Chapter 18 Economy of Information Systems · direct costs can be greatly reduced if a company goes for current rental solutions, such as Cloud ... Chapter 18 * Economy of Information

Chapter 18 * Economy of Information Systems * Bob Travica ©

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Chapter 18

Economy of Information Systems Information systems (IS) are the engines of business. The power they provide has to be continually assessed. How much do IS cost? What are the returns that IS contribute to? These basic questions pinpoint essential economic logic behind IS. To get the answers, one needs to understand costs and benefits associated with various IS. Some items can be expressed in monetary terms (tangibles), while others are not readily or ever transferable to such terms (intangibles). Cost/benefit analysis sets the basis for applying various models for valuing economy of IS. All these concepts are discussed in the chapter. You will also learn about different methods of acquiring the software and hardware used in IS. As it makes references to examples of IS and business processes discussed in preceding chapters, this chapter is a way of summarizing the previous discussion. Economic aspects of IS (IS economy) are assessed in system planning and during its production stage. The production stage assessments are carried regularly on the annual basis. Although a financial perspective is in the centre of these assessments, managers also looks at intangible aspects, such as the contribution of a system to employees’ morale. The cost/benefit analysis is a necessary component in any assessment of IS economy. Costs and benefits can be tangible (expressed in monetary terms) or intangible (not expressed directly in monetary terms). The character of costs and benefits determines the methods of analysis. For the analysis of tangibles, analysts and managers usually use capital budgeting methods focused on the size of financial returns from an IS, or on the returns’ timing. Intangible costs and benefits are accounted for in mixed methods, along with appropriate tangibles. Two methods described in this chapter are portfolio analysis, and the balanced scorecard.

Tangible Costs Tangible costs of an IS are generated in direct investment in the system development as well as recurring costs during the system’s actual use. Some of the standard costs are:


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Direct investments in software and hardware

IS installation and employee training

Operating costs

Productivity loss and opportunity cost with underperforming IS.

Direct investments are made when an IS is developed. The software must be created, purchased, licenced, or rented. Different acquisition methods can be used for the same system (more below). Hardware is usually purchased, but rental options are also available. The initial direct costs can be greatly reduced if a company goes for current rental solutions, such as Cloud Computing services (more discussion below). To install an IS, facilities for the equipment should be arranged. This is another cost item. Then, employees have to be trained, and cost for that absorbed as well. Operating costs have to be covered throughout the life cycle of an IS. Therefore, these are recurring costs. Typical cost items are the pay for IS staff, IS maintenance, overhead for the facilities housing the equipment, data transfer costs (operational costs of a corporate network or costs of renting communications lines). Note that some of the system development costs are recurring costs too, such as software licencing costs and various rental options for software and hardware. A system that does not perform as expected generates costs measured by a drop in productivity and opportunity costs. A typical example of opportunity costs is the business time loss when IS users troubleshoot the system instead of performing the expected work with it. This may happen in the early stages of IS use. When the economic side of an IS is being planned, it is important to estimate as closely as possible the total cost of ownership (TCO). TCO is the sum of all monetary costs from the initial planning of a system through its development, during the system use, and to the very end-point of disposing the hardware. As the compounds used in micro-electronic components contain some pollutants, hardware must be deposited via particular legal procedures that incur certain costs. This cost item will grow in importance and size over time. Coming up with a TCO figure helps to avoid making unsound investment decisions and falling into a budget crunch. Hidden costs create challenges in assessing TCO, so the assessor has to deal with probabilities and flexible margins.

Intangible Costs Intangible costs are not measured in dollars or other monetary terms. However, if some of the intangible costs are prolonged, they may turn into tangible costs. So, some costs that first appear as intangibles may eventually become tangible expenses. Here are more important intangible costs:


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Learning effort

Motivation loss

Resistance to new IS/processes

Loss of external customer’s satisfaction due to underperforming IS

Limitations in decision making due to underperforming IS.

The effort of learning how to use a new IS and to perform the associated business process is an intangible cost. The learning effort is about a mental strain and investment, and it should be differentiated from the tangible cost of training. Employees may experience some loss of motivation as they are being made to switch to new systems and processes. This loss shows up first as an intangible cost. But if negative attitudes toward the innovation cause a drop in productivity of a significant number of employees, then tangible costs would eventually surface. The late majority of system adopters at first resist accepting new systems and associated processes. With the parallel system deployment this resistance equals to a lower system acceptance rate, while operations may not suffer much. But if the system deployment is direct, then the resistance shows up as a tangible cost of productivity loss. A loss of an external customer’s satisfaction can be a consequence of an improperly performing IS. This is obvious with systems supporting processes that have an external customer (both institutional and individual). Example processes are sales, customer relations, delivery logistics, and financial accounting. This cost is indicated in a diminished goodwill. In B2C e-commerce, due to vastly increased retail offerings, diminished goodwill can promptly turn to a loss in sales – a tangible cost. If a system cannot create outputs needed for effective decision making, then limitations in a decision making process become a cost item. Since the path between a decision and the financial performance is usually not straightforward, these limitations can for long be considered an intangible cost. The implication is that a company may not know how much limited decisions do really cost.

Tangible Benefits

Tangible benefits of IS are the most evident in savings. These are some of the usual saving benefits:

Labor cost savings

Labor cost avoidance

Process time savings.


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As automation substitutes for manual labor, savings on labor costs are normally associated with new IS. These happen both in the service and manufacturing sector. Exceptions may happen when new systems are used just to turn paper trail into the electronic without changing process design. New, well-designed TPS usually have a capacity to support an increased volume of operations. This scaling up capability makes it possible to avoid adding more employees proportionally to the business growth, which is usually necessary with paper trail or with older IS. Thus, labor cost avoidance represents a substantial tangible benefit from IS. When a new IS is properly planned and designed, the underlying process is optimized in design, which in turn reduces process time. System speed and other non-functional characteristics also contribute to reducing process time. In the case of inventory process, the saved time reflects on a quicker turnover of the inventory, which may reduce expenses for the interest paid for loans invested in the inventory (e.g., the raw materials in manufacturing, or the purchased goods in wholesale). Additional tangible benefits from IS are:

Organizational performance gains

Better decision making resulting in income increase

Cutting losses by improved management control. Organizational performance gains are visible with the model which was introduced in Chapter 5 and depicted in Figure 1. When business processes are improved with IS, the organizational

productivity can increase. In turn, financial results improve and in particular those related to investments in IS. For example, the cost/benefit ratio decreases, where the numerator reflects costs of IS development and operations, while the denominator reflects the income increase attributed to the processes. For example, a production process executes with a higher productivity thus generating a bigger gross income. This is the case in capital intensive areas, such as manufacturing.

Figure 1. Organizational performance gains with IS

DSS enable decision making that can result in income increase. Examples were discussed in Chapter 9 in the context of product markets and cross selling.


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Improved management control with IS helps to cut direct losses. An example previously discussed involved a new ERPS that helped in detecting fraudulent purchasing transactions (see Chapter 13). Finally, when a TPS helps to reduce data entry and processing errors, there is no need to repeat the same activities and to waste business time and labour. (This benefit was addressed while discussing the electronic format in Chapter 2.)

Intangible Benefits

Intangible benefits from IS are as follows:

Customer satisfaction with no immediate financial gain

Better control and decision making with no immediate financial gain

Document appearance improvement

Increased knowledge capabilities. As studied previously, customer value is a measure of business process performance. Customer value can be many things. One such thing managers continually pay attention to is customer satisfaction. A better business process that serves an external customer can increase

satisfaction of that customer. This principle is the mirror image of the intangible cost mentioned above that a drop in the external customer’s satisfaction can be a consequence of an improperly performing IS. In the case of increased satisfaction, the challenge is to understand subjective reasons behind the satisfaction. Another part of challenge is to transform the increased satisfaction to a tangible benefit. For example, a customer service process that efficiently responds to a customer’s needs certainly makes a happier customer. A happier customer is a retained, loyal customer. But customer loyalty does not increase financial returns unless it motivates an increase in spending. If that really happens, then the company hosting the improved customer service IS/process reaps a tangible benefit. These relationships are depicted in Figure 2.

Figure 2. Intangible and tangible benefits of customer satisfaction


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Better control and decision making with DSS, MIS, TPS and ERPS may not always translate into monetary gains. For example, a system for tracking employees’ expenses enables executives to tighten up control over budget spending. But this control gain does not translate into money making. In fact, there is evidence of one such system that was simply put atop of the old expense tracking process. Since it was difficult to use, the system actually created the opposite effect – a loss in employees’ productivity and notable opportunity costs due to the troubleshooting time and repetition of the same steps. Improvements in IS are associated with improvements in the document appearance. This effect applies to the word processing, graph creation, drawing functionality and document layout. These capabilities improve the look of organizational documentation. An organization taking advantage of these capabilities enjoys an intangible benefit of matching the ever raising professional standards. Management should ensure that standards of document appearance are met. However, if the users spend unnecessarily too much time on formatting tasks, this intangible benefit may turn even into a tangible loss measured in the business time wasted. KWS help systematic knowledge management and ultimately increase knowledge capabilities of a firm. Advancing professional knowledge is necessary for making new, more attractive products. However, before such products are made and get past market testing, the KWS-based increase of knowledge capabilities remains an intangible benefit.

Financial Assessments of IS Economy

When an IS is planned, the planners try to come up with assessments of tangible costs and benefits the best they can. These assessments are then used for making capital budgeting models that test the economic justification for developing the IS. Then, when the system is in regular use, annual evaluations of these models are being performed. Capital budgeting models can test (a) the size of returns from an IS, and (b) the timing of such returns. As for the models based on returns size, there is a number of options, such as the Benefit/Cost Ratio, Net Present Value, and Return on Investment. Looking at the three listed ratios, the higher a ratio is, the more economically valuable an IS indeed is. Here is one example of the Benefit/Cost Ratio. If an IS returns $120,000 in its production life, while its total costs are $100,000, then B/C=$120,000/$100,000 = 1.2. Or, on each dollar invested the system returns $1.2 or a 20 cents yield. The bigger the B/C ratio, the more economically valuable the system is. Note that all financial calculations that cover more than year should use the present value of money. Simply, all future returns as well as spending for operational costs are discounted for


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some rate (e.g., the rate of inflation). Spreadsheet software usually supports automatic calculation of the present values of spending and earning (note the NPV function in Excel). As for the models based on returns timing, their goal is to figure out the point in time when the expected returns will or do occur. There is a number of capital budgeting models in this rubric, including the Payback Period, and Break-Even Analysis. In general, the shorter the wait period, the more economically valuable a system is. For an example of the Payback Period, assume that an IS costs $100,000 to build, and that it returns $25,000 annually. When you divide the investment with the returns amount, the result is four years (100,000/25,000=4). In this example, it takes four years for the investment in the system to get paid back. A more precise calculation would use NPV. Another example is Break-Even Analysis depicted in Figure 3. The figure shows a spending curve starting at some point at the vertical axis – the direct investment in an IS. The other curve is

returns represented as sales attributable to the system. This curve starts from the value zero. The analyst looks for the intersection of these two curves. This the break-even point, at which the spending and returns are even. Before this point, the system’s economy was in the loss area, as more money was spent than earned. After the break-even point, the system generates profit. When the analysis drops a line from the break-even point down to the horizontal axis representing time, it gets apparent that the break-even point is three years.

Figure 3. Break-Even Analysis

Mixed Methods of Assessing IS Economy Mixed methods use both tangible and intangible costs and benefits. Two methods are discussed below: Portfolio Analysis and Balanced Scorecard. Portfolio Analysis Any organization, at any time, needs a number of systems. It depends on many criteria which one will actually be built. Portfolio Analysis helps in making this decision based on assessing the risks associated with optional IS. Risk is a potentially aggravating or damaging event or characteristic. Risk assessments of IS are performed in the planning stage of system development and they involve rational decision making. Some of the risk factors are overstepping the available budget and time, technology-related uncertainty and learning


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challenges, the size of a system development project, and the magnitude of organizational change associated with the new system. To assess a risk, the analyst has minimally to assess the probability of a risk factor and its impact or “weight.” Risk factors are assessed in probabilistic terms, usually, ranging from 0 to 1 (or 0-100%). A risk analyst attempts to assess the probability that a particular risk factor will occur. In addition, each factor is assigned a weight representing its impact on the completion of a system development project. Then, the simplest risk assessment would be to multiply these two terms. The risk across all risk factors are then summed up. The same would be done for other systems considered. Finally, risk figures would be compared across the systems. For example, a complex system like ERPS costs lots of money to develop and maintain over time, so there is a financial risk of not being able to finance the system if revenues drop due to a likely recession. If probability of this financial problem is 0.8, and the weight of this problem is

8 on a 1-10 point scale (1 is low, 10 is high), then the financial risk for this ERPS is 0.8x8=6.4. So, the risk is apparently serious (64% of 10). Further, a technological risk may be related to the maturity of particular ERPS technology and the capability of a company’s IS staff to properly maintain the system. Say, p=0.7, and weight=6; risk=4.2 (42%). As this

score is below the usual break point of 50%, technology can be taken as a lower risk, although not minor. The total risk for the ERPS is 6.4+4.2=10.6 of 20 as the possible maximum. In system planning, a system optional to the ERPS modules analyzed would be next assessed on financial and technological risks, and its total risk compared with that of the ERPS. The lower risk system would be favoured. Balanced Scorecard Balanced Scorecard focuses on achieving organizational goals with IS. Think of this method as a list of select areas that a company monitors in order to measure its overall performance. These can be financials, customer relations, a growth potential, and some key business processes that depend on the nature of business and organizational goals. Some of these can be measured in tangible terms (e.g., business processes), while others are assessed in intangible terms (e.g., a growth potential). The Balanced Scorecard method is used so that the IS contribution to these performance indicators is assessed in defined intervals. Figure 4 shows a balanced scorecard.


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Figure 4. Balanced Scorecard

Software and Hardware Acquisition The software and hardware used in electronic IS can be acquired by (a) developing it (applies to software only), (b) buying, and (c) renting. Combinations of the three options are possible; for example, a company can develop some software, while it buys and rents other parts of software used in the same system. Each option is discussed below. Developing Software Developing software is a method of acquiring software by relying on the company’s own IS department to write software. This is also called in-house development or home-grown software. A larger company may have hundreds of people employed in its IS department. Some of the staff does nothing else but writing software for new IS, or for maintaining current IS and responding to ad-hoc users’ requests. Computer, network and other hardware is typically purchased, unless the company is a hardware provider. In the in-house development model, a company’s IS department is in charge of hardware acquisition, system installation and all other aspects of system development. The in-house development offers a number of advantages, and the main ones are:

Close business fit

Independence.

The close business fit specifically means that software is written and the whole system is developed to support precisely the company’s business needs. The company’s IS staff understand the business well, and management control extends over the development process.


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Contrast this with external development of IS, where the software developer may not always be tuned to a practical business area but rather tries to sell some familiar software solutions (in business lingo, these are called “canned” or “cookie cutter” solutions). As for management control, the extent of its application is based on a contract with a software vendor (consultant). But contracts can rarely cover all responsibilities of the vendor, which makes management control limited. The independence advantage means that a company controls the future system development and technical expertise. The system can be maintained according to the company’s needs, and the company does not need to wait in line with other customers to get its system-related requests satisfied. There are two main downsides to the in-house system development:

High cost

Technology obsolescence.

This is the most expensive method of acquiring software. It involves the entire slate of system development costs. When purchasing software, a company enjoys economy of scale as the software vendor spreads the development cost over multiple customers, which reduces the software price for a customer. There is no such economy of scale with the in-house system development. To keep up with the technological progress, the company must continually invest in education of the IS staff and exploration of new IT. This requires stable IS budgets. However, the IS function is typically considered a cost centre in companies. In time of recession, cost cutting strategies often affect IS departments. This implies less money for following technological progress and getting technologically obsolete, even if just temporarily. Buying Software Buying software is a method of acquiring software in the market. Today, software markets are quite developed and global. Due to differences in the international economic development, software is cheaper to produce in developing than in the developed countries. Some developing countries have the needed technical expertise. Combine that with the character of software product, which makes it easy to develop anywhere and transfer via computer networks. Software vendors in the developed economies take advantage of these opportunities and make a part of their development “off-shore,” that is, in developing countries. For example, IBM hires staff in India and SAP does the same in east Europe. But there are also software companies in developing countries that compete in global software markets. An example is India’s Tata Group. Software vendors make either standard off-the-shelf software or custom-built software. As the name indicates, off-the-shelf software is a product like any other. Every customer gets the same


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product without any variation; as with mass-made clothing items, “one size fits all.” Main pros of this acquisition method are:

Lower price

Technological progress.

With off-the-shelf software, the customer company enjoys a significant economy of scale reflected in affordable prices. The company does not absorb the development cost or the cost for keeping IS staff. Off-the-shelf software products usually deploy latest technologies, because software vendors compete among themselves and strive to differentiate their products. So, the customer is likely to get technologically current product. On the con side, two items deserve attention:

Looser business fit

Hidden expenses.

The “one size fits all” software may not fit closely with the customer’s needs. The fit with business is looser than with home-grown software. Another problem is that additional investments have to be made for the programming work that will connect off-the-shelf software with other system components. As the magnitude of final interventions may not be readily visible, off-the-shelf software involves hidden costs.

The second purchasing option is to obtain custom-built software. This option resembles building software to the needs, but it is carried out by an external vendor. When a company with the IS needs decides to turn to a software market in spite of having its own IS staff capable of system development, that management practice is called “outsourcing” (sourcing outside of company). The motivation for outsourcing lies in savings. Pros of the custom software option are:

Moderate business fit

No software development cost. As customer software developers differentiate their offers from off-the-shelf software products, the customer company gets software that has a moderate fit with its business needs. There is no such a close match as with the in-house development, but the fit is closer than with


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off-the-shelf software. It often happens that the software vendor allocates a team of developers and business analysts to work at the client premises in order to learn business and the client’s specific wants. When a system is developed and rolled out to the client, the vendor stays with the company to maintain the system. The second benefit for the client company is like with off-the-shelf software – avoiding software development costs. Cons of the custom software option are:

Higher cost

Vendor lock-in.

Custom software is more expensive than off-the-shelf software. By analogy, custom-made shoes are more comfortable but they cost more than mass-produced shoes. There is a direct initial cost for custom software and maintenance costs to cover. Another possible drawback is that the client company can get too dependent on the vendor. In extreme cases, the company cannot make any more significant intervention into the system without the vendor. Apart from financial implications, this situation brings danger of the vendor’s can going out of business and leaving the client without any support. Renting software and Hardware Rental options are available with IS resources as with any other goods. Rentals can be in three forms: (a) Licencing, (b) Pay-per-use, and (c) Cloud-based. With licensing, the customer gets fully functioning software for a certain period of time (usually for a whole year). When the license expires, software still works but it is not updated. For some software products the failure to renew a license can quickly lead to a greatly diminished functionality, if any at all (e.g., ERPS, security protection software, and operating systems). Another rental option is event-based. The client pays for using a part of software. This pay-per-use method is used more and more, as system developers exploit IS components accessible via the Internet. Parts of an IS can be designed in this way rather than an entire system. The last rental form is based on Cloud computing (Cloud, for short). Cloud is a new business model of supplying software, hardware or an entire IS by Cloud providers. Cloud providers are main, well-known software and hardware companies as well as many new companies that create this new industry. Just about any IS resource can be rented, including application software, data storage, databases, and any piece of hardware. Accounting/finance, customer relationship management, supply chain and almost any other domain of IS support can be sourced from the Cloud. Advantages of using Cloud services are:

Savings

Technological progress.


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Users of Cloud services enjoy significant savings. If full systems are rented from the Cloud, it means that the client company has to possess just some computers for accessing the Cloud-based systems, plus a network and Internet access. There is neither system development nor system maintenance costs. The payment method is pay-per-use, so the IS expenses can directly correlate with the volume of business operations. The second benefit of Cloud is in having access to the latest IT. To stay competitive, Cloud providers have to keep updating the systems they rent out. Results of this pressure are business processes on the client side, which have superior performance. As a new sort of service, Cloud still has a number of disadvantages, and specifically:

Client-Provider synchronizing

Security

Vendor lock-in.

In the case of full system renting, synchronizing business processes between client and vendor can be a challenging task. In a way, the Cloud provider should function as if it is the client company’s IS department. Second, there is a risk of compromising confidentiality of the client’s business data. System security is at test on the vendor side and in data transfer. Third, as with the custom software model, there is a heightened possibility of the vendor lock-in when total IS services are rented. The client has no control over system development and must count on the vendor’s understanding of business and its evolution. Finally, pricing models of Cloud services are just evolving, which causes danger of hidden IS costs. In summary, each option of acquiring software and hardware has its pros and cons, and it is up to a specific company to make their optimal choices vis a vis particular IS.

Questions for Review and Study 1. Discuss three tangible costs of IS; be sure to name the system(s) discussed.

2. Discuss three intangible costs of IS; be sure to name the system(s) discussed. Why are the

costs intangible and can they become tangible?

3. Discuss three tangible benefits of IS; be sure to name the system(s) discussed.

4. Discuss three intangible benefits of IS; be sure to name the system(s) discussed. Why are the benefits intangible and can they become tangible?

5. By using an example, discus intangible and tangible benefits of customer satisfaction in relation to IS.


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6. By using an example, discuss intangible and tangible costs of lacking customer satisfaction in relation to IS.

7. Discuss one capital budgeting model applicable to IS. What is the challenging part of it?

8. Discuss portfolio analysis applicable to IS.

9. Discuss the balanced scorecard methodology applicable to IS.

10. Specify two similarities and two differences between developing IS by acquiring off-the-shelf software versus in-house development.

11. Specify two similarities and two differences between developing IS by acquiring custom-built software versus in-house development.

12. Specify two similarities and two differences between developing IS by acquiring off-the-shelf software versus renting system resources (software, etc.).

13. Discuss three pros and three cons of acquiring total IS services via Cloud computing.

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Chapter 18 Economy of Information Systems · direct costs can be greatly reduced if a company goes for current rental solutions, such as Cloud ... Chapter 18 * Economy of Information