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Chapter 14
Information Technology For Management 6
th
Edition
Turban, Leidner, McLean, Wetherbe
Lecture Slides by L. Beaubien, Providence College
Revised by: A.C. Stylianou
John Wiley & Sons, Inc.
Information Technology
Economics
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Learning Objectives
Identify the major aspects of the economics of
information technology.
Explain and evaluate the productivity paradox.
Describe approaches for evaluating IT
investment and explain why is it difficult to do it.
Explain the nature of intangible benefits and the
approaches to deal with it.
List and briefly describe the traditional and
modern methods of justifying IT investment.
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Learning Objectives (Continued)
Identify the advantages and disadvantages of
approaches to charging end users for IT services
(chargeback).
Identify the advantages and disadvantages of
outsourcing.
Describe the economic impact of EC.
Describe economic issues related to Web-based
technologies including e-commerce.
Describe causes of systems development failures,
the theory of increasing returns, and market
transformation through new technologies.
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Moores Law
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Computing Power vs. Benefits
What does growth in computing power mean
in economic terms?
First, most organizations will perform
existing functions at decreasing costs over
time and thus become more efficient.
Second, creative organizations will find new
uses for information technologybased on
the improving price-to-performance ratio
and thus become more effective.
What is the payoff from IT investments?
How can it be measured?
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We need to evaluate
the productivity
the benefits
the costs
other economic aspects of information
technology
Computing Power vs. Benefits (cont.)
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Productivity - One measure
Productivity is a ratio that measures
outputs versus inputs. It is calculated by
dividing outputs by inputs.
On a company by company basis major
benefits from information technology
investments have been shown. However,
it is very hard to demonstrate, at the
level of a national economy, that the IT
investments have really increased
outputs or decreased inputs.
The discrepancy between measures of
investment in information technology
and measures of output at the national
level has been called the productivity
paradox.
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Productivity - One measure (cont.)
Does the Productivity Paradox
Matter?
Individual organizations are not so
interested in the effect on the
economy as a whole.
Impact on individual organization has
much to do with how IT is
administered, with good planning,
more effective management.
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IT Investment Organizational
Performance: An Indirect
Relationship
Intermediary factors mediate the relationship.
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Importance of Evaluation
Almost 50% of capital investment in the US is
in IT. This number is growing.
In order to get the most out this investment,
organizations need to properly manage it.
This includes measuring benefits and costs
and controlling ineffective or risky
investments.
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IT Investment Categories
Distinguishing between investments in
infrastructure and investments in specific
applications can assist the analysis.
IT infrastructure, provides the foundations for IT
applications in the enterprise (data center, networks,
date warehouse, and knowledge base). Investments
in infrastructure are long-term investments shared
by many applications throughout the enterprise.
IT applications, are specific systems and programs
for achieving certain objectives (payroll, inventory
control, order taking). The large number of
applications and the fact that some are shared by
several departments, makes evaluation of their costs
and benefits complex.
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Value of Information
One measurement of the benefit of an investment is
the value of the information provided.
The value of information is the difference between the
net benefits (benefits adjusted for costs) of decisions
made using information and the net benefits of
decisions made without information.
Value of information = Net benefits with information - Net benefits without information
A Capital Investment Decision
Decision to automate is a capital investment
decision. Can use traditional evaluation
methods:
ROI
NPV
IRR
Payback Period
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Costing IT Investments
Placing a dollar value on the cost of IT investments is not a simple
task. One of the major issues is to allocate fixed costs among
different IT projects. Fixed costs are those costs that remain the
same in total regardless of change in the activity level.
Another area of concern is the Life Cycle Cost; costs for keeping it
running, dealing with bugs, and for improving and changing the
system. Such costs can accumulate over many years, and
sometimes they are not even anticipated when the investment is
made.
There are multiple kinds of values (tangible and intangible)
improved efficiency
improved customer relations
the return of a capital investment measured in dollars or
percentage
many more
Probability of obtaining a return depends on probability of
implementation success
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A Probabilistic/Opportunity Analysis
Examine Potential Benefits
Sales
Transaction, subscription, advertising,
affiliate fees
Globalization
Value-added services/content
Reduction in transaction costs: search
costs, information costs, negotiation costs,
decision costs, monitoring costs
Reducing risk by providing better quality
information
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Evaluating Intangible Benefits
IT projects generate intangible benefits
such as increased quality, faster product
development, greater design flexibility,
better customer service, or improved
working conditions for employees.
These are very desirable benefits, but it is
difficult to quantify them with a monetary
value.
Intangible benefits can be very complex and
substantial.
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Make rough estimates of monetary values for
all intangible benefits, and then conduct a
NVP or similar financial analysis.
Scoring Matrix or Scorecard
Evaluating Intangible Benefits (cont.)
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Sawhneys (2002) suggestions:
Think broadly and softly.
Supplement hard financial metrics with soft ones
(perhaps more strategic in nature; e.g., customer
satisfaction)
Pay your freight first.
Think carefully about short-term benefits that can
pay the freight for the initial investment in the
project.
Follow the unanticipated.
Keep an open mind about where the payoff from
IT and e-business projects may come from.
Evaluating Intangible Benefits (cont.)
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Business Case Approach
One method used to justify investments in
projects is referred to as the business case
approach.
A business case is a written document used
by managers to garner funding for specific
applications or projects.
Its major emphasis is the justification for the
required investment.
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The business case
provides the bridge between the initial plan
and its execution.
provides the foundation for tactical decision
making and technology risk management.
helps to
clarify how the organization will use its resources
justify the investment
manage the risk
determine the fit of an IT project with the organizations
mission
Business Case Approach (cont.)
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A Business Case for IT Investment
Five Parts
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Evaluating IT Investment
Conclusion: IT investment decisions
pose different problems from traditional
capital investment decisions.
However, even though the relationship
between IT benefits and performance
may not be clear, some investments
should be better than others.
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IT Investment appraisal methods are
categorized into the following four types.
Financial (NPV & ROI) methods consider
only impacts that can be monetary-valued.
They focus on incoming and outgoing cash
flows.
Multicriteria (Information economics and
Value analysis) appraisal methods consider
both financial impacts and non-financial
impacts that cannot be expressed in monetary
terms. These methods employ quantitative
and qualitative decision-making techniques.
Methods for Evaluating and Justifying
IT Investment
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Ratio (IT expenditures vs. total turnover)
methods use several ratios to assist in IT
investment evaluation.
Portfolio methods apply portfolios (or
grids) to plot several investment
proposals against decision-making
criteria.
Methods for Evaluating and Justifying
IT Investment
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Costing IT Economic Strategies
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Total Cost of Ownership
TCO is a formula for calculating the cost of owning,
operating, and controlling an IT system. The cost
includes:
acquisition cost (hardware and software)
operations cost (maintenance, training,
operations, )
control cost (standardization, security, central
services)
Can also compute total benefits of ownership
(tangible and intangible) and compare to TCO.
The following evaluation methods are
particularly useful in evaluating IT
investments.
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Information economics is an approach
that focuses on key organizational
objectives, including intangible benefits.
Information economics incorporates the
familiar technique of scoring
methodologies, which are used in many
evaluation situations.
Specific Evaluation Methods (cont.)
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A scoring methodology evaluates
alternatives by assigning weights and
scores to various aspects and then
calculating the weighted totals. The analyst:
1. Identifies all the key performance issues
2. Assigns a weight to each one
3. Each alternative in the evaluation receives a
score on each factor, usually between zero
and 100 points, or between zero and 10.
4. These scores are multiplied by the weighting
factors and then totaled. The alternative with
the highest score is judged the best.
Specific Evaluation Methods (cont.)
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It is much more difficult to evaluate infrastructure
investment decisions than investments in specific
IS application projects. Since many of the
infrastructure benefits are intangible and are
applicable to different present and future
applications.
One method to assess infrastructure investments
is the use of Benchmarks - objective measures of
performance. These measures are often available
from trade associations or from consulting firms.
Specific Evaluation Methods (cont.)
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Metrics are measurable standards against which
actual performance can be compared. For
example:
IT expenses as percent of total revenues
percent of downtime (time when the computer is
unavailable)
CPU usage as a percentage of total capacity
percentage of IS projects completed on time and
within budget.
Percentage of IT budget within the corporate budget.

Specific Evaluation Methods (cont.)
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A new approach for evaluating IT investments is to
recognize that they can increase an organizations
performance in the future.
Instead of using only traditional measures like NPV
to make capital decisions, financial managers look
for opportunities that may be embedded in capital
projects. These opportunities, if taken, will enable
the organization to alter future cash flows in a way
that will increase profitability. These opportunities
are called real options.
Specific Evaluation Methods (cont.)
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Common types of real options include:
the option to expand a project (so as to capture
additional cash flows from such growth)
the option to terminate a project that is doing
poorly (in order to minimize loss on the project)
the option to accelerate or delay a project.
Specific Evaluation Methods (cont.)
Real Option Valuation of IT Investment
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The balanced scorecard method evaluates the
overall health of organizations and projects. It
advocates that managers focus not only on short-
term financial results, but also on four other areas:
finance, including both short- and long-term
measures
customers (how customers view the organization)
internal business processes (finding areas in which
to excel)
learning and growth (the ability to change and
expand)
Specific Evaluation Methods (cont.)
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Activity-based costing (ABC) views the
value chain and assigns costs and
benefits based on the activities.
Expected Value Analysis (EV) estimates
possible future benefits by multiplying
the size of the benefit by the probability
of its occurrence.
Specific Evaluation Methods (cont.)
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Costing IT Economic Strategies
In addition to identifying and evaluating
the benefits of IT, firms need to account
(track) for its costs.
Accounting systems should
provide an accurate measure of total IT
costs for management control.
charge users for shared IT investments
and services in a manner that is
consistent with the achievement of
organizational goals.
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Two strategies for costing of IT services:
ISD is an unallocated cost center
All expenses go into an overhead account. With this
approach IT is free and has no explicit cost, so
there are no incentives to control usage or avoid
waste.
Chargeback
Cost recovery is an approach where all IT costs are
allocated to users as accurately as possible, based
on actual costs and usage levels.
Behavior-Oriented Chargeback set IT service
costs in a way that meets organizational objectives
not necessarily corresponding to actual costs.
Costing IT Economic Strategies (cont.)
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Outsourcing - strategy for obtaining the
economic benefits of IT and controlling its costs
by obtaining IT services from outside vendors
rather than from internal IS units within the
organization
Offshore outsourcing
ASPs and Utility Computing. Application service
provider (ASP) manages and distributes
software-based services and solutions from a
central, off-site data center, via the Internet.
Costing IT Economic Strategies (cont.)
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Outsourcing Risks
Vendor underperformance, overbilling
Poaching the application developed for you
is also sold to others
During contract, vendor changes financial
terms or re-prices services
Loss of control over IT decisions
Loss of critical IT skills
Vendor lock-in
Loss of control over data
Loss of employee morale and productivity
Hidden costs
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Outsourcing Strategies
Understand the project
Divide and conquer smaller more
manageable pieces reduce risk
Align incentives with accurately measured
performance
Write short-term contracts or have
negotiating provisions for revisions where
necessary
Control subcontracting
Do selective outsourcing e.g., not strategic
applications
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Cost Reduction
Comparison between regular & digital products
For regular products, increased quantity beyond a certain point,
requires increased overhead and marketing costs.
Variable cost for digital products is very small
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Economic Effects of EC
It can shift economic curves even for non-digital products.
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Web-based Systems
Economic Strategies
Web-based systems can increase productivity and
profitability considerably. However, the justification of EC
applications can be difficult. Usually one needs to prepare a
business case that develops the baseline of desired results,
against which actual performance can and should be
measured. The business case should also cover both the
financial and non-financial performance metrics against
which to measure the e-business implementation and
success.
Many decisions to invest in Web-based systems are based on
the assumption that the investments are needed for
strategic reasons and that the expected returns cannot be
measured in monetary values.
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IT Failures
Information technology is difficult to manage and
can be costly when things do not go as planned. A
high proportion of IS development projects either
fail completely or fail to meet some of the original
targets for features, development time, or cost.
Many of these are related to economic issues,
such as an incorrect cost-benefit analysis.
The economics of software production suggest that,
for relatively standardized systems, purchasing or
leasing can result in both cost savings and increased
functionality. Purchasing or leasing can also be the
safest strategy for very large and complex systems.
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MANAGERIAL ISSUES
Constant growth and change. The power of the
microprocessor chip doubles every two years, while
the cost remains constant. This ever-increasing power
creates both major opportunities and large threats as
its impacts ripple across almost every aspect of the
organization and its environment. Managers need to
continuously monitor developments in this area to
identify new technologies relevant to their
organizations, and to keep themselves up-to-date on
their potential impacts.
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Shift from tangible to intangible benefits. Few
opportunities remain for automation projects that
simply replace manual labor with IT on a one-for-one
basis. The economic justification of IT applications will
increasingly depend on intangible benefits, such as
increased quality or better customer service. In
contrast to calculating cost savings, it is much more
difficult to accurately estimate the value of intangible
benefits prior to the actual implementation. Managers
need to understand and use tools that bring intangible
benefits into the decision-making processes for IT
investments.
MANAGERIAL ISSUES (cont.)
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Not a sure thing. Although IT offers
opportunities for significant improvements in
organizational performance, these benefits are
not automatic. Managers need to very actively
plan and control implementations to increase the
return on their IT investments.
MANAGERIAL ISSUES (cont.)
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Chargeback. Users have little incentive to control
IT costs if they do not have to pay for them at all.
On the other hand, an accounting system may
allocate costs fairly accurately to users but
discourage exploration of promising new
technologies. The solution is to have a chargeback
system that has the primary objective of
encouraging user behaviors that correspond to
organizational objectives.
MANAGERIAL ISSUES (cont.)
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Risk. Investments in IT are inherently more
risky than investments in other areas. Managers
need to evaluate the level of risk before
committing to IT projects. The general level of
management involvement as well as specific
management techniques and tools need to be
appropriate for the risk of individual projects.
MANAGERIAL ISSUES (cont.)
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Outsourcing. The complexities of managing IT,
and the inherent risks, may require more
management skills than some organizations
possess. If this is the case, the organization may
want to outsource some or all of its IT functions.
However, if it does outsource, the organization
needs to make sure that the terms of the
outsourcing contract are in its best interests both
immediately and throughout the duration of the
agreement.
MANAGERIAL ISSUES (cont.)
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Increasing returns. Industries whose primary
focus is IT, or that include large amounts of IT in
their products, often operate under a paradigm
of increasing returns. In contrast, industries that
primarily produce physical outputs are subject to
diminishing returns. Managers need to
understand which paradigm applies to the
products for which they are responsible and
apply management strategies that are most
appropriate.
MANAGERIAL ISSUES (cont.)
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Chapter 14
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