Sunday, September 01, 2013

IT Economics For Business - I

Total Cost of Ownership (TCO): It seeks to capture the full cost of an IT asset from initial purchase through implementation and operation to maintenance and “end of life” costs. This is a cost-based approach which does not equate to value. It is useful for measuring IT value because it allows comparison of alternative implementations that will meet the same business need and, presumably, have very similar values to the business. If the TCO of one alternative is significantly less than the others, then it represents better value for money. It includes consideration like training costs, security costs, scalability costs, and the costs of reliability deficiencies. TCO incorporates perspectives that are not purely financial.

Limitation: It involves predicting future costs. This limitation can be minimised over time by tracking actual costs but, by then, the investment decision has been made.

Return on Investment (ROI):
It means calculating the revenue that the business generates or the costs that it saves in return for the investment that it is making. For an IT investment to be approved by the business, the IT Providers and the business must work together to demonstrate that the business will get its money back with a nice profit in an acceptable period of time (the payback period). In reality, ROI is typically expressed as a percentage of the investment, either annually or over the duration of the project with the cash flows rendered as net present values. Typically, the assumed discounting rate is called the internal rate of return (IRR) and is linked to the cost of capital of the business or the amount of interest the business will pay to borrow the money make the investment. Acceptable IRRs and payback periods vary immensely from business to business but an IRR of at least 20% and a payback period of one to three years are a reasonable starting point for a discussion. It is very widely used to justify IT investments, particularly for new projects. Having said that there is still the problem of predicting the future, ROI provides a good way to compare the financial value of very different projects and also provides hurdles, through the payback period and IRR, that quickly cut off further, costly consideration of some projects.

Limitation: Organisations often have good systems established for making their investment decisions using ROI but may have weak systems for monitoring the actual ROI achieved and using historic data on project ROI results to inform their current and future investment decisions. Another limitation with ROI is that cost savings must be in real money rather than theoretical “efficiencies.” For example, a projection that an IT investment will save the business 12% of staff time is only a real cash flow if it results in the employment of 12% less staff. It is fair to note that the staff may not necessarily be terminated but may deploy their efforts to other productive work; however, this is rarely monitored or measured carefully.

Economic Value Added (EVA):

This approach starts with the assumption that the organisation exists to provide economic value to its shareholders. This may not be entirely true for not-for-profit organisations but the approach still has value. The calculation and comparison of Economic Value Added is very similar to ROI except that the benchmark used for making investment decisions is not the IRR but the opportunity cost of using the money to make other business investments, (e.g., leaving the money in the bank rather than funding projects).

Source/Credit : The Business Value of IT

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