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CHAPTER 9: COST AND BENEFIT ANALYSIS

Chapter Objectives
At the end of this chapter, you would have learnt: tangible and intangible costs/benefits; major cost categories; break-even analysis; payback period; marginal efficiency of investment.

Esse tia! Rea"i #s $%r this Chapter undamentals of !ystems Analysis, "erry # Ardra it$%erald&'()*+, ,iley # !ons, -nc. ./hapter '0, page 1'0 - 1'2, 13'4 !ystems Analysis and 5esign, 6endall # 6endall &'())+, 7rentice-8all -nternational, -nc. ./hapter '3, page 9*9 - 9*14

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I tr%"(cti%
/osts and benefits are two major determinants in deciding the fate of any proposed systems. A proposed system may have the ability to fulfil all the information re:uirements. 8owever, this does not guarantee that the proposed system will be developed. ;he decision is based on whether the benefits can outweigh the costs or not. /onse:uently, it is essential for systems analysts to be familiar with the techni:ues used in performing cost and benefit analysis. ;his knowledge not only allows them to be aware of management concern but also allows them to provide effective supporting arguments for the implementation of the proposed system if it is deemed operational, technical and economically feasible. -t is always essential for a system analyst to be able to :uantify his/her suggestions. A systems analyst is responsible for determining the costs and benefits of the proposed system. 8owever, in certain cases the systems analyst may propose alternative systems. -n such situation, the systems analyst needs to develop several cost and benefit analysis. ;here are two different types of costs and benefits. ;he two types of cost are tangible and intangible costs. ;he two types of benefit are tangible and intangible benefits. ,e will discuss these concepts in section (.3. -t is not easy to effectively estimate the costs and benefits of any proposed system. <any factors need to be considered and not all factors can be readily identified. <oreover, a lot of the factors are difficult to measure. = ;he following notes, from here onwards, are e>tracted/modified from: undamentals of !ystems Analysis, "erry # Ardra it$%erald, ,iley # !ons, -nc. &'()*+. ;he following :uestions can help to identify the factors involved in estimating the cost and benefit of any proposed system: ,hat are the major cost categories of the entire system? ;hese may include items such as communication circuit costs, hardware costs, software costs, maintenance costs, personnel costs, and the like. ,hat methods of cost estimating are available and what accuracies can be achieved? /an all costs be identified and accurately estimated? /an the benefits be identified? ,hich benefits cannot be estimated in dollar terms? ,hat criteria will management use when evaluating these estimates? @nd of notes e>tracted/modified from: undamentals of !ystems Analysis, "erry # Ardra it$%erald, ,iley # !ons, -nc. &'()*+.

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Ta #ib!e a " I ta #ib!e C%sts*Be e$its

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Ta #ib!e C%sts

;angible costs are those costs that can be easily identified and determined by the system analyst. @>amples of tangible costs are listed as follows: urniture costs. /osts of software. /osts of e:uipment. /ost of file conversions. /osts of different supplies. !alaries of personnel involved. -nsurance for the new e:uipment and/or special facilities. /osts of leasing or renting e:uipment and/or special facilities.

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I ta #ib!e C%sts

-ntangible costs are the direct opposite of tangible costs. -t is not only difficult to identify them at times but also hard to project an accurate estimate. @>amples of intangible costs are listed as follows: /osts of hardware maintenance. /osts of losing the competitive edge over its competitors. /osts of training and disruption of normal work routine due to high turnover rate. /osts of decrease in market share due to increased customer dissatisfaction and/or unable to cope with the current demand.

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Ta #ib!e Be e$its

Tangible benefits are those benefits that can be readily identified and measured. @>amples of tangible benefits are listed as follows: @limination of tedious manual operating costs. 5irect cost reduction, for instance less spoilage or waste.

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-ncrease in sales due to e>pansion of system capability and/or better control procedures to cope with increasing demand.

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I ta #ib!e Be e$its

-ntangible benefits are those benefits that cannot be readily identified &at times+ and measured. @>amples of intangible benefits are listed as follows: = -ncrease customer satisfaction. -ncrease service :uality by implementing better control procedures. !ave paper and paper handling costs by creating a less paper work environment. -mprove decision making process by improving information accessibility speed. ;he following notes, from here onwards, are e>tracted/modified from: undamentals of !ystems Analysis, "erry # Ardra it$%erald, ,iley # !ons, -nc. &'()*+.

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Three -aj%r C%st Cate#%ries


,hen you are estimating or calculating costs, there are three major cost categories that must be taken into account. ;hey are investment costs, implementation cost and annual operating costs.

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I vest.e t C%sts

-nvestment costs are nonrecurring capital outlays to ac:uire or develop new e:uipment, new software, new facilities and etc. or instance, when you buy a new computer, the purchase price is the investment cost. 8owever, the organisation can convert this investment cost to annual operating cost by renting or leasing the new computer. -nvestment costs may include the followings: computers; disks/tapes; communication network; software; and special facilities.

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I.p!e.e tati% C%sts

-mplementation costs are one-time outlays to create or install new capability. !ame as investment costs that one-time implementation costs can be converted into an annual operating cost if the product is leased. ;his is because the lease might include the initial installation in its monthly lease payments. -mplementation costs usually are different from investment costs in that your own personnel are used to install the new system. @>amples of implementation costs are user training and relocating people or e:uipment costs. -mplementation costs may include the followings: costs of moving e:uipment and company personnel; costs for locating electrical outlets and telephones; cost of file conversions; cost of removing the current system; refurbishing costs; and furniture costs.

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(a! Operati # C%sts

Annual operating costs are the recurring outlays re:uired to operate the system on a month-to-month or year-to-year basis. Annual operating costs may include the followings: costs of leasing or renting e:uipment and/or special facilities; costs of maintaining e:uipment and programs additional personnel salaries.; costs of different supplies; insurance for the new e:uipment and/or special facilities.

;he following e:uation combines these three major cost categories into a single system cost figure giving the annual cost. Annual /ost A -nvestment /ost B -mplementation /ost B Annual Cperating /ost @stimated !ystem Dife in Eears = @nd of notes e>tracted/modified from: undamentals of !ystems Analysis, "erry # Ardra it$%erald, ,iley # !ons, -nc. &'()*+.

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;he following notes, from here onwards, are e>tracted/modified from: !ystems Analysis and 5esign, 6endall # 6endall, 7rentice-8all -nternational, -nc. &'())+.

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Brea/0eve A a!1sis
ocusing on the costs allows the systems analyst to determine the break-even capacity of the proposed system which means to determine the point &known as break-even point+ at which total costs, which includes investment, implementation and annual operating costs, of the current system and the proposed system intersect. Freak-even point represents the point at which it becomes profitable for the business to implement the proposed system. -t helps the systems analyst and management make better business decisions.

Degend Freak-even point /ost of the proposed system /ost of the current system /ost

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1 Eears

Figure 9.1: Break-even Analysis Det us analyse figure (.', we can clearly notice that the costs of the proposed system initially are higher than the current system. 8owever, shortly before two and a half years, the proposed system reaches the break-even point and from there onwards it becomes less e>pensive for the organisation to operate the proposed system than the e>isting one.

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Dra2bac/3s4 %$ Brea/0eve A a!1sis

,e should be aware of one serious drawback of this techni:ue; i.e. break-even analysis assumes that benefits remain the same, regardless of which system is in place. = @nd of notes e>tracted/modified from: !ystems Analysis and 5esign, 6endall # 6endall, 7rentice-8all -nternational, -nc. &'())+.

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;he following notes, from here onwards, are e>tracted/modified from: undamentals of !ystems Analysis, "erry # Ardra it$%erald, ,iley # !ons, -nc. &'()*+.

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Pa1bac/ Peri%"
7ayback period is one of the most fre:uently used techni:ues in judging the profitability of a system. or e>ample, if a new computer-based information system costs H*00,000 and is e>pected to yield H'00,00 per year, its payback period is * years &before ta>es+. ;he payback period is defined as the number of years re:uired to accumulate earnings sufficient to cover its costs. ;he e:uation for before ta> payback period is listed as follows: 7AI where 7 I A A A payback period, investment and average annual return on investment.

As mentioned earlier the payback period criterion ranks projects in terms of number of years to payback. ;here are two factors that must be e>amined closely. ;he two factors are: the rate at which funds flow in ta>es

Assuming two projects each has a 1-year payback period with different funds flow in rate as shown in ;able (.'. ,hich project do you think you will select?

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;able (.': 7ayback period for projects A and F A (a! Ret(r First Year H'0,000 3G,000 A (a! Ret(r Sec% " Year H'0,000 G,000 A (a! Ret(r Thir" Year H'0,000 G,000 A (a! Ret(r F%rth Year H'0,000 G,000

Pr%ject A F

T%ta! Ret(r H10,000 10,000

Fased on the rate at which funds flow in, clearly project F would be selected because a larger amount of the investment could be recovered during the first year &H3G,000+. As you know, the second factor concerns ta>es which vary from country to country. Jevertheless, corporate income ta>es lengthen the payback period. ;he e:uation for payback period when we take ta>es into consideration is listed as follows: 7A &' K ;+ I

;he only difference between the before and after ta> payback period e:uations is the symbol ; which represent the corporate ta> rate in percent. After taking ta>es into consideration, the denominator becomes smaller, therefore the payback period is definitely prolong. = @nd of notes e>tracted/modified from: undamentals of !ystems Analysis, "erry # Ardra it$%erald, ,iley # !ons, -nc. &'()*+.

@>ample: - A H10,000 7 A 10,000 A 1 years '0,000 7A I A H'0,000 ; A 0.3* Fefore ta>es

10,000 AG.1*(G years After ta>es &' K 3*+ '0,000 As you can see corporate ta> rate has a detrimental effect on payback period. -t can lengthen the payback period by a significant duration depending on the corporate ta> rate at the time of computation. = ;he following notes, from here onwards, are e>tracted/modified from: !ystems Analysis and 5esign, 6endall # 6endall, 7rentice-8all -nternational, -nc. &'())+.

Jo doubt this method offers an easy way to judge the worthiness of any proposed system, it has three drawbacks that limit its usefulness. ;he drawbacks are listed as follows: '. 3. 9. = -t is strictly a short-term approach to investment and replacement decisions. -t does not consider the importance of how repayments are timed. -t does not consider total returns from the proposed systems that may go well beyond the payback year. @nd of notes e>tracted/modified from: !ystems Analysis and 5esign, 6endall # 6endall, 7rentice-8all -nternational, -nc. &'())+.

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;he following notes, from here onwards, are e>tracted/modified from: undamentals of !ystems Analysis, "erry # Ardra it$%erald, ,iley # !ons, -nc. &'()*+.

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-ar#i a! E$$icie c1 %$ I vest.e t


;he marginal efficiency of investment &<@-+ is the rate of return that a potential system is e>pected to earn after all of its costs &e>cept interest e>penses+ are recovered. ;his method can also be known as internal rate of return &-II+. -t is widely used by many financial specialists to judge the worthiness of any potential investments. -n order for any investments to be deemed feasible the <@- or -II must be e:ual to or greater than the organisationLs cost of capital from banks or wherever the company obtains the funds. ;he formula for <@- is listed as follows:

i>ed -nvestment A

Ieturn over Cperating e>penses &'st year+ B &' B r+'

Ieturn over Cperating e>penses &3nd year+ B &' B r+3

Ieturn over Cperating e>penses in the Dast year &Jth++ of the asset life MB &' B r+n

E7a.p!e: Assuming a new system has a fi>ed investment of H'0,000 and an asset life of 3 years. At the end of the first year of its life it is e>pected to yield a return on investment of HG,G00 and at the end of the second year a return on investment of H2,0G0. H'0,000 A HG,G00 B H2,0G0 & ' B r+' &' B r+3 !olving the above e:uation gives us a value of '0N for r. Assuming the current interest rate is GN, this means that r &<@-+ is greater than the current interest rate, therefore this investment is deemed economically feasible under this financial analysis techni:ue. Cne can consult the financial staff of the firm to get the specific interest rate which the firm must pay to obtain funds. 8owever if the information is not available, the <@- might be compared with the prime rate, i.e. the rate that banks charge their best customers. = @nd of notes e>tracted/modified from: undamentals of !ystems Analysis, "erry # Ardra it$%erald, ,iley # !ons, -nc. &'()*+.

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C% c!(si%
A good systems analyst should keep in mind that various financial analysis techni:ues should be used to achieve a more comprehensive e>amination and make better decisions.

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