Evaluating Investments in Information Technology

Shannon Crump

December 9, 2002

ISM 6021

Pressures to Justify IT Initiatives

• Current economic climate places increased pressure on CIO’s to justify the high cost of IT initiatives

• The history of failed IT projects forces senior executives to evaluate the costs versus the benefits of IT endeavors

- FoxMeyer Drug bankruptcy after $65M failed IT project

- Dow Chemical scrapped a 7-year $500M IT initiative

Evaluating Investments in IT in Governmental Agencies

• The Office of Management and Budget Director (OMB) established guidelines for government agencies to evaluate IT initiatives

- In 1996, executive agencies obligated $26M for IT initiatives and operations.- The President’s Management Agenda of 2002 calls for better use of IT in making the federal government more citizen-centered

and results oriented. - Currently, agencies are assembling IT investment proposals for the FY

2004 President’s Budget.- Under OMB Guidelines, this process includes review of proposals by

agency Chief Information Officers, IT Investment Review Boards, and senior leadership.

OMB Guidelines for EvaluatingIT Initiatives

• The It investment process and agency designs should match the culture and organizational structure of the agency.

• The OMB lists three attributes critical to successful investment evaluation. 1- Senior management attention throughout the life of the IT project.

2- The overall mission focus is a critical attribute that links strategic planning to the agency’s goals and needs. 3- Comprehensive approach to IT investment

Three Phases of OMB Investment Process

• Selection

- Screening of IT project proposals

- Analyzing risks, costs and benefits

- Prioritizing projects based on risk and

potential return

- Determining the right mix of projects to

optimize agency system

- Make the final cuts

Three Phases of OMB Investment Process

• Control - Monitoring projects or systems against the projected costs, schedule, and performance

- Taking action to correct deficiencies - Proper control of IT investment costs allows

senior management to identify risks by using a comparison of actuals versus expected during the life of the project; allows for adjustments

Three Phases of OMB Investment Process

• Evaluation - Conduct post implementation reviews, which are designed to compare actual results to the initial proposals in terms of cost, schedule, performance, and mission improvement. - Senior management team evaluates the project to determine the necessary adjustments and consider alternatives to the implemented system.

Issues in the Business Sector

• Increasing pressure to deliver benefits in a shorter timeframe.

• In current economic climate, CIO’s are expected to justify IT projects in quantitative terms.

• A survey in 2000 indicated that 80% of the 150 executives surveyed have been required to justify IT projects in terms of financial strength.

• CIO’s must develop ways of evaluating IT projects in terms of cost versus benefits

The Trouble with ROI in IT Project Planning

• IT represents an irreversible investment under uncertainty.• IT projects cover a wide range of business applications.• Lack of historical data for evaluation• IT projects are commonly met with a number of changes

during the life of the project.• CIO’s are forced to continuously reevaluate and make

changes to IT projects; these changes result in unpredictable costs in many cases

Option Pricing Methods

• OPM enables the analyzer to consider the potential of an IT project as a building block to future IT advancements.

• Follow-up projects are considerably less expensive, as the foundation has already been built and financed.

• Real options pricing models allow the user to value the benefit of management learning over time.

Concepts of OPM’s

• Operating flexibility and growth opportunities - The value of flexibility offered by the initial IT initiative offers management the option of engaging in future projects. - IT can provide access to new markets - The ability to realize technological advancements more rapidly and less costly allows an improved competitive position in the market.

- IT initiatives can result in better adaptability to changing market demands and customer needs.

Option Pricing Method Calculation

• NPV is the amount of money an investment is worth, taking into account its cost, earnings, and the time value of money.

• Calculating traditional NPV only results in a loss on many IT projects, as the initial capital investment for a start up project is generally more considerable than follow-up projects with added benefits.

IT projects expanded NPV = IT project’s traditional NPV + related option value

Time to Expiration

• In order to assign the value of option rights, the consideration of time to expiration is essential.

• Time to expiration is defined as the length of time between the acquisition of an option and its expiration.

• Options become obsolete as opportunities to add value expire.

Identifying the Optimal Time

• Ideally, companies want to use up as much of the time to expiration as possible, as this gives managers more time to evaluate the most optimal technological moves in a rapidly changing IT environment.

• Unfortunately, the opportunity cost of prolonging the next initiative can force firms to move quickly.

• The goal of the organization is to determine the best ways to evaluate the optimal time and strike a balance between opportunity costs and option value over time.

Problems in Financial Models Used for IT Project Analyses

• Capital outlay for IT endeavors is substantial, while benefits are realized in future periods

• Investment costs can be measured quantitatively, as they are tangible

• Difficulty exists in measuring benefits quantitatively, as they are intangible

• Rapidly changing technology results in numerous changes over the life of an IT project

- estimates tend to vary with numerous changes- changes make investment predictions complex and difficult

to measure