Lecture Accounting information systems: Chapter 14 - Richardson, Chang, Smith

Chapter 14 - Evaluating AIS investments. After reading this chapter, you should be able to: Articulate similarities and differences between major IT initiatives and other capital investments, explain the major steps in the economic justification of an IT initiative, explain potential benefits of IT initiatives and how to evaluate them,...

Evaluating AIS Investments

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• LO#5 Describe potential risks of IT initiatives and

corresponding risk mitigation techniques

• LO#6 Apply capital budgeting techniques to assess the value of an IT initiative

Large IT Projects Require Economic

Justification

• Worldwide IT spending forecast to exceed $4 trillion by 2015 (according to the Gartner

Group in January 2013)

• IT projects require large amounts of capital

and capital is limited

• Selecting one project often means foregoing

others

• IT projects often involve changes in business processes that will affect substantial portions

of the organization

• Capital budgeting techniques provide a

systematic approach to evaluating

investments; yet, many organizations find it

difficult to evaluate IT projects using

traditional techniques

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Business Case for IT Initiatives

Should answer these questions:

1. Why are doing this project?

2. How does it address key business issues?

3. How much will it cost and how long will it

take?

4. What is the return on investment and

payback period?

5. What are the risks of doing the project?

6. What are the risks of not doing the project?

7. What are the alternatives?

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The Economic Justification Process

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Assessing Business Requirements

• Refer to information on the balanced

• Consider other enabling changes that in

conjunction with the technology will

accomplish substantial business change

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Examples of Complementary Changes

3. Cost savings—opportunities to modify

business processes to reduce low

value-added or manually intensive activities, to

improve capabilities to manage assets to

increase efficiencies, or to reduce errors

business processes to avoid cost increases

in the future

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Estimating Relevant Costs

Estimating Relevant Costs

– Direct costs necessary to operate, maintain,

and administer the technology

– Indirect costs of user downtime and lost

productivity, such as time spent on

self-training, peer support, end user data

management

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Assessing Risks

• Alignment risk—the solution is not aligned

with the strategy of the firm

• Solution risk—the solution will not generate

projected benefits

• Financial risk—the solution will not deliver

expected financial performance

• Project risk—the project will not be completed

on time within budget

• Change risk—the firm or part of the firm will

not be able to change

• Technological risk—the technology will not

deliver expected benefits

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Identifying Risk Mitigation Techniques

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IT Initiative

Risks Risk Mitigation Examples

Alignment Risk Use the Balanced Scorecard Framework (Chapter

13) to assess the link to strategy Solution Risk Use sensitivity analysis to consider likely

alternative benefit levels Financial Risk Interview other users of similar IT; follow a

structured Balanced Scorecard Management Process (Chapter 13)

Project Risk Assure active top management support for the

project Change Risk Conduct training and create employee incentives

for successful use of the new IT Technological

Risk

Require hardware and software vendors to demonstrate that their systems can meet requirements

Combining Benefits, Costs, and Risks

• Fully understand the financial implications of

the investment

– Determine the relevant time frame for costs

and benefits

– Select appropriate discount rates to apply

– Prepare capital budgeting financial metrics

– Assess the sensitivity of results to the

assumptions

• Select the best alternative and summarize

Capital Budgeting Financial Metrics

both compare the costs with benefits of an IT

project The breakeven point is where the

total value of benefits equals that of total

costs The payback is the number of periods

needed to recover the project’s initial

investment

• Payback Period = Initial

Investment/Increased cash flow per period

• Assume an IT project is expected to cost

$20,000 up front, and it will provide net

benefits that average $16,000 per year for

the next 3 years

years

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Capital Budgeting Financial Metrics

• Net present value

• Sum of the present value present value of all

cash inflows minus the sum of the present

value of all cash outflows Each cash

outflow/inflow is discounted to its present

value

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Present Value = CFt/(1 + r)t

Capital Budgeting Financial Metrics

• Internal rate of return (IRR)

• Discount rate that makes the project’s net

present value equal to zero

• financial calculators and spreadsheet

software, such as Microsoft EXCEL,

Microsoft Excel, use an iterative technique for calculating IRR Starting with guess, they

cycle through the calculations until the result

is accurate

• The IRR and NPV functions are related in

that if you use the IRR as the discount rate (r)

in calculating NPV, your NPV is zero

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Capital Budgeting Financial Metrics

• Accounting rate of return (ARR)

initiative divided by the initial investment cost

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Financial Metric Strength Weakness

understand Widely used

Ignores the time value of money as well as both costs and benefits occurring after the payback period.

Accounting Rate of

Return

Relates estimates to standard accounting ratios using accrual accounting Shows impact on operating income.

Also ignores the time value of money Assumes cash flows in all periods are similar.

money Incorporates cash flows over the life of the IT initiative

Compares the dollar value of the benefits from an IT initiative to the initial investment.

Larger projects tend to have larger net present values Does not show rate of return on investment Sensitive to discount rate applied.

Internal Rate of

Return

Considers the time value of money Incorporates cash flows over the life of the IT initiative

Computes the unique rate of return for the initiative Not sensitive to a selected discount rate.

Fails to consider the size of the project Sensitive to timing of the cash flows

Test Sensitivity to Changes in

Assumptions

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Prepare the Value Proposition

• Assemble the analysis for each alternative IT initiative and recommend the preferred

alternatives

• Focus on these five questions:

1 The change and technology proposed

2 The anticipated benefits (related to the firm’s

critical success factors)

3 The group(s) within the firm that will benefit

4 The timing of the benefits

5 The likelihood of achieving those benefits as

planned

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