$28,385

$29,640

$29,925 $28,030 $ 30,075 $ 30,015 $ 30,906

Cash flow

(revenue - expense)

(29,175)

(12,795)

(1,805) 45 12,555 19,615 29,410 30,085 22,420 33,965 39,685 40,134

Accumulated cash

flow ($29,175)

($41,970)

($43,775)

($43,730)

($31,180)

($11,565)

$17,845

$47,930 $70,350 $104,315

$144,000

$184,134

Cash-Flow Analysis …• The following table illustrates the performance of

a new computer service over a one year period. Revenues for the first month in operation (January) were $22,000. Operating expenses (including facility preparation) were $51,175, which resulted in a net expenditure of $29,175. Break-even occurs at the end of the fourth month (April). The cash flow then was $45, although the accumulated cash flow was $ 43,730. This was the result of excess expenses over revenues, facility preparation costs, and the like. Accumulated cash flow began to turn positive. This was the beginning of the payback period.

INTERPRET RESULTS OF THE ANALYSIS AND FINAL ACTION

Interpret Results of the Analysis and Final Action

• When the evaluation of the project is complete, the results have to be interpreted.

• cost/benefit analysis is a tool for evaluating projects rather than a replacement of the decision maker. In real-life business situations, whenever a choice among alternatives is considered, cost/benefit analysis is an important tool.

Interpret Results of the Analysis and Final Action …

• Like any tool, however, it has problems:• Valuation problems. Intangible costs and benefits are

difficult to quantify, and tangible costs are generally more pronounced than tangible benefits. In most cases, then, a project must have substantial intangible benefits to be accepted.

• Distortion problems. There are two ways of distorting the results of cost/ benefit analysis. One is the intentional favoritism of an alternative for politi cal reasons. The second is when data are incomplete or missing from the analysis.

• Completeness problems. Occasionally an alternative is overlooked that compromises the quality of the final choice. Furthermore, the costs related to cost/benefit analysis may be on the high side or not enough costs may be considered to do a complete analysis. In either case, the reliability of the final choice is in doubt.

THE SYSTEM PROPOSAL

THE SYSTEM PROPOSAL• The final decision following cost/benefit analysis is

to select the most cost-effective and beneficial system for the user. At this time, the analyst pre pares a feasibility report on the major findings and recommendations.

THE SYSTEM PROPOSAL …• A written feasibility report should include the following:• I. TITLE PAGE Defines the name of the project and who it is

for• II. TABLE OF CONTENTS List various parts; features, and

exhibits, showing page numbers• III. SCOPE Present a brief explanation of the system

boundaries• IV. STATEMENT OF PROBLEM Describe current system• Describe proposed system Indicate how proposed system will

solve the problem(s)• V. SUMMARY/ABSTRACT (optional) Give executive a

summary of project, highlighting benefits• VI. COST/BENEFIT STATEMENT List benefits and savings in

quantitative terms Present dollar savings versus costs Summarize cost of new equipment, one-time charges, etc. Quantify net savings and expected returns

THE SYSTEM PROPOSAL …• VII. IMPLEMENTATION SCHEDULE Submit

implementation plan Specify human resources, requirements, systems and procedures, etc. Include PERT-CPM or Gantt chart

• VIII. HARDWARE CONFIGURATION (optional) Lay out computer configuration Describe terminal network and equipment (CRTs, printers, etc.) List communication equipment (data sets, lines, etc.)

• IX. CREDITS Give credit to those who contributed to the project study

• X. APPENDIX Include exhibits, correspondence on project, and other miscellaneous documentation

COMPARISIONEvaluation Method

Procedure Advantages Limitations

Net benefit

Total benefits minus total costs

Easy to calculate Easy to interpret Easy to present

Does not account for the time value of money

Present value

P = F/[(l + i)n]F = Future value of an investment F = P (1 + i)n

Easy to calculateEquates different investment opportunities with various costs and benefits and discount ratesAccounts for time value of money

It is only a relative (not absolute) measure of a project's return on investment

Net present value

Discounted benefits minus discounted costs

Relatively easy to calculate Accounts for time value of money

It is only a relative (not absolute) measure of a project's return on investment

Payback Investment divided by yearly savings Compares costs and benefits of candi date system

Easy to calculateHas straightforward interpretation for choice between two or more alter natives for candidate systems

Conservative economic measure Applied to one opportunity at a timeDoes not compare profitability of multiple investment alter nativesDos not allow for time value ofmoney.

Break-even

Compares costs of using present and candidate systems

Easy to understand Does not allow for time factor and depreciation value of money

Cash-flow Revenue minus expense on a period-by-period basis

Combines benefits of break-even and payback methods

Ignores time value of money For a limited time period, it does not take into account the prof itability of the project Ignores behavioral implications of the numbers in the financial statement

COST BENEFIT ANALYSIS

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