Cost benefit analysis helps to give management a picture of the costs, benefits
and risks. It usually involves comparing alternate investments.
Cost benefit determines the benefits and savings that are expected from the
system and compares them with the expected costs.
The cost of an information system involves the development cost and maintenance
cost. The development costs are one time investment whereas maintenance costs
are recurring. The development cost is basically the costs incurred during the
various stages of the system development.
Each phase of the life cycle has a cost. Some examples are :
2. Operating costs,
e.g. , Wages
Another classification of the costs can be:
It includes the cost of purchasing or leasing of computers and it's peripherals.
Software costs involves required software costs.
It is the money, spent on the people involved in the development of the system.
These expenditures include salaries, other benefits such as health insurance,
conveyance allowance, etc.
Expenses incurred during the preparation of the physical site where the system
will be operational. These can be wiring, flooring, acoustics, lighting, and air
Operating costs are the expenses required for the day to day running of the
system. This includes the maintenance of the system. That can be in the form of
maintaining the hardware or application programs or money paid to professionals
responsible for running or maintaining the system.
These are variable costs that vary proportionately with the amount of use of
paper, ribbons, disks, and the like. These should be estimated and included in
the overall cost ofthe system.
We can define benefit as
Profit or Benefit = Income - Costs
Benefits can be accrued by :
- Increasing income, or
- Decreasing costs, or
The system will provide some benefits also. Benefits can be tangible or intangible,
direct or indirect. In cost benefit analysis, the first task is to identify each
benefit and assign a monetary value to it.
The two main benefits are improved performance and minimized processing costs.
Further costs and benefits can be categorized as
Tangible or Intangible Costs and Benefits
Tangible cost and benefits can be measured. Hardware costs, salaries for professionals,
software cost are all tangible costs. They are identified and measured.. The purchase
of hardware or software, personnel training, and employee salaries are example
of tangible costs. Costs whose value cannot be measured are referred as intangible
costs. The cost of breakdown of an online system during banking hours will cause
the bank lose deposits.
Benefits are also tangible or intangible. For example, more customer satisfaction,
improved company status, etc are all intangible benefits. Whereas improved response
time, producing error free output such as producing reports are all tangible benefits.
Both tangible and intangible costs and benefits should be considered in the evaluation
Direct or Indirect Costs and Benefits
From the cost accounting point of view, the costs are treated as either direct
or indirect. Direct costs are having rupee value associated with it. Direct benefits
are also attributable to a given project. For example, if the proposed system
that can handle more transactions say 25% more than the present system then it
is direct benefit.
Indirect costs result from the operations that are not directly associated
with the system. Insurance, maintenance, heat, light, air conditioning are all
Fixed or Variable Costs and Benefits
Some costs and benefits are fixed. Fixed costs don't change. Depreciation of
hardware, Insurance, etc are all fixed costs. Variable costs are incurred on regular
basis. Recurring period may be weekly or monthly depending upon the system. They
are proportional to the work volume and continue as long as system is in operation.
Fixed benefits don't change. Variable benefits are realized on a regular basis.
Performing Cost Benefit Analysis (CBA)
Cost for the proposed system ( figures in USD Thousands)
Benefit for the propose system
Profit = Benefits - Costs
= 300, 000 -154, 000
= USD 146, 000
Since we are gaining , this system is feasible.
Steps of CBA can briefly be described as:
- Estimate the development costs, operating costs and benefits
- Determine the life of the system
- When will the benefits start to accrue?
- When will the system become obsolete?
- Determine the interest rate
This should reflect a realistic low risk investment rate.
Select Evaluation Method
When all the financial data have been identified and broken down into cost
categories, the analyst selects a method for evaluation.
There are various analysis methods available. Some of them are following.
- Present value analysis
- Payback analysis
- Net present value
- Net benefit analysis
- Cash-flow analysis
- Break-even analysis
Present value analysis:
It is used for long-term projects where it is difficult to compare present
costs with future benefits. In this method cost and benefit are calculated in
term of today's value of investment.
To compute the present value, we take the following formula Where,
i is the rate of interest &
n is the time
Present value of $3000 invested at 15% interest at the end of 5th year is calculates
P = 3000/(1 + .15)5
Table below shows present value analysis for 5 years
Estimation Future Value
Cumulative present Value of Benefits
Net Present Value : NPA
The net present value is equal to benefits minus costs. It is expressed as
a percentage of the investment.
Net Present Value= Costs - Benefits
% = Net Present Value/Investments
Example: Suppose total investment is $50000 and benefits are $80000
Then Net Present Value = $(80000 - 50000)
% = 30000/80000
Once we have determined what is estimated cost and benefit of the system it
is also essential to know in what time will the benefits are realized. For that
break-even analysis is done.
Break -even is the point where the cost of the proposed system and that of
the current one are equal. Break-even method compares the costs of the current
and candidate systems. In developing any candidate system, initially the costs
exceed those of the current system. This is an investment period. When both costs
are equal, it is break-even. Beyond that point, the candidate system provides
greater benefit than the old one. This is return period.
Fig. 3.1 is a break-even chart comparing the costs of current and candidate
systems. The attributes are processing cost and processing volume. Straight lines
are used to show the model's relationships in terms of the variable, fixed, and
total costs of two processing methods and their economic benefits. B' point is
break-even. Area after B' is return period. A'AB' area is investment area. From
the chart, it can be concluded that when the transaction are lower than 70,000
then the present system is economical while more than 70,000 transaction would
prefer the candidate system.
Some projects, such as those carried out by computer and word processors services,
produce revenues from an investment in computer systems. Cash-flow analysis keeps
track of accumulated costs and revenues on a regular basis.