Business Strategy Assignment

Cost Benefit
Analysis
Submitted by: Kranti Deori PRN NO.9030241013

SCIT-ITBMI
9/16/2010
Cost Benefit Analysis

The term Cost benefit analysis is used frequently in business planning and
decision support. The term, however, has no precise or standard definition beyond
the idea that both positive and negative impacts are going to be summarized and
then weighed against each other. The term also has no universally agreed spelling.
It is written as cost benefit, cost/benefit, cost-benefit, or benefit/cost for instance.
Because the term "cost benefit analysis" does not refer to any specific approach or
methodology, the business person who is asked to produce one should take care to
find out what is expected or needed.

The term covers several varieties of business case analysis, such as:

 Return on investment (ROI analysis)

 Financial justification

 Total cost of ownership analysis (TCO)

 Return on Investment: What is ROI analysis?

Return on Investment (ROI) analysis is one of several commonly used

approaches for evaluating the financial consequences of business investments,
decisions, or actions. ROI analysis compares the magnitude and timing
of investment gains directly with the magnitude and timing of investment costs.
A high ROI means that investment gains compare favorably to investment
costs.

 In the last few decades, ROI has become a central financial metric for asset
purchase decisions (computer systems, factory machines, or service vehicles, for
example), approval and funding decisions for projects and programs of all kinds
(such as marketing programs, recruiting programs, and training programs), and

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Cost Benefit Analysis

more traditional investment decisions (such as the management of stock

portfolios or the use of venture capital).

• The ROI Concept

• Simple ROI for Cash Flow and Investment Analysis
• ROI vs NPV, IRR, and Payback Period
• Other ROI Metrics

The ROI Concept

 Most forms of ROI analysis compare investment returns and costs by

constructing a ratio, or percentage. In most ROI methods, an ROI ratio greater
than 0.00 (or a percentage greater than 0%) means the investment returns more
than its cost. When potential investments compete for funds, and when other
factors between the choices are truly equal, the investment—or action, or
business case scenario—with the higher ROI is considered the better choice, or
the better business decision.

 One serious problem with using ROI as the sole basis for decision making, is that
ROI by itself says nothing about the likelihood that expected returns and costs
will appear as predicted. ROI by itself, that is, says nothing about the risk of an
investment. ROI simply shows how returns compare to costs if the action or
investment brings the results hoped for.(The same is also true of other financial
metrics, such as Net Present Value, or Internal Rate of Return). For that reason,
a good business case or a good investment analysis will also measure the
probabilities of different ROI outcomes, and wise decision makers will consider
both the ROI magnitude and the risks that go with it.

 Decision makers will also expect practical suggestions from the ROI analyst,
on ways to improve ROI by reducing costs, increasing gains, or accelerating
gains (see the figure above).

Simple ROI for Cash Flow and Investment Analysis

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Cost Benefit Analysis

 Return on investment is frequently derived as the “return” (incremental gain)

from an action divided by the cost of that action. That is “simple ROI,” as used
in business case analysis and other forms of cash flow analysis. For example,
what is the ROI for a new marketing program that is expected to cost $500,000
over the next five years and deliver an additional $700,000 in increased profits
during the same time?

 Simple ROI is the most frequently used form of ROI and the most easily
understood. With simple ROI, incremental gains from the investment are divided
by investment costs.

 Simple ROI works well when both the gains and the costs of an investment are
easily known and where they clearly result from the action. In complex business
settings, however, it is not always easy to match specific returns (such as
increased profits) with the specific costs that bring them (such as the costs of a
marketing program), and this makes ROI less trustworthy as a guide for decision
support. Simple ROI also becomes less trustworthy as a useful metric when the
cost figures include allocated or indirect costs, which are probably not caused
directly by the action or the investment.

Competing Investments: ROI from Cash Flow Streams

 ROI and other financial metrics that take an investment view of an action or
investment compare investment returns to investment costs. However each of
the major investment metrics (ROI, internal rate of return IRR, net present value
NPV, and payback period), approaches the comparison differently, and each
carries a different message. This section illustrates ROI calculation from a cash
flow stream for two competing investments, and the next section ( ROI vs. NPV,
IRR, and Payback Period) compares the differing and sometimes conflicting
messages from different financial metrics.

 Consider two five-year investments competing for funding, Investment A and

Investment B. Which is the better business decision? Analysts will look first at

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Cost Benefit Analysis

the net cash flow streams from each investment. The net cash flow data and
comparison graph appear below.

Other ROI Metrics

Other financial metrics are also treated as ROI figures at times.

In financial statement analysis—where analysts assess the financial health and

business performance of companies—“Return on Invested Capital,” “Return on
Capital Employed,” “Return on Total Assets,” “Return on Equity,” and “Return on
Net Worth,” are sometimes called “return on investment.”

In still other cases, where the focus is cash flow analysis, the term ROI has been
used to refer simply to the cumulative cash flow results of an investment over time,
such as shown in the preceding section. Some people also refer to other financial
metrics as "ROI," such as "Average Rate of Return" or even Internal Rate of Return
(IRR).

In brief, several different return on investment metrics are in common use and the
term itself does not have a single, universally understood definition. Therefore,
when reviewing Refigures, or when asked to produce one, it is a good idea to be
sure that everyone involved:

 Defines return on investment the same way

Understands the limits of the concept when used to support business decisions.

All of these approaches to cost benefit analysis attempt to predict the

financial impacts and other business consequences of an action. All these
approaches have the same structural and procedural requirements for building a
strong, successful business case. They differ primarily in terms of:

 How they define "cost" and "benefit" in practical terms.

 Which costs and benefits are included for analysis?

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Cost Benefit Analysis

 Which financial metrics are important for decision makers and planners?

Financial Justification

Financial justification is a business case that asks whether or not an

investment is justified—in financial terms. Financial justification, in other words, is a
business case analysis that helps decision makers decides whether or not to go
forward with a proposed action. The financial justification case is also created for
accountability purposes, to establish later that decision makers complied with
regulations and policies, and that the action taken represents a good business
decision.

The results of a financial justification business case address questions like these:

 Does the proposed software system represent the best use of funds?

 Can we use the proposed new building to improve our financial position?

 Will the proposed security service "pay for itself"?

It is distinguished from other business case approaches only by the special

emphasis on financial decision criteria. Otherwise, a strong financial justification has
the same characteristics as other kinds of business cases.

Just which criteria determine justification in any one case depend heavily on the
organization's business objectives and the current business situation. A profit-
making company with aggressive sales growth goals will probably focus on different
criteria than a non-profit or government organization driven by the need to deliver
high quality services. A company with cash flow problems or a net loss on the
income statement will have different financial priorities than a company that is in
excellent financial health.

A crucial early step in designing the financial justification business case, therefore,
is to determine specifically which financial criteria are important to decision makers

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Cost Benefit Analysis

in the present situation. Depending on their needs and priorities, financial

justification may be decided by any one or several criteria like the following:

 Projected net cash flow

 Net present value (NPV) of the projected cash flow (discounted cash flow
analysis

 Internal rate of return (IRR)

 Return on investment (ROI) for the proposed action

 Payback period

 Total cost, or Total cost of ownership

 Total capital costs

 Total operating expenses

 Cost per transaction (or cost per person, cost per seat, cost per ... etc.)

For a working spreadsheet examples of financial metrics calculations, download

either the free financial metrics too or the more in-depth coverage in Financial
Metrics Pro.

All of these criteria can be derived from business case cash flow projections, which
are usually estimated for a period of several years or more. Each criterion says
something different about the advisability of making the investment.

Total Cost of Ownership Analysis (TCO) / Cost of Ownership (COO)

A Cost of Ownership analysis (or Total Cost of Ownership, TCO Analysis), is

a business case designed especially to find the lifetime costs of acquiring,
operating, and changing something. TCO analysis often shows there can be a large
difference between the price of something and its long term cost.

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Cost Benefit Analysis

Those who purchase or manage computing systems have had a high interest in
TCO since the 1980s, when the potentially large difference between IT cost and IT
purchase price started drawing the attention of IT vendor marketing (largely from
competitors of IBM). The five year cost of ownership for major computing systems
can be five to eight times the hardware and software acquisition costs.

Today, TCO analysis is used to support acquisition and planning decisions for a wide
range of assets that bring significant maintenance or operating costs across a long
usable life. Total cost of ownership is used to support decisions involving computing
systems, vehicles, buildings, laboratory equipment, medical equipment, factory
machines, and private aircraft, for instance. Today, TCO analysis for these kinds of
assets is a central concern in

 Budgeting and planning

 Asset life cycle management

 Prioritizing capital acquisition proposals

 Vendor selection

 Lease vs. buy decisions.

Case study of Cost – benefit analysis

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Cost Benefit Analysis

Infosys - Lean IT Transformation , Reduce total cost of

ownership , guarantee, quality of service and achieve
business Agility .

The traditional IT has multiple fixed and variable cost components involved.
Organizations have invested a large fixed amount for initial infrastructure setup and
continue to send variably for management, monitoring, support for these IT systems
to sustain day to day business operations.

LEAN IT TRANSFORMATION:

Lean IT transformation is an attempt to resolve problems faced by IT industries by

creating new IT models and switching from company owned IT hardware, software
and services to per-use based model. It focuses on reducing IT infrastructure and
related liabilities to reduce total cost of ownership. It leverages the latest trends in
computing technology and next generation SaaS(software as a service) business
model. This approach will help organization to significantly reduce the total cost of
ownership, help achieve desired business agility and guarantee quality of services
through new IT service models.

Here is the illustration of cost benefit analysis of lean IT transformation approach in

enterprise collaboration scenario.

Strategy Business Benefit

Hardware-as-a-service • Significant savings in the fixed infrastructure

cost
Datacenter-as-a-service
• Significant savings in the variable & on-going
costs related to upgrades, support,
maintenance, monitoring & admin

• Flexibility to choose hardware services provider

and reduces hardware/infrastructure lock-in
issues

Software-as-a-service • Significant savings in the fixed software license

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Cost Benefit Analysis

Platform-as-a-service cost

• Significant savings in the variable and on-going

cost related to software upgrades, support,
maintenance and management.

IT services • Considerably savings by leveraging shared

service models, packaged software + service
Software + services
models and hosted models for custom
application and related services

• Competitive evaluation of different service

providers along with stringent penalty clauses
can help realizing best in class quality of
service, business agility and flexibility

Negotiate service • Guaranteed quality of services in terms of

provider service level performance, scalability and availability
agreements(SLA)

Negotiate service Guaranteed quality of services in terms of support,

provider operation level response and resolution duration, terms around
agreements(OLA) upgrades and maintenance of software, hardware and
storage.

Enterprise collaboration scenario: Lean IT Transformation

• Email Exchange

• Messenger or communicator

Per user per month cost is low for the above communication process.

Lean IT transformation is a high level approach for the next generation IT service for
organizations of any size. It promise significant cost savings, desired business agility
and guaranteed quality of services. The current IT trends and various leading
analyst reports are showing that organizations have started thinking to move

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Cost Benefit Analysis

towards lean IT in parts. There are multiple challenges to realize all the benefits of it
and also manage seamless and smooth transition, however for several mature
scenario it is worth taking the risk.

Reference: -

http://www.solutionmatrix.com/cost-benefit-analysis.html .

http://www.infosys.com/cloud-computing/white-papers

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