Evaluate alternative solutions against project constraints



Evaluate alternative solutions against project constraints

Inside this reading

Budget constraints 2

Estimating project costs 3

Estimating project benefits 5

Cost benefit analysis 7

Other constraints 14

Summary 16

Budget constraints

The most important constraint you will need to consider when trying to identify the best solution to a problem is the budget constraint. This is done by looking at the economic feasibility of each solution. Since most problems can be overcome if enough money is spent it is necessary to identify how much money needs to be spent and if the business is prepared to spend that money to achieve the required outcome.

Reflect:

Think about the following small case study:

You’re car has broken down and you are currently going to work by train. When you go to the local garage to check on the repairs you are told that there are three options. You can either fix the engine that is in your car, or you can have a new engine put into your car or you can buy a new car!

You have to make a decision on what you are going to do and quite likely that decision will be dependent on your budget. If money is no object, you might decide to buy a new car, however in your current situation you decide to go for the cheapest option, which will be to fix the engine that you have.

To determine economic feasibility you will need to perform a cost/benefit analysis. This will compare the costs of implementing a solution with the expected cost returns or benefits to be gained from it. Unless there are other over-riding reasons, solutions are not implemented unless the benefits outweigh the costs.

Reflect:

Using the same scenario of your car, you might decide to do an economic feasibility study to see which one of the options will give you the most benefit for the money that you have to spend. What would you consider in your cost benefit analysis?

Fixing the existing engine is the cheapest option, however since it is quite old, it is possible that something else may go wrong with it in the next couple of years and you will have to pay to have it taken apart to fix again. Replacing the engine with a new one might be a better option as it should not break down again but it will be more expensive in the short term. Buying a new car might be a more attractive option as it will give you all of the new features that you would like that don’t exist in your old car, but it is a much more expensive option and you may not be able to justify spending that amount of money at the moment.

The first step in performing a cost benefit analysis is to estimate:

• the costs of the solution

• the benefits or savings that the solution will provide to the company

Estimating project costs

The costs of the solution can be broken down into two main divisions:

• Development costs

• Operating costs.

Development costs include all of the costs associated with developing a system to solve the problem and, for that reason, occur once only. These are sometimes called 'one-off' costs.

Operating costs include all of the costs involved in running the system on an ongoing basis, and are often referred to as recurring costs or life cycle costs, since they occur throughout the life of the system. They are usually defined on an annual basis.

For an IT solution, to estimate the development costs of the new system you must include:

• The costs associated with obtaining the additional equipment that is needed

• The costs of developing or purchasing any necessary software

Reflect:

In the car scenario, what would the one-off costs be? What would be recurring costs?

One-off costs would be the costs of solving the problem, i.e. all of the costs involved in repairing the car or buying a new one. The recurring costs are the costs of operating or running the car on an annual basis, i.e. petrol, registration, insurance, etc.

Development costs

These include all of the costs of developing and implementing the new solution and, for an IT solution, can be broken down into capital costs, software development costs and conversion costs.

Capital costs are the costs of purchasing the necessary equipment to implement the new system, and, for an IT solution, will include:

• Computer Hardware

• Computer Software

• Office Equipment

Hardware costs will include:

• The purchase of new computers and peripherals

• The upgrading of current equipment that will still be used

• New workstations

• Communication equipment.

Software costs may include the purchase of:

• General purpose software, such as database management systems, compilers, CASE tools, other software packages

• Specific software application packages, for example payroll or inventory software

• Office equipment.

Once you have determined what equipment is needed, these capital costs can be estimated by contacting potential suppliers.

Reflect:

In the car scenario, if you have decided to replace the engine then the garage mechanic will need to determine exactly what the specifications for the engine are and then contact the companies that sell engines to find out which ones can supply this particular engine and how much it will cost.

Software development costs are the costs associated with developing the new system and include things like:

• Computer charges, e.g. costs of running the computer to develop the system

• Personnel charges, e.g. salaries of staff employed just for this project

• Training of computer personnel to use any new software development tools

• Office supplies, e.g. stationery

• Work lost due to disruption, e.g. time spent by the users in interviews, etc.

• Communication charges, e.g. telephone costs

• Travel, e.g. costs of staff traveling to JAD sessions

• Contingency costs—an allowance added to the estimate to cover any unexpected costs that may arise

Conversion costs are the costs associated with converting the existing system to the new system and may include:

• Data conversion – converting the data from the format of the old system to a format that the new system will accept. This may involve significant data entry costs if the existing data is on paper, as it will have to be keyed into the new system.

• Training of the employees to understand and use the new system

• Parallel running – if the old system is going to continue to operate at the same time as the new system for a period to ensure that there are no problems in the changeover, then there will be extra costs associated with running two systems to achieve the same outcome.

Development costs may be difficult to determine. It is not easy to anticipate what problems may occur during the development that could affect the cost. A thorough risk analysis of the project should help to reduce unforeseen circumstances and experience of previous similar projects will help considerably.

Operating costs

Operating costs are the costs of running the new system and are usually calculated for a one year period. These annual operating costs may be either:

• Fixed costs

• Variable costs.

Fixed costs are things like:

• Administrative costs

• Salaries for the permanent staff

• Hardware and software maintenance

• Licensing and leasing fees, for hardware and software

Variable costs are those that may vary each year, such as:

• Depreciation of hardware – there are depreciation scales set by the tax department which allow different percentages of deductions for depreciation each year for several years

• Supplies – the volume of supplies you use each year will vary depending on the volume of business that the company does

• Wages for temporary staff – if you need to employ temporary staff, the number of these staff and the time periods that you employ them for may vary each year depending on the workload on your permanent staff

Estimating project benefits

The reason for developing a new solution is usually to improve the operation of the existing system or to incorporate new features that do not exist in the original system. In either of these situations the expected outcome should be to generate benefits from the new solution. To evaluate the economic feasibility of the alternative solutions you will need to identify and quantify the benefits that each solution will generate.

There are two types of benefits:

• Tangible benefits

• Intangible benefits.

Tangible Benefits

Tangible benefits are those that you can measure (usually by an increase in cash flow). An increase in cash flow can be achieved by either increasing the revenue of the company or by reducing its costs.

Increasing the revenue of the company can be done by increasing the selling price of the products that they sell or by increasing the number of products that are sold.

Reducing the costs of a business means reducing the costs of any or all of the departments that make up the business. Costs may include:

• Personnel – the salaries of the staff

• Hardware – the costs of buying or leasing the equipment

• Production – the costs of producing the products that the company sells

• Inventory – the costs of purchasing and storing the parts that are used to make the products, and storing the finished products before they are sold

• Interdepartmental communication – the costs of telephone systems, email, internal mail systems

Intangible benefits

Intangible benefits are those that cannot be measured or cannot have a dollar value put on them but are nevertheless important to the success of the business, for example:

• goodwill

• increased customer satisfaction

• public image

• improved employee morale

• improved environmental conditions

Reflect:

A bank installs an automatic teller machine outside its building. After six months the number of customers coming into the bank to do their banking has dropped to a level that the bank can operate with two less staff working on the counter. What do you think a tangible benefit of the ATM might be?

What do you think an intangible benefit might be?

A tangible benefit would be the reduction in staff costs of two staff, which can be measured by their salaries. An intangible benefit may be increased customer satisfaction since customers do not have to wait in queues inside the bank any more. This is an intangible benefit since you cannot put a dollar value on customer satisfaction but it may mean that the customers will keep their accounts at this bank rather than moving to another bank that has more convenient facilities.

Estimate the costs of not developing the new system

Keep in mind that in some circumstances there may be costs associated with not developing a new system and you should take these into account where they occur.

Reflect:

In the above discussion about the bank, what do you think might be a cost of not installing the ATM?

One cost might be that some of the customers might take their accounts to another bank that has more convenient facilities, such as an ATM.

Cost benefit analysis

Do the costs outweigh the benefits?

Now that you have identified and estimated all of the costs and benefits of the new solution you will be able to work out if the benefits will outweigh the costs of development. If they do not then it is highly unlikely that you will be given the go-ahead to continue with this solution.

When you start to examine the costs and benefits, you will see that the costs are incurred during the period of development whereas the benefits occur over the following, say, 1 or 5 years.

How do you compare a dollar now with a dollar in several years time?

To do any sort of realistic comparison of the costs and benefits you will need to first of all make sure that the dollar values that you are comparing have the same worth. In this situation interest rates and inflation rates become important.

Think about the following two situations:

If you invest a dollar today, in a year’s time you might have $1.05, since your dollar has earned five cents of interest.

However, if instead of saving that dollar you were to spend it on buying a soft drink, that soft drink has really cost you $1.05 because of the five cents of interest that you missed out on.

In the study of Economics this concept is called ’Opportunity Cost’. It considers the value of the interest which could have been earned by a dollar if it had not been spent.

Similarly, you know that the dollar you earn next year won’t be worth as much as the one you earned this year. Prices increase with inflation and an item which cost you $100 today may well cost $104 next year.

This change in the value of money over a period of time is referred to as the 'Time Value Of Money'.

To perform an accurate cost benefit analysis you must take into account both of these concepts.

There are some Economic and Accounting strategies that you can use to compare the costs of a solution to its benefits. The most popular of these are:

• Payback Analysis

• Present Value Analysis

• Return on Investment Analysis

Let’s look at an example to see how these are used

A particular system costs $5,000 to develop and is estimated to save $2,500 per year. This is the difference between the operating costs of the old system and the operating costs of the new system.

The future benefits (i.e. cost savings) can be shown in a table as follows:

|Year |Cost Savings |

|1 |$2500 |

|2 |$2500 |

|3 |$2500 |

|4 |$2500 |

|5 |$2500 |

Table: Example of Future Benefits

Remember that when estimating future costs and benefits you need to take into account the time value of money.

How?

The initial investment is $5,000

The future benefits are $2,500 per year

The investment is made ’this year’ i.e. you have its present value.

However, the benefits occur in the future (they have future value) and you should not compare present values with future values. You must therefore first of all convert the future values to present values.

In other words:

'What is the present value of a $2,500 saving in 2 years time?'

There is a formula that you can use to convert these future values to present values, as shown below:

Future value = present value (1 + interest rate)n

Where n = the year into the future.

If you want to find out what the present value is and you already know the future value, you can change the formula around:

Present value = future value/(1 + interest rate)n

So, the answer to the question 'What is the present value of a $2,500 saving in 2 years time?' will be found by setting the future value to $2,500, setting 'n' to 2 and selecting the current interest rate.

For the example, you can use an interest rate of 5% (written as decimal '0.05'). The formula then becomes:

Present value = 2500/(1+0.05)2

When the formula is evaluated it becomes

Present value = 2500/(1.1025)

Giving an answer of $2268, rounded to whole dollars.

In other words, $2,500 in two years time is only worth the same as $2,268 today.

You can now extend the table by estimating the present values against future savings for each of the next five years.

You should also add a column for the total or cumulative value of savings for each year. For example, after two years the total savings generated by the new system will be the savings for the first year plus the savings for the second year.

|Year |Future savings |(1 + i)n |Present value of savings |Cumulative value |

| | | | |of savings |

|1 |$2,500 |1.05 |$2,381 |$2,381 |

|2 |$2,500 |1.1025 |$2,268 |$4,649 |

|3 |$2,500 |1.1576 |$2,160 |$6,809 |

|4 |$2,500 |1.2155 |$2,057 |$8,866 |

|5 |$2,500 |1.2763 |$1,959 |$10,825 |

Table: Example of cumulative savings

Now that you have converted the costs and benefits to the same time value of money you can carry out some meaningful comparisons

Payback Analysis

This involves calculating how long it will take for the solution to pay for itself, that is when the savings from the new solution are equal to the costs of developing it. This is called the Payback Period.

Many organisations set a minimum payback period for projects to be undertaken. If it will not pay for itself in, say, three years then the company will not be prepared to go ahead with it.

Using the example above:

After 2 years the benefits or savings are $4,649

After 3 years the benefits or savings are $6,809

Since the development cost was $5,000 it will pay for itself or ’break-even’, sometime during year 3. (This is when the savings equal $5,000).

You now need to work out at what point in the third year this break-even point will occur.

At the end of year 2, the savings made totaled $4,649. Since the development cost was $5,000 it follows that the remaining savings of $351 to break-even will be made at some point in year 3. At the end of year 3, $2,160 of savings was made.

The portion of the whole of year 3’s saving that this represents is:

$351/$2160, which is approximately 0.16 of the total savings for the year.

Therefore the payback period is 2.16 years

Present Value Analysis

This technique calculates the difference between the present value of the benefits and the present value of the initial investment.

In the previous example, after 5 years, the present value of the benefits is $10,825.

The present value of the initial $5,000 investment is still $5,000.

The Net present value (NPV) is therefore $10,825 - $5,000, which is $5,825.

This is a positive net present value. Any project with a positive net present value is considered to be economically feasible, since, over a set period of time, the benefits are greater than the original cost.

Return on Investment (ROI) Analysis

This technique simply expresses the net present value as a percentage of the initial investment

In the previous example, the net present value was calculated at $5,825.

The initial investment was $5000.

Expressing this as a percentage will give:

$5825/$5000 which is 117%, rounded to 2 decimal places

This return has been calculated over a five year period. An annual return will be obtained by dividing the five year return by 5.

In this example the annual return will be 117/5, which is 23% per year

This figure is called the Return on investment or ROI. An ROI of 23% would be very good.

The return on investment is an important value as you can use it to make comparisons between different types of investments. To determine if it is worth investing in this project you can compare the return on the initial investment in the project with the return that would be obtained by putting that initial sum of money in some other investment, such as a bank, shares, property etc.

The minimum acceptable return on investment for a project would usually be the return that could be obtained from investing in a secure investment such as bank bills.

Reflect

Think about the following small case study:

A large oil company is considering a project to upgrade its computer systems. The feasibility study has been done and the ROI for the project has been calculated at 10%. The financial accounting department has looked at this figure and knows that it can get a 12% ROI if it builds a new petrol station.

In this case, unless there were more urgent reasons for upgrading the computer system, the company would not go ahead with it since it could get a better return on the initial investment from the new petrol station. This relates back to the original discussion of ’Opportunity cost’ – in this case the ’Opportunity cost’ would be the 2% difference between the two investment options.

Example

Suppose you had a proposed project which would cost $10,000 to implement and then produce savings as shown:

|Year |Savings |

|1 |$3,000 |

|2 |$4,000 |

|3 |$2,000 |

|4 |$2,000 |

|5 |$2,000 |

Table: Example of savings

The lifespan of the project is expected to be just 5 years and the interest rate is 5%. Should the project go ahead?

Answer to example

|Year |Future Savings|(1 + i)n |Present Value |Cumulative Value |

|1 |$3,000 |1.05 |$2,857.14 |$2,857.14 |

|2 |$4,000 |1.10 |$3,628.12 |$6,485.26 |

|3 |$2,000 |1.16 |$1,727.68 |$8,212.94 |

|4 |$2,000 |1.22 |$1,645.40 |$9,858.34 |

|5 |$2,000 |1.28 |$1,567.05 |$11,425.39 |

Table: Answer to example with cumulative values

Development cost = $10,000

Payback period = No of years for development cost = cumulative value of savings

4years = $9,858.34

Portion of 5th year = (10000-9858.34)/1567.05 =0.09

Payback period = 4.09 years

NPV = cumulative savings—development cost

= $1,425.39

Return on investment = NPV/development cost

= 14.25% over 5 years

= 2.85% per annum

At this rate, the project should probably not go ahead!

Why? Because the payback period is more than 4 years, the ROI is only 2.85% (you’d get better returns at the bank!), even though the NPV is positive.

Tools for performing cost benefit calculations

As you have seen in the above examples, the calculations required to perform the comparisons are just a matter of some fairly simple arithmetic. However, there are many software tools available that will do these calculations for you. The most popular tool is Microsoft Excel, which has several functions for calculating the net present value of a series of future values.

Practise activity 1

Open a blank Microsoft Excel worksheet and have a look at the help function for the keyword 'NPV'. Make sure that you understand the examples provided. Now have a look at the 'PV' function. These two functions have slightly different uses – which one will you use to do the calculations in the previous example? Why? Now go ahead and perform the calculations using your chosen function. Compare the results with those given in the example. If there is a difference can you explain it?

(See end of this document for feedback)

One of the main advantages of using a spreadsheet package to perform your cost benefit analysis calculations is that you can easily perform modelling or 'what if' scenarios to test the financial returns based on varying interest rates. It is simply a matter of changing the value in the cell that you wish to vary and the complete set of figures can be automatically recalculated. This will help you to quickly and easily determine what effect cost, benefit or interest variations will have on the economic feasibility of your solutions.

Practise activity 2

In the Excel spreadsheet that you used in the previous activity, try changing the interest rate used to calculate the present value of the future savings. What do you notice about the results if the interest rate increases to 10%?

(See end of this document for feedback)

Other constraints

So far you have looked at the budget constraint, since this is usually the most important and is the one which is most likely to determine the solution that will be chosen. There are other constraints, however, that you should consider when trying to evaluate which solution will be the best for the company.

Deadlines

In some cases there may be an absolute deadline for the implementation of the new system. For example, if the company is trying to be the first to market with a new concept the competitive advantage may be lost if the project is not completed by a set date. In this case, any solutions that cannot be implemented by this deadline may not be considered.

Available resources

This includes the staff, hardware and software resources that are available for product development. Once again, if the company does not have the necessary resources and is not prepared to obtain them, then any solutions that have this requirement will not be feasible.

Technical

The new system may have to run on the existing hardware and software. This may be a major constraint if some of the solutions require state of the art technology, and may be a deciding factor.

The present staff may not have the necessary technical expertise to develop the new system – it may be possible to overcome this constraint by employing new permanent or contract staff who have the necessary skills, but this will impact on the budget.

The equipment to be used may not have the required capacity to cater for increased workload or to provide an acceptable level of performance. If the existing equipment is to be used you must also consider the impact to the end users already using the equipment, as well as the new users. The new system will not be acceptable if it means that the existing users will get a reduced level of service.

Organisational issues

There may be constraints on the way that the company does business and so changes to this may not be possible. In this situation the new solution will have to work within the existing procedures.

The company may have organisational standards that indicate a specific development methodology or set of development tools that must be used and this will affect the choice of solution.

Legal or Statutory Requirements

Legal or statutory requirements of the business may impact on the choice of solution, for example, contractual provisions or government regulations.

The solution you select to recommend to the client should be the one that best fits all of the above constraints. It should ideally conform to current organisational standards, be able to evolve into the future and be usable in other contexts within the organisation.

Strategies for identifying project constraints

Project constraints are easier to detect with experience but how do you get experience before having any practice. It’s a bit like the student having freshly left school and applying for a job requiring five years experience.

Don’t be afraid to ask colleagues for support, particularly those with experience in developing feasibility reports. Also, make sure that you research any previous similar projects and look at the constraints. The same constraints may apply to your project.

Summary

To select the best possible solution to the client’s problem it is necessary to examine each of the alternatives against the project constraints. You will already have identified and documented these constraints as part of your analysis of the requirements.

The major constraint for a project will usually be the budget constraint and so it will be necessary to perform a cost benefit analysis for each solution to identify if it is economically feasible. This involves estimating the costs and benefits of the solution and comparing these values to make sure that the benefits will ultimately outweigh the costs. There are several accounting techniques that you should consider to make this comparison in terms that the business will be able to use to make a final decision, such as present value analysis, return on investment analysis and payback analysis.

Feedback to activities

Feedback to practice activity 1

The NPV function will be needed for the calculation as it can be used with variable values – for the PV function the values must be the same. Any differences in values will be due to rounding.

For example = NPV (5%, 3000,4000,2000,2000,2000) – 10000 = $1425.39

Feedback to practise activity 2

As the interest rate increases the savings and therefore the return on investment (ROI) decreases.

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