535handout_6 - IS/PM 535 Handout#6 Information Technology...

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1 IS/PM 535 Handout #6 Information Technology Investment: Decision-Making Methodology by Marc J. Schniederjans, Jamie L. Hamaker and Ashlyn M. Schniederjans World Scientific Publishing Co © 2004 From DePaul 24x7 books, Extracted text for instructional and printing purpose. Chapter 6: Cost/Benefit Analysis Introduction In this chapter we introduce a classic financial IT methodology called "cost/benefit analysis." It is a methodology that seeks to overcome some of the limitations of the return on investment (ROI) methodology discussed in Chapter 5 . It does this in part by considering the usual cost information found in ROI analysis, but combined with "benefits" (not considered in ROI). As such it considers the all important and often intangible "value-added" contributions of personnel and managers. By bringing into the analysis more relevant criteria, cost/benefit analysis has become one of the most commonly used and appreciated financial methodologies in IT investment decision-making. What is Cost/Benefit Analysis? Cost/benefit analysis involves the estimation and evaluation of the net benefits associated with alternative courses of action. This technique most often entails comparing the present value of benefits associated with an investment to the present value of the costs of the same investment. Cost/benefit analysis is a widely used decision-making tool in both public and private settings and for a wide variety of different problems, including IT investment decision-making (Brown, 2001; Farbey, et al. , 1992; Farbey, et al. , 1993; Ryan, 2002; Sassone, 1988). Cost/benefit analysis involves identifying costs and benefits for each alternative investment, discounting the costs and benefits back to the present, and selecting the best alternative according to a pre-specified criterion. Cost/benefit analysis may be used to evaluate an independent investment and to select one or several among a set of independent or dependent investments. Cost/benefit analysis may be used for ex ante (i.e., before project analysis), ex post (i.e., after project analysis) and in medias res (i.e., in progress analysis) investment evaluations. Like most analyses, cost/benefit analysis involves a series of steps or stages. Figure 1 shows five common stages in conducting a cost/benefit analysis. These sequential stages include: defining the problem, identifying costs and benefits, choosing a criterion, comparing alternatives, and performing sensitivity analysis. Each phase is discussed in more detail in the following sections.
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2 Figure 1: The five stages of cost/benefit analysis. Define problem Defining the problem is extremely important in any type of decision-making, including IT investment decision-making. Analyzing the problem and defining is the only way to allow for the appropriate alternative solutions to be generated. Problem definition involves an in depth analysis of the situation; investigating the needs and requirements of an IT. After analysis, the problem may be defined and alternative solutions may be identified. A well-defined problem includes a specification of the
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