Software Economics. Introduction to Business Case Analysis. Session 1

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Reynold Marsh
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1 Software Economics Introduction to Business Case Analysis Session 1

2 Who am I? Sweden PhD Student in Computer Science (Business Process Management) Masters in Business Administration Worked with development at Handelsbanken Worked with Business Cases (> 10 years) 2

3 Who are you? Please present yourselves (max 1 min per person) Name What is your work experience (where and what do you do)? Any experience with budgets or investment calculations? Have you worked with investments proposals? Have you had experience with sales (selling a product or service to an existing or potential customer)? 3

4 Course Objectives Know what a Business Case is and being able to do a basic Business Case Analysis Be able to calculate, use, understand and reason about measures (NPV, ROI, IRR etc.) used for investment calculations. 4

5 Structure Session 1: Basics of Business Case Analysis What is a business case? Principles of Business Case Analysis Benefits Time Value and NPV Sangar Case Study Session 2: Basic Measurements for Business Case Analysis ROI, IRR, Payback Period Selver Case Study Presentation of your Assignments Session 3: TCO and Funding Examples of cases TCO Funding IT B&K Case Study 5

6 Readings Look at the course page. 1. IT Value Chain Management Maximizing the ROI from IT Investments by Thomas Pisello. 2. Economics of Information Technology by Hal R. Varian. 6

7 Outline of Session 1 (today) 1. What is a Business Case? 2. Why is it important? 3. Some principles of Business Case Analysis 4. Introduction to basic Business Case Tools 7

8 What is a Business Case? A type of decision-making tool used to determine the effects a particular decision will have on profitability. A business case should show how the decision will alter cash flows over a period of time, and how costs and revenue will change. 8

9 What is a Business Case? A business case covers the Information needed for decision makers to show that an idea being considered makes financial sense. 9

10 Simple Example 15 minutes, in groups of 5-6 persons. Scenario: You are the general manager of a software development company. Your company s profit is decreasing due to ongoing recession. 1. How can you improve your profit? Give 3 suggestions on how this can be done. 2. How much would your profit improve with each of the 3 suggestions (make assumptions)? 3. How much would it cost to implement your suggestions? 10

11 Due to lack of financial means and resources, you can only implement one of the suggestions. Which one will you choose and why? How would you argue for your case? 11

12 Why is Business Case Analysis Important? 1. It costs money and takes people to make investments (in our setting, IT investments). 2. There is a limit to the availability of financial and human resources. 3. Therefore we need to choose wisely what we invest in. 4. Business Case Analysis gives us the information that will help us make more wise decisions and choices. 5. Measurements gives us an effective tool to compare different cases against each other. 12

13 Business Side of IT In a survey of 130 senior IT executives found that 80 % say that lack of financial skills makes quantifying IT benefits difficult. (I.T. Staffs Lack Financial Chops For Project Analysis, 03/24/2003, By Eric Chabrow, InformationWeek) IT people and business people speak different languages. As an IT person, it is VERY beneficial to be able to communicate the benefits of what you are trying to achieve in a non-technical language so business people (decision makers) understand you and your case. Although not the typical IT metrics they are what business understands. Business side of IT is business. Business Case is the medium to sell the investment. 13

14 Business Case Principles There are quantifiable (tangible) and qualitative (intangible) factors (benefits, gains) associated with investments. All investments (money) have time value. There is always an alternative to the investment (at least to do nothing) Opportunity Cost. There is always a risk with investments, so we want to be compensated for this risk. 14

15 Structure of Benefits Higher Profitability Higher Revenues Lower Costs New Markets Better Customer Service New Products Better IT support Higher Efficiency 15

16 Tangible Benefits Tangible benefits Easier to measure and more measurable Revenue changes, Profit Margins, Cost Reductions etc. Can use NPV, ROI etc. to measure and compare. 16

17 Benefits over time 17

18 Intangible Benefits Harder to measure (but it is possible), strategic value such as: Brand Advantage no direct sales increase or hard to measure but increased perceived value of corporate brand (sponsoring events) Strategic Advantage important for corporate objective (acquisition of other companies) Intellectual Capital increasing access to and knowledge of staff (data warehouse, business intelligence) Organizational Advantage increasing organizational efficiency (instant messaging, mobile computing) Risk Avoidance preventing harmful things (back up solutions, security) Mandatory investments that are a must (governmental regulations and compliance) 18

19 Time Value of Money Money today is worth less (or more) than the same sum of money in the future. Therefore, the value of money is dependent on time. Why? Inflation: Level of prices of goods and services go up over time. The value of your money will decrease over time, that is, you can buy less with the same amount of money as time passes. Interest rate: The cost of borrowing money / the price you charge to lend money. Increases the value of your money over time. Real rate 19

20 Future Value Future Value: What is the value of a given sum of money in the future? What does the value depend on? Future value = present value x (1 x interest rate) number of periods FV = PV x (1+i) n i = risk free rate n = years 20

21 Compound Interest Interest rate is given on both the nominal and the interest rates received. FV = Future value N = Nominal amount i = annual nominal interest rate (not considering the compounding) n = number of times the interest is compounded per year t = number of years 21

22 Example You have developed a software and will get paid EUR. However, due to complications, you will receive the money in 5 years. How much is your money worth in 5 years given that the interest rate is 1%? Which alternative would you choose? 1. You get EUR now in your pocket or 2. You get EUR one year from now? 22

23 Present Value Present Value: What is the value of a future sum of money today? Just reverse the future value formula. FV = PV x (1+i) n PV = FV / (1+i) n i = risk free rate n = years But what do we do when we have several future values spread over several years? 23

24 Net Present Value Same as PV but sum of PV for each year. 24

25 NPV formula Net Cash Flow for each year (Cash in Cash out) i = discount rate N = total number of years 25

26 Example Exercise (20 minutes) in groups of 4-5 Upgrade from XP to Vista or not? One time investment cost (license, manpower, etc.): 2000 PCs License is 150 $ per PC (year 0) Installation: 25 $ per PC (year 0) Yearly maintenance cost: $ (starting year 1) Yearly benefit: $ (starting year 1) Years to next upgrade: 4 (next upgrade starts beginning of year 5) Rate of return: 8% What is the NPV and is it a good investment? 26

27 Solution to example 27

28 Interpreting NPV A positive NPV means the cash inflows are greater than the cash outflows when they are discounted to their present value. The investment adds value, you get more money than you invested. A negative NPV means that cash inflows are less than the cash outflows when discounted to their present value. The investment results in you having less money. A NPV at zero means that no value is added or subtracted to your investment. 28

29 There is always an alternative Opportunity Cost When deciding to invest or not, you always have an alternative to compare with. If no other investment alternatives, the alternative is to do nothing, no-action, not to invest. Investing should be compared to at least the alternative of not doing anything. 29

30 Baseline versus Upside Scenario You always have at least two scenarios to invest or not to. If you continue business as usual (not to invest), that is your baseline scenario. If you invest, hopefully you will get a better scenario, the upside scenario. We are interested in the added value of investing, i.e. what we get more if we invest as compared to not investing (increment). 30

31 Introduction to financial terms Turnover/Revenue Cost of Revenue/Cost of Goods Sold (COGS) Gross Profit or Gross Margin Operating Expenses Operating Income or Loss Financial Income and Expenses Net Profit 31

32 Income Statement Example 32

33 Income Statement Example 33

34 Types of Costs 34

35 Income Statements Search for Income Statements of two different companies. (in groups of 4-5, 10 minutes) Answer these questions In which country do they have their HQ? In which industry are they operating (airline, hotel, technology, consulting etc.) What terms do they use in their income statements? 35

36 Example of Set up 36

37 Timing of Cash Flows Possible final value Annual Revenues or Savings Cash Inflow Year 0 Year 1 Year 2 Year 3 Year n Cash Outflow Annual Costs Possible final cost Initial or Upfront Investment 37

38 Summary of Today What is a business case? Why do we use business cases? What are some basic business case principles? Business Case Tools What is Future Value? What is Present Value? What is NPV (Net Present Value)? How do we interpret NPV? 38

39 Practice Sangar Business Case - Calculating NPV. Ill give the background. What do you need to know in order to calculate the NPV? I am the business owner you are the consultants, ask me about the numbers. 39

40 Next week We will look at more business case tools ROI (Return on Investment) IRR (Internal Rate of Return) Payback Period Thank you and see you next week! 40

Today I am. A. Ready for some serious learning. B. Enjoying being away from work. C. Hungry, skipped breakfast. D. Loving Tartu

Today I am. A. Ready for some serious learning. B. Enjoying being away from work. C. Hungry, skipped breakfast. D. Loving Tartu Welcome Today I am A. Ready for some serious learning B. Enjoying being away from work C. Hungry, skipped breakfast D. Loving Tartu E. Tired, I just want to go home How many hours did you spend on this