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Software EconomicsIntroduction to
Business Case Analysis
Session 2
Georg Singer
georg.singer ät ut . ee
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Course Objective
• Introduce the principles and methods of Business Case Creation
• Emphasize the role of measures like NPV, ROI, TCO, IRR and the like for investment decisions
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Structure of the course
• Last Session
– The setting
– Definition of Business Case
– Business Case Principles
– Time Value of Money
– PV, NPV
• Today
– More business case concepts
• Next Session
– Pitching session
– You sell me your business case
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Today’s Session
• Return on Investment (ROI)
• Internal Rate of Return (IRR)
• Payback Period/Break Even Analysis
• Total Cost of Ownership (TCO)
• More about benefits & risk
• Case Study Preparation
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ROI – a very general concept
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Return on Investment ROI – The formula
• A general concept, where the earnings are expressed as a proportion of the outlay
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Investopedia explains Return On Investment -ROI
Keep in mind that the calculation for return on investment and, therefore the definition, can be modified to suit the situation -it all depends on what you include as returns and costs. The definition of the term in the broadest sense just attempts to measure the profitability of an investment and, as such, there is no one "right" calculation.
For example, a marketer may compare two different products by dividing the revenue that each product has generated by its respective marketing expenses. A financial analyst, however, may compare the same two products using an entirely different ROI calculation, perhaps by dividing the net income of an investment by the total value of all resources that have been employed to make and sell the product.
This flexibility has a downside, as ROI calculations can be easily manipulated to suit the user's purposes, and the result can be expressed in many different ways. When using this metric, make sure you understand what inputs are being used.
Source: Investopedia
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Cost – Benefit Analysis
• When people say ROI analysis they mean Cost-Benefit analysis
• Compares the project costs versus the projected benefits over time
– Analyzes positive and negative cash flows (benefits vs. costs)
• First step in the quantification of a project
• Cost – Benefit Analysis = Proposed Plan - Base Case = Incremental Cash flow/Profit/ Etc. (Gain)
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Simple Example - ROI
For each $ that you put into this project, you get $ 2.4 back.
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Interpretation of the ROI measureScenario Type Interpretation Impact on Decisions
ROI >0 Project generates positive returns
If in line with strategyproject (with highest positive ROI shall be carried out)
ROI <0 Project generatesnegative returns
Project shall not be carried out unless intangible benefits justify a go decision
ROI = 0 Project does neither generate nor lose money
Decision must be based on other criteria
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Remarks
• ROI only states relative gains, it says nothing about absolute gains
• For making a sound decision, always use a combination of measures
• If you want to reflect the risk in the project, you can use the following formula
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Exercise - ROI calculation Exercise
• 10 minutes, everybody alone
• ROI CALCULATION EXERCISE.pdf
• Exercises\Solution E-Learning.xlsx
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Session Progress
• Return on Investment (ROI)
• Internal Rate of Return (IRR)
• Payback Period/Break Even Analysis
• Total Cost of Ownership (TCO)
• More about benefits & risk
• Case Study Preparation
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IRR – “How risky can it be?”
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Internal Rate of Return (IRR)
• The Discount Rate which makes the NET Present Value of a project equal to zero
• Also called rate of return
• Measures the profitability of investments
• Interpretation: The higher the IRR the more desirable to carry out the project
– It’s a relative measure; does not say anything about the absolute returns of a project
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Example
• Initial = I(0) = - € 100,000
• Year 1 = I(1) = + € 175,000
• Year 2 = I(2) = + € 175,000
• Year 3 = I(3) = + € 175,000
• For this set of net cash flows, the IRR calculation that yields a NPV of zero is 166%.
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Session Progress
• Return on Investment (ROI)
• Internal Rate of Return (IRR)
• Payback Period/Break Even Analysis
• Total Cost of Ownership (TCO)
• More about benefits & risk
• Case Study Preparation
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Payback Period – “when are we profitable?”
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Payback Period (time)
• The time period from the start of the project until the cumulative cash flow turns positive
• The point where benefits exceed costs is often called the Break even point (BEP).
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Example – Payback Period
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Break Even Analysis (unit sales)
• The break-even point (BEP) is the point at which cost and revenue are equal
• one has "broken even“
• BEP (in terms of unit sales)
• Total Revenue=Total Costs
• Break Even (in terms of unit sales) = Fixed Costs / (Selling Price − Var.Costs)
• Selling Price – Var. Costs = “Margin”
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Example
• Software company
• Fixed costs (salaries, rent): $ 5 mio per month
• Sells software packages online for $ 105 each
• Production costs(variable costs) for each package: $5
• What is the BEP in terms of unit sales?
• BEP=5.000.000/(105-5)= 50.000 pieces/month
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Exercise 2 – 45 minutes – 10 teams• A company wishes to improve its “Engage to Close process”
(Sales) by applying a CRM solution.
• The costs of the project are tallied, and the business process “AS IS” versus “TO BE: efficiency and effectiveness” are analyzed and summarized on slide 25
• Please calculate :– the ROI each year, as well as the 2- year ROI and total ROI of the
project
– the payback period
– the risk adjusted total ROI using a discount factor of 15 %
– the 1-year IRR, 2-year IRR and total IRR
• Please analyze the possible post project scenarios regarding the development of revenue and costs.
• Summarize the data of your analysis in a table of the structure illustrated on slide 24
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Realistic post project scenarios
Revenue (after project implementation)
Costs (after project implementation)
Interpretation (what does this mean for the project ?)
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Example
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15 minutes break!
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Session Progress
• Return on Investment (ROI)
• Internal Rate of Return (IRR)
• Payback Period/Break Even Analysis
• Total Cost of Ownership (TCO)
• More about benefits & risks
• Case Study Preparation
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Total Cost of Ownership - TCO
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TCO
• Concept analyzes the financial impact of deploying an information technology product over its life cycle
• TCO analysis includes all costs; software, hardware, maintenance, training, etc.
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The lifecycle
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• Computer hardware and programs
– Network hardware and software
– Server hardware and software
– Workstation hardware and software
– Installation and integration of hardware and software
– Purchasing research
– Warranties and licenses
– License tracking - compliance
– Other migration expenses
– Risks: susceptibility to vulnerabilities, availability of upgrades, patches and future licensing policies, etc.
• Operation expenses
– Infrastructure (floor space)
– Electricity (for related equipment, cooling, backup power)
– Testing costs
– Downtime, outage and failure expenses
– Diminished performance (i.e. users having to wait, diminished money making ability)
– Security (including breaches, loss of reputation, recovery and prevention)
– Backup and recovery process
– Technology training
– Audit (internal and external)
– Insurance
– Information technology related personnel
– Corporate Level Management time
• Long term expenses
– Replacement
– Future upgrade or scalability expenses
– Decommissioning (closedown)
Types of Expenses over the life cycle
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TCO Applied - Make or Buy Decision
Source:
http://www.developer.com
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Summary of measures covered in this course
Concept
NPV Net Present value, reflects the projects time value of net cash flows
ROI Measures the projects gains as a percentage of the costs
TCO Looks at total project costs over the whole life cycle
IRR Discount rate, which makes the NPV zero
Payback Period The time period from the start of the project until the cumulative net cash flow turns positive
Break Even Point BEP (in terms of unit sales) is the number of units, that need to be sold, in order for the revenue to reach the size of the costs
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Session Progress
• Return on Investment (ROI)
• Internal Rate of Return (IRR)
• Payback Period/Break Even Analysis
• Total Cost of Ownership (TCO)
• More about benefits & risk
• Case Study Preparation
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A little more about Benefits & Risks
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Types of Benefits
• Tangible Benefits and its measures
– NPV
– ROI
– Payback Period
– IRR….
• Intangible Benefits
– strategic impacts whose benefits are not reliably quantifiable in absolute monetary terms.
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Types of intangible benefits
• Brand Advantage – no direct sales increases but increased perceived value of corporate brand
• Strategic Advantage – highly important for an intended corporate objective
• Competitive Advantage – Being able to release solutions faster (Supply chain management, project management tools etc.)
• Intellectual Capital – increase in relevant knowledge gained by the staff (business intelligence, data warehousing etc.)
• Organizational Advantage - Enabling an organization to function more effectively (instant messaging, wireless communications, mobile computing)
• Risk Avoidance – To prevent from something harmful to happen (backup systems (reduce risk of data loss), security (risk of external threats), e-commerce (risk of losing a market opportunity))
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Risks
• Over 70% of IT projects still fail (to deliver all the benefits they promise; in time, within budget)
• Discounting the returns is essential in order to minimize surprises
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TODO - Preparation of pitching session (3.session)
• You have already built 10 groups with Marlon
• Each group will randomly be assigned one out of 4 business cases to be prepared for session 3
• Case Studies\Team Distribution Case Studies.xlsx
• The cases are distributed now
• You have 2 weeks to prepare the cases
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Background Info - Business Cases
• Kellogg School of Management, US, excellent
• You are selling the case to me
• Realistic Scenario: I know very little about the project and I have very little time.
• So be efficient and good in selling
• Power Point Presentation
• If a sensitivity analysis is required, please skip this one. Just another tool.
• Some cases came with excel exhibits. I will send those to the team leaders later to be distributed to the team members.
Lets look at the cases in more detail now
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CASE 1 : B&K Distributors
• Calculating ROI for a Web-Based Customer Portal
• Additional Questions (just additional – solution not limited to those questions)– What is the ROI for the proposed Web portal project?
– How much value is generated from cost savings associated with the project?
– How much value lies in the improvement of revenues?
– What additional factors should be included in the ROI analysis?
– If you were B&K’s CEO, would you move forward with the project? Why or why not?
Questions?
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CASE 2: San Diego City Schools
• ERP in a public school system
• Additional questions are included in the text
Questions?
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CASE 3: Teradata
• Data Mart Consolidation ROI at GST• Calculate best, worst and most likely scenarios and be realistic in the data.
(Hint: Find the 2 uncontrollable variables and work out best, most likely and worst case scenarios for ROI, IRR etc.)
• Additional questions (not the only ones):
– What is the project’s ROI and the payback period?
– Of the best, worst and expected cases, which should you present to GST?
– How much upfront capital is needed for this project and what financing options would you recommend?
– How would you recommend dealing with Richard’s personnel concerns?
– If you were Johnson and Richards, would you move forward with the consolidation project?
Questions?
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CASE 4: CRM at GST
• ROI for a Customer Relationship Management Initiative at GST
• Additional Questions (not the only ones):
– What cash-outflow investment is required to initiate the proposed acquisition program?
– What sort of monthly cash flows should GST expect to realize from the new program?
– What is the expected ROI? Expected payback?
– How does the team’s decision to utilize a three-year horizon affect the ROI? Payback?
– How should the team incorporate its discussion of data reliability into the Business Impact Assessment?
– Should Kolks and Johnson adopt Teradata’s proposed acquisition solution?
– Are there any other factors Johnson and Kolks should consider prior to making their decision?
Questions?
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• Thank you and see you in two weeks!
