Economic Analysis of Alternative Solutions IT Acquisition Template 7

# Economic Analysis of Alternative Solutions IT Acquisition Template 7

Introduction Economic analysis is a management tool that assist in determining, analyzing, and documenting the financial costs and financial benefits of alternatives. The product of the economic analysis of an IT acquisition alternative solution is a projection of the risk-adjusted financial return on investment (ROI) and the net present value (NPV) of the investment. The material below discusses the concepts underlying economic analysis. At the end, it provides a link to an economic analysis worksheet that applies the concepts and generates risk-adjusted ROI and NPV figures for an IT acquisition alternative or a proposal.

NPV Versus ROI Comparisons of the ROI and NPV of the competing alternative solutions will identify the alternative that is most advantageous from a financial standpoint. Both ROI and NPV are used in making the comparisons because they have different meanings and both provide valuable information for the decision makers. ROI is a ratio that compares two quantities, such as investing \$3 million and receiving \$5 million in return in terms of current dollars over a five-year period. This is an ROI of 67% (i.e., net gain divided by the cost, or \$2 divided by \$3, where both the net gain and the cost are in today’s dollars). NPV, on the other hand, is a figure that depicts the present value of the projected future stream of benefits and costs. It can determine, for example, that the value of an IT investment over, say, the next five years is, in terms of today’s dollars, \$2 million more than its \$3 million cost. In other words, the \$3 million investment is expected to produce an NPV (net gain) of \$2 million in terms of today’s dollars. Which is better, an ROI of 67% or a NPV of \$2 million? With the example given here, there is no difference. But there is usually a difference. For example, it is possible to get a 67% return on a \$100 project, so telling us that the return will be 67% does not give us enough information. Similarly, the NPV figure of \$2 million does not by itself tell us the rate of return we can expect on the dollars invested. We need both the ROI and the NPV to get a proper financial picture. When the ROI and NPV are computed using the same set of data, we will know both the rate of return as well as the total amount of net gain that will be produced in terms of today’s dollars.

Providing Data for the Economic Analysis Generally, when an alternative solution is identified, its benefits, costs, and risks are documented in some detail. The cost information as well as insights on risks can be generated through the preparation of a work breakdown structure for each alternative solution. The economic analysis, using information from the WBS and its financial documentation for each alternative solution, can be used to identify the solution expected to generate the best financial return.

Risk Data and Risk Adjustments The ROI and NPV generated by the economic analysis need to be “risk-adjusted” to take into account the probability that not all of the financial benefits may be realized. Template 6 enabled you to perform a risk analysis of the alternative solutions. Now the question is how will the risks identified for an alternative solution (taking into account the planned risk mitigation) likely to affect the benefits expected from implementing that alternative solution. In general, the effect of risk on the expected benefits is a matter of informed judgement. Template 7 takes the form of an economic analysis worksheet that you can download, as provided in the week 5 content area. A separate Economic Analysis is prepared for each alternative solution. In making entries in a worksheet, decisions need to be made on how each type of expected financial benefit will be affected by risk in each year of the projected life cycle. These risk-estimate inputs enable the Worksheet to calculate risk-adjusted benefits over the life cycle of the project.

Benefits and Costs Data Benefits Data Template 2 summarized the new capabilities or functionalities that any solution to the problem must satisfy. These are important benefits of a satisfactory alternative solution. Each alternative solution must satisfy these requirements but each alternative solution may have other benefits beyond those new capabilities or functionalities. These benefits need to be identified and quantified in financial terms. The financial benefits data can then be entered into the Economic Analysis Worksheet for the life cycle of the IT system. Cost Data The Economic Analysis Worksheet also require cost data for the life off the IT system. You will use the cost information generated in the preparation of the work breakdown structures (Template 5). There are a number of approaches to improving the reliability and validity of cost estimates and projections, but they are beyond the scope of your present course and this activity. Estimating and projecting cost is often one of the weakest aspects of IT acquisition planning. Sometimes in the zeal to get a proposal approved, costs are minimized, overlooked, or hidden in biased and faulty assumptions. Sometimes it is simply a lack of knowhow. Organizations that implement a professional approach to estimating and projecting cost benefit in many ways, not the least of which is more effective project management.

Selecting a Common Life Cycle Period The same number of life cycle years should be used for each of your alternative solutions when making entries in the Economic Analysis Worksheets. If a life cycle of three years is used for one alternative solution, a three-year life cycle must also be used for the other alternative solution. The same number of years for the life cycle is used for every alternative solution so they have a common period over which results can be compared. Usually, this means using the number of years equivalent to the alternative with the shortest life cycle (often three or four years). However, the selection of the life

cycle period to use must be done with good judgement because alternatives often have different years when they have their peak payoffs. For example, if one alternative has a 3-year life cycle with its peak payoff in years 2 and 3, and a second alternative has a 4-year life cycle with its peak payoff in years 3 and 4, some will argue that it would not be fair to use a 3-year period to make a comparison. Could a 4-year or 5-year life cycle period be used for both alternatives? The answer is yes, but then it will be necessary to provide 4 or 5 years of data for each of the alternatives. A decision will need to be made to select the number of years that provides the best comparison, whether it is 3, 4, or 5 years. Where does one get the data for years 4 and 5 when one of the alternatives has, say, a 3-year life cycle? One approach is to continue the shorter-life alternative past its operational “Obsolescence” date by using the year 3 data for year 4 and, if needed, for year 5, with some adjustments if needed. The adjustments can include any added cost and or changes in the benefits that are likely to occur in years 4 and 5. The important point is that the comparisons of the alternative solutions need to be made over the same period of time.