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Cost Benefit Analysis

Developing an IT application is an investment. Since after developing that application it provides the organization with profits. Profits can be monetary or in the form of an improved working environment. However, it carries risks, because in some cases an estimate can be wrong. And the project might not actually turn out to be beneficial.

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 :

  • Personnel

  • Equipment

  • Supplies

  • Overheads

  • Consultants' fees

Cost and Benefit Categories

In performing Cost benefit analysis (CBA) it is important to identify cost and benefit factors. Cost and benefits can be categorized into the following categories.

There are several cost factors/elements. These are hardware, personnel, facility, operating, and supply costs.

In a broad sense the costs can be divided into two types

1. Development costs-

Development costs that are incurred during the development of the system are one time investment.

  • Wages
  • Equipment

2. Operating costs,

e.g. , Wages
Supplies
Overheads

Another classification of the costs can be:

Hardware/software costs:

It includes the cost of purchasing or leasing of computers and it's peripherals. Software costs involves required software costs.

Personnel 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.

Facility costs:

Expenses incurred during the preparation of the physical site where the system will be operational. These can be wiring, flooring, acoustics, lighting, and air conditioning.

Operating costs:

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.

Supply costs:

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.

Benefits

We can define benefit as
Profit or Benefit = Income - Costs

Benefits can be accrued by :

- Increasing income, or
- Decreasing costs, or
- both

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 process.

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 indirect costs.

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)

Example:

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.

  1. Present value analysis
  2. Payback analysis
  3. Net present value
  4. Net benefit analysis
  5. Cash-flow analysis
  6. 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

Example:

Present value of $3000 invested at 15% interest at the end of 5th year is calculates as

P = 3000/(1 + .15)5
= 1491.53

Table below shows present value analysis for 5 years

Year
Estimation Future Value
Present Value
Cumulative present Value of Benefits
1 3000 2608.69 2608.69
2 3000 2268.43 4877.12
3 3000 1972.54 6949.66
4 3000 1715.25 8564.91
5 3000 1491.53 10056.44

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
% = 30000/80000
=.375

Break-even Analysis:

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.

Cash-flow Analysis:

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.


  

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