© 2004 Managing the Information Technology Resource, Jerry N. LuftmanChapter 14 - Slide 1 Chapter 14 Assessing the Value of IT Managing the Information Technology Resource Jerry N. Luftman

© 2004 Managing the Information Technology Resource, Jerry N. LuftmanChapter 14 - Slide 2 Chapter Outline Importance of assessing IT value Traditional financial measures to show value Applying improved financial measure Evaluating portfolio of IT investment projects Activity-based management Difference between showing value and measuring value Leveraging assets of IT for competitive advantage How IT governance is shared responsibility How enterprise can benefit from processes

© 2004 Managing the Information Technology Resource, Jerry N. LuftmanChapter 14 - Slide 3 Traditional Financial Approaches Return on Investment (ROI) –Net Earnings from Operations ÷ Net Assets –Used to asses value of IT investments –Has limitations Residual Income –Similar to measure of excess profit –Operating Income ÷ Financial Opportunity Cost of Investment base

© 2004 Managing the Information Technology Resource, Jerry N. LuftmanChapter 14 - Slide 4 Traditional Financial Approaches Economic Value Added (EVA) –Uses capital asset pricing model –Identifies cost of capital for specific division or business unit –Removes distortions to investments decision by GAAP –Expenditures should be capitalized and amortized Net Present Value (NPV) –Firm chooses between alternative investment opportunities to advance market value –Evaluate projects based on measurable cash flows

© 2004 Managing the Information Technology Resource, Jerry N. LuftmanChapter 14 - Slide 5 Real Options Decision to pursue investment project can be deferred for period of time Opportunity to create IT investment at future time Mapping five characteristics of investment opportunity Reduce uncertainty by deferring decision Interest income can be earned during deferral period Ability to react to changing uncertain conditions during deferral period by altering investment decisions

© 2004 Managing the Information Technology Resource, Jerry N. LuftmanChapter 14 - Slide 6 Mapping IT Investment Characteristics to Financial Call Option Characteristics Source: adapted from Luerhrman, T.A., Capital Projects as Real Options: An Introduction, Harvard Business School Teaching Note (1994).

© 2004 Managing the Information Technology Resource, Jerry N. LuftmanChapter 14 - Slide 7 Decision Tree Analysis Capable of accounting for firm’s revisions of strategies and operations under uncertainty Probabilities derived from past information or future information that can be obtained Management chooses alternative that maximizes risk-adjusted NPV

© 2004 Managing the Information Technology Resource, Jerry N. LuftmanChapter 14 - Slide 8 Source: adapted from Luehrman, T.A., Capital Projects as Real Options: An Introduction, Harvard Business School Teaching Note (1994). Decision Tree Analysis vs. Real Option Analysis

© 2004 Managing the Information Technology Resource, Jerry N. LuftmanChapter 14 - Slide 9 Black-Scholes Model for European Call Option V c = N(d 1 ) PV (assets to be acquired) – N(d 2 ) (PV(expenditure)/e f rt

© 2004 Managing the Information Technology Resource, Jerry N. LuftmanChapter 14 - Slide 10 Real Option Valuation of Individual Investment Traditional financial analysis of investment projects has shortcomings –Parker, Benson, Trainor

© 2004 Managing the Information Technology Resource, Jerry N. LuftmanChapter 14 - Slide 11 Buss Framework for Individual Investment Investment projects ranked for 4 criteria: –financial benefits –intangible benefits –technical importance –fit with business objectives Each criterion comprised of relevant elements Each element scored for IT investment project and total score derived Sum obtained across four criteria used to compare IT investment against competing projects

© 2004 Managing the Information Technology Resource, Jerry N. LuftmanChapter 14 - Slide 12 Oracle Corp. Decision Model Create committee of stakeholders affected by IT investment Define intangible benefits of IT investment Define intangible risks associated with IT investment Establish weights to relative importance of tangible benefits Estimate on scale of zero to five the likelihood of each benefit and risk observed Multiply likelihood estimate by weight established for factor and add up products

© 2004 Managing the Information Technology Resource, Jerry N. LuftmanChapter 14 - Slide 13 Real Options Analysis Build consensus among participants in IT investment decisions They couple financial calculations with intangible benefits and risks, aspects of strategic concern

© 2004 Managing the Information Technology Resource, Jerry N. LuftmanChapter 14 - Slide 14 “Tomato Garden” of IT Investment Project Source: adapted from Luehrman, T.A., 1998b “Strategy as a Portfolio of Real Options,” Harvard Business Review, September-October (1998).

© 2004 Managing the Information Technology Resource, Jerry N. LuftmanChapter 14 - Slide 15 Evaluating IT Investment Portfolio Ensure IT investment proposals are understood in terms of expected business outcomes, efforts needed to reach outcomes, and risks involved Ensure IT investments will advance value of firm Ensure risks associated with IT investments are in line with acceptable risk profile Ensure IT investments are aligned with business strategies

© 2004 Managing the Information Technology Resource, Jerry N. LuftmanChapter 14 - Slide 16 Trigeorgis’ Framework Objective of value management refers to broad measure of NPV Strategic NPV = Traditional NPV of expected cash flows + Value of operating options from flexible management + Investment interaction effects Strategic management of investments requires management of collection of future investment opportunities and options Appropriate control targets are necessary for effective implementation of value-maximizing approach

© 2004 Managing the Information Technology Resource, Jerry N. LuftmanChapter 14 - Slide 17 3 Phases of Trigeorgis’ Framework

© 2004 Managing the Information Technology Resource, Jerry N. LuftmanChapter 14 - Slide 18 Activity-Based Management Measures Activity-based costing –Methodology that measures cost and performance of activities, resources, and cost objects Activity-based management –Discipline that focuses on the management of activities as the route to improving value received by the customer and profit achieved by providing this value

© 2004 Managing the Information Technology Resource, Jerry N. LuftmanChapter 14 - Slide 19 TCO and TBO Concepts Total Cost of Ownership (TCO) –Acquisition cost of materials is only portion of true costs of a product or process Total Benefit of Ownership (TBO) –Considers benefits of competing products or processes instead of just focusing on individual costs

© 2004 Managing the Information Technology Resource, Jerry N. LuftmanChapter 14 - Slide 20 TCO Analysis Concerns Addressed Provide predictable costs and level budgets Determine which IT resources can be applied to firm’s core mission How to determine current costs and services How to increase service levels at affordable cost How to track or recognize actual ongoing IT costs How to find cost-effective way of improving IT expertise How to determine most effective implementation strategy to improve effective/efficient delivery of IT

© 2004 Managing the Information Technology Resource, Jerry N. LuftmanChapter 14 - Slide 21 Differentiating Features of TVO Approach IT and business management must work together Firm needs to move from pure cost center perspective to one emphasizing value creation Managers must evaluate and manage collection or portfolio or projects

© 2004 Managing the Information Technology Resource, Jerry N. LuftmanChapter 14 - Slide 22 Resources for More Methodologies Applied information economics – Balanced scorecard – – Economic value added –

© 2004 Managing the Information Technology Resource, Jerry N. LuftmanChapter 14 - Slide 23 Resources for More Methodologies Economic Value Sourced – Portfolio management – – Real option valuation –

© 2004 Managing the Information Technology Resource, Jerry N. LuftmanChapter 14 - Slide 24 Value Management Framework Examples

© 2004 Managing the Information Technology Resource, Jerry N. LuftmanChapter 14 - Slide 25 Application of Expanded Value Management Framework

© 2004 Managing the Information Technology Resource, Jerry N. LuftmanChapter 14 - Slide 26 Governance Is Shared Responsibility IT and business managers need to work together Combined application of: –Real options –Value management –Portfolio analysis as tools –Metrics –Indicators

© 2004 Managing the Information Technology Resource, Jerry N. LuftmanChapter 14 - Slide 27 Enterprise Can Benefit from Processes IT work adds value to business Ongoing process that continues to evolve and change All units must work toward same strategic goals of firm Combination of financial measures, nonfinancial measures, and partnerships leveraging IT assets Encourage staff to embrace practices