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

Chapter 14
Evaluating AIS
Investments

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Learning Objectives
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•

•

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LO#1 Articulate similarities and differences between
major IT initiatives and other capital investments
LO#2 Explain the major steps in the economic
justification of an IT initiative
LO#3 Explain potential benefits of IT initiatives and
how to evaluate them
LO#4 Assess potential costs of IT initiatives and how
to evaluate them
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
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LO# 1

Large IT Projects Require Economic
Justification
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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
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of the organization


LO# 2

Business Case for IT Initiatives
Should answer these questions:
1.

Why are doing this project?

2.

How does it address key business issues?

3.

4.

How much will it cost and how long will it
take?
What is the return on investment and
payback period?

5.

What are the risks of doing the project?

6.

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What are the risks of not doing the
project?

LO# 2

The Economic Justification Process

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LO# 2

Assessing Business Requirements
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Refer to information on the balanced
scorecard in Chapter 13
IT initiatives should reduce one or more gaps
between the firm’s current and desired
performance levels as indicated by the firm’s
strategy map
IT alone is usually not sufficient to achieve
important changes
Consider other enabling changes that in
conjunction with the technology will14-6

LO# 2

Planned IT Initiatives

Potential Benefits

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LO# 2

Examples of Complementary Changes
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Training employees

•

Redefining job descriptions

•

Reconfiguring tasks

•

Offering incentives to make changes

•

Others?

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LO# 3

Estimating Benefits
1.

2.

3.

4.

Revenue enhancement—creating new sales
opportunities
Revenue protection—protecting existing
revenue streams
Cost savings—opportunities to modify
business processes to reduce low valueadded or manually intensive activities, to
improve capabilities to manage assets to
increase efficiencies, or to reduce errors
Cost avoidance—opportunities to14-9
modify


LO# 4

Estimating Relevant Costs
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Acquisition Costs
–

Direct costs to acquire and implement
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Hardware

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Software

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Networking

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Development

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Project Management

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Consulting

•

Training

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LO# 4

Estimating Relevant Costs
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Operating Costs
–

Direct costs necessary to operate, maintain,
and administer the technology
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Hardware replacements

•

Software upgrades

•

Maintenance contracts

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Help desk support

•

Ongoing training

•

Administration
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•


LO# 5

Assessing Risks
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•

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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
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not be able to change.


LO# 5

Identifying Risk Mitigation Techniques
IT Initiative
Risks
Alignment Risk
Solution Risk
Financial Risk

Project Risk
Change Risk
Technological
Risk

Risk Mitigation Examples
Use the Balanced Scorecard Framework (Chapter
13) to assess the link to strategy

Use sensitivity analysis to consider likely
alternative benefit levels
Interview other users of similar IT; follow a
structured Balanced Scorecard Management
Process (Chapter 13)
Assure active top management support for the
project
Conduct training and create employee incentives
for successful use of the new IT
Require hardware and software vendors to
demonstrate that their systems can14-13
meet


LO# 2

Combining Benefits, Costs, and Risks
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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
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the reasons for that choice


LO# 2

Capital Budgeting Financial Metrics
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Payback period and breakeven analysis—
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
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LO# 2

Capital Budgeting Financial Metrics
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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
Present Value = CFt/(1 +
value.
r)t

Where:
CF = cash flow for period
t, and
r = discount rate (typically
the firm’s weighted

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LO# 2

Capital Budgeting Financial Metrics
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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.
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The IRR and NPV functions are related
in


LO# 2

Capital Budgeting Financial Metrics
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Accounting rate of return (ARR)
The average annual income from the IT
initiative divided by the initial investment cost
ARR = (average annual income from IT
initiative)
/(total IT initiative investment
cost)

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Strengths and Weaknesses of Financial
Metrics
Financial Metric
Strength
Weakness
Payback Period

Easy to calculate and
understand. Widely used.

Accounting Rate of Relates estimates to standard
Return
accounting ratios using accrual

accounting. Shows impact on
operating income.
Net Present Value Considers the time value of
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.
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.

LO# 2

Ignores the time value of money as
well as both costs and benefits
occurring after the payback period.
Also ignores the time value of money.
Assumes cash flows in all periods are
similar.
Larger projects tend to have larger net
present values. Does not show rate of
return on investment. Sensitive to

discount rate applied.

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

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LO# 2

Example
Discount
rate
Project 1
Benefits
Costs
Cash Flow
Payback
NPV
IRR

10%
Year 0
$20,000
-$20,000

Year 1
$20,000
$7,500

$12,500

Year 2
$20,000
$7,500
$12,500

Year 3
$30,000
$7,500
$22,500

Total
$70,000
$42,500
$27,500

1.26
$16,908
52%

Note that total cash flow is equal but NPV
and IRR are not, due to time value of
money. Try it in EXCEL using the NPV and
IRR functions!
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Average
$23,333
$10,625

$15,833


LO# 2

Test Sensitivity to Changes in
Assumptions

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LO# 2

Prepare the Value Proposition
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•

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

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