Application Problems

Suppose a firm went through a request for proposal, vendor proposals, benchmarking, and the final choice of a- system that can be purchased or leased. Under the purchase option:

   a. The price tag is $500,000.

   b. The expected useful life is five years, and the salvage value is $40,000.

   c. The vendor allows a trade-in on the user's old hardware of $100,000.The book values                                                        $70,000, and there is a remaining life of one veal'.

   d. Maintenance service is available at $8,000 per year.

    Under the lease option:

a. Lease charges are $110,000 per year under a five-year contract.

b. Lessor's (vendor) maintenance fees are $8,000 per year.

c.  There is no trade-in allowance, although a third party is offering 75,000 for the old equipment.

d. Cost of capital to the user is 10 percent, and the effective tax rate b 40 percent.

Assignment

Determine the net present value applied to the purchase/lease options. Keep in the following:

a. The benefits derived from either option are assumed to be equal.

b. When using the net present value method, you are looking for the net present value of either cash inflows or cash outflows.

 c. Show all cash inflows and outflows net of their tax effect.

 d. Proceeds from the sale of the old system are reduced by the tax on the gain from the sale.

 e. Tax benefits that result from the deductibility of the service contract, the payments and depreciation are taken into account in the analysis. The effect is a reduction in the cash outflows related to the expenditures.

 f. Maintenance, lease payments, and depreciation are annuities, fixed amounts payable over a period of time.

Summary

1. Data analysis is a prerequisite to cost/benefit analysis. From the anal.' sis, system design requirements alternative system and me identified evaluated. The analysis of the costs and benefits of each alternative\ guides the selection prose. Therefore knowledge of cost and benefit tegories and evaluation methods is important.

  2. In developing cost estimates, we need to consider hardware, personnel, facility, operating, and supply costs. In addition, a system is expected to provide benefits. We need to identify each benefit and assign it a monetary value for cost/benefit analysis.

   3. Cost/benefit analysis gives a picture of the various costs, benefits, and rules associated with each alternative system. The procedure entails:

   a. Identifying the costs and benefits pertaining to a project.

   b. Cate90tizing the various costs and benefits for analysis.

   c. Selecting a method of evaluation.

   d. Interpreting the results of the analysis.

   e. Taking action.

  4. Costs and benefits are classified as tangible 01' intangible, direct or indirect, fixed or variable:

   a. Tangible costs: Outlays of cash for an item or activity.

   b. Intangible costs: Those that have financial values not easily measured.

   c. Direct costs: Those where a dollar figure can be directly associated. with a project.

   d. Indirect costs: The results of operations not directly associated with a system or activity.

   e. Fixed costs: They are constant and do not change-nonrecurring. 

   f . Variable costs: They are proportional to work volume.

   5. When all financial data have been identified, the analyst must select a method of evaluation. Them are several methods available:

   a. Net benefit analysis: Involves subtracting total costs from total benefits. its  is easy to calculate, interpret, and present. The main draw­ back is not· accounting for the time value of money and not discounting future cash flows.

   b. Present value analysis: Calculates the costs and benefits of the system in terms of today's value of the investment and then compares.

   c. Net present value: Discounted benefits minus discounted costs. It is relatively easy to calculate and accounts for the time value of money.

   d. Payback analysis: A common measure of the relative time value of a project. It determines the time it takes for the accumulated benefits to equal the initial investment. It is easy t.0 calculate and allows the ranking of two or activities.

  e. Break-even analysis: The point at which the cost of the candidate system and that of the current one are equal.

  f. Cash-flow analysis: Keeps track of accumulated costs and revenues on a regular basis.

 6. Once the evaluation of the project is complete, actual results are compared against standards 01' alternative investments. The decision to pt an alternative system can be highly subjective, depending on the analyst or user's confidence in the estimated cost and benefit values and the magnitude of the investments.

The System Proposal

The final decision following cost/benefit analysis is to select the most effective and beneficial system for the user. At this time, the analyst pares a feasibility report on the major findings and recommendations

As explained in Chapter 7, the report is a detailed summary of the investigation that has been carried out. It outlines the options and recommendations. It is presented to management for determining whether a candidate system should be designed. Effective reports follow carefully planned formats of the management can understand and evaluate without having to read entire document. 

Interpret Results Of The Analysts And Final Action

When the evaluation of the project is complete, the results have t interpreted. This entails comparing actual results against a standard or result of an alternative investment. The interpretation phases as well as the subsequent decision phase are subjective, requiring judgment and intuition. Depending on the level of uncertainty, the analyst may be confronted with a single known value or a range of values. In either case, is measures such as net benefit analysis are easier to calculate and p than other measures, although they do not discount future cash flows can be modified to include the time value of money, the net benefit me would be comparable to the net present value method. More complex measures such as net present value account for the time value of money but are more difficult to evaluate and present.

The decision to adopt an alternative candidate system can be subjective, depending on the analyst or end user's confidence in estimated costs and benefits and the magnitude of the investment.

In summary, cost/ benefit analysis is a tool for evaluating projects rather than a replacement of the decision maker. In real-life business situations, whenever a choice among alternatives is considered, cost benefit analysis is an important tool. Like any tool, however, it has problems:

1. Valuation problems. Intangible costs and benefits are difficult to quantify, and tangible costs are generally more pronounced than tangible fits. In most cases, then, a project must have substantial intangible be to be accepted.

2. Distortion problems. There are two ways of distorting the results of benefit analysis. One is the intentional favoritism of an alternative for p cal reasons. The second is when data are incomplete or missing from analysis.

3. Completeness problems. Occasionally an alternative is overlooked compromises the quality of the final choice. Furthermore, the costs related to cost/benefit analysis may be on the high side or not enough costs may be considered to do a complete analysis. In either case, the reliability of final choke is in doubt

Cash-Flow Analysis

 Some projects, such as those carried out computer and word processing services, produce revenues from an in investment in computer systems. Cash-flow analysis keeps track of accumulated costs and revenues on a regular basis. The "spread sheet" fennel also provides break-even and payback information.

Revenues for the first month in operation January) were $22.000. Operating expenses (including facility preparation) were $51,1.which resulted in a net expenditure of $29,175. Break-even occurs at the of the fOUl1h month (April). The cash flow then was $45, although accumulated cash flow was $ - 43,730. This was the result of excess expenses over revenues, facility preparation costs, and the like. Accumulated cash flow began to turn positive. This was the beginning of the pa,) period. The evaluation methods are summarized in

Break-Even Analysis

Break-even is the point where the cost of the candidate system and that of the current one are equal. Unlike the payback method that compares costs and benefits of the candidate system, break­ compares the costs of the current and candidate systems. When a "date system is developed, initial costs usually 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 (profit) than the old one-a return period.

 The attributes are processing cost and processing volume. Straight lines are used to show the model's relationships in terms the variable, fixed, and total costs of the two processing methods and economic benefits. Intersection B' indicates the point where the total of processing 65,000 transactions by the current system is equal to the to cost of using the candidate system. The shaded area beyond that point the return period. The shaded area AB'A' is the investment period. According to the chart, then, it would be more economical to process manually when volume is below 65,000 transactions during a given time period. Processing volume above B' favors the oandidate system.

Net Present Value

Net Present Value. The net present value is equal to discounted benefits minus discounted costs. Our $3,000 microcomputer investment yields a cumulative benefit of $4,758.51, or a net present gain of $1,7.'58.51.This value is relatively easy to calculate and accounts for the time value of money. The net present value is expressed as a percentage of the investment-in our example:

Payback Analysis

 The payback method is a common measure of the relative time value of a project. It determines the time it takes for the accumulated benefits to equal the initial investment. Obviously, the shorter the payback period, the sooner a profit is realized and the more attractive is the investment. The payback method is easy to calculate and allows two or more activities to be ranked. Like the net profit, though, it does not allow for the time value of money.

The payback period may be computed by the following formula:

Overall cost outlay    (A x B) + (C x D) Years + Installation time (G)

-----------------------=-------------------------------= -------------------------------

Annual cash return        5      +       2                     Years to recover

Elements of the formula:

(A) Capital investment (includes escalation costs)

(B) Investment credit (i.e., 1.00 - 0.08 = 0.92; must use current rate' 

(C) Cost investment (Le., site preparation-includes escalation)

(D) Company's federal income tax bracket

(E) State and local taxes

(F) Life of capital (expected)

(G) Time to install system 

(H) Benefits and savings

(1) Projects benefits (includes escalation)

(2) Depreciation (Capital investment - Salvage  :- Expected Life) 

(3) State and local taxes (percent)

(4) Benefits before FIT (federal income tax): (1) - (2) - (3) = (4)

(5) Benefits after FIT:.(4)  - [(4) x (D)]

Example of Calculation Elements

(A) Capital investment in a new computer                                      $200,000

(B) Investment credit difference (100% - 8% investment credit)                  92/

(C) Cost investment (site preparation)                                                      $ 25,000                                          

(D) Company’s income tax bracket difference                                               54%

(100% - 46%)

(E) State and local taxes                                                                                    2%

(F) Life of capital (no salvage value)                                                          5 years

(G) Time to install system                                                                           1 year  

(H) Benefits (include escalation or inflation)                                           $250,000                                   

Calculation

(1) Benefits before depreciation and taxes (H)

(2) (2) Less depreciation {$200,000(A)15[Life(FJJ}

(3) Less state and local taxes [$200,000 X O.OUE)]

(4) (4) Benefits before FIT

             Less tax difference ($206,000 x 0.46)

(5) Benefits after FIT

Formula calculation

{$200,000(A) x 0.92(B)} + {$25,000(C)x 0.54(D)}

---------------------------------------------------------------- =

           $111,240                +            $40,000

               (5)                                         (2)

                                                                                                                     197,500

                                                                                       ($184,000+13,500) or -------------

                                                                                                                           151,240

              $ 197,500

            ---------------= 1.3 years plus installation time (G)

                                = 2.3 years to recover investment

     2 years and 4 months is the payback period

Present Value Analysis

 In developing long-term projects, it is often difficult to compare today's costs with the full value of tomorrow’s benefits. As we have seen, the time value of money allows for interest rates, inflation, and other factor’s that alter the value of the investment. Furthermore, certain investments offer benefit periods that vary with different projects. Present value analysis controls for these problems by calculating the costs and benefits of the system in terms of today's value of the investment and then comparing across alternatives.

A critical factor to consider in computing present value is a discount rate equivalent to the forgone amount that the money could earn if it were invested in a different project. It is similar to the opportunity cost of tile funds being considered for the project.

Suppose that $3,000 is to be invested in a microcomputer for our safe posit tracking system, and the average annual benefit is $1,500 for the four-year life of the system. The investment has to be made today, whereas the benefits are in the future. We compare present values to future values by considering the time value of money to be invested. The amount that we are willing to invest today is determined by the value of the benefits at the end a given period (year). The amount is called the present value of the benefit.

To compute the present value, we take the formula for future value = P/(l + i) and solve for the present value (Pl as follows:

                                                               P = (1 + i)

So the  present value of $1,500 invested at 10 percent interest at the end of fourth year is:

                         1,500

                     --------------

                      (1 + 0.10)4

                 1,500 = $1,027.39

                 --------

                   1.61

That is, if we invest $1,027.39 today at 10 percent interest, we can expect to have $1,500 in four years. This calculation can be represented for each year where a benefit is expected.

Net Benefit Analysis

Net benefit analysis simply involves subtracting total costs from total benefits. ,It ,is easy to calculate, easy to interpret and easy to present. The main drawback is that it does not account for time value of money and doe~ not discount future cash flow. Cash flow amounts are shown for three time periods: Period 0 is the present period, followed by two succeeding periods. The negative numbers represent cash outlays. A cursory I the numbers show that the net benefit is $550.

The time value of money is extremely important in evaluation processes. Let us explain what it means. If you were faced with an opportunity that generates $3,000 a year, how much would you be willing to in Obviously, you'd like to invest less than the\$3,000. To earn the same ill five years from now, the amount of investment would 'be even less. Suggested here is that money has a time value. Today's dollar and to row's dollar are not the same. The time lag accounts for the time Val money.

The time value of money is usually expressed in the form of into the funds invested to realize the future value. Assuming compounded interest, the formula is:

where

F = Future value of an investment. 

P = Present value of the investment.

i = Interest rate per compounding period.

n = Number of years.

For example, $3,000 invested in Treasury notes for three years at 10 percent interest would have a value at maturity of:

                                  

F =. $3,000(1 + 0.10)

=1 = 3,000(1.33) 

=$3,993

Select Evaluation Method

When all financial data have been identified and broken down into categories, the analyst must select a method of evaluation. Several evaluation methods are available, each with pros and cons. The common methods are:

   1. Net benefit analysis.

   2. Present value analysis.

   3. Net present value. 

   4. Payback analysis.

   5. Break-even analysis. 

   6. Cash-flow analysis.

Savings Versus Cost Advantages

Savings are realized when there is some kind of cost advantage. A cost advantage reduces or eliminates expenditures. So we can say that a true savings reduces or eliminates various costs being incurred. In this installation, $131,870 was saved through a reduction in personnel, handling charges, and proof machine rental. After deducting processing charges of $90,990, the net savings fro the online system was $40,880. This is a savings that provides relief from current costs. It is realized specifically as a result of the additional processing costs incurred in the new system.

There are savings, however, that do not directly reduce existing costs. To illustrate, examine the following case:

A systems analyst designed an online teller system that requires 14 new terminals. No reduction in personnel is immediately planned. Renovation of the bank by and the teller cages will be required. The primary benefits are:

1. Savings in tellers' time to update accounts and post transactions. 

2.Faster access and retrieval of customer account balances.

3. Availability of, additional data for tellers when needed.

4. Reduction of transaction processing errors. 

5. Higher employee morale.

6.Capability to absorb 34 percent of additional transactions.

This is a case where no dollars can be realized as a result of the costs: Ted for the new installation. There might be potential savings if additional transactions help another department reduce its personnel. Similarly, management might set a value (in terms of savings) on the improved accuracy of teller activity, on quicker customer service, or on the psychological benefits from installing an online teller system. Given the profit motive, savings (or benefits) would ultimately be tied to cost reductions. Manage meant has the final say on how well the benefits can be cost-justified.

Direct Or Indirect Costs And Benefits

From a cost accounting t of view, costs are handled differently depending on whether they are or indirect. Direct costs are those with which a dollar figure can be direct associated in a project. They are applied directly to the operation. Example, the purchase of a box of diskettes for $35 is a direct cost because we can associate the diskettes with the dollars expended. Direct benefits also can be specifically attributable to a given project. For example a new system that can handle 25 percent more transactions per day is a direct benefit.

Indirect costs are the results of operations that are not directly associated with a given system or activity. They are often referred to as overhead. A system that reduces overhead realizes a savings. If it increases overhead, it incurs an additional cost. Insurance, maintenance, protection of the computer center, heat, light, and air conditioning are all tangible costs, but it is difficult to determine the proportion of each attributable to a specific activity such as a report. They are overhead and are allocated among users according to a formula.

Indirect benefits are realized as a by-product of another activity or system. For example, our proposed safe deposit billing system that provide profiles showing vacant boxes by size, location, and price, will help management -decide on how much advertising to do for box rental. Information about vacant boxes becomes an indirect benefit of the billing even though it is difficult to specify its value. Direct and indirect costs and benefits are readily identified for tangible costs and benefits, respectively.

Classifications Of Costs And Benefits

The next step in cost and benefit determination is to categorize cost and benefits. They may be tangible or intangible, direct or indirect, fixed or variable. Let us review each category.

Tangible or Intangible Costs and Benefits. Tangibility refers to the ease with which costs or benefits can be measured. An outlay of cash for a specific item or activity is referred to as a tangible cost. They are usually shown as disbursements on the books. The purchase of hardware or software, personnel training, and employee salaries are examples of tangible costs. They are readily identified and measured.

Costs that are known to exist but whose financial value cannot be accurately measured are referred to as intangible costs. For example, employee morale problems caused by a new system or lowered company image is an intangible cost. In some cases, intangible costs may be easy to identify but difficult to measure. For example, the cost of the breakdown at an online system during banking hours will cause the bank to lose deposit and waste human resources. The problem is by how much? In other cast intangible costs may be difficult even to identify, such as an improvement in customer satisfaction stemming from a real-time order entry system.

Benefits are also classified as tangible or intangible. Like costs, they are often difficult to specify accurately. Tangible benefits, such as campier jobs in fewer hours or producing reports with no errors, are quantifiable Intangible benefits, such as more satisfied customers or an improved carper rate image, are not easily quantified. Both tangible and intangible costs benefits, however, should be considered in the evaluation process.

Management often tends to deal irrationally with intangibles by ignoring them. According to oxenfeldt, placing a zero value on intangible benefits is wrong.1 Axel rod reinforces this point by suggesting that if intangible costs and benefits are ignored, the outcome of the evaluation may be quite different from when they are included. It indicates the degree of uncertainty surrounding the estimation costs and bet1efits. If the project is evaluated on a purely tangible basis, benefits exceed costs by a substantial margin; therefore, such a project is considered cost effective. On the other hand, if intangible costs and benefits included, the total tangible and intangible costs exceed the benefits, which makes the project an undesirable investment. Furthermore, including   all costs increases the spread of the distribution (compared with the tangible-only distribution) with respect to the eventual outcome of the project.

Costs And Benefits Identification

Certain costs and benefits are more easily identifiable than others. For example, direct costs, such as the price of a hard disk, are easily identified from company invoice payments or canceled checks. Direct benefits often relate one-to-one to direct costs, especially savings from reducing costs in the activity in question. Other direct costs and benefits, however, may not be well defined, since they represent estimated costs or benefits that have some uncertainty. An example of such costs is reserve for bad debt. It is c discerned real cost, although its exact amount is not so immediate.

A category of costs or benefits that is not easily discernible is opportunity costs and opportunity benefits. These are the costs or benefits forgone by selecting one-alternative over another. They do not show in the organization's accounts and therefore are not easy to identify.

Procedure For Cost/Benefit Determination

There is a difference between expenditure and investment. We spend to get what we need, but we invest to realize a return on the investment. Building a computer-based system is an investment. Costs are incurred throughout life cycle. Benefits are realized in the form of reduced operating costs, improved corporate image, staff efficiency, or revenues. To what extent benefits outweigh costs is the function of cost/benefit analysis.

Cost/benefit analysis is a procedure that gives a picture of the various costs, benefits, and rules associated with a system. The determination of costs and benefits entails the following steps:

   1. Identify the costs and benefits pertaining to a given project.

   2. Categorize the various costs and benefits for analysis.

   3. Select a method of evaluation.

   4. Interpret the results of the analysis.

   5. Take action.

Cost And Benefit Categories

In developing cost estimates for a system, we need to consider several cost elements. Among them are hardware, personnel, facility, operating, and supply costs.

1. Hardware costs relate to the actual purchase or lease of the computer and peripherals (for example, printer, disk drive, tape unit). Determining the actual cost of hardware is generally more difficult when various users than for a dedicated stand-alone system share the system. In some cases, the best way to control for this cost is to treat 'it as an operating cost.

2. Personnel costs include EDP staff salaries and benefits (health insurance, vacation time, sick pay, etc.) as well as pay for those involved in developing the system. Costs incurred during the development of a system are one-time costs and are labeled developmental costs. Once the system is installed, the costs of operating arid maintaining the system become recurring costs.

3. Facility costs are expenses incurred in the preparation of the physical site where the application or the computer will be in operation. This includes wiring, flooring, acoustics, lighting, and air conditioning. These costs are treated ac one-time -costs and are incorporated into the overall cost estimate of the candidate system.

4. Operating costs include all costs associated with the day-to-day operation of the system; the amount depends on the number of shifts, the nature of the applications, and the caliber of the operating staff. There are various ways of covering operating costs. One approach is to that operating cost as overhead. Another approach is to charge each authorized user for the amount of processing they request from the system. The amount charged is based on. Computer time, staff time, and volume of the output produced. In any case, some accounting is necessary to determine how operating costs should be handled.

5. Supply costs are variable costs that increase with increased use of paper, ribbons, disks, and the like. They should be estimated and included in the overall cost of the system.

A system is also expected to provide benefits. The first task is to identify each benefit and then assign a monetary value to it for cost/benefit analysis. Benefits may be tangible and intangible, direct or indirect, as we shall see later.

The two major benefits am improving performance and minimizing the crust of processing. The performance category emphasizes improvement in the accuracy of or access to information and easier access to the system by authorized users. Minimizing costs through an efficient system-error control or reduction of staff-is a benefit that should be measured and included in cost/benefit analysis.

Data Analyis

Data analysis is a prerequisite to cost/benefit analysis. System investigation and data gathering lead to an assessment of current findings. Our interest is in determining how efficiently certain steps are performed, how they contribute to achieving the intended goals, and the cost of making improvements. Let us return to our safe deposit scenario (from Chapter 4) to illustrate the point

This safe deposit department was authorized to double its capacity from 4,000 to 8,000 boxes in an effort to meet increased demand. Consequently, the number of employees changed from three to five, with one employee assigned full-time to billing. Analysis of the data collected made it obvi011S that customers were frequently billed too late, too often, or not at all. Access to customer information or status of vacant boxes was a nightmare. Customer lines were long, and service was jeopardized.

The representative facts for the safe deposit department are shown in such as the volume of work, nature of processes, physical facilities, and personnel. From the analysis, the system design requirements are identified. These features must be incorporated into a candidate system to produce the necessary improvements. The system requirements are:

1. Better customer service

 2.    Faster information retrieval.

 3.      Quicker notice accuracy.

 4.    Better billing accuracy.

5. Lower processing and operating costs.

 6.  Improved staff efficiency.

7. Consistent billing procedure to eliminate errors.

To achieve these design objectives, several alternatives must be evaluated, there is seldom just one alternative. The analyst then selects those that are feasible economically, technically, and operationally. The approach may emphasize the introduction of a computerized billing system, replacement of staff, improved billing practices, changes in operating procedures, or a combination of several options.

As you can imagine, each approach has its benefits and drawbacks. For example, one alternative is to introduce a computer-based safe deposit tracking and billing system designed to improve billing accuracy and notice preparation and lower processing and operating costs. It would also promote staff efficiency by allowing the existing staff to concentrate on customer service and provide online information on box availability and the like. The drawbacks include lying off the billing clerk who recently got married and strong resistance by the majority of the staff to a computerized environment.

Another alternative might be simply to devise a semiautomatic (ferries wheel type) system that organizes master cards and customer records and improves their access. A word processing system might be introduced to speed the preparation of billing notices. The edit feature of word processors would improve the accuracy in billing preparation. If these were the only two alternatives available, which alternative must be selected? An analysis of the costs and benefits of each alternative guides the selection process. Therefore, the analyst needs to be familiar with the cost and benefit categories and the evaluation methods before a final selection can be made. Details on these topics are given in the next section.