Management of
Computer System
Performance
Chapter 5
Identification of IT Cost
Identification of IT Cost
Agenda

Analytical approaches to Cost Benefit Analysis.
Objective:

Students should be able: to identify the costs
related to IT implementation.
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Identification of IT Costs

It costs are usually divided into two
elements; Direct and Indirect costs.



Specific allocations are a function of Accounting
Practices and may differ.
Direct Costs-Labor, Materials, Facilities, Services
and Supervision
Indirect Costs-Administration, Fringe, G&A, Sr.
Management. Etc.
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Identification of IT Costs


Labor
 Designers - Site Layout/Color Coordination
 Text/Content Editors
 Site Programmers - HTML, DHTML, JAVA, JavaScript,
CGI, Perl, C, C++, Visual Basic
 System Administrators for the Servers
 System Administrators for the BackOffice Environment.
Material
 Network Infrastructure - Routers, Hubs, Bridges and
Gateways
 Network Computers - Servers and Workstations
 Software - Development Tools, (new and upgrades),
Application S/W, Server S/W, Security S/W
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Identification of IT Costs



Facilities
 You have to have Office Space to put your workers, the
cost may be allocated directly to your project (depending
of size, etc.).
 Make sure that those costs are allocated from day one. A
nine month of accumulated facility charges against your
budget in month ten can inflict crippling damage
Services
 Telecomm services / Bandwidth or Internet Connections.
 System support costs (maintenance contracts)
Supervision
 Mid Level Management is responsible for their
departments actions. They will participate at some level.
 Coordination with department managers across many
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departments is key to controlling costs.
Identification of IT Costs

Licenses



Shrink Wrap - Perpetual, usually one user or one PC only.
Shrink Wrap Server  Limits the number of “Clients” on the System.
 Limits the number of other servers it can interface with.
 Limits its role as a server (Primary /domain/Print)
System (Midrange) - Perpetual or annual, depending on
the provider and OEM.
 One system only.
 Maintenance is Extra.
 May limit the number of concurrent users.
 May limit the number of applications running on it.
 May require S/W OEM installation.
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Identification of IT Costs



Site Licenses
 Usually for a fixed geographic location.
 Set (NTE) number of users (ex.: 20,000)
 Usually perpetual.
 Maintenance is extra (includes patches).
 Upgrades are extra.
Seat Licenses
 Same as site less geographic restrictions.
System (MVS) - Annual, one System.
 Usually monitored by CPU Serial Numbers.
 Maintenance and annual renewal are extra.
 May shut down the system if renewal expires.
 May require S/W OEM installation.
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Identification of IT Costs


Indirect Costs - Administration, Fringe, G&A,
Sr. Management. Etc.
These are usually outside of your control,
however, items to look for in budget roll ups
include;



Purchasing Labor Charge backs
Hiring Cost Charge Backs
G&A Changes
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Identification of IT Costs


System Licenses, the new model
 The servers are configured with the capability to record
usage. Pricing becomes a function of the base price of
the application plus individual time.
Budget Component Swags for a Business to
consumer POS Operation [12 Months]






H/W =
3%,
S/W =
4%,
Design (Excluding Coding) = 26%,
Development and Integration = 29%,
Maintenance =
38%
Marketing/Advertising (POS) 10x
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Identification of IT Costs

IT changes when associated with Business
Process Re-engineering almost always cause
some impacts on staffing.



These vary from erosion of performance to layoffs and
morale impacts.
These types of changes can be very detrimental to an
organization during the change process and should be
recognized as elements for mitigation.
These are negative costs associated with IT change
and should be recognized as such.
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Review
Financial Concepts Reviewed


Future value (FV) - refers to the amount of money
to which an investment will grow over a finite
period of time at a given interest rate. Future
value is the cash value of an investment at a
particular time in the future dependent on interest
or other methods of return.
Present Value (PV) - The current value of one or
more future cash payments, discounted at some
appropriate interest rate.
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Review
Financial Concepts Reviewed


Net Present Value (NPV) - The present value of
an investment's future net cash flows minus the
initial investment. If positive, the investment
should be made (unless an even better
investment exists), otherwise it should not.
Cash Flow - A measure of a company's
financial health. Equals cash receipts minus
cash payments over a given period of time; or
equivalently, net profit plus amounts charged off
for depreciation, depletion, and amortization.
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Review
Financial Concepts Reviewed


Rate of Return - The annual return on an
investment, expressed as a percentage of the
total amount invested.
Internal Rate of Return (IRR) - The rate of
return that would make the present value of
future cash flows plus the final market value of
an investment or business opportunity equal the
current market price of the investment or
opportunity.
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Project Valuation


The key component to any IT project valuation is
to calculate ROI.
The key concepts to this calculation are




The project’s Present Value (PV) and Net Present
Value (NPV),
The time value of money (TVM),
The project’s internal rate of return (IRR).
These formulas are interrelated and used to
measure a project’s value to the corporation as
compared to other opportunity costs.

Comparisons require consistent measurement.
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PV (Present Value)


Present Value is referred to as a calculation of
discounted cash flow.
Example: $1 received in one year is actually
worth $1/(1+r) today



where r is called the discount rate and is the annual
rate of return one could expect on a similar
investment.
if r is 10%, a dollar received in one year is worth $1/1.1
= 91 cents today.
cash received two years from now should be
discounted by (1 + r )2, so that the dollar received two
years in the future is worth $1/(1.1)2 = 83 cents today.
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PV (Present Value)

A series of cash flows C1, C2, C3…Cn received in time
periods 1, 2, 3…n, then the value of these cash flows today
is calculated from the discounted sum
PV =
CF1
(1 + r)1
+
CF2
(1 + r)2
+
CF3
(1 + r)3
+…+
CFn
(1 + r)n
Where n is the number of time periods and
 PV is called the Present Value of the cash flows.
Discounting a series of cash flows is mathematically
equivalent to weighting cash received in the near term more
than cash received further in the future.


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NPV (Net Present Value)
NPV is defined in Business Finance by Pierson & Bird as:
"the difference between the present value of the net cash inflows generated
by a project and the initial outlay".
Net Present Value (NPV)

The calculation of the discounted projected cash flows
of the investment less the initial cash invested
[
CF1
(1 + r)1
+
CF2
(1 + r)2
+
CF3
+…+
(1 + r)3
CFn
] – I =NPV
(1 + r)n
Legend
1.
Cash Flow (CF)- The net cash flow for each year that the NPV is to be applied.
2.
Discount Rate (r) - The discount rate or investment yield rate for the organization.
The interest rate used in discounting future cash flows; also called the
"capitalization rate."
3.
Duration (n) - the total number of years for which the calculation is to be applied.
4.
I = The initial investment.
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How is NPV used?

When making investment decisions, strive to
invest in positive NPV projects.


If the NPV of a project is negative, this means
that the initial investment is greater than the
present value of the expected cash flows.
Investments in projects with negative NPVs
should not be made, since they do not add value
to the firm and actually extract value.
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The Discount Rate

PV and NPV depend upon the discount rate (r).
CF1 ………..
(1 + r)1


“r” is derived from used for investments in a specific
industry is defined by the expected return of the
combined debt and equity of the firm for a given industry.
“r” may be calculated from the Capital Asset
Pricing Model (CAPM) and is averaged and
weighted using the Weighted Average Cost of
Capital (WACC).
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Capital Asset Pricing Model


This formula is designed to identify the correct value for “r” at
current and future times.
“r” will change over time so do NOT fall into that trap.
r = Krf + B ( Km - Krf)



r = The Required Rate of Return, (or just the rate of return).
Krf = The Risk Free Rate (the rate of return on a "risk free
investment", such as U.S. Government Treasury Bonds)
B = Beta (Risk Tolerance where B>1 indicates a Risk Taker
or if B<1, indicates a Risk Averse position).


The Beta for a firm is usually determined by the CFO or Board
Km = The expected return on the overall investment.
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WACC

WACC=An average representing the expected return on all
of a company's investments.
 Each source of capital, such as stocks, bonds, and other
debt, is weighted in the calculation according to its
prominence in the company's capital structure.
 Included in the WACC calculation are all capital sources
including: common stock, preferred stock, bonds, and any
other long term debt.
 Note: As this implies, alternative invests, such as those
made in the market are considered opportunity costs. They
are a legitimate alternative to investing in IT projects.


If they can generate better returns than IT Projects, as
managers, where should they invest their money.
As an IT person, that’s not what I want to hear but as a
Manager, that is the correct answer.
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WACC

WACC is calculated by multiplying the cost of each capital
component by its proportional weighting and then summing:
WACC= E/V x Re + D/V x Rd x (1-Tc)
Where:
 Re = cost of equity
 Rd = cost of debt
 E = the market value of the firm's equity
 D = the market value of the firm's debt
 V=E+D
 E/V = percentage of financing that is equity
 D/V = percentage of financing that is debt
 Tc = the corporate tax rate
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IRR

The IRR is the compounded annual rate of
return the project is expected to generate.

It is related to the NPV.


The IRR is the discount rate at which the NPV of
the project is zero.
That is, the IRR is the average discount rate
where the cash benefits and costs exactly
cancel.

Identifies the minimum revenues to offset costs.
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Internal Rate of Return (IRR)
Internal Rate of Return (IRR)

The calculation of the discount rate that will make
the present value of the projected cash flows equal
to the investment. The IRR formula is as follows:
NPV = C0 + (A1 – C1) + (A2 – C2) + (A3 - C3) + … + (An – Cn)
(1 + IRR) (1 + IRR)2
(1 + IRR)3
(1 + IRR)n


=0
Where A1, A2, A3…An are the positive cash benefits and
C0, C1, C2, C3…Cn are the costs of the project in each time
period 0, 1, 2, 3, …, n.
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How is IRR used?


IRR is greater than the project discount
rate, or WACC, you should consider
accepting the project - this is equivalent
to a positive NPV project.
When the IRR is less than the WACC the
project should be rejected, since investing
elsewhere could produce a higher rate of
return.
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The Period for the Analysis


The analysis time period should match the system’s
life cycle (the projected duration of its use).
The system life cycle includes the following
stages/phases:




Requirements gathering stage of the project.
The planning stage which would include:
 Design and development
The execution or implementation stage and,
Operation and maintenance
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System Life Cycle explained



A system life cycle ends when the system is
terminated or is replaced by a system that has
significant differences in processing, operational
capabilities, resource requirements, or system
outputs.
Significant differences is a very subject term, and
some organizations may feel that a 10% change is
significant, while others may that the change must
be over 30% to be significant.
Consider that the Cobol Mainframe should already
be history…but it is still in use in many companies.
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Payback Period
Payback Period

The calculation of the number of years that are required for
the discounted projected cash flows to equal the initial
investment.

The Payback Period formula is as follows:
Payback Period =
Initial Investment
(NPV of Savings / N Years)
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Return on Investment (ROI)
Return on Investment (ROI)

The calculation evaluates the discounted projected cash
flows derived from the savings generated by the project
divided by the initial investment.

There are several formulas that provide this information:
The initial ROI for Savings formula is as follows:

ROI = Project Outputs - Project Inputs x 100%
Project Inputs
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ROI (Return on Investment)

ROI is as an income model is shown as
follows:


or you can use the Dupont formula:


ROI = Income/Investment
ROI = (Income/Sales) * (Sales/Investment)
or include interest costs:

ROI = (Income + Interest)/Sales *
(Sales/Investments)
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Summary

Know and understand PV, NPV, IRR.



Understand the concept of CAPM and WACC
Understand how they interrelate
Assume these are exam questions.
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Homework


Read “Cigna’s Problems”. This is downloadable
from the http://www.TheEBusinessSite.com
Be prepared to discuss each concept.
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