MIS 488 – Fall 2001
Research Paper: Selecting Information Technology Projects
November 26, 2001
Business investment in information technology has exploded during recent years. “Spending on e-commerce projects will jump more than 35% this year (2000) and 25% in 2001.” (Rural Telecommunications) At the same time, the number of projects available to choose from has also increased. Companies must now choose between investments such as Business-to-Business e-commerce, Business-to-Consumer e-commerce, automating human resources/employee benefits functions, supply chain management, ERP systems, etc. The demand for new technology spending has increased the pressure on companies’ limited resources, so they must be able to identify those projects that match their business and economic goals.
According to the Rural Telecommunications article, recent trends show that companies are reducing their spending on traditional information technology projects and boosting their budgets for e-commerce initiatives. This shift in IT spending is mostly driven by higher expected payoffs from e-commerce projects.
Many methods have been used to try to establish an economic value for IT projects. These valuations are used to compare different projects and to select those projects, which will provide the greatest benefit to the company. As Marchewka states in his article, “Effective IT planning remains a key issue for managers who seek to maximize the return on their investments in information systems.”
This paper will look at some of the methods used to establish values used for project selection. While there are many intangible benefits of IT investments, the paper will mostly concentrate on methods that attempt to provide an economic value for project selection because in the current economic environment “many corporations won’t commit to new tech purchases unless they see the benefits spelled out in black and white.” (BusinessWeek e.biz, pEB24)
If companies had unlimited resources, investment project selection would not be an issue. But the fact is that each company has a limited amount of resources and they seek to get the maximum economic return from those resources. In recent years, we have seen some companies investing in IT projects without adequately justifying the economic benefits. Now that the technology stock market bubble has burst, investors no longer reward companies simply for investing in the latest technology. “In an environment characterized by increasing user expectations and pressure to accomplish more with fewer resources, IT managers must continually make informed decisions regarding the allocation of scarce resources among new projects and the maintenance or reengineering of existing systems.” (Marchewka)
Technology projects can be very expensive, running into several millions of dollars for the initial development. In addition, “Information Technology is one of the largest items in most organization's budgets.” http://www.oulton.com Therefore, when calculating a projects cost, companies need to not only look at the initial development cost, but they also need to look at ongoing annual maintenance cost related to the new project.
Today, more than ever, companies are searching for ways to economically justify IT projects because of the current economic recession, and the pressure from shareholders to increase stock prices. “The business value returned by information technology investments is being viewed with increasing skepticism by executives and boards of directors. They want guarantees that their IT investments will deliver the value they expect.” (Gabler) As stated in the BusinessWeek e.biz articles: There’s going to be a search for more short-term payback. The projects getting the green light are those with proven track records for delivering results. Executives only want to fund projects that promise to pay off fast. (pEB18) This cost justification not only applies to new projects, but also to projects that are currently in the process of being developed - “Executives are demanding to see proof of future returns before deciding to keep projects going.” (BusinessWeek e.biz, pEB26)
As with any investment, IT projects present certain risks that a company needs to assess prior to making a decision to move forward with the project. “Managing the risks associated with investments in IT represents an important, but understudied, aspect of the IT planning process.” (Marchewka) The risks associated with IT Investments usually involve the companies ability to develop the project on time and within budget, to integrate the new project into their existing systems and business environment, and the ability of the companies employees to use to new technology to gain the maximum benefit. There is a risk that the companies employees, or the consultants that they have hired will not have the knowledge and expertise needed to successfully develop the project. The following quotes demonstrate the results of inadequate risk assessment:
· “Only 28% of major tech projects fully meet expectations, according to researcher The Standish Group. Yet a September survey of nearly 500 corporate information technology executives by researcher Jupiter Media Metrix inc. showed that 59% of their do-it-yourself ROI studies forecast gains.” (BusinessWeek e.biz, pEB24)
· “Meta Group estimates that half of all new United States software projects will go way over budget. The Standish Group says 52.7% of information systems projects overrun their schedules and budgets, 31.1% are canceled, and only 16.2% are completed on time and on budget. Ambler found an 85% failure rate in the development of large-scale software projects.” (Jiang)
Richard J Martin, in his article titled Selecting an Appropriate Client/Server Application, identified two areas most often associated with project failure:
Due to the combination of limited resources available for investments, the high rate of project failures, and the pressure from investors/owners to improve economic returns, all IT projects must now be justified through an analysis of the economic benefit to be provided by each investment. “While the strategic benefits of IT investments can be significant, the risks associated with IT failure have never been greater. Given that IT organizations must function within an environment of limited resources, effective IT planning remains a key issue for managers who seek to maximize the return on their investments in information systems.” (Marchewka)
The primary reasons that companies invest in IT are to reduce operating costs and to increase revenues. The cost savings are typically easier to quantify than revenue increases because revenue increases are generally based on projections, while the cost savings estimates can be made by specifying existing costs which can be eliminated as a result of the investment. Other benefits include improved customer or supplier interactions, improved data integrity and improved customer service.
Projects that are less easily valued, but are still seen as essential investments include web initiatives that are tied directly to core business goals, customer-focused projects that let clients help themselves to information online, and knowledge management projects that help companies better manage and share the information that has been learned by their employees. These types of projects are important, but are often hard to quantify because it is difficult to establish a direct link between functions such as giving a customer online access to there account and a cost savings associated with online access. For example, many Banks now have online access for their customers, but they still must operate bank branches, teller windows, ATM’s and telephone banking services, because the customer is likely to continue to use multiple service delivery methods in addition to the new online access. The new service may make it less likely that an individual customer will move their business to a competitor, but these values are generally rough estimates at best. Even for these intangible type benefits, a rough estimate of the value is usually calculated to justify the cost of the investment. This provides an important role in evaluating projects with tangible cost savings against these projects with intangible values.
“Four basic approaches have been advocated for selecting IT projects: cost/benefit analysis, scoring or ranking models, management science models, and the portfolio management approach.” (Marchewka) This paper focuses on the cost/benefit analysis methods because those methods appear to be getting the most usage in today’s economic environment. “Cost/benefit analysis, the traditional approach for selecting projects, is an attempt to quantify the costs and savings (or profit) associated with potential projects. … Cost/benefit analysis is advantageous because it provides a quantative measure of the worth of a project in language that managers can readily understand.” (Marchewka)
The most common methods used in cost/benefit analysis are Return on Investment (ROI), Break-Even Analysis, and Net Present Value (NPV). The ROI, Break-Even, and NPV valuation methods are standard methods that have been used for decades in business. These methods are typically used for all investment decisions, including both IT and Non-IT related projects.
Return on Investment
“ROI is a measure of the monetary benefits obtained by an organization over a specified time period in return for a given investment. Looking at it another way, ROI is the extent to which the benefits (outputs) exceed the costs (inputs). ROI can be used both to justify a planned investment and to evaluate the extent to which the desired return was achieved.” www.fastrak-consulting.co.uk/tactix/Features/tngroi/tngroi.htm
When a company uses ROI to evaluate projects, the company typically has a minimum required ROI for a project to be approved. This approach is based on the company’s cost of capital. Each company has a different cost of capital and each company’s required ROI is different, often depending on the company’s appetite for risk and their shareholders expectations for company performance. The cost of capital can be tied to an opportunity cost. For example, a company has extra cash on hand. They know that they can earn 5% by investing this money in a bank account. Therefore, any investments (IT and Non-IT) must provide a return of at least 5% to make it an equally valuable investment.
In addition, the company may require that the internal project have a greater return, say 10%, than the bank investment to compensate for the greater risk of the internal investment (the bank deposit would be guaranteed, while the internal project may fail causing a loss of principal invested and potential interest earnings). If the source of the company’s capital is borrowed funds (banks or bond market), the company would require that projects have an ROI that exceeds the cost of borrowing. In this case, the company would also likely require a risk premium for the internal project. “It is during the process of project selection that managers must decide whether a project offers a reasonable return on investment and whether the project falls within an acceptable level of risk.” (Marchewka)
Additional ROI Resources
· Sample ROI calculators: http://www.arnoc.com
· Other ROI resources: http://www.cuna.org
Break-even analysis uses a time line to determine how long it will take for the project to become profitable, adding to net income rather than subtracting from it. When companies use this method of analysis, they typically are looking for projects that will become profitable in the shortest time period. When using this method, companies are recognizing the potential risk of time – the risk that market or technological conditions will change, making the proposed project obsolete.
“The principle idea behind break-even analysis is that all costs are variable (which means they vary with output), fixed (which means they are relatively constant over time) or a combination of both. Theoretically, after fixed costs are covered, each dollar of sales will have to cover only variable costs. The break-even point at which a firm makes no profit or sustains no loss can be computed or it can be determined from a graphic presentation of the relationship between revenue, cost and volume of productive capacity.” http://www.muextension.missouri.edu
If the information is presented graphically, a steep incline in the cost line will represent a project with high maintenance cost after the initial investment. Conversely, a flatter incline in the cost line represents a project with low ongoing maintenance after the initial investment. Break-even analysis compares time to profitability, but does not consider total economic value to be provided by each project over their lifespan.
Additional Break-Even Point Information
The NPV method is based on the time value of money. This method recognizes that a dollar today does not have the same value of a dollar in one year or any other point in the future and that a dollar invested to day will need to earn a certain amount just to retain its value at a future date. At a minimum, this rate of return must be equal to the rate of inflation. If this method is used, projects will be compared using there expected annual returns. The project that is selected will generally have the greatest expected future value.
NPV is a very popular method of valuing potential projects. “By 1994, 95% of the companies indicated that discounted cash flow analysis was either very important or somewhat important in getting a project accepted. The three most common techniques used are internal rate of return, net present value, and payback. Of these three techniques, net present value provides the "best" answer.” http://hsb.baylor.edu
It is important to accurately determine the costs and benefits that are used to justify the value of an IT investment. There are many ways to look at the cost and benefits of a particular project, but those individuals involved in presenting the estimated value need to make sure that all parties involved agree on the inputs and outputs of the project. “When expectations are not specifically defined, funding authorities and recipients tend to substitute their own expectations- positive or negative. We have seen technically successful projects viewed as business failures because the users’ unrealistic expectations went unchecked.” (Gabler)
When calculating monetary costs of a new project, make sure that you include variable operating costs along with the up-front fixed cost such as hardware, software and labor costs. This is important because the servicing cost after development and implementation can cost several times the initial investment of a project over the project’s lifespan. After calculating up-front development cost, “they have to identify their variable costs, then calculate the money they can save or the new sales they can log adding technology.” (BusinessWeek e.biz, pEB24)
It is also important to recognize that costs estimates can change or may be inaccurate. “It is beneficial to conduct a sensitivity analysis that allows one to consider the likelihood of different conditions occurring and their impact on the project’s likely returns.” (Marchewka)
Benefits are also most often stated in monetary terms such as dollars of cost savings, dollars or revenue increases or percentage of profit increases over existing profit levels. Cost savings are easier to quantify because a company knows how much it cost to maintain employment of each employee, how much is cost to operate a warehouse and how much is cost to process an invoice. When a project proposes to eliminate any of these costs, the value can be justified by referring to the historical cost data. Potential revenue increases are educated guesses at best, but in some cases, there is historical information available from similar projects, which can be used to justify the estimations of revenue increases. However, there are some benefits that are hard to quantify, as stated in BusinessWeek e.biz “The real payoff comes when companies change the way they interact with customers and suppliers, organize their factories, and move products around the world.” (pEB19) There are many ways to state intangible benefits such as, “will reduce customer response time form days to minutes, or will provide immediate access to account status over the internet.” (Gabler) The challenge is representing these intangible benefits in economic terms so that a project with intangible benefits can be fairly compared to a project with mostly economic quantifiable benefits.
The research shows that there are many other ways to define costs and benefits of a new project. Here are two examples of articles that suggest alternate methods of defining costs and benefits:
“A true cost-benefit analysis should include a review of both quantitative and qualitative outcomes. Use your list of bottlenecks and workarounds as a reference for potential performance activities that will produce an ultimate savings.” (McGoldrick)
There are online resources available to help estimate costs and benefits, but you should be careful when using these resources, because they are usually provided by a vendor who is trying to sell a product or service, so they may not be completely accurate and do not fully reflect you particular businesses situation. “Online calculators, where a company asks questions about a business and gets answers based on a formula, give only rough estimates of possible savings.” (BusinessWeek e.biz, pEB24)
The articles used as research for this paper have varying opinions as to which method is the best method for IT project valuation and selection. “…It is often difficult to apply standard cost/benefit techniques to IT projects ‘due to the strategic impact of intangible benefits arising from IS projects’. The use of cost/benefit analysis alone may distort the project selection process by failing to account for important qualitative or subject factors.” (Marchewka) One limitation of traditional cost/benefit analysis “is that the returns of any particular project may change over the course of a project due to changes in the various dimensions of IT project risk.” (Marchewka)
Most advocate using some measure of intangible benefits to justify the investment - “Measuring total cost of ownership in dollar terms alone doesn’t cut it anymore – service quality and business impact must also be factored in.” (Vijayan)
Each method used for cost/benefit analysis (ROI, Break-Even and NPV) has some limitation to its ability to provide an accurate value so that individual projects can be compared. The problem with NPV is summarized below:
“Net present value analysis has some associated limitations that can result in the value of a project being underestimated. A traditional net present value analysis makes implicit assumptions concerning an expected scenario of cash flows. It presumes management's passive commitment to a certain "operating strategy" (e.g., to initiate the project immediately, and operate it continuously at a set scale until the end of its pre-specified expected useful life). It also ignores the synergistic effects that an investment project can create. Net present value analysis usually underestimates investment opportunities because it ignores management's flexibility to alter decisions as new information becomes available. Because of these limitations, 76% of firms accept projects that fail quantitative analysis.” http://hsb.baylor.edu
ROI does not consider the size of the projects being compared. Basing a decision on ROI only could force a company to enter into a large project instead of a smaller project, even if the larger project subjects the company to far greater risk (if the project fails, it may financial impair the company is the project represents a substantial portion of the company’s capital and resources). “ROI studies aren’t and exact science. Measuring results is a vital discipline.” (BusinessWeek e.biz, pEB25)
There are also online tools available for calculating ROI, but you should be careful with placing too much reliance in these tools. “ROI calculators can give rough estimates in as little as 10 minutes. The calculators, often on a supplier’s Web site, walk a company through a series of questions, and then spit out a forecast based on the answers. The estimates are the least reliable of all the ROI approaches.” (BusinessWeek e.biz, pEB24)
Break-even analysis can work well for projects of similar size, but is not a good comparison tool to use when comparing both large and small dollar projects. The method ignores the fact that a project may provide a much smaller long-term benefit than a competing project. For example, a small project may have a break-even point at six month from the start of the project. A larger project that costs twice as much may not break-even until 12 months after the start of the project. Base on the analysis of the break-even points, the company may choose to go with the smaller project. The analysis would ignore the fact that after two years, the larger project would have produced three times the dollar savings as the smaller project.
Many companies consider e-commerce initiatives vital to their survival. “What might endanger that survival is too much emphasis on short-term results. Key longer-range projects could be put on hold. Firms that focus too much on cost savings may miss out on the productivity gains down the road.” (BusinessWeek e.biz, pEB19)
It is apparent that there is no consensus as to which method is the best. In my opinion, a company should use a combination of methods to select IT projects. While intangible benefits can be important, it is more reasonable to focus on economic valuations in the current economic environment. Using a combination of ROI and NPV would ensure that a company gets the most return on their investment while also considering the long-term aspect of the project. In certain cases when a company is evaluating two projects of similar size, the break-even analysis would be appropriate because it would limit the time risk by selecting a project that would recoup the initial cost early and provide net benefits to the company sooner. As with most decisions, a company needs to assess their current situation, the market situation and their competition prior to determining which method to use to evaluate IT projects. The best method to use would likely change from time to time as market and technological changes occur.
There are many methods used to select IT investment projects. The criteria used to select a project vary for each industry, company and project. Most decisions are made based on an economic cost/benefit analysis, but this is not always the best method because it focuses on short-term gains at the instead of long-term goals. Research shows support for many different methods of selecting projects, so it is unlikely that we will see a consensus anytime soon. The best advice is to assess you own situation, you industry’s situation and your competitive position before committing to any large, long-term projects. After deciding to pursue a project, the costs and benefits should be calculated using the method that is most appropriate to your individual situation.
Gabler, James M. “IS can help ensure value from IT investments.” Managed Healthcare Executive March 2001, Vol. 11 Issue 3, p46
“IT Budgets Give Way to E-commerce Spending” Rural Telecommunications Jul/Aug 2000, Vol. 19 Issue 4. p8
Jiang, James J. “Software Project Risks and Development Focus” Project Management Journal Mar 2001, Vol. 32 Issue 1, p4 (6 pages)
Vijayanm, Jaimkumar “The New TCO Metric” Computerworld 6/18/2001, Vol. 35 Issue 25, p36
Martin, Richard J “Selecting an appropriate client/server application/(Part 9)” Journal of Systems Management Sep 1994, Vol. 45 No. 9, p28-29
McGoldrick, Terry “Choosing a clinical information system” Nursing Management 51-55 30 Nov 1999, No. 11, p51-55
Keenan, Faith and Mullaney, Timothy “Let’s Get Back to Basics,” BusinessWeek e.biz Oct 29, 2001: p EB26-28
Hamm, Steve “Sizing Up Your Payoff Forecasts of gains from e-business investments don’t always pan out” BusinessWeek e.biz Oct 29, 2001: p EB24-25
Rocks, David “The Net As a Lifeline A tough economic environment makes the Web even more important for companies attempting to cut costs, generate new revenues, and better serve customers” BusinessWeek e.biz Oct 29, 2001: p EB16-23
Marchewka, Jack T and Keil, Mark “Portfolio Theory Approach For Selecting and Managing IT Projects” Information Resources Management Journal Fall 1995, Vol. 8 No. 4, p5-14