The E-Commerce Cost-Benefit and Investment Appraisal Model

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THE COSTS & BENEFITS
OF E-BUSINESS
REPORT
TO
SCOTTISH ENTERPRISE
February 2000
JLH Consulting
1.
INTRODUCTION TO THIS REPORT
Background to this Report
JLH Consulting was commissioned by Nigel Laurie at Glasgow Development Agency
(GDA) in January 2000 to develop an investment appraisal model, to help managers
make better decisions with regard to investing in e-commerce.
Through its experience in running the e-Trade Package and providing support to
Glasgow companies, GDA had found that it was particularly difficult for companies
in business-to-business markets to demonstrate the business case for investing in the
implementation of e-commerce systems.
Objectives of the Assignment
The main aim of this piece of work has been to develop an investment appraisal
model which can:

Help managers make objective and informed decisions as to whether or not to
invest in e-commerce, so that they are aware of the costs, benefits and opportunity
costs

Be used to convince Boards and potential funders to back such investments

Enable managers to track actual against projected costs and revenues
Methodology
The following research was conducted in the course of this assignment:

Desk research and Internet research including an extensive review of publications
on investing in e-commerce and articles in journals and newspapers

A review of existing investment appraisal models within e-Trade and the Digital
Advantage programme

Interviews with Scottish companies which have implemented e-commerce
systems or are considering whether to invest in e-commerce (Appendix )

Interviews with some suppliers, to find out what tools they are using when trying
to convince companies to invest in e-commerce systems (Appendix )

Interviews with potential funders, such as banks, angels and venture capitalists
(Appendix )

Interviews with some of GDA’s e-commerce advisors and accountants, lawyers
and other professional advisors providing assistance to companies (Appendix )
1
Contents of This Report
This report summarises the key findings and conclusions from the consultancy work
carried out by Julian Lawson Hill and Gordon Brown during January and February
2000.
The remainder of the report is structured as follows:
2.
3.
4.
5.
6.
7.
Overview of Current Appraisal Models
Development of the E-Commerce Model
The Cost-Benefit Model
Quantifying Intangible Benefits
Risk and Sensitivity Analysis
Practical Tools
2
2.
OVERVIEW OF CURRENT APPRAISAL MODELS
Summary
Cost was identified in a U.S. study by Cahners In-Stat as the most common and
greatest impediment to expanding e-commerce. Three basic cost concerns were
identified:

Lack of funds for up-front implementation costs

Lack of monthly cash flows to maintain sites

The probability that there would not be a real return on investment
In reviewing what has been written in the press in this area, both in the United States
and in the UK, we can conclusively say that companies on both sides of the Atlantic
are finding it very difficult to justify the investment in e-commerce using current
appraisal models.
Interestingly, most of those companies which have implemented or are in the course
of implementing e-commerce solutions have not made detailed financial calculations
or projections. They have just forged ahead with their investments.
The general consensus from those who are in favour of investing in e-commerce is
that while the exact costs and benefits are difficult to measure, a good business case
can be made in terms of the strategic benefits to companies from investing and the
threats to businesses of not investing in e-commerce.
In Scotland as a whole, however, there are a lot of “e-com-sceptics”: Managing
Directors and Finance Directors who believe that it is only worth investing in ecommerce if there is a demonstrable effect on the bottom line. This scepticism
suggests there is a need for a sound business model for e-commerce.
Current Investment Appraisal Models
A number of investment appraisal models have been used over the years to help
managers and directors decide whether to invest in new plant, new processes and new
technologies. Examples are:





Return on Investment
Return on Capital Employed
Payback
Cash Flow Analysis
Discounted Cash Flow
3
However there are problems in using any of these traditional methods without
adaptation when considering an investment in e-commerce:

None of these traditional models is really comprehensive enough. A good model
has to take into account a wide range of internal and external costs and benefits

The financial models over-emphasise the financial impacts and do not emphasise
the overall impacts on the business

Some of the most important benefits of e-commerce are strategic benefits, which
are difficult to quantify

It is difficult to put an accurate value on the reach of e-commerce in terms of
potential customers

It is difficult to measure revenue and profitability attributable to the Web alone
when other factors may also be important in the purchasing or supply chain

It is particularly difficult to forecast costs and benefits with a great degree of
accuracy over time. It therefore becomes difficult to estimate discounted cash
flows and other sophisticated financial models
Gut Feel
Most companies which have decided to invest in e-commerce have done so very
much based on gut feelings:

If companies have perceived possible strategic benefits over their competitors they
have invested in the e-commerce technology

Many e-commerce investments have also been implemented because of strategic
threats from competitors

Several companies have just felt that it is worth taking a punt on e-commerce and
are investing in it to see what return on investment it will bring, prior to investing
more serious money
The E-Com Sceptics
Scottish businessmen are not generally noted for their wish to “take a punt” and this
has been reflected in the GDA’s experience in the e-Trade Package. In constructing a
model for e-commerce, it is important that various factors are included:

Where possible, costs and benefits should be quantified so that the effects on the
bottom line is clear
4

The model should be balanced, so that it highlights the strategic and intangible
benefits as well as the more tangible, financial costs and benefits

When the benefits of investing in e-commerce are not clear, two scenarios should
be considered and worked through: the cost-benefits of investing in e-commerce
and the impact on the business and the cost-benefits of doing nothing and the
impact on the business in that case
The next section of this report goes on to look at the development of the E-Commerce
model in more detail.
5
3.
DEVELOPMENT OF THE E-COMMERCE MODEL
Considerations in Developing the Model
When we were starting work on this project there were three considerations which we
had in developing the model:

That it should take into account the heterogenous nature of Glasgow companies –
all types of sectors and sizes of business, mixture of business-to-business and
business-to-consumer markets

That it should be understandable, useable by and useful to marketing managers,
managing directors and non-accountants

That it should be robust in terms of financial analysis and stand up to scrutiny
from bankers, potential investors and financial managers
Glasgow Companies
Glasgow companies come in all shapes and sizes:

Medium and large sized companies, many of whom are well established and in
“traditional” Glasgow sectors such as engineering, industry and manufacturing

Smaller, fast growing companies, many of whom are in software, other high
technology and service industries

Start-ups which are just getting under way
As in other economies, Glasgow has a mixture of companies servicing business-tobusiness and business-to-consumer markets. These companies have different
commerce characteristics or attributes (shown in the box below):
Commerce Attributes
Business-to-Consumer
Business-to-Business
One-time, Occasional
 Buying Patterns 
Repeat, Familiar
Shopping, Browsing
 Buying Process
Ordering, Restocking
Price, Availability
 Buying Criteria 
Transitory, Short-term
Trading Relationship Established, Ongoing
Usually Simple
 Sales Transaction 
6

Service, Quality,
Delivery, Price
Often Complex
The model we have developed tries to take these characteristics into account, as well
as the level of sophistication of the company with regards to e-commerce and its
aspirations:
Client E-Commerce Sophistication
Customer-Facing

No experience of e-commerce and no web site at all

A basic brochure-ware site or on-line catalogue

A simple e-commerce site with on-line ordering

A more developed e-commerce site with on-line payment
Internal

No networking of internal systems

Basic networking of internal systems for internal issue

Linking of customers to internal systems

Linking of suppliers to internal systems

Full integration of customers and suppliers with the company’s systems

Other back-end features such as links to fulfilment, despatch, logistics etc.
Supplier-Facing

No links to suppliers

Basic information for suppliers

Full exchange of information with suppliers

On-line procurement
Use by Marketing Managers, Managing Directors and Non-Accountants
One of GDA’s main requirements was that the model should be understandable and
useable by non-financial managers. This has been one of our main considerations in
developing the e-commerce model.
We spoke to a number of Glasgow companies and also received a great deal of input
from First Thursday members, many of whom are in the process of developing their
own business plans. This greatly informed the development of the business model.
7
The idea of costs and benefits is widely understood by all businesspeople, not just
accountants and economists, so this is the approach we have adopted in developing
the model.
A checklist of the key costs and benefits was developed and is shown in the next
section of the report.
Instructions and help on considering the main costs and benefits is given so that it is
as easy as possible for a non-financial manager to use the checklist in his own
situation.
The way in which the model should be used really depends on the target audience and
what they will be expecting. At its simplest, the model might help the owner-manager
consider the impact on his business; at an intermediate level, the checklist might help
a manager to develop an outline business case presentation; and at its most
sophisticated, the checklist can be used to help a non-financial manager develop a
spreadsheet to justify the business case more formally in financial terms.
Robust Financial Analysis
One of GDA’s other requirements was that the model should be robust and stand up
to scrutiny from bankers, potential investors and financial managers.
Again, the cost-benefit approach is recognised by accountants, corporate financiers
and funders as being a sensible way for a company to consider the issues and present
its business case.
In conducting the research for this project we have spoken to bankers, venture
capitalists, angels, corporate financiers and a category of advisors which I have
termed “fundfinders” for their input.
As a result, we have developed an Excel spreadsheet cashflow template, based on the
cost-benefit approach, to help managers present a formal financial business case,
should it be required.
8
4.
THE COST-BENEFIT MODEL
The following two pages show the cost-benefit model which we developed, based on
our review of the literature and extensive testing with companies and potential
investors.
As explained previously this generic model has been designed with the following
features:

The model is designed to be mainly used by existing businesses wanting to use ecommerce, but we have also tried to ensure it is applicable to dot.com start-ups

In designing it we have tried to consider as many different e-commerce business
models as possible, using tangible and intangible benefits to build a balanced
business model

At the same time, we have tried to keep the model relatively short and easy to use

The model is supposed to act as a prompt list for people to consider the issues

There is a "Help" section to guide users and explain any complicated issues

We have developed an Excel cash-flow analysis in parallel with this
Costs
The costs have been split into two categories as follows:


Implementation costs
Operational costs
Benefits
The benefits have been split into five categories:





Strategic business benefits
Tangible benefits
Tangible but non-financial benefits
Intangible benefits
Cost savings and cost avoidance
Risks and Sensitivity Analysis
The final section asks a number of questions related to sensitivity and risk analysis,
which should be considered by companies as part of their consideration of ecommerce.
9
The E-Commerce Cost-Benefit and Investment Appraisal Model
Costs
Implementation Costs









Hardware costs, software costs, costs of integration with legacy systems
Costs of site development (in-house or outside consultants)
Project management costs
Staff costs (dedicated staff input required)
Training requirements
Internet access costs, hosting costs, domain registration fees
Initial marketing costs (traditional marketing methods, banner ads, registering with search
engines, printing on literature, public relations)
Transaction costs
Costs of translations
Operational Costs












Site maintenance and development costs (in-house or outside consultants)
Costs of upgrading and adding capacity
Staff costs and costs of consultancy, if required
On-going staff training
Trouble-shooting
Internet access costs, hosting costs
Electricity and telecommunications costs
Security costs
On-going marketing costs (banner ads, e-mail shots, traditional marketing activities)
Fulfilment, distribution and delivery costs
Transaction costs
Costs of handling foreign enquiries (languages, currencies, VAT, duty)
Benefits
Strategic Business Benefits







Improved relationships with customers and trading business partners
Company’s image and credibility, meeting and exceeding customers’ expectations
Access to Global markets and new markets, international markets, new customers
Ability to tie in customers and suppliers
Accelerated product introductions
Threats of not investing in e-commerce, pre-empting actions by suppliers and competitors
Value of the business and creation of assets which would be valuable, could be sold on
Tangible Benefits






New customers and new markets
Increased market share
Cross-selling/ selling up
Increased revenues from sales
Revenues from advertisers
Move business into more profitable areas
10






Improved margin on direct business with customers
Reduced stock lead times
Improved stock control
Improved speed of processing
Improved accuracy of processing
Improved efficiency and productivity of staff
Tangible but non financial benefits









Improved communication between staff, customers and suppliers
Improved information on customers
Improved management information
Improved manufacturing information
Improved procurement information
Faster speed to market
Increase routes to market
Improved quality and accuracy of documents, reduced errors
Quicker turnaround of quotations and business proposals
Intangible Benefits









Improved customer service
Customer product tracking
Improved information on customers and feedback from customers
Improved customer satisfaction
Improved customer loyalty
Improved sales forecasting
Better materials requirements planning
Improved purchasing information
Improved production scheduling
Cost Savings and Cost Avoidance









Reduced communication costs (telephone, fax and postage)
Reduced costs of supplies
Reduced costs of procurement (staff time)
Reduced costs of sales literature and documentation
Reduced costs of trade exhibitions
Reduced costs of travel and time spent face-to-face with customers
Reduced costs of stock
Reduced costs of warehousing
Reduced costs of enquiry handling, order processing and administration
Risk and Sensitivity Analysis







How likely are the projected results?
By how much can they be wrong?
What are the risks to achieving these results?
What can we do to maximise the results?
Ability to ramp up or shut down activities as conditions dictate
Threats of not investing in e-commerce
Danger of alienating existing customers, agents, distributors, suppliers
11
5.
QUANTIFYING INTANGIBLE BENEFITS
Turning Intangible Benefits into Tangible Benefits
One of the most powerful techniques for strengthening the business case of an ecommerce investment is to attempt to convert intangible benefits (with no measurable
monetary value) into tangible ones (with a defined monetary value).
The Intangible-Tangible Value Continuum
£0

£££££
Unquantified

Quantified
Benefits uncertain

Benefits clear
No value/low value

Real value
INTANGIBLE

TANGIBLE
Do You Need To Quantify Them?
The key problem with the approach adopted by accountants and financial directors is
that they look only at hard numbers such as costs, revenues, profitability and return on
investment. However, the main benefits of investing in e-commerce may simply not
be tangible.
By focusing in on the bottom line, there is a danger that the bigger, strategic picture is
missed. It therefore makes sense to highlight the strategic issues as part of a balanced
business case rather than prepare a line-by-line financial analysis. If there are
particularly compelling business reasons why the company should be undertaking the
investment, even though there is a negative or unacceptably low return on investment,
these reasons should be stated.
The first question is therefore: do you need to quantify the strategic and intangible
benefits at all?
12
Quantify the Value of the Benefit’s Effects
If you do have to attempt to quantify the intangibles, one method that may be used is
to quantify the value of the benefit’s effects.
For example, “improved relationships with customers” may have a highly quantifiable
effect on such things as customer loyalty and retention rates. One benefit may be to
reduce the cost of sales; another may be to reduce marketing costs; another may be to
increase the average order value; and new customers may be attracted by positive
word of mouth.
The important thing is that the link between the effects is logical, the assumptions
used are credible and therefore the target audience will find the case believable.
We have listed some of the most important of the benefit’s effects under the “tangible
benefits” section of the model.
Look for Links to Tangible Benefits
A second way is to look the other way round for links between strategic and
intangible benefits to tangible benefits, using the headings outlined in the model.
Value the Cost of Not Investing in E-Commerce
A third method of attempting to present the cost-benefits in a way in which the
intangible elements are highlighted may be to consider two scenarios:
1.
2.
The value of investing in e-commerce and the impact on the business
The value and impact of carrying on business without making the investment
This may help tease out a quantifiable value for some of the strategic and intangible
benefits, which can then be incorporated into the financial analysis.
Use a Scoring Matrix
A scoring matrix is another method which can be used to present a balanced business
case by taking into account strategic and intangible benefits as well as financial
criteria.
One method of scoring might be to consider the importance of each strategic or
intangible attribute as far as the company is concerned and then the likely impact in
terms of cost or benefit of implementing the e-commerce solution.
In using a scoring matrix to build the business case, members of the Board would
probably have to be involved in agreeing the importance of each attribute and the
impact e-commerce would have. It would make little sense to develop the scoring
matrix without taking into account the beliefs of the Board at an early stage.
13
On the other hand, using a scoring matrix may help the person making the business
case to focus in on those strategic and intangible benefits which are likely to be of
most importance and interest to the company.
Example
In the following example, the importance of each attribute to the company is scored
out of 10 (0 = not at all important to 10 =extremely important) and the potential
impact of e-commerce from –10 to +10 (-10 = negative impact, 0 = neither positive
nor negative impact and +10 = very positive impact)
Improved relationships with customers and trading business partners
Importance
9/10
Impact of e-commerce +8
Score:
9 x 8 = +72
Company’s image and credibility, meeting and exceeding customers’ expectations
Importance
6/10
Impact of e-commerce +5
Score:
6 x 5 = +30
Access to Global markets and new markets, international markets, new customers
Importance
2/10
Impact of e-commerce +9
Score:
2 x 9 = +18
So, in this case, the presenter should highlight the importance of improved
relationships with customers and trading business partners.
Conclusion
First, managers responsible for preparing the business case for investing in ecommerce should consider their target audience.
While a financial analysis is important, the Managing Director, the Board and
potential investors should consider the strategic benefits of e-commerce for their
company and the extent to which e-commerce will help achieve the company’s
strategic objectives.
If there is still a need to prepare a more detailed business case, there are several
techniques which can help the manager to value the most important strategic and
intangible benefits in financial terms.
14
6.
RISK AND SENSITIVITY ANALYSIS
Uncertainty and Risk
One of the biggest difficulties in preparing a good business case to justify an
investment in e-commerce surrounds the uncertainty of future costs and benefits,
revenues and profitability. It therefore makes it very difficult to determine the return
on investment with any accuracy.
Uncertainties which might have major impacts on future projections include:




Estimated transaction volumes
Predicted future prices
Competitors’ actions
Changed market conditions
One other feature of e-commerce is the speed of change. Managers need to consider
the flexibility of the business to respond and how quickly production and sales can be
either ramped up or scaled down, depending on business generated through ecommerce.
Questions Which Might Be Asked
Senior managers and the Board might ask questions like these:




How likely are the projected results?
By how much can they be wrong?
What are the risks in achieving these results?
What can we do to maximise the results?
An Appropriate Response
The danger is that without some sort of risk and sensitivity analysis, senior managers
and the Board may set higher “hurdle rates” or require shorter payback periods for ecommerce because of what they see as the inherent risks.
There are many complex methods of conducting risk and sensitivity analysis, but the
most important thing to do is to identify those assumptions which have the most
impact on the bottom line. These can then be varied and plausible pessimistic and
optimistic scenarios produced.
At its most simple, a best case/worst case scenario can be produced. When placed
alongside the assumptions, this will enable other managers to consider an e-commerce
investment in the same way as any other business investment and decide accordingly.
Use of risk and sensitivity analysis can therefore improve the plausibility of the
business case to sceptical business managers.
15
7.
PRACTICAL TOOLS
The Model
Returning to GDA’s objectives, we have tried to develop a model which:

Takes into account the heterogenous nature of Glasgow companies

Is understandable, useable by and useful to marketing managers, managing
directors and non-accountants

Is robust in terms of financial analysis and can withstand scrutiny from bankers,
potential investors and finance managers
For ease of use, we have split the generic cost-benefit model in two:


A model for existing businesses looking to implement e-commerce
A model for new dot.com start-ups
The cost-benefits for both are the same, but we have attempted to highlight what we
believe to be the most important attributes for each group.
Help Section
A “Help” section has been developed to provide assistance to business managers
unfamiliar with any terms covered in the model.
Use of the Model
As indicated in one of the previous sections, we would see the model being used
potentially in three ways:

To aid managers in the thinking process and to help them consider the costs and
benefits of e-commerce for their business

As an outline for presentations to senior managers and the Board

As the basis of calculations for a spreadsheet which will present the financial data
simply and concisely
The Spreadsheets
Two cash flow spreadsheets have been developed in line with the two versions of the
generic model: one for existing businesses; the other for dot.com start-ups.
16
In developing the spreadsheets we have attempted to stay as close to the cost-benefit
model as possible so that managers can slot in values quickly and easily.
Although normally a cash flow analysis would be required over three years for
business planning purposes, many of those we spoke to felt that it would be very
difficult to project more than two years ahead. Consequently, the spreadsheets cover
two years.
A feature of the spreadsheets is a one page financial summary which can be used for
discussions with senior managers and directors. The detail behind this summary page
lies within the two pages of month-by-month analysis.
Simple questionnaire
One other tool which we have developed is a simple financial questionnaire which is
designed to prompt users at the beginning of the process and help them determine the
level of depth of financial analysis needed.
GDA’s e-Trade Website
We would recommend that GDA puts up the following elements on its e-Trade
website:





The financial questionnaire
The E-commerce Models
The “Help” Section
The Excel Spreadsheets
This report (for users who require more background)
17
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