Evaluating Investments in Information Technology Shannon Crump December 9, 2002 ISM 6021

Pressures to Justify IT Initiatives Current economic climate places increased pressure on CIO’s to justify the high cost of IT initiatives The history of failed IT projects forces senior executives to evaluate the costs versus the benefits of IT endeavors - FoxMeyer Drug bankruptcy after $65M failed IT project - Dow Chemical scrapped a 7-year $500M IT initiative

Evaluating Investments in IT in Governmental Agencies The Office of Management and Budget Director (OMB) established guidelines for government agencies to evaluate IT initiatives -In 1996, executive agencies obligated $26M for IT initiatives and operations. -The President’s Management Agenda of 2002 calls for better use of IT in making the federal government more citizen- centered and results oriented. -Currently, agencies are assembling IT investment proposals for the FY 2004 President’s Budget. -Under OMB Guidelines, this process includes review of proposals by agency Chief Information Officers, IT Investment Review Boards, and senior leadership.

OMB Guidelines for Evaluating IT Initiatives The It investment process and agency designs should match the culture and organizational structure of the agency. The OMB lists three attributes critical to successful investment evaluation. 1- Senior management attention throughout the life of the IT project. 2- The overall mission focus is a critical attribute that links strategic planning to the agency’s goals and needs. 3- Comprehensive approach to IT investment

Three Phases of OMB Investment Process Selection - Screening of IT project proposals - Analyzing risks, costs and benefits - Prioritizing projects based on risk and potential return - Determining the right mix of projects to optimize agency system - Make the final cuts

Three Phases of OMB Investment Process Control - Monitoring projects or systems against the projected costs, schedule, and performance - Taking action to correct deficiencies - Proper control of IT investment costs allows senior management to identify risks by using a comparison of actuals versus expected during the life of the project; allows for adjustments

Three Phases of OMB Investment Process Evaluation - Conduct post implementation reviews, which are designed to compare actual results to the initial proposals in terms of cost, schedule, performance, and mission improvement. - Senior management team evaluates the project to determine the necessary adjustments and consider alternatives to the implemented system.

Issues in the Business Sector Increasing pressure to deliver benefits in a shorter timeframe. In current economic climate, CIO’s are expected to justify IT projects in quantitative terms. A survey in 2000 indicated that 80% of the 150 executives surveyed have been required to justify IT projects in terms of financial strength. CIO’s must develop ways of evaluating IT projects in terms of cost versus benefits

The Trouble with ROI in IT Project Planning IT represents an irreversible investment under uncertainty. IT projects cover a wide range of business applications. Lack of historical data for evaluation IT projects are commonly met with a number of changes during the life of the project. CIO’s are forced to continuously reevaluate and make changes to IT projects; these changes result in unpredictable costs in many cases

Option Pricing Methods OPM enables the analyzer to consider the potential of an IT project as a building block to future IT advancements. Follow-up projects are considerably less expensive, as the foundation has already been built and financed. Real options pricing models allow the user to value the benefit of management learning over time.

Concepts of OPM’s Operating flexibility and growth opportunities - The value of flexibility offered by the initial IT initiative offers management the option of engaging in future projects. - IT can provide access to new markets - The ability to realize technological advancements more rapidly and less costly allows an improved competitive position in the market. - IT initiatives can result in better adaptability to changing market demands and customer needs.

Option Pricing Method Calculation NPV is the amount of money an investment is worth, taking into account its cost, earnings, and the time value of money. Calculating traditional NPV only results in a loss on many IT projects, as the initial capital investment for a start up project is generally more considerable than follow-up projects with added benefits. IT projects expanded NPV = IT project’s traditional NPV + related option value

Time to Expiration In order to assign the value of option rights, the consideration of time to expiration is essential. Time to expiration is defined as the length of time between the acquisition of an option and its expiration. Options become obsolete as opportunities to add value expire.

Identifying the Optimal Time Ideally, companies want to use up as much of the time to expiration as possible, as this gives managers more time to evaluate the most optimal technological moves in a rapidly changing IT environment. Unfortunately, the opportunity cost of prolonging the next initiative can force firms to move quickly. The goal of the organization is to determine the best ways to evaluate the optimal time and strike a balance between opportunity costs and option value over time.

Problems in Financial Models Used for IT Project Analyses Capital outlay for IT endeavors is substantial, while benefits are realized in future periods Investment costs can be measured quantitatively, as they are tangible Difficulty exists in measuring benefits quantitatively, as they are intangible Rapidly changing technology results in numerous changes over the life of an IT project - estimates tend to vary with numerous changes - changes make investment predictions complex and difficult to measure