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A CFO's Perspective on ERP/CRM

A framework to analyze the business, economic, and financial implications

of deploying ERP/CRM on various computer platforms

CIOview Corporation 1740 Massachusetts Avenue Boxborough, MA 01719 +1 (978) 635-9540

www.cioview.com

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Table of Contents Executive Summary..........................................................................................5

Table 1: ERP/CRM TCO Summary...............................................................5 Platform Migration .........................................................................................6 The Results...................................................................................................7 Drilling Down ................................................................................................7 What-if? .......................................................................................................7

Table 2: Total Cost of Ownership (CFO Ready) ............................................8 Table 3: Financial Analysis ........................................................................9

Final Analysis................................................................................................9 Introduction ..................................................................................................10

Basic Assumptions.......................................................................................11 Table 4: New Initiative ...........................................................................11 Table 5: Workload Refinement.................................................................12 Table 6: Total Cost of Ownership Summary...............................................13

Hardware ...................................................................................................14 Utilization Rate.........................................................................................14

Table 7: Application Hardware .................................................................15 Table 8: Utilization Assumptions ..............................................................16 Table 9: Database and QA Servers...........................................................17 Table 10: Database Hardware .................................................................18

Size of Box ..............................................................................................19 Table 11: Hardware Choices....................................................................19

Resource Allocation...................................................................................19 Storage......................................................................................................20

Table 12: Storage Cost Factors................................................................20 Software ....................................................................................................21

Type of Platform.......................................................................................21 Number of Boxes ......................................................................................21 Split Between OEM and ISV .......................................................................21

Table 13: Software Factors .....................................................................21 Networking.................................................................................................22

Table 14: Network Factors ......................................................................22 Services .....................................................................................................23

Table 15: Services Factors ......................................................................23 Facilities.....................................................................................................24

Table 16: Facilities Factors......................................................................24 Personnel ...................................................................................................25

Average Personnel Salaries ........................................................................25 Server Environment ..................................................................................25 Utilization Rates .......................................................................................25

Table 17: Personnel Factors ....................................................................26 Downtime...................................................................................................27

Cost........................................................................................................27 Revenue Model.........................................................................................27 Published Rate .........................................................................................27

Table 18: Downtime Assumptions ............................................................28 Table 19: Downtime Factors....................................................................29

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Support and Maintenance .............................................................................30 Table 20: Support and Maintenance .........................................................30

Financial Results .........................................................................................31 Table 21: Total Cost of Ownership Summary.............................................31

Financial Assumptions..................................................................................32 Financial Methodology: Overview...................................................................33

Benefits...................................................................................................33 Costs ......................................................................................................33 Summary ................................................................................................34

Financial Basics ...........................................................................................34 Internal Rate of Return (IRR) .....................................................................34 What is Return on Investment? ..................................................................36 What is Net Present Value? ........................................................................36 What is a Payback Period? .........................................................................37 What is Internal Rate of Return?.................................................................37

The Bottom Line..........................................................................................37

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Executive Summary Enterprise Resource Planning and Customer Relationship Management (ERP/CRM) systems can provide access to information that previously was unavailable to an organization. The result can be multi-million dollar savings and a level of customer service previously unattainable. Having said this, how does one decide what level of IT spending is warranted to attain the uptime that system users demand? How does one determine what the total system costs will be over 1, 2, 3 and even 5 years? What is the Total Cost of Ownership (TCO) for ERP/CRM when deployed on the major computing platforms -- UNIX, NT, Mainframe and Linux? And finally, which is the optimal computing platform for a specific ERP /CRM implementation? Selecting the ideal computer platform for a new IT endeavor is a resource-intensive and complex task. Even trying to estimate the costs and resources required by one platform routinely involves: • Several days of expert system-sizing and configuration analysis • Gathering large amounts of pricing data • Forecasting personnel requirements as well as future salary levels • Putting together training budgets • Estimating the financial impact of downtime, etc.

Table 1: ERP/CRM TCO Summary

For most IT professionals putting together a budget for a new IT application is a major undertaking. Collecting the same amount of data for multiple computer platforms or operating systems then comparing those costs is overwhelming. Few companies have the resources to compare the cost of deploying a new application from one platform to another. As a result, the vast majority of platform purchases are made largely on the acquisition costs -- hardware and software. If one were to take a traditional approach UNIX would be $6,385,806, NT would be $5,396,962 and a mainframe solution would run a distant third at $6,692,664. Clearly the decision is a toss-up between NT and UNIX and conventional wisdom would look no further than

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that. Yet the result of a TCO study tells a very different story indeed. The acquisition costs of hardware and software commonly represent less than 28% of the Total Cost of Ownership (TCO). In fact, lower initial costs actually may mean higher overall costs when all ongoing expenditures are included. Companies looking beyond a 3-year investment horizon must be doubly careful concerning high ongoing costs. As Table 1 suggests the acquisition cost for NT hardware and software in this case is $5,396,962, while in comparison the UNIX acquisition costs are $6,385,806. Prior to TCO analysis these figures might have led most of us toward an NT-based solution. However, when you look at the TCO for NT it is $32,148,027 as compared to a TCO for UNIX of $16,605,747. Clearly in this particular case NT is not going to be an economically viable approach. Anyone who has been involved in a large-scale IT project knows how difficult it is to estimate the financial and human resources required to implement successfully a new system. Intuition suggests it would be substantially easier to estimate the resources required to migrate an existing ERP/CRM system from one computing platform to another. Many companies are discovering that the answer to TCO migration questions can be just as elusive as the cost of building new systems.

Platform Migration Certainly it is conceptually easier to estimate the hardware, software and personnel requirements for migrating an application than it is for a new IT initiative. However, a great deal of data still must be collected, verified and analyzed. A thorough audit of the existing hardware, software, personnel resources, as well as downtime must be completed before a platform analysis can begin. For most companies, the overhead of analyzing one platform over another introduces more than enough levels of complexity without adding a third or a fourth option. IT shops commonly are regarded as favoring one platform either due to existing staff expertise or a preferred vendor relationship. However, studies by International Data Corporation (IDC) and other major consulting companies have found that IT shops commonly understand the vast majority of the nuances associated with platform analysis. The difficulty is that despite platform selection normally being a multi-million dollar decision, most IT shops traditionally have not had the tools to be able to complete a rational comparison.

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The Results Most companies want to complete a platform analysis at various levels of detail. At the highest level of assessment most organizations need to review their respective costs for: • Hardware • Storage • Software • Networking • Services • Facilities • Personnel • Downtime • Support and Maintenance As Table 1 shows these costs can vary quite substantially when evaluating one platform to another. Most companies will benefit from exploring in more detail those cost categories that show large discrepancies from one platform to another. The ability to review the major cost categories at increasing levels of granularity is key in completing an accurate TCO analysis.

Drilling Down For example, in the context of facilities costs some companies prefer to look at their initial and ongoing costs. There also are companies that simply want to break those costs out into categories such as racks and cabling, floor space, power consumption etc. Still other companies want to reach down to the detailed level of cost per kilowatt of power. This idea of being able to drill down to increasingly granular levels of detail is key in establishing accurate cost data as well as creating a well-documented costing model.

What-if? Having been presented with an accurate TCO picture, financial management commonly wants to complete various “what-if” assessments. This typically will include allowing certain cost categories, such as downtime, temporarily to be ignored. Financial management also normally prefers to see the results reflect different depreciation assumptions, cost of capital values and even varying tax rates. Financial management also may want to see the trade-off between cheaper boxes and more system management resources, and even review the likely impact of implementing a system in one geographic location as compared to another. In summation, the ability to complete a wide variety of what-if scenarios rapidly is becoming a baseline requirement for a good platform analysis. Table 2 illustrates the total cost of ownership over time for all the platforms under consideration. The results illustrated below show the costs of the different platforms after depreciation and taxes have been taken into consideration.

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Table 2: Total Cost of Ownership (CFO Ready)

Table 2 shows that although NT and UNIX still show an approximate $14.5 million difference in TCO, the effect of depreciation and taxes was to narrow substantially the initial $16 million difference. Meanwhile the TCO cost for a mainframe with a UNIX front end when taxes and depreciation are accounted for is $18,023,792 -- more than $2 million less expensive than a pure UNIX deployment.

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Table 3 allows one to see how simple changes to the underlying financial assumptions can impact the TCO. A similar “what-if” facility should be available from a technical perspective.

Table 3: Financial Analysis

Final Analysis In the final analysis there are many elements that influence the Total Cost of Ownership (TCO) and therefore the applicability of one platform over another for a specific workload. In the case of our ERP/CRM endeavor the size of the database represents an exogenous variable. There are many more facets that play a key role in determining the optimal solution. This White Paper examines each of the major variables in-depth and provides a documented trail of the underlying assumptions that a good TCO analysis should include.

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Introduction Determining the cost of implementing or migrating an ERP/CRM solution requires the gathering and analysis of a huge amount of data. In addition, a number of basic design issues can have a tremendous impact on the likely cost picture. The major cost categories that this White Paper reviews include: • Hardware • Storage • Software • Networking • Services • Facilities • Personnel • Downtime • Support and Maintenance Each of these cost categories has been examined in great detail using CIOview’s TCOnow! for ERP/CRM software. This platform analysis software allows a consistent approach to be in place and, perhaps most importantly, ensures different model scenarios can be easily evaluated. For example, one can see how purchasing a slightly greater number of cheaper hardware boxes increases personnel and support costs more than negating the savings typically realized from lower hardware expenditures. This TCOnow! software allows one to review costs at varying levels of detail. In fact, one can drill down to the level of entering in the power cost as a factor in determining facilities costs. Irrespective of whether one utilizes a software product, sophisticated spreadsheets or a stubby pencil, an ERP/CRM system requires a significant investment. The ongoing costs can be large and, while the benefits can be great, it is important that the platform selected be suitable for current needs as well as future requirements. Later in this White Paper we describe the key decision drivers that impact your TCO and allows the reader to review in detail how the major assumptions will impact the costs of alternative platforms. After reviewing the major cost items in detail there is a methodology description and, for readers wishing more information, details on the software used for this analysis are at CIOview.com.

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Basic Assumptions Clearly there is a baseline set of assumptions that must be present to begin the TCO assessment. Table 4 showcases the major assumptions made in this case.

Table 4: New Initiative

One of the first basic assumptions that must be made is the makeup of the specific workload that will be done by the ERP/CRM solution. Certain types of workloads tend to be more easily processed by one computing architecture over another. So, for example, a workload that is highly serial in nature tends to be more efficiently processed by a mainframe, as opposed to a highly parallel workload that is more efficiently dealt with by a UNIX system. Certainly the total number of users for your ERP/CRM application will have an impact on the computing resources required. In this example we have assumed 1,500 users with 10% of them being power users, 20% average users and 70% classified as casual users. Another major assumption made in this case is that there will be between 501 and 1000 transactions per minute. Since ERP/CRM systems are commonly business-critical, it would seem reasonable that the required uptime would be 24x7x365. Many companies are seeing their ERP/CRM systems grow at better than 50% per annum; therefore, a number of 35% for future annual growth would seem reasonable. The growth rate of a business-critical system is a key component since most companies will want to know the TCO of the system fully configured for growth.

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Table 5: Workload Refinement

Table 5 is a simple way to refine the workload further. The efficiencies of different computing architectures are very workload-sensitive and the more that can be known about these architectural efficiencies the more accurately one can begin to assess the computing resources required.

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Table 6: Total Cost of Ownership Summary

Having answered the questions necessary to assess what kind of basic system resources one needs, one rapidly can begin to estimate the costs associated with deploying an ERP/CRM solution on a variety of different computing platforms. Table 6 shows that a cursory analysis would suggest that NT, with a hardware price of approximately $6.25 million in this case, would be a reasonable choice as compared to UNIX hardware, costing $9.8 million-plus, and a UNIX/Mainframe configuration with hardware costs of more than $7.6 million. Although Table 6 still shows NT with a significant lead after software costs are included, after one reviews the costs of personnel and downtime NT appears to be a less probable platform candidate. The demise of NT as an economical solution in this case really is due to the high cost of personnel ($25,225,232), which in turn primarily is driven by the large number of servers necessary for an NT deployment. Furthermore, NT’s ranking also is lowered by our selection of an example that requires the system to be up and running 365 days a year, 24 hours per day. Since most NT systems generally have experienced an uptime rating of between 97% and 98%, the cost of downtime in this case is estimated to exceed $12.5 million, as compared to a cost of approximately $3.7 million for UNIX downtime and $345,000 for a mainframe solution. Personnel costs are estimated to exceed $25 million in the case of NT while UNIX should run at a little more than $4.8 million and a mainframe solution will between $2.8 million and $3.03 million. Facilities costs will be $791,000 higher for NT because NT will require many more servers, which translates into more racks and cabling as well as floor space and power. There is little difference between the

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different platforms for services and networking costs while storage costs remain constant across all platforms. Software is the only remaining category that displays a large difference between the two platforms. In this category UNIX will come in at around $3.4 million as compared to almost $6.3 million for a mainframe solution. In fairness to the mainframe a large part of that cost is systems management software, and this can be reduced substantially if this is purchased from the OEM. Finally support and maintenance costs are about $750,000 more for UNIX than a mainframe and the TCO for UNIX is $19,778,352 as compared to a mainframe solution with a UNIX front-end costing $18,832,281. However, as you drill down into each category one can see the opportunity to reduce costs savings for both platforms. Clearly there are cases where an NT solution will make sense, where Unix will be the obvious answer and where a Mainframe purchase -- whether in combination with UNIX or Linux -- will be the better buy. The key task in the platform analysis process is to identify the factors central to determining the optimal solution. This White Paper is designed to give you a way to accomplish this so that future platform decisions will be based on sound business principles in combination with technical preferences.

Hardware Historically, when costing major IT projects the focus has been on minimizing hardware and software costs. However, these costs, as Table 1 shows, in some cases can be as low as 28% of the TCO. Having said this, the platform selected will drive most of the other project expenditures. As a result, selection of the hardware platform is the crux of the entire project. Hardware costs are driven largely by: • Utilization rate • Size of box • Resource Allocation Utilization Rate The utilization rate refers to the percentage of the processing power of a box (computer) that is being used. Obviously, if one expects only a low utilization rate that will translate into a need either for more powerful and, as a result, more expensive boxes, or simply more boxes. Estimating a reasonable utilization rate requires care: companies routinely over-estimate the utilization rates they expect to obtain. The result will be an under-estimation of the power and number of machines required. This all too often results in many companies spending large amount of money to acquire additional boxes at a later date. It is important to note that the average utilization rate also includes test systems and backup, etc. These functions commonly run at a 1-2% utilization rate and therefore significantly deflate the overall utilization rate of the total box population. As a result, estimating the utilization rate is the cornerstone of an accurate assessment of the computing power required for a particular ERP/CRM deployment.

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Table 7: Application Hardware

Table 7 reveals that a pure UNIX solution requires 24 application boxes and one back-up box. Meanwhile a mainframe solution with a UNIX front-end needs a similar number of application boxes. In contrast NT would need a whopping 174 boxes!

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Table 8: Utilization Assumptions

Our utilization assumptions for the Application Boxes are detailed in Table 8. You will notice that NT is only at 5% as compared to 25% for the UNIX application machines and 33% for Linux. Conventional wisdom in the UNIX world is to size the application servers to be large enough so that an application server can be used as a backup for the database server. This tends to avoid having large amounts of computing resources simply sitting there as a backup resource.

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Table 9: Database and QA Servers

The table above shows that for the database and Quality Assurance functions of our ERP/CRM solution we have allocated more than $4 million for UNIX hardware, and a little more than $1.7 million for a mainframe deployment.

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Table 10: Database Hardware

Our utilization assumptions are quite different for the database server as compared to the application boxes. The database server is going to experience a much more heads down environment and therefore utilization rates will be much higher. In the case of UNIX we made an assumption that the utilization rate would be 50%, 25% for NT and 80% for a mainframe. The real advantage for the mainframe in this case is that it can operate at very high utilization rates and it can handle a mixed workload such as high-performance database tasks while at the same time functioning in the QA and back-up role. The economic impact of utilization rates is key in determining what size and therefore cost of server is required.

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Size of Box There are a number of trade-offs associated with what size boxes are purchased. For example, purchasing fewer large boxes typically will result in higher initial costs, but ongoing costs may be lower due to a need for fewer IT support staff thereby lowering employee costs. The size of the boxes, particularly in the deployment of an ERP solution, very much is dictated by the size of the database box required. In order to keep hardware costs at a reasonable level it is normal to use an application system as a backup for the database server. Therefore the main considerations for hardware selection are the combination of utilization rates that one reasonably can experience, with the trade-off between higher priced boxes and lower personnel costs.

Table 11: Hardware Choices

Resource Allocation The cost of boxes for backup, quality assurance, testing, etc., can be extensive. Since most of these boxes only are being used occasionally their utilization rate is typically very low yet the cost is high. Platforms that allow these functions to be completed on non-dedicated boxes can result in very large financial savings.

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Storage Storage is the cost category that probably has the least variation in results when going from one platform to another. Certainly one can argue that, on a per-gigabyte basis, storage costs may experience a small variability in favor of NT, but in general the difference is really minimal in the totality of the overall cost picture. Certainly, one can spend as little as 6 cents per megabyte for mainframe storage, to several magnitudes more for a Storage Area Network (SAN). However, for platform analysis purposes the key point is that all storage options tend to be fairly equally priced.

Table 12: Storage Cost Factors

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Software Software costs are largely driven by: • Type of platform selected • Number of boxes required • Split between OEM and ISV software Type of Platform Generally speaking the platform you select will impact the software costs that you are likely to endure. Number of Boxes Some software vendors price their products based on the number of users while others price based on the number of CPU’s. As a result, selecting a different platform will change software prices, as will the number of boxes. Split Between OEM and ISV If the analysis leads towards a mainframe solution it is important to estimate carefully how much of the software is provided by the Original Equipment Manufacturer (OEM) as opposed to the Integrated Software Vendor (ISV), since in particular this will significantly impact the cost of system management software.

Table 13: Software Factors

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Networking Networking expenditures is arguably the most elusive set of costs to anticipate and control. Much more so than other cost categories in a TCO analysis, networking costs are highly influenced by what is already in place. The current network topology is key to future networking costs and without a very detailed assessment it is all but impossible to determine an accurate cost picture. Having said this, one can produce a fairly accurate estimate if you avoid the most common mistakes in a TCO analysis, such as: • Presuming that there are no incremental networking costs because you can

simply use your existing network capacity • Trying to recover some of the original investment in your networking

infrastructure. Only ongoing costs or incremental expenditures should be included in your TCO analysis

• And finally, recognizing that a centralized versus a distributed processing environment has very substantial implications for your networking costs

Despite all the previous caveats and warnings, networking costs tend to be influenced largely by the number of network connections. In general, having a large number of small boxes will increase network costs, while mainframe networking is largely influenced by the number of network cards required, which in turn is a function of the amount of traffic present.

Table 14: Network Factors

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Services The number of days that will be required to get an ERP/CRM system up and running will vary depending upon the number of users and the number of different functions those users require. In addition, the number of power users, as compared to the number of casual or normal users, also will influence the amount of professional services required for a successful implementation. A basic decision is required, between using in-house resources and relying largely on a professional service provider. It is important to recognize from a financial perspective that if in-house personnel are used one must account fully for their costs, irrespective of whether or not they are being used productively at the moment. A fair evaluation of a professional services company will review cost, but also recognize that time to market has significant financial value. In addition, design elements that make system users more productive also can be part of the benefit of using an outside provider.

Table 15: Services Factors

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Facilities The cost of facilities can be an important factor, particularly when considering construction of a new data facility in one of the more expensive urban settings. Beyond the cost of floor space, the outlay for racks and cabling can be extensive. Power costs also vary significantly from one geographical location to another.

Table 16: Facilities Factors

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Personnel Personnel costs are driven largely by: • Average personnel salaries and cost structure • Extent to which the server environment is cloned • Utilization rate of servers Average Personnel Salaries Personnel costs obviously start with the average salary costs and benefits of the IT staff required to support this new IT initiative or migration. Then the portion of corporate overhead (if any) has to be allocated. Server Environment The number of IT personnel ultimately required is driven by the total number of boxes and how many of them are cloned. In other words, how standard the systems are (in terms of operating system, software stack, system management tools, etc.) highly influences the average number of servers that each employee or Full Time Equivalent (FTE) can effectively manage. In a highly cloned environment the average system management ratio could be as high as 1 person for every 20 machines (file/print and firewalls). For highly differentiated server environments the people-to-server ratio may be as low as 1:2, effectively creating a tenfold increase in personnel costs. In fact, depending upon specific ERP/CRM needs the server ratio may be as low as 1:1 (for database servers), ranging up to as high as 1:5 (for application servers). Utilization Rates The utilization rate obtained on servers also is a key driver of personnel costs because with a high utilization rate fewer boxes are required and therefore less people are needed.

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Table 17: Personnel Factors

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Downtime Increasingly, even scheduled downtime where machines are taken down for routine maintenance during off-hours is being viewed as a cost to business. The cost of un-scheduled downtime in most cases is substantially higher and as a result most companies scrutinize it in one of three ways: • Cost- or productivity-based • Revenue model • Published per-minute rate (ranges from a low of $500 too as much as $9,000 in

some cases) Cost If we elect to use a cost model one simply has to estimate the average number of users that will be affected by any downtime incident. Then we must determine what percentage of productivity will be lost by not having access to the ERP/CRM system. These two numbers are multiplied by the average salary and benefits of the user population. One then can derive an average cost per minute of downtime. At that point one can take the expected annual number of lost minutes due to downtime and multiply by the average cost per minute. This will give the annual cost of downtime. Revenue Model If one expects the new IT initiative to generate substantial revenue then it makes sense to use the revenue approach to calculate the cost of downtime. In this case one simply estimates the annual financial benefits from the application, multiply this by the annual number of minutes of expected downtime, and then deflate this by the number of people expected to call back later to complete their transaction. Even when generating substantial revenue, when the system goes down not all of that revenue will be lost. Some customers will elect to call back later to complete their transaction. Published Rate Many consulting organizations have completed studies recently trying to ascertain the true cost of downtime. Clearly, if users simply cannot get a report printed because the system is down the impact on productivity is fairly low. However, if the finance folks are at the end of the quarter and cannot get to the financial functions the productivity hit is fairly high. As a result, consultants have found the per-minute cost of downtime can range from $500 to as much as $9,000. Either way one elects to calculate downtime, the financial cost in many cases can be quite staggering. Downtime costs are largely driven by: • Platform selected • Efficiency of system management tools and personnel

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• Specific system configuration choices Inherently the downtime attainable for a company is dependent on the platform. However, if one skimps on software by reducing expenditures on system management tools, you are likely to pay the price with increased downtime. Furthermore, system management staff will not remain state-of-the-art without a continual investment in training. In addition, there are specific hardware-design choices that can be made to increase uptime but these opportunities tend to be platform specific and have significant processing power implications.

Table 18: Downtime Assumptions

Clearly one has to start with some basic assumptions concerning downtime. Inherently some computer architectures and operating systems are more reliable than others, by how much it up for debate. In this case we started with the notion that a mainframe would gain a small incremental improvement over a pure UNIX solution.

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Table 19: Downtime Factors

There are many different ways to determine the cost per minute of downtime. Most companies and consultants would argue that irrespective of the methodology used for a mission critical system such as ERP/CRM one should begin the analysis at $500/minute and go up from there. In this example we have used a very paltry $219/minute. Despite this low cost of downtime UNIX ends up with a cost of $1.24 million, while NT nears $4.2 million. Downtime costs are becoming a growing portion of the TCO analysis process and the dollar impact of downtime can very often be the deciding factor in final platform selection process.

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Support and Maintenance The annual cost for support and maintenance is largely driven by the hardware choices that are made for database and application servers as well as how other hardware is configured. Finally, the choice of application software vendor will dictate the amount of ancillary software required in the form of middleware, database technology and systems management software. In turn this will influence highly total support and maintenance expenditures.

Table 20: Support and Maintenance

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Financial Results Given the estimated costs entered for this project, the financial results would be: Total Cost of Ownership for Unix: $16,605,747 Total Cost of Ownership for NT: $32,148,027 Total Cost of Ownership for Mainframe/Pseries: $14,421,043 Total Cost of Ownership for Mainframe/Linux: $21,616,856 These results are impacted by a number of factors including the underlying financial assumptions.

Table 21: Total Cost of Ownership Summary

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Financial Assumptions The following financial assumptions were used in this analysis: • Depreciation Method: MACRS • Depreciation Schedule: 5 years • Taxation Rate: 33% • Cost of Capital: 9% • Capitalization Threshold: $100,000 There are a number of depreciation methods from which one may select. Modified Accelerated Cost Recovery System (MACRS) is the default for the United States, simply because the Internal Revenue Service favors it for IT projects. The number of years that you elect to depreciate over (“deprecation schedule”) also can be customized. The tax rate is defaulted to the average for our industry but can be changed at will. The cost of capital takes into account how much you would pay for money if you elected to finance this project. The cost of capital or discount rate also can take into account a number of complicating factors, such as our company's debt-to-equity ratio, the amount of risk inherent in the project, etc. The default value is 10% and the vast majority of companies will be within two percentage points of this number. The Capitalization Threshold is the dollar value at which you depreciate your costs, as opposed to expensing them in a single financial period. Some cost elements such as services cannot typically be depreciated. The capital threshold defaults to a value of $100,000. If costs are lower than $100,000, they are expensed; if costs are higher, they are depreciated.

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Financial Methodology: Overview CIOView uses generally accepted accounting and capital budgeting techniques to produce a reliable set of financial metrics for your IT investment. These metrics may include return on investment (ROI), internal rate of return (IRR), payback period, and net present value (NPV). Each of these measures requires a set of financial assumptions concerning taxes, depreciation, cost of capital, etc. The following discussion details how CIOview treats these issues for the purpose of calculating the results. The fundamental concept that underlies all of the financial calculations in CIOView’s products is that benefits do not begin to accrue until all the up-front costs necessary for deployment, such as hardware, software, services, and training, have taken place. Therefore, initial costs are incurred in the period before benefits are received, while ongoing support and maintenance costs are treated as occurring at the same time as benefits. Benefits Benefits start to build up once users go into production with the application, and are treated as annual savings that recur every year. For example, if an initial rollout of 100 users in year one achieves $10,000 timesavings, that savings also will take place in years two and three. Timesavings attributable to any additional users in years two or three would be in addition to this $10,000 annuity. Costs Costs are treated in several ways, depending on the nature and timing of the cost. Initial costs required before the software application can be deployed to a given set of end users are treated as occurring in the period before benefits are counted. For example, if you need to spend $15,000 on PCs for year 1 users before they can use the application, this cost will appear in the initial cost column. Initial costs pertaining to year 2 users are treated as occurring in year 1. This is done to maintain the integrity of the way costs and benefits are incurred. Costs also can be treated differently depending on whether they are expensed or capitalized. Expensed costs are written off in full, while capitalized expenses are depreciated over time. CIOview uses a default capitalization threshold of $100,000. When cumulative expenditures on hardware, software, networking, and/or training total more than the capitalization threshold in a given year, these expenditures are capitalized. Capital expenses are reported on the corporate balance sheet and even though they represent a cash outflow for the year, they are not tax deductible. However, they are added in after tax for cash flow calculations. CIOview includes four depreciation methods for IT purchases: MACRS, Straight Line, Double Declining, and Sum of Years Digits. Five-year MACRS is used as the default.

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Summary Many companies use slightly modified approaches depending on their industry, capitalization structure, applicable taxes and depreciation, etc. Therefore, the results from CIOview may not always be identical to customized methodologies.

Financial Basics There are many different techniques to measure the financial attractiveness of any large financial endeavor such as an IT project. The vast majority of companies use one or more of the following approaches to make their "go or no-go" investment decisions: • Return on Investment (ROI) • Net Present Value (NPV) • Payback Period Internal Rate of Return (IRR) To better understand the above terms we will work through all of them using the same simple example. Imagine Widget Manufacturing Co. plans to roll out New Software to one hundred employees within the next 12 months. Let's assume that the initial costs for this deployment will be $10,000 and that it brings a productivity boost to Widget Manufacturing worth $5,000 per year. Before discussing the above techniques, it is important to understand two concepts that form the basis for the financial metrics. They are: • Discount Rate • Present Value Discount Rate Assume Widget Manufacturing has $10,000 cash it can use any way it wants. It could buy new software, or it could invest it in the bank at a 10% interest rate. Let's say Widget decides not to buy CRM/ERP and instead invests all $10,000. After one year, Widget would have $10,000 plus interest on $10,000 at a 10% rate. So Widget would have $10,000 + ($10,000 * 10%), or $11,000. During year two, Widget decides not to take any money out of the bank. This means it is investing $11,000, not just the initial $10,000 amount. So at the end of the second year, it then has $11,000, the sum at the end of the first year, plus interest on $11,000 at a 10% rate. At the start of year three, this means Widget has $11,000 + ($11,000 * 10%), or $12,100. If Widget leaves all its money invested during year three, it will build up 10% interest on $12,100 and will end the year with $12,100 + ($12,100 * 10%), or $13,310. This process easily can be expressed by saying that the amount Widget has after "x" number of years is equal to its initial principal (here $10,000) multiplied by its rate of

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return to the power of "x." After three years, Widget has $10,000 * (100%+10%)^3, or $13,310. This is defined as compound interest. The interest rate to the power of "x" is the compounded interest rate. The discount rate is simply the opposite of the interest rate used in the above compound interest example. To calculate a discount rate, you have to start with your final amount and try to get back to your initial investment. At what rate would you have to discount the $13,310 Widget has in year 3 for it to equal the initial $10,000? In other words, what discount rate would satisfy the equality $10,000 = $13,310/(100%+discount rate)^3? For Widget's investment of $10,000, the discount rate is 10%. Present Value Imagine now Widget is considering implementing new software. Widget then will want to compare the return from implementing CRM/ERP, let's say over three years, to the return they could get just by leaving money in the bank and expending no effort. But the benefit of implementing New Software is not simply three years times $5,000 (annual benefit) per year, or $15,000. This approach does not take into account the time value of money. “Time value of money” means that money received now is worth more than money received later. Intuitively, think of the concept of immediate gratification. Most people, for example, would prefer to get paid their entire salary on January 1 than to have to wait throughout the year to receive all of it. The $5,000 annual benefit Widget Manufacturing will receive for the next three years is worth less than $15,000 sitting in Widget's bank account right now. Widget cannot pay its employees or suppliers right now with money it won't have for three years. In finance, time value of money is expressed as the present value of a future sum of money. Present value builds off of our earlier concepts of compound interest and the discount rate. To find the present value of a future benefit, one asks, "What is ‘x’ number of dollars to be received in the future worth to me right now?" Clearly, based on the concept of time value of money, "x" dollars in the future is worth less than "x" dollars now. But how much less? This is where the compound interest and the discount rate become important. $5,000 that Widget will receive next year is numerically equal to some "y" amount of dollars Widget has invested in the bank now. This "y" dollar is the present value. It answers the question, "What sum of money must I have today to equal $5,000 I will receive a year from now?" To calculate this "y" dollar amount, we have to use the discount rate, which, as explained before, is the backwards interest rate. Present value is equal to the future benefit divided by 1+ the discount rate. So for Widget, the present value of $5,000 received in 12 months is $5000/(100% + the 10% discount rate), or about $4500. If Widget had $4500 now and invested it, it would have about $5,000 in 12 months. However, Widget Manufacturing wants to know the value of benefits it will receive over three years. We need to find out the present value of $5,000 received after one year, $5,000 received after two years, and $5,000 received after three years. Again, the concept of compound interest is useful. Think of the present value over multiple Years as a slightly reversed compound interest. Instead of multiplying by

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the compounded interest rate, you divide each annual benefit by 1+discount rate compounded by the number of years. So the present value of Widget's annual benefit of $5,000 would be: End of Year One End of Year Two End of Year Three Benefit $5,000 $5,000 $5,000 Present Value of = $5,000/(1.1) = $5,000/(1.1)^2 = $5,000/(1.1)^3 Benefit = $4,545.45 = $4,132.23 = $3,756.57 The present value of all $15,000 received over three years would be $4545.45 + 4132.23 + 3756.57 = $12,434.26. What is Return on Investment? Return on Investment (ROI) is arguably the most popular metric when it is necessary to compare the attractiveness of one business investment to another. Your return on investment equals the present value of your accumulated net benefits (gross benefits less ongoing costs) over a certain time period, divided by your initial costs. It is expressed as a percentage over a specific amount of time; in IT purchasing, three years is the most common time span since technology often effectively is obsolete after this time. The equation for a three-year ROI is: (Net benefit year 1 / (1+discount rate) + net benefit year 2 / (1+discount rate) + net benefit year 3 / (1+discount rate)) / initial cost. Each year 1 + discount rate must be compounded. So if the initial cost for your manufacturing company's small new software rollout was $10,000, your annual benefits less annual costs are constant at $5,000 for the next three years, and the discount rate is 10%, your 3-year ROI would be: ($5,000 / (1 + .1) + $5,000 / (1 + .1)^2 + $5,000 / (1 + .1)^3)/$10,000 = 124% While ROI tells you what percentage return you will get over a specified period of time, it does not tell you anything about the magnitude of the project. So while a 124% return may seem attractive initially, would you rather have a 124% return on a $10,000 project or a 60% return on a $300,000 investment? That is why you will often want to know the Net Present Value. What is Net Present Value? Net Present Value (NPV) gives you a dollar value of your expected return and therefore indicates the magnitude of your project. It is calculated by summing the present value of the net benefits for each year over a specified period of time, then subtracting the initial costs of the project. A positive NPV means that the project generates a profit, while a negative NPV means that the project generates a loss. The equation for a three-year NPV is: (net benefit year 1 / (1+discount rate) + net benefit year 2 / (1+discount rate)^2 + net benefit year 3 / (1+discount rate)^3) - initial costs. If we take the hypothetical manufacturing company's new software rollout example, the NPV would equal: $5,000 / (1 + .1) + $5,000 / (1 + .1)^2 + $5,000 / (1 + .1)^3 - $10,000 = $2,434 The great thing about NPV is that it tells you about the dollar value of your savings; the downside is that it doesn't tell you when savings will occur.

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What is a Payback Period? Simple Payback period is used to find out how long it will take for an investment to show a profit. It is important when time and cash flow are in issue. It is the time it takes for your project to recoup the funds expended, and normally is expressed in years or months. The equation for a simple payback period is: initial cost / annual net benefit. So, if we use the same new software rollout example as before your simple payback period is: $10,000/$5,000 = 2 years Payback is very easy to calculate but it doesn't tell you about the magnitude of your savings, or even how your investment performs after your benefits equal the initial costs. What is Internal Rate of Return? Internal Rate of Return (IRR) is the most sophisticated of the above metrics and often is used to analyze large, multi-year investments. IRR equals the percentage rate by which you have to discount the net benefits for your time period until the point that they equal the initial costs. IRR is closely related to net present value. The rate of return calculated by IRR is the discount rate you would need to apply to your benefits to obtain a net present value of zero. The expression for IRR (in this case, a three-year IRR) is: initial costs = net benefit year 1 / (1+IRR) + net benefit year 2 / (1+IRR)^2 + net benefit year 3 / (1+IRR)^3.IRR often is calculated through a trial-and-error process or data table, since solving the above equation is very time-consuming. If we use the same new software rollout example as before, the IRR would equal 23%. This gives an NPV of ($5000 / 1.23 + $5000 / 1.23^2 + $5000 / 1.23^3) - $10000 = 0, which follows the relationship between NPV and IRR. IRR may be thought of as a kind of turbo-charged ROI. It is particularly useful when you are making a multi-year investment with costs that change radically from one year to the next. But it still suffers from ROI's main weakness, which is that it does not give any indication of the magnitude of the project involved.

The Bottom Line Each of these financial measures has its respective strengths and weaknesses. Different companies will place varying amounts of emphasis on each of the different metrics. To get a clear and complete picture of a prospective investment, you will benefit from having access to all of these measures. Disclaimer

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This software and the data contained herein do not have any express or implied warranty. TCOnow! is a state of the art financial decision support tool designed to provide as complete an analysis as possible. There are however many factors that can significantly influence the actual results. Time to deploy, cost overruns, competitive developments, and changes in business management or strategy can all dramatically influence the attractiveness of any IT investment. Consequently, CIOview Corp. can offer no guarantees or warranties whether explicit or implicit regarding the actual financial results of your IT investment. Copyright 2001. CIOview Corp. Patents Pending All Rights Reserved.