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Chapter 14Chapter 14Assessing the Value of ITAssessing the Value of IT

Managing the Information Managing the Information Technology ResourceTechnology Resource

Paula GouldingPaula Goulding

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Chapter OutlineChapter Outline Importance of assessing IT valueImportance of assessing IT value Traditional financial measures to show valueTraditional financial measures to show value Applying improved financial measureApplying improved financial measure Evaluating portfolio of IT investment projectsEvaluating portfolio of IT investment projects Activity-based managementActivity-based management Difference between showing value and measuring Difference between showing value and measuring

valuevalue Leveraging assets of IT for competitive advantageLeveraging assets of IT for competitive advantage How IT governance is shared responsibilityHow IT governance is shared responsibility How enterprise can benefit from processesHow enterprise can benefit from processes

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Traditional Financial ApproachesTraditional Financial Approaches

Return on Investment (ROI)Return on Investment (ROI)– Net Earnings from Operations Net Earnings from Operations ÷ Net Assets÷ Net Assets– Used to asses value of IT investmentsUsed to asses value of IT investments– Has limitationsHas limitations

Residual IncomeResidual Income– Similar to measure of excess profitSimilar to measure of excess profit– Operating Income ÷ Financial Opportunity Cost Operating Income ÷ Financial Opportunity Cost

of Investment baseof Investment base

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Traditional Financial ApproachesTraditional Financial Approaches

Economic Value Added (EVA)Economic Value Added (EVA)– Uses capital asset pricing modelUses capital asset pricing model– Identifies cost of capital for specific division or business Identifies cost of capital for specific division or business

unitunit– Removes distortions to investments decision by GAAPRemoves distortions to investments decision by GAAP– Expenditures should be capitalized and amortizedExpenditures should be capitalized and amortized

Net Present Value (NPV)Net Present Value (NPV)– Firm chooses between alternative investment Firm chooses between alternative investment

opportunities to advance market valueopportunities to advance market value– Evaluate projects based on measurable cash flowsEvaluate projects based on measurable cash flows

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Real OptionsReal Options Decision to pursue investment project can be Decision to pursue investment project can be

deferred for period of timedeferred for period of time Opportunity to create IT investment at future timeOpportunity to create IT investment at future time Mapping five characteristics of investment Mapping five characteristics of investment

opportunityopportunity Reduce uncertainty by deferring decisionReduce uncertainty by deferring decision Interest income can be earned during deferral Interest income can be earned during deferral

periodperiod Ability to react to changing uncertain conditions Ability to react to changing uncertain conditions

during deferral period by altering investment during deferral period by altering investment decisions decisions

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Mapping IT Investment Characteristics to Mapping IT Investment Characteristics to Financial Call Option CharacteristicsFinancial Call Option Characteristics

Source: adapted from Luerhrman, T.A., Capital Projects as Real Options: An Introduction, Harvard Business School Teaching Note (1994).

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Decision Tree AnalysisDecision Tree Analysis

Capable of accounting for firm’s revisions of Capable of accounting for firm’s revisions of strategies and operations under uncertaintystrategies and operations under uncertainty

Probabilities derived from past information Probabilities derived from past information or future information that can be obtainedor future information that can be obtained

Management chooses alternative that Management chooses alternative that maximizes risk-adjusted NPVmaximizes risk-adjusted NPV

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Source: adapted from Luehrman, T.A., Capital Projects as Real Options: An Introduction, Harvard Business School Teaching Note (1994).

Decision Tree Analysis vs. Real Option AnalysisDecision Tree Analysis vs. Real Option Analysis

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Black-Scholes Model for European Black-Scholes Model for European Call OptionCall Option

Vc = N(d1) PV (assets to be acquired) – N(d2)(PV(expenditure)/ef

rt

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Real Option Valuation Real Option Valuation of Individual Investmentof Individual Investment

Traditional financial analysis of investment Traditional financial analysis of investment projects has shortcomingsprojects has shortcomings– Parker, Benson, TrainorParker, Benson, Trainor

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Buss Framework for Individual InvestmentBuss Framework for Individual Investment

Investment projects ranked for 4 criteria:Investment projects ranked for 4 criteria:– financial benefitsfinancial benefits– intangible benefitsintangible benefits– technical importancetechnical importance– fit with business objectivesfit with business objectives

Each criterion comprised of relevant elementsEach criterion comprised of relevant elements Each element scored for IT investment project and Each element scored for IT investment project and

total score derivedtotal score derived Sum obtained across four criteria used to compare Sum obtained across four criteria used to compare

IT investment against competing projectsIT investment against competing projects

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Oracle Corp. Decision ModelOracle Corp. Decision Model Create committee of stakeholders affected by Create committee of stakeholders affected by

IT investmentIT investment Define intangible benefits of IT investmentDefine intangible benefits of IT investment Define intangible risks associated with IT Define intangible risks associated with IT

investmentinvestment Establish weights to relative importance of Establish weights to relative importance of

tangible benefitstangible benefits Estimate on scale of zero to five the likelihood Estimate on scale of zero to five the likelihood

of each benefit and risk observedof each benefit and risk observed Multiply likelihood estimate by weight Multiply likelihood estimate by weight

established for factor and add up productsestablished for factor and add up products

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Real Options AnalysisReal Options Analysis

Build consensus among participants in IT Build consensus among participants in IT investment decisionsinvestment decisions

They couple financial calculations with They couple financial calculations with intangible benefits and risks, aspects of intangible benefits and risks, aspects of strategic concernstrategic concern

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““Tomato Garden” of IT Investment ProjectTomato Garden” of IT Investment Project

Source: adapted from Luehrman, T.A., 1998b “Strategy as a Portfolio of Real Options,” Harvard Business Review, September-October (1998).

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Evaluating IT Investment PortfolioEvaluating IT Investment Portfolio

Ensure IT investment proposals are understood in Ensure IT investment proposals are understood in terms of expected business outcomes, efforts terms of expected business outcomes, efforts needed to reach outcomes, and risks involvedneeded to reach outcomes, and risks involved

Ensure IT investments will advance value of firmEnsure IT investments will advance value of firm Ensure risks associated with IT investments are in Ensure risks associated with IT investments are in

line with acceptable risk profileline with acceptable risk profile Ensure IT investments are aligned with business Ensure IT investments are aligned with business

strategiesstrategies

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Trigeorgis’ FrameworkTrigeorgis’ Framework

Objective of value management refers to broad Objective of value management refers to broad measure of NPVmeasure of NPV

Strategic NPV = Traditional NPV of expected cash Strategic NPV = Traditional NPV of expected cash flows + Value of operating options from flexible flows + Value of operating options from flexible management + Investment interaction effectsmanagement + Investment interaction effects

Strategic management of investments requires Strategic management of investments requires management of collection of future investment management of collection of future investment opportunities and optionsopportunities and options

Appropriate control targets are necessary for Appropriate control targets are necessary for effective implementation of value-maximizing effective implementation of value-maximizing approachapproach

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3 Phases of Trigeorgis’ Framework3 Phases of Trigeorgis’ Framework

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Activity-Based Management MeasuresActivity-Based Management Measures

Activity-based costingActivity-based costing– Methodology that measures cost and Methodology that measures cost and

performance of activities, resources, and cost performance of activities, resources, and cost objectsobjects

Activity-based managementActivity-based management– Discipline that focuses on the management of Discipline that focuses on the management of

activities as the route to improving value activities as the route to improving value received by the customer and profit achieved by received by the customer and profit achieved by providing this valueproviding this value

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TCO and TBO ConceptsTCO and TBO Concepts

Total Cost of Ownership (TCO)Total Cost of Ownership (TCO)– Acquisition cost of materials is only portion of Acquisition cost of materials is only portion of

true costs of a product or processtrue costs of a product or process

Total Benefit of Ownership (TBO)Total Benefit of Ownership (TBO)– Considers benefits of competing products or Considers benefits of competing products or

processes instead of just focusing on individual processes instead of just focusing on individual costscosts

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TCO Analysis Concerns AddressedTCO Analysis Concerns Addressed

Provide predictable costs and level budgetsProvide predictable costs and level budgets Determine which IT resources can be applied to Determine which IT resources can be applied to

firm’s core missionfirm’s core mission How to determine current costs and servicesHow to determine current costs and services How to increase service levels at affordable costHow to increase service levels at affordable cost How to track or recognize actual ongoing IT costsHow to track or recognize actual ongoing IT costs How to find cost-effective way of improving IT How to find cost-effective way of improving IT

expertiseexpertise How to determine most effective implementation How to determine most effective implementation

strategy to improve effective/efficient delivery of ITstrategy to improve effective/efficient delivery of IT

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Differentiating Features of Differentiating Features of TVO ApproachTVO Approach

IT and business management must work IT and business management must work togethertogether

Firm needs to move from pure cost center Firm needs to move from pure cost center perspective to one emphasizing value perspective to one emphasizing value creationcreation

Managers must evaluate and manage Managers must evaluate and manage collection or portfolio or projectscollection or portfolio or projects

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Resources for More MethodologiesResources for More Methodologies

Applied information economicsApplied information economics–http://www.hubbardross.comhttp://www.hubbardross.com

Balanced scorecardBalanced scorecard–http://www.bscol.comhttp://www.bscol.com–http://www.aquent.comhttp://www.aquent.com

Economic value addedEconomic value added–http://www.sternstewart.comhttp://www.sternstewart.com

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Resources for More MethodologiesResources for More Methodologies

Economic Value SourcedEconomic Value Sourced– http://www.metagroup.comhttp://www.metagroup.com

Portfolio managementPortfolio management– http://www.metricnet.comhttp://www.metricnet.com

– http://www.metagroup.comhttp://www.metagroup.com

Real option valuationReal option valuation– http://www.pwcglobal.comhttp://www.pwcglobal.com

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Value Management Framework ExamplesValue Management Framework Examples

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Application of Expanded Value Application of Expanded Value Management FrameworkManagement Framework

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Governance Is Shared ResponsibilityGovernance Is Shared Responsibility

IT and business managers need to work IT and business managers need to work togethertogether

Combined application of:Combined application of:– Real optionsReal options– Value managementValue management– Portfolio analysis as toolsPortfolio analysis as tools– MetricsMetrics– IndicatorsIndicators

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Enterprise Can Benefit from ProcessesEnterprise Can Benefit from Processes

IT work adds value to businessIT work adds value to business Ongoing process that continues to evolve Ongoing process that continues to evolve

and changeand change All units must work toward same strategic All units must work toward same strategic

goals of firmgoals of firm Combination of financial measures, Combination of financial measures,

nonfinancial measures, and partnerships nonfinancial measures, and partnerships leveraging IT assetsleveraging IT assets

Encourage staff to embrace practicesEncourage staff to embrace practices