1 Cost Analysis Yale Braunstein School of Information Management & Systems

2 How does this course differ from all other project-related courses at SIMS? We explicitly look at alternatives. We care about economic feasibility. [others ?]

3 Why do we want to know costs? We need to measure and understand costs –To help the organization Operate efficiently & effectively Allocate scarce resources Choose between competing projects –To meet legal & organizational requirements

4 General introduction to our approach Identify opportunities & alternatives for meeting them Agree on selection/evaluation criteria Apply the criteria Make choices/decisions and monitor results A nine-step, more detailed approach is on the web and in the handout. A complete manual is available in the computer lab.detailed approach

5 Special problems with new technologies New technologies, in general, and IT, in particular, often cause problems –Exact costs are unknown/unknowable –Only some benefits are quantifiable –New technology projects can change the organization, its outputs, etc.

6 Costing terms Costs are misleadingly concrete. It is important to understand: –Allocated vs. out-of-pocket costs –Sunk costs –Opportunity costs –Fixed, variable & total costs –Joint costs –Marginal or incremental costs Consistency is VERY important

7 Costs depend on your perspective Department costs vs. project costs Current costs vs. future costs; upfront costs vs. continuing costs; etc. –(More on this later) For public projects: CTA, CTG, CTN

8 Costs vs. Prices We need to distinguish between costs and prices –Energy in California ! –DSL (component-by-component) “Fully distributed costs” or “allocated costs” are very popular and can easily mislead –The leased-line anecdote…a true story of faulty economic logic in a major university

9 Where to Get Cost Information Statistical studies Engineering studies –Simulations –Bills of Materials Comparables –Case studies –Previous experience (at your organization & elsewhere)

10 Additional considerations We do a sensitivity analysis to identify those factors that have the major impacts on costs Try to understand the issues relating to economies of scale and scope. –Computer automation in publishing example –See Morton * : IT potentially increases productivity by lowering transaction costs…if you reorganize work. * Michael Scott Morton, “How Information Technologies can Transform Organizations,” in Rob Kling, Editor, Computerization and Controversy (San Diego: Academic Press 1996)

11 Cost-benefit analysis We distinguish between cost-benefit analysis and cost-effectiveness analysis –In CBA, both costs and benefits are measured in dollars –In CEA, only the costs are measured in dollars; we use non-monetary measures for the benefits Examples: increased reliability, reduced lag times

12 Time value of money General rules: –Dollars spent at different times have different costs to the organization –Dollars received at different times have different values to the organization –Therefore, we need to explicitly account for timing of cash flows (in & out) We “discount” future flows to the present to obtain their “present value”

13 Calculating PVs Logic: Take each year’s cash flow and “discount” it back to the present using the “discount rate” See spreadsheet with examplesspreadsheet with examples

14 Three ways to compare projects Payback period – NEVER use this Internal rate of return – very common, but has problems –One: assumption about re-investment –Two: multiple solutions possible –Three: (most important) can lead to incorrect choices with MX projects Net present value – the preferred approach

15 Review: General principles 1.Focus on total costs OR incremental costs, whichever is appropriate Are we introducing something entirely new or a change in an existing system? 2.Comparability of data is important Timing matters Have similar start & end points 3.Know what is in and what is out

16 Using the principles Sunk costs are sunk – ignore them You need to know the purpose of the analysis –Planning for the future vs. benchmarking current operations Forecasting & Projections –Know what is changing