Custom Software Systems The Software Build Versus Buy Decision A Necessary First Step

Custom Software Systems

The Software Build Versus Buy

Decision

A Necessary First Step


Does my Company or Department Need Software?Complex series of linked spreadsheetsCurrent process is labour-intense Data resides in many disparate sources without integration agentCaptured data not robust enough to provide meaningful analysisNo formalized process in place for business challengeCurrent databases at capacityUsers abandoned current system because of complexityBusiness has grown – MIS have notBusiness units cannot share information easilyImportant knowledge from organization is not being capturedData integrity issuesEtc.


What Are Your Software Options?Purchase commercial off-the-shelf (COTS) or commercial enterprise software packages

Must be applications available to meet your business challengeDevelop the required application in-house

Requires experienced development team Opportunity cost assessment by project

Develop the application through a third party software developerOnly option if commercial application does not exist or you do not have access to internal development teamAttractive option if internal development team lacks capacity or experience


Relationship Between Size and SuccessInverse relationship between size of development project and probability of success

Table below is for in-house developed applications*Outsourced 3rd party probabilities are better, but same relationship exists

* Khaled El Emam, K Sharp Technology Inc., Software Process and Methodology Seminar, Toronto, Ontario 2003

Project Size People Time (months) Success

< $750k 6 6 55%

$750k-$1.5M 12 9 33%

$1.5M-$3M 25 12 25%

$3M-$6M 40 18 15%

$6M-$10M 250+ 24+ 8%

$10M+ 500+ 36+ 0%


Advantages of BuyingLower initial costs (as a general rule)Reduced time to deploymentVery rich features/bells and whistles


Disadvantages of BuyingOngoing per user licensingAnnual maintenance contractAnnual support contractVendor due diligence/selection time commitment

Always include end usersPaying for all embedded software features even if you will only use a small sub-setMight meet general requirements but not necessarily specific onesMight require extensive customization

Consultant fees might be larger than the cost of the applicationCombining COTS-based components from different software vendors still requires internal development

Development efforts can be significantCOTS component-based system is always subject to the volatility of the COTS components (frequency of new releases)

Limited or no influence with software vendor regarding future application features


Arguments for Building an Application In-House Are:We know our company’s processes better than anyone elseWe can develop precisely what we needWe have direct control over future development and can react quickly with modifications as the business changesWhen we build it, we have a complete understanding of how it worksSince it is proprietary, we never have to worry that our competition will get it as wellThe company has already paid the sunk (fixed) cost of the development team salariesThere are no COTS software applications that even come close to providing the specialized required functionality


Potential Pitfalls of Building an Application In-House:You do not consider other options because you have in-house developers

Tendency to skip due diligence phase and ROI analysisNo estimation or underestimation of effort and costOverestimating the capabilities of your in-house development teamDevelopers required to perform current job and develop new applications at the same time

Communication gap between management and in-house development teamIs there a project management layer in your organization to act as liaison?Vague definition of project deliverables

Tendency for “scope creep” and associated “cost creep” to occur during development

Unrealistic deadlines from managementIgnoring opportunity, maintenance and support costs

Maintenance costs are about 55% ** of the total cost during the product life cycleInsufficient resources on an ongoing basis

** I.C. Harris, “Using an Economic Model to Time Reuse Strategies,” 5th Annual Workshop on Software Reuse, 1992


Potential Pitfalls of Building an Application In-House: (Cont’d)Tendency to cut corners to keep costs low

Inadequate time allotted for software designLittle or no beta testingLack of a quality assurance processDocumentation is overlooked or avoidedInsufficient involvement from business units requesting software

Lack of up-to-date design capabilitiesInternal politicsDifficult, if not impossible to calculate an accurate ROI for in-house development projects

Impossible to measure opportunity costs before the opportunities present themselves


Increasing Your Chances at Successfully Developing In-HouseStart small and only develop within your team’s capabilitiesBuild a repeatable successful process to developing in-house applicationsPartner with a third party developer to gain knowledge and reduce riskProvide ongoing training for entire development team If in-house development should be a core competency for your organization, then commit resources to build capabilities


Arguments for Building Through OutsourcingBusiness challenge is unique and you do not have access to an in-house development teamIn-house team lacks the required capability/resources/timeManagement communicates with project or relationship managers and not the development team

Elimination of management/developer communication gapMonolithic application development is vendor core competence

Efficient system of application development already in placePower to hold vendor accountable for progress and quality of work Leverage the expertise and core competence of the vendorA good vendor will offer innovative ideas learned from other projectsMaintenance and support can be outsourced on an ongoing basis so that internal resources are not tied up“Scope creep” cannot occur unless original deliverables are altered

Associated additional costs are immediately known


Arguments for Building Through Outsourcing (Cont’d)Application can be built to fit the challenge perfectlyYour organization can focus on its core competenciesThe costs can be clearly quantified Opportunity to pass pricing risk to vendor

Your organization does not pay for development hiccupsOutsource vendors estimate development times wellOutsource vendors require well defined deliverables

Your organization is forced to invest time to carefully scope out projectSignificant quality assurance testingUp-to-date design capabilitiesYour project does not tie up internal resources


Potential Pitfalls of Building Through OutsourcingMay have to bring vendor up the curve on your business practices and procedures relating to business challengeVendor may have rigid pricing structure that shifts pricing risk to customer

Per hour pricing versus up front pricing proposalMight be tied to vendor for future upgradesWill they offer training and support?Are they financially stable?Will they take up too much of your time?Can they effectively communicate with your project team members and management?Do they possess capability to design an intuitive application that your end users will actually use?


Financial AnalysisReturn on Investment (ROI) is a standard measure of project profitability

Discounted profits over life of project expressed as % of initial investmentValue that represents the benefits received from a project against the total costs of the project

Financial forecasting accuracy relies on reasonable assumptionsThe accuracy of your valuation will be directly correlated to the effort that you put into assumptions about future eventsIt might seem impossible to attach dollar amounts to certain itemsOnly include costs that would be incurred if the application were implementedDirect benefits tend to be easier to measure and predict than indirect benefits

Costs and benefits must be recognized on a timeline when they are expected to occur

Initial project costs occur at time zero on a timeline, all other costs and benefits are recognized at the end of the year in which they occur

All financial analyses must incorporate the time value of moneyDiscounting future cash flows to achieve a value at time zero, or today


Net Present Value (NPV)NPV is the sum of the present values of the net annual benefits minus the initial dollar investment requiredEstimate the future cash flows over the life of the applicationThe hypothetical example on the next slide is simplistic in its assumptions

No salary adjustments, no increases in maintenance or support costs over time, etc.


Net Present Value (NPV) Cont’d

Time (years) 0 1 2 3 4 5 6 7 8 9 10

Initial Cost (100,000)

Inflows (Benefits)Strategic Advantage Over Competition 10,000 10,000 10,000 10,000 10,000 10,000 10,000 10,000 10,000 10,000

Reassigning Human Resources 15,000 15,000 15,000 15,000 15,000 15,000 15,000 15,000 15,000 15,000

Time Saving From Automation 20,000 20,000 20,000 20,000 20,000 20,000 20,000 20,000 20,000 20,000

Decreased Training Requirements 5,000 5,000 5,000 5,000 5,000 5,000 5,000 5,000 5,000 5,000

Decreased FTE Headcount 50,000 50,000 50,000 50,000 50,000 50,000 50,000 50,000 50,000 50,000

Better Management Decisions 50,000 50,000 50,000 50,000 50,000 50,000 50,000 50,000 50,000 50,000

Decreased Employee Turnover 30,000 30,000 30,000 30,000 30,000 30,000 30,000 30,000 30,000 30,000

Increased Production/Job Satisfaction 5,000 5,000 5,000 5,000 5,000 5,000 5,000 5,000 5,000 5,000

Elimination of Errors 5,000 5,000 5,000 5,000 5,000 5,000 5,000 5,000 5,000 5,000

Opportunity Costs 20,000 20,000 20,000 20,000 20,000 20,000 20,000 20,000 20,000 20,000

Outflows (Costs)Maintenance Fee (10,000) (10,000) (10,000) (10,000) (10,000) (10,000) (10,000) (10,000) (10,000) (10,000)

Software Support Fee (5,000) (5,000) (5,000) (5,000) (5,000) (5,000) (5,000) (5,000) (5,000) (5,000)

Additional System Requests - - (25,000) - - (25,000) - - (25,000) -

Net Inflow 195,000 195,000 170,000 195,000 195,000 170,000 195,000 195,000 170,000 195,000

Net Cash Flow (100,000) 195,000 195,000 170,000 195,000 195,000 170,000 195,000 195,000 170,000 195,000


Net Present Value (NPV) Cont’dDiscount all future cash flow estimates so that we can get a value today

Discounted cash flow (DCF) valuationFirst, you must determine a discount rate

Your required rate of return or cost of capital for the project that also reflects the risk of the projectOur example assumes 15%

Each future cash flow is discounted back to today’s dollar termsCash flows farther out will be discounted more heavily than those that occur earlier a.k.a. time value of moneyOur initial investment amount occurs today, so do not discount that amount because it is already in today’s dollar termsr = discount rate, n = year


Net Present Value (NPV) Cont’d


Net Present Value (NPV) Cont’dSum the initial cost (-$100,000) and all of the discounted cash flows

NPV = $844,307Project accept/reject decision based on whether NVP amount is positive or negative

Our NPV is positive, so go ahead with the software purchase because return to organization will be above our required 15%

Unfortunately, NPV is not widely used as a decision making tool for projectsMany companies fixated on a percentage of returnNPV valuations are in dollar amountsMany proposed projects might have a positive NPV


Internal Rate of Return (IRR)IRR is the discount rate that makes the NPV of a project equal zero

Single rate of return that summarizes the merits of the projectAllows for an “apples to apples” comparison on a percent return basisIRR is just another way of looking at NPV in percent terms

In our example, when you set the NVP to zero, the IRR is 193%Well above our required rate of 15%

Word of caution about IRR calculations, they work for conventional project cash flows

First cash flow (initial investment at time zero) is negative and all remaining cash flows are positiveNon-conventional cash flows might have multiple rates of return where the NPV is zeroMany computer financial packages do not compensate for this problem and will return the first or lowest IRRUse NPV calculations for non-conventional cash flows

IRR has a practical advantage over NPV in certain circumstancesNPV cannot be estimated unless we can determine the appropriate discount rate firstIRR can be estimated without a discount rate


Payback PeriodAmount of time needed for an investment to generate cash flows to recover its initial costs

The point at which total benefits equal total costsWidely understood and used, particularly when evaluating IT projects

In the example above from the NPV section, at the end of year one, we have $195,000 in cash flow

Greater than initial cost of the software (-$100,000)Payback period occurs during the first year (100,000/195,000 = .51 years or just over 6 months)


Payback Period Method Has Some Serious ShortcomingsCalculated by simply summing future cash flows

There is no discounting of cash flows, so the time value of money is ignoredWithout discounting of future cash flows, your project will appear more attractive than it really is

No required rate of return used, therefore the risk level of the project is never captured

Very risky projects are treated the same as low risk projectsHow quickly an investment recovers its initial amount invested does not measure risk (lottery ticket or casino)Risk is captured in your required rate of return (government bond versus high tech startup)

No economic rationale for determining the correct cutoff periodArbitrary cutoff

Tends to bias user toward short term investmentsIgnores cash flows beyond the cutoffA project that takes a few years to get up to speed and then creates phenomenal returns would be rejected strictly on its cash flow profile


How to Use Payback PeriodPerform a discounted payback period analysis

Determine your discount rate and discount the future cash flows before performing the payback analysisInherent risk of project capturedTime value of money is included through DCF valuationVery few individuals ever perform discounted payback period analysis

Put very little weight on analysis resultsUse as general guide when looking at two fairly comparable projects

Use only as a quick and dirty “back of an envelope” valuation methodJust another valuation metric to be used in conjunction with the others Do not base your accept/reject decision solely upon it


Profitability Index (PI) or Benefit/Cost RatioPresent value of future cash flows divided by the initial investment

present value of future cash flows is another term for discounted cash flows (DCF)PI is larger than 1 for positive NPV projects and less than 1 for negative NPV projects

For our example, the PI would be 9.44PI measures “bang for the buck”

For each dollar invested, the organization receives $9.44 in valueThe PI, IRR and NPV valuation methods are related

Results presented in different fashions


Using NPV, IRR, Discounted Payback Period and PIProject “A” has a higher NPV and Payback Period than Project “B”Project “A” also has a lower IRR and PI than Project “B”

Even though Project “B” provides a greater return and more bang for the buck, the dollar amount of that return might be limitedProject “A” might provide more value because of the dollars it returns even though it provides a lower rate of return

Base your decision on all factors combined, not only one valuation metricAlso consider size, scope and dollar value to organization

NPV IRR Discounted Payback Period

PI

Project “A” $1,000,000 22% 3.8 years 2.8

Project “B” $10,000 100% 1.1 years 10.5


Return on Investment (ROI)Return ratio that compares the net benefits of a project verses its total costs

Relative value of a project's cumulative net benefits (benefits less costs) over the analysis period, divided by the project's cumulative total costs, expressed as a percentage

ROI = Average Net Benefits Initial CostsInclude time horizons when using ROI

People tend to talk about ROI without including time horizonsROI as a comparison of two or more projects must use equal time-frames

The ROI figures below belong to our original example:844% over the life of the project84% per year over a ten year period329% over the first three years110% per year over the first three years

Taxes and depreciation can also have an impact on your financial analyses


ConclusionsAs a general rule of thumb, the more generic that your business challenge is, the more likely you are to find a commercially available software solution

Highly unique business challenges and requests will most likely require a customized solution (in-house or outsourced)

An organization that regularly produces successful in-house applications will have an efficient development system in placeDo not ignore the success rate statistics of in-house development

If developing is not a core competence, then outsource Outsourcing development can add value and offer flexibility

convert fixed costs into variable costsYour organization concentrates on its core businessLeverage best-of-breed knowledge for non-core tasks

Complex software decisions are always difficult to makePerform your due diligence so that you are comfortable with your choicesA sound financial analysis based on reasonable and detailed assumptions will support your decisionWeigh financial returns against other factors (risk, timing, platform issues, user acceptability, competitive issues, feasibility considerations, etc.)


Insidus Custom Software Systems

www.insidus.com(905) 773-7182

Documents

Custom Software Systems The Software Build Versus Buy Decision A Necessary First Step