Software Economics Introduction to Business Case Analysis. Session 2

Software Economics Introduction to Business Case Analysis Session 2 Georg Singer georg.singer ät ut. ee

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 2/49

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 3/49

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 4/49

ROI a very general concept 5/49

Return on Investment ROI The formula A general concept, where the earnings are expressed as a proportion of the outlay 6/49

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 7/49

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) 8/49

Simple Example - ROI For each $ that you put into this project, you get $ 2.4 back. 9/49

Interpretation of the ROI measure Scenario Type Interpretation Impact on Decisions ROI >0 ROI <0 ROI = 0 Project generates positive returns Project generates negative returns Project does neither generate nor lose money If in line with strategy project (with highest positive ROI shall be carried out) Project shall not be carried out unless intangible benefits justify a go decision Decision must be based on other criteria 10/49

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 11/49

Exercise - ROI calculation Exercise 10 minutes, everybody alone ROI CALCULATION EXERCISE.pdf Exercises\Solution E-Learning.xlsx 12/49

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 13/49

IRR How risky can it be? 14/49

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 15/49

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%. 16/49

Payback Period when are we profitable? 18/49

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). 19/49

Example Payback Period 20/49

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 21/49

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 22/49

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 23/49 illustrated on slide 24

Realistic post project scenarios Revenue (after project implementation) Costs (after project implementation) Interpretation (what does this mean for the project?) 24/49

Example 25/49

15 minutes break! 30/49

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 31/49

Total Cost of Ownership - TCO 32/49

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. 33/49

The lifecycle 34/49

Types of Expenses over the life cycle 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) 35/49

TCO Applied - Make or Buy Decision Source: http://www.developer.com 36/49

Summary of measures covered in this course Concept NPV ROI TCO IRR Payback Period Break Even Point Net Present value, reflects the projects time value of net cash flows Measures the projects gains as a percentage of the costs Looks at total project costs over the whole life cycle Discount rate, which makes the NPV zero The time period from the start of the project until the cumulative net cash flow turns positive 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 37/49

A little more about Benefits & Risks 39/49

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. 40/49

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)) 41/49

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 42/49

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 43/49

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 44/49

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? 45/49

CASE 2: San Diego City Schools ERP in a public school system Additional questions are included in the text Questions? 46/49

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? 47/49

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? 48/49

Thank you and see you in two weeks! 49/49