TOWARDS AN APPROACH TO MEASURE AND JUSTIFY INVESTMENTS IN A TECHNOLOGY INFRASTRUCTURE

Presentation OverviewPresentation Overview

Background Definition of an IT infrastructure 2-phased approach to measure and justify

infrastructure investments • assessing the cost and value of IT infrastructure• justifying additional expenditures

Conclusion

BackgroundBackground Development and support of IT infrastructure:

• Key responsibility of IS function in the 1990s (Rockart, 1992)• 1 of 10 critical tasks for IT managers (Niederman et al, 1991)

Technical and managerial challenges

• technical technical -->> functionality, efficiency, maintainability (Davenport & Linder, 1994; Weill et al., 1993)

• managerialmanagerial -->> identifying / measuring benefits and justifying additional expenditures (McKay & Brockway, 1989; Weill, 1992)

BackgroundBackground

Infrastructure expenditures = 46% of total IT expenditures (Weill et al, 1995)

However, there is a lack of guidelines on how to measure and justify these expenditures

Focus of this paper:

• How to assess the business value of the firm’s installed infrastructure resources?

• How to justify additional investments in an IT infrastructure?

ITIT Infrastructure Defined Infrastructure Defined

Integrated set of technical components coupled with human capabilities to form a shared foundation for supporting internal & external business activities of an organization.

It impacts organizational performance indirectly by enabling applications that provide business value

ASSESSING COST AND VALUEASSESSING COST AND VALUE

Payoff assessment of IT assets:– How well are we doing today?– Who well are we positioned to compete?

Question 1– Requires understanding of the current investments in

different infrastructure components and sources of value Question 2

– depends on the level of current investments and the role of ITI

Justifying additional ITI Justifying additional ITI investmentsinvestments

Characteristics of ITI investments:• large initial expenditures• payoff uncertainty; risk• intangible benefits to many stakeholders over a long

period of time

Many approaches to ITI investment justification are possible • form capital budgeting to “gut feel”

Approaches are contingent upon ITI role

Justifying additional ITI Justifying additional ITI investmentsinvestments

“UTILITY” infrastructure

• resources aimed at providing cost savings via economies of scale

• net present value approach (Weston & Brigham, 1985)

– reasonable estimates of inflows/outflows of money and discounted rate

Justifying additional ITI Justifying additional ITI investmentsinvestments

“DEPENDENT” infrastructure

• resources aimed at enabling the current strategy of the firm

• cost-benefit analysis methodology (Toraskar & Joglekar, 1993)

– identifying tangible as well as intangible costs/ benefits

Justifying additional ITI Justifying additional ITI investmentsinvestments

“ENABLING” infrastructure

• resources aimed at providing flexibility to quickly respond to changing business needs

• future benefits are much harder to define ahead of time

• “real option” approach (Kambil et al., 1993)

Net Present Value MethodNet Present Value Method

Traditional capital investment technique• net cash flows, discount rate (I.e. project’s cost of

capital), initial cost, project’s expected life

Using NPV to justify ITI investments• deriving present value of the net cash flows associated

with the investments (I.e. cost savings from economies of scale)

• discounting cash flows at the cost of capital• subtracting cost of ITI resources from the resulting

amount

Net Present Value MethodNet Present Value Method

Pros/ Cons of NPVPros/ Cons of NPV• quantitative and mostly accurate estimates of the

investment’s value

• applicable only if inflows and outflows of money and the discount rate could be reasonably estimated

• What about expenditures with a negative ROI that play a critical role in the long-term competitive stance of the organization?

Cost-Benefit Analysis MethodCost-Benefit Analysis Method

Applied to public investment decisions in flood control and national defense areas (I.e. complex, uncertain)

Five phases:

• Identification of benefits• Measurement of tangible benefits and description of

intangible benefits• Explicit valuation of both types of benefits• Final assessment of ITI investment alternatives

Cost-Benefit Analysis MethodCost-Benefit Analysis Method

Pros / Cons of CBAPros / Cons of CBA

• measures both types of benefits• but too much emphasis on quantification of

intangibles• bias towards investments with a short-term payoff• lack of consideration for risky and uncertain

strategic investments

““Real Option” method Real Option” method

Valuing the “option” to invest in future ITI that would in turn, provide value in the long run (Kambil et al, 1993)

5-step process:

• derive traditional NPV estimate for the project (I.e. investment in ICASE environment)

• estimate project cost (I.e. initial infrastructure investment + cost to expand the project a year from now)

• define an option

• estimate the option value

• make the investment decision

““Real Option” methodReal Option” method

Pros/ Cons ROMPros/ Cons ROM

• systematic approach to estimate and quantify the value of uncertain future projects made possible by initial ITI investments

• complex method

• relies on robust estimates of expected cash flows and the cost of exercising the “real option”

ConclusionConclusion

ITI investments are large, uncertain and risky

Thus, it is difficult to tie such investments directly to organizational performance

The application of the proposed payoff assessment approach• the first step towards addressing the managerial

challenge of measuring and justifying ITI investments