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Chapter 10 Funding IT . Jason C. H. Chen, Ph.D. Professor of MIS School of Business Administration Gonzaga University Spokane, WA 99258 USA chen@jepson.gonzaga.edu. Learning Objectives. Understand how IT costs are best allocated across an organization.
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Chapter 10Funding IT Jason C. H. Chen, Ph.D. Professor of MIS School of Business Administration Gonzaga University Spokane, WA 99258 USA chen@jepson.gonzaga.edu
Learning Objectives Understand how IT costs are best allocated across an organization. Describe the method that is most likely to be fair and accurate. Define how companies determine what the real costs are for IT investments (TCO and Activity-based costing). Identify which metrics (ROI, NPV, etc.) that should be used to evaluate IT investments. Understand the uses and benefits of business cases.
Real World Examples The CIO of Avon Products Inc. relies heavily on hard-dollar metrics like NPV, and IRR to demonstrate business value in IT investments. Although not the typical IT metrics they are what business understands. Avon uses payback, NPV, IRR and risk analysis for every investment. Business side of IT is similar to the business itself.
Funding IT Resources Who pays for IT? Users, IT department, Corporate, etc. There are three main funding methods: Chargeback Allocation Corporate budget The first two are done for management reasons, while the latter recovers costs using corporate coffers
Chargeback IT costs are recovered by charging individuals, departments, or business units Rates for usage are calculated based on the actual cost to the IT group to run the system and billed out on a regular basis They are popular because they are viewed as the most equitable way to recover IT costs However, creating and managing a chargeback system is a costly endeavor
Allocation Recovers costs based on something other than usage, such as revenues, log-in accounts, or number of employees Its primary advantage is that it is simpler to implement and apply There are two major problems: The 'free rider' problem Deciding the basis for charging out the costs True-up process is needed where total IT expenses are compared to total IT funds recovered from the business units.
Corporate Budget Here the costs fall to the corporate “bottom line”, rather than levying charges on specific users or business units In this case there is no requirement to calculate prices of the IT systems and hence no financial concern raised monthly by the business managers However, the drawbacks of the three methods are shown in the next slide (Figure 10.1).
Overview The most basic method of determining costs is to add up all of the hardware, software, network, and people involved in IS. Real cost is not as easy to determine. Most companies continue to use the over-simplistic view of determining cost and never really know the real cost.
Activity Based Costing Activity Based Costing (ABC)counts the actual activities that go into making a specific product or delivering a specific service. Activities are processes, functions, or tasks that occur over time and have recognized results. They consume assigned resources to produce products and services. Activities are useful in costing because they are thecommon denominator between business process improvement and information improvement across departments ABC is the process of charging all costs to “profit centers” instead of “cost centers.”
Total Cost of Ownership Total Cost of Ownership (TCO) is fast becoming the industry standard It looks beyond initial capital investments to include costs associated with technical support, administration, and training. This technique estimates annual costs per user for each potential infrastructure choice; these costs are then totaled. Careful estimates of TCO provide the best investment numbers to compare with financial return numbers when analyzing the net returns on various IT options
TCO Component Breakdown TCO estimates should be computed per component and then divided among all users who access them (servers, printers, etc.) For more complex situations. Such as when only certain groups of users possess certain components, it is wise to segment the hardware analysis by platform Soft costs, such as technical support, administration, and training are easier to estimate than they may first appear. Informal support is harder to pin down
TCO as a Management Tool TCO also can help managers understand how infrastructure costs break down It provides the fullest picture of where managers spend their IT dollars as TCO results can be evaluated over time against industry standards Even without comparison data, the numbers that emerge from TCO studies assist in decisions about budgeting, resource allocation, and organizational structure
Business Case • A business case is a structured document where all relevant information needed to make a decision is laid out. It is similar to a legal case. • The business case for an IT project is • a way to establish IT priorities. Determine which projects to invest in • an opportunity to identify how IT and the business will • deliver new benefits, • gain commitment from business managers, • and create a basis for monitoring the investment • Primary elements are listed in Figure 10.4 • Critical to business case is to identify • costs and benefits, • Financial and non-financial. • Fig 10.5 shows how these benefits are identified.
Figure 10.5 - Classification Framework for Benefits in a Business Case
IT Portfolio Management IT investments should be managed as any other investment would be managed by an organization. IT Portfolio Management refers to the process of evaluating and approving IT investments as they relate to other current and potential IT investments. Often involves picking the right mix of investments. Goal is to fund and invest in most valuable IT initiatives that taken together as a whole, generate maximum benefits to the business.
Asset Classes IT Portfolio According to Weill and Aral, there are four asset classes of IT investments: Transactional systems – systems that streamline or cut costs on business operations. Informational systems – any system that provides information used to control, manage, communicate, analyze or collaborate. Strategic systems – any system used to gain competitive advantage in the marketplace. Infrastructure systems – the base foundation or shared IT services used for multiple applications (e.g., servers, networks, databases and laptops)
Relative Investment Profile Average firm allocates 54% to infrastructure each year and only 13% to transactional systems. Service companies (such as food service) allocate: 26% to informational systems 18% to transactional systems 45% to infrastructure systems 11% to strategic systems Figure 10.6 contains a sample of the cost-risk-benefit analysis. Figure 10.7 summarizes a typical IT portfolio. Table 10.8 summarizes the differences of strategies.
Investment Costs Purchase of new call center hardware and software: £250,000 Cost of implementation technical consultants: £120,000 Internal systems development costs (for configuration): £150,000 Infrastructure upgrade costs: £75,000 Business change costs: £270,000 Training costs: £80,000 Total: £945,000 Net increase in annual systems support and license costs: £80,000 Risk Analysis Technical Risks: Complexity of the systems functionality Number of system interfaces and systems being replaced Financial Risks: Confidence in some investment costs—especially business change Confidence in the evidence for some of the benefits Business criticality of areas affected by the system Organizational Risks: The extent of changes to call center processes and practice Limited existing change management capability Call center staff capability to promote more technical services Customer willingness to share information for profiling purposes Figure 10.6 – Sample cost-risk-benefit analysis
Costs and Benefits of IT Investments • Tangible vs. Intangible • What are the intangible benefits? • tighter systems integration • faster response time • more accurate data • better leverage to adopt future technologies • better customer loyalty
Valuing IT Investments Monetary costs and benefits are important but not the only considerations I making IT investments. Soft benefits, such as the ability to make future decisions are often part of the business case for IT investments, make it difficult to measure the payback of IT investment First, IT can be a significant part of the annual budget, thus under close scrutiny. Second, the systems themselves are complex, and calculating the costs is an art, not a science. Third, because many IT investments are for infrastructure, the payback period is much longer than other types of capital investments. Fourth, many times the payback cannot be calculated because the investment is a necessity rather than a choice, and there is no tangible payback Figure 10.6 show the valuation methods used.
IT Investment Monitoring “If you can’t measure it, you can’t manage it”. Management needs to make sure that money spent on IT results in organizational benefit. Must agree upon a set of metrics for monitoring IT investments. the metrics are often financial in nature (ROI, NPV, etc.). other metrics include logs of errors encountered by users, end-user surveys, user turnaround time, logs f computer and communication up-/downtime etc. business-focused metrics include number of contacts with external customers, sales revenue accrued from web channels, new business leads generated.
The Balanced Scorecard Focuses attention on the organization’s value drivers (which include financial performance) Companies use it to assess the full impact of their corporate strategies on their customers and workforce, as well as their financial performance over a period of time. This methodology allows managers to look at their business from four perspectives: customer, internal business, innovation/learning, and financial Figure 10.7 shows the relationship of these perspectives.
Innovation/ Figure 10.7 The Balanced Scorecard perspectives
The Balanced Scorecard Applying the categories of the balanced scorecard to IT might mean interpreting them more broadly than originally conceived. For example, customer perspective for MIS scorecard might be a user within the company (not the external customer of the company) The questions asked when using this methodology are: How do customers see us? (Customer) At what must we excel? (Internal business) Can we continue to improve and create value? (Innovation and learning) How do we look to shareholders? (Financial)
The IT Balanced Scorecard A scorecard used within the IT department. Helps senior IS managers understand their organization’s performance, and measure it in a way that supports its business strategy For example, at FirstEnergy, three business value drivers are identified: reliability, finance, and winning culture The IT scorecard is linked to the corporate scorecard, by insuring that the measures used by IT are those that support the corporate goals Helps senior managers understand their organization’s performance.
IT Dashboards IT dashboards summarize key metrics at any given point in time for senior managers in a way that provides quick identification of the status of the organization (both inside and outside the IT department, for example executive offices) Dashboards provide frequently-updated information on areas of interest within the IT department. The data tends to focus on project status or operational systems status. Problems can also be identified and handled without waiting for the monthly CIO meeting Built on information contained in other apps.
Options Pricing Options pricing has long been used on financial assets as a method of locking in a price to be paid in the future. The concept of options can be extended to evaluating IT investments, i.e., IT projects is viewed as a option to exchange the cost of the project for its benefits down the road. Options pricing offers management the opportunity to take some future action in response to uncertainty about changes in the business and its environment. It offers a risk-hedging strategy to minimize the negative impact of risk when uncertainty can be resolved by waiting to see what happens. Fig 10.13 offers a simple example of how it works.
(0.5) ($350,000 - $100,000) $130,000 (0.5) ($20,000 - $100,000) (0.5) ($350,000 - $100,000) $130,000 favorable unfavorable favorable unfavorable Figure 10.13 NPV vs. Option Pricing View.
Option Pricing View They are especially applicable in the following situations: When an investment can be deferred. In helping managers strike a balance between waiting to obtain valuable information and forgoing revenues or strategic benefits from an implemented project. For emerging investments. For prototyping investments. For technology-as-product investments. Downside – sensitive to certain parameters, especially volatility.
Trigeorgis’ Framework • Objective of value management refers to broad measure of NPV • Strategic NPV = Traditional NPV of expected cash flows + + Value of operating options from flexible management Investment interaction effects • Strategic management of investments requires management of collection of future investment opportunities and options • Appropriate control targets are necessary for effective implementation of value-maximizing approach
The Risks of Information System Success 1. Systems that change the basis of competition to a company’s disadvantage 2. Systems that lower entry barriers 3. Systems that bring on litigation or regulation 4. Systems that increase customer’s or suppliers’ power to the detriment of the innovator 5. Bad timing 6. Investments that turn out to be indefensible and fail to produce lasting advantage 7. Systems that pose an immediate threat to large, established competitors 8. Inadequate understanding of buying dynamics across market segments 9. Cultural lag and perceived transfer of power N Dr. Chen,The Trends of the Information Systems Technology
Who Pays for the Internet? • 1.4 billion users on the Internet. • 21.9% of the world’s population • Not one pays a “bill” to the Internet. • Service providers (telephone companies, etc.) provide access for a fee. • These fees alone do not “pay” for the Internet. • Several organizations are responsible for portions of the Internet. • Internet Society (ISOC) • Internet Engineering Task Force (IETF) • Internet Corporation for Assigned Names and Numbers (ICANN)
So Who Pays? • US Government through the National Science Foundation subsidizes a portion. • Provide a backbone for science, engineering and education. • Academic institutions and corporations bear some of the cost by providing access. • Service providers pay for systems linked together over the backbone. • Users pay service providers, so they pay for the Internet. • So, everyone who uses the Internet pays for it.
