Business Case Analysis Guideline
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Table of Contents
1.Financial Analysis Techniques
1.1Present Value and Future Worth Concept
1.2Cost/Benefit Analysis
1.3Payback Analysis
1.4Investment Opportunity Analysis
1.4.1Return On Investment
1.5Breakeven Analysis
1.6Value Chain Analysis
1.7Pareto Analysis
2.The Comparison of Financial Analysis Techniques
Appendix A: Cost Checklist
References
Table of Tables
Table 1: Comparison of financial analysis techniques
Table of Figures
Figure 1: Breakeven Analysis
Figure 2: Value Chain Analysis
Figure 3: Pareto Chart
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- Financial Analysis Techniques
This section presents necessary financial concepts (e.g. present value) and financial analysis techniques for evaluating software business case analysis.
1.1Present Value and Future Worth Concept
One of the most basic financial concepts used in business case analysis is “cost-of-money” [1]. Present value is the cost-of-money on a given date of future payments (i.e. discounted to reflect the time value of money) [2, 3]. For example, to determine the worth in today’s dollars of the $10K that will receive in next 2 years can be calculated from the following formula.
where F is cash flow
r is interest rate per time period
n is the number of time periods
D is the discount rate calculated from interest rate
Therefore, the value in today’s dollars of the $10K that will receive in next 2 years (assume that the interest rate is 0.8%) is
The concept of discount rate and present value is often applied to other financial analysis techniques [1].
1.2Cost/Benefit Analysis
The first type of analysis used widely is cost-benefit analysis. For this type of analysis, cost and benefit have to be identified (see appendix A, the cost checklist of IICM-sw process for developing software system). Reifer [1] suggests using the following worksheet template for analyzing cost-benefit.
Cost Benefit Analysis WorksheetNonrecurring Costs
- Course adaptation ______
- Course conduct ______
- Other ______
- Cost avoidance ______
- Cost saving ______
- Other ______
Recurring Costs
- Courseware
- Continuing
- Other ______
- Improved employee
- Reduced turnover ______
- Other ______
Total Costs ______/ Total Benefits ______
Note: According to Reifer [1], cost avoidance deals with future, not current, expenditures while cost saving deals with current expenditures.
A cost-benefit ratio is used to determine the cost effectiveness of a business case proposal, and all benefits and costs should be expressed in discounted present value [1, 4].
1.3Payback Analysis
“The payback analysis is used to determine the number of periods required to recover one’s investment – the payback period [1].”
Payback period is a measure of time such as payback period is 2.0 years. Investment options can be compared by using the payback period; the shorter payback is the better option [1, 5].
1.4Investment Opportunity Analysis
1.4.1Return On Investment
Return-On-Investment (ROI) analysis is related to cost-benefit-analysis because to determine the ROI value, investment costs and benefits have to be identified as monetary value. “Return on investment is frequently derived as the “return” (incremental gain) from an action divided by the cost of that action [6].”
Moreover, to determine ROI involved with future years (not only for the current year), the time value of money typically needs to be considered [11]. Therefore, ROI is the ratio of the total present value of net benefits during the service life of the project to the total present value of the costs [7]. Consequently, the higher ROI is the better option [5].
1.5Breakeven Analysis
This type of analysis is used to determine the point where the benefits equal costs which normally this point is a function of volume [1].
According to [8], “The definitions used in Breakeven Analysis are
a. Fixed Cost:The sum of all costs required to produce the first unit of a product. This amount does not vary as production increases or decreases, until new capital expenditures are needed.
b. Variable Unit Cost:Costs that vary directly with the production of one additional unit.
c. Expected Unit Sales:Number of units of the product projected to be sold over a specific period of time.
d. Unit Price:The amount of money charged to the customer for each unit of a product or service.
e. Total Variable Cost:The product of expected unit sales and variable unit cost. (Expected Unit Sales * Variable Unit Cost)
f. Total Cost:The sum of the fixed cost and total variable cost for any given level of production. (Fixed Cost + Total Variable Cost)
g. Total Revenue:The product of expected unit sales and unit price.
(Expected Unit Sales * Unit Price)
h. Profit (or Loss):The monetary gain (or loss) resulting from revenues after subtracting all associated costs. (Total Revenue - Total Costs)
i. Break Even:Number of units that must be sold in order to produce a profit of zero (but will recover all associated costs).
(Break Even = Fixed Cost / (Unit Price - Variable Unit Cost))”
For example [9], if variable unit cost is $2.50, fixed cost is $500.00, expected unit sales is 250, and unit price is $5.00, total variable cost, total cost, total revenue and profit can be calculated and plot as the following graph.
Figure 1: Breakeven Analysis
From the graph, the breakeven is at 200 units. Therefore, more than 200 products must be sold to make a profit.
1.6Value Chain Analysis
Value chain analysis is another useful approach to evaluate value of different options by using the form of decision tree [1]. The value of each alternative can be determined by using the expected value.
whereHi = the highest possible value for option i,
Mi = the most likely value for option i,
Li = the lowest possible value for option i,
The formula above is used to compute expected value for mean of a bell-shaped curve, or normal distribution [1]. The following is the example of value of 3 options.
Figure 2: Value Chain Analysis [1]
For non-normal distribution, the expected value can be calculated from the probabilities of occurrence and value of it [15].
whereAi is alternative I,
P(Sj) is the occurrence probability of state of nature Sj,
Vij is the value of state Sj of alternative i
1.7Pareto Analysis
“This analysis is based on the Pareto principle, which states that a few of the problems are responsible for most of the effect, sometimes called the 80-20 rule [1].” To illustrate, the following Pareto chart shows that CBB, VSS, and CNS functions (about 20% of overall functions) cause 80% of defective costs.
Figure 3: Pareto Chart
Thus, “Pareto charts provide insight into causes of problems [1].”
According to [10], “there are seven steps to identifying the important causes using Pareto Analysis:
- Form a table listing the causes and their frequency as a percentage.
- Arrange the rows in the decreasing order of importance of the causes, i.e. the most important cause first.
- Add a cumulative percentage column to the table.
- Plot with causes on x-axis and cumulative percentage on y-axis.
- Join the above points to form a curve.
- Plot (on the same graph) a bar graph with causes on x-axis and percent frequency on y-axis.
- Draw a line at 80% on y-axis parallel to x-axis. Then drop the line at the point of intersection with the curve on x-axis. This point on the x-axis separates the important causes on the left and less important causes on the right.”
- The Comparison of Financial Analysis Techniques
This section presents the situations where each analysis technique is proper to used (i.e. corresponding to its objective) and the limitations or drawbacks of each technique in tubular format as showed below.
Table 1: Comparison of financial analysis techniques
Financial Analysis Techniques / Objectives / Limitations/DrawbacksCost-Benefit Analysis (Cost/Benefit Ratio)
Benefit-Cost Analysis
(ROI = NPB/NPC) [11] / Simple technique for evaluating the cost effectiveness of a business case proposal [1]. / -Accuracy problem: the outcome of the analysis based on the accuracy of estimating costs and benefits [11].
-Only financial costs and benefits are considered within the analysis [12].
Payback Analysis / To determine how long the project will take to earn back the money spent on [13]. / -The straight payback method does not consider the time value of money [13]. To solve this problem net present value and internal rate of return should be considered.
-The investment after the end of payback period is ignored [1].
Breakeven Analysis / This analysis is used to determine the breakeven point when benefits and costs are functions of volume [1]. / -It assumes that fixed costs are constant which it may be not [14].
-It assumes that variable costs are constant per unit of output (i.e. linearity) [14].
Value Chain Analysis (Expected Value of alternatives) / This analysis is useful for dealing with uncertainty in evaluating alternatives (options) [1]. / -
Pareto Analysis / This analysis is useful for evaluating the source of most system’s failure costs [1]. / -This analysis possibly excludes important problems which may be small initially, but which grow with time. Thus, other analytical tools (e.g. Failure mode and effects analysis and Fault tree analysis) should be combined [16].
Appendix A: Cost Checklist
Costs in Exploration PhaseEffort-Related / Monetary
1 / Identify project scope
2 / Project plan and schedule
3 / Analyze current system
4 / Assess win conditions
5 / Search/Research suppliers/web services/COTS/NDIs
Costs in Valuation Phase
Effort-Related / Monetary
1 / Evaluate/Assess candidate suppliers/web services/COTS/NDIs
2 / Source selection
3 / Prototyping
4 / Define operational concepts
5 / Define and negotiate requirements; Wiki WinWin sessions
6 / Define architecture
7 / Perform business case analysis
8 / Prototyping
9 / Software/Service Trial Version
Costs in Foundation Phase
Effort-Related / Monetary
1 / Evaluate candidate COTS/NDIs/web services
2 / Prototyping
3 / Architecting
4 / COTS/NDIs tailoring
5 / Foundation development cost
6 / Prepare development iteration plan
7 / Prepare transition plan
8 / Develop test cases
9 / Infrastructure (including hardware, network and communication cost) for prototype
10 / Software/COTS for prototype
Costs in Development Phase
Effort-Related / Monetary
1 / Process development
2 / Infrastructure development
3 / Implementation/Product development
4 / Custom code
5 / Integration
6 / Glue code
7 / Testing and Evaluation
8 / Bug fix/Problem tracking
9 / Transition/Installation and Deployment
10 / Education and Training
11 / Infrastructure (including hardware, network and communication cost)
12 / Software upgrade
13 / Software/COTS license
Software/COTS Acquiring
14 / Registration fee
15 / Membership fee
16 / Service connection fee
17 / Web service utilities
18 / Promotion and outreach
19 / Reusable assets/COTS
Costs in Operation Phase
Effort-Related / Monetary
1 / Architecture maintenance
2 / Software system maintenance (Back-end)
3 / Asset maintenance
4 / Front-end maintenance
5 / Process updates
6 / Ensuring secure service
7 / Performance improvement
8 / Bug fix/Problem tracking
9 / Upgrade services
10 / Education and Training
11 / Regression Test
12 / User/Customer support
13 / Infrastructure (including hardware, network and communication cost)
14 / Infrastructure Maintaining
15 / Software upgrade
16 / Software license/Acquiring SW
17 / Reusable assets/COTS
18 / Registration fee
19 / Membership fee
20 / Service connection fee
21 / Transaction fee
22 / Resource utility fee
23 / Hosting fee
24 / Domain name fee
25 / Promotion and outreach
Costs in various phases
Effort-Related / Monetary
1 / Risk Management
2 / Service/COTS/NDIs provider interaction
3 / Learning effort
4 / Cost of failure
5 / Documentation
6 / Review and Commitment;
Architecture Review Board
7 / Quality Management
8 / Assess and Plan to mitigate risks
9 / Plan and Manage project
10 / Assess project status
11 / Assessment support (external assessment team)
12 / Identify roles and responsibilities
13 / Configuration Management
14 / Distribution Management
15 / Client Meeting
16 / Client Representative Meeting
17 / Maintainer Meeting
18 / Personnel (Employees)
19 / Consultants
20 / Academicians
21 / Independent QA
22 / Independent audits
23 / Configuration Management tools
24 / Client
25 / Client Representative
26 / Maintainer
27 / User
Note: The cost checklist is developed from the cost information in ICM-EPG, the projects’ business case analysis of software engineering course (CSCI577ab 2008-9), discussion lecture about web-service cost during ICM process of CSCI577b 2009, and the cost information in Software Cost Estimation with COCOMO II by Barry W. Boehm, Chris Abts, A. Winsor Brown, Sunita Chulani, Bradford K. Clark, Ellis Horowitz, Ray Madachy, Donald J. Reifer, Bert Steece.
References
[1] D. J. Reifer, "Making the Business Case: Principles, Rules, and Analysis Tools," in Making the Software Business Case: Improvement by the Numbers, 1st ed., A. Ed. New York: Addison-Wesley, 201, pp. 53-75.
[2] CSCI510 Lecture, Chapter 14 Present versus Future Expenditure and Income
[3] "Present value," Wikipedia, Apr. 8, 2009. [Online]. Available: [Accessed: Apr. 18, 2009].
[4]"Benefit-cost ratio," Wikipedia, Mar. 13, 2009. [Online]. Available: [Accessed: Apr. 18, 2009].
[5] "Business Case Analysis – Solution Matrix Ltd.," Solution Matrix Ltd., [Online]. Available: [Accessed: Apr. 18, 2009].
[6] "The Simple Return on Investment," Solution Matrix Ltd., [Online]. Available: [Accessed: Apr. 18, 2009].
[7] "Benefit-Cost Ratio," Prof. Ram M. Shrestha, Jun. 21, 2007. [Online]. Available: [Accessed: Apr. 21, 2009].
[8] "The Break-Even Calculator," Weatherhead School of Management. [Online]. Available: [Accessed: Apr. 21, 2009].
[9] "The Breakeven Analysis," KJE Computer Calculation LLC. [Online]. Available: [Accessed: Apr. 21, 2009].
[10] D. Haughey, "Pareto Analysis Step by Step," ProjectSmart.co.uk. [Online]. Available: [Accessed: Apr. 21, 2009].
[11] "Cost-benefit analysis," Wikipedia, Apr. 16, 2009. [Online]. Available: [Accessed: Apr. 22, 2009].
[12] "Cost Benefit analysis," MindTools. [Online]. Available: [Accessed: Apr. 22, 2009].
[13] "Business Owner’s Toolkit: Payback Period Analysis," Business’s Owner’s Toolkit. [Online]. Available: [Accessed: Apr. 22, 2009].
[14] "Break even analysis," Wikipedia, Apr. 6, 2009. [Online]. Available: [Accessed: Apr. 22, 2009].
[15] CSCI510 Lectures, Chapter 19 Coping with Uncertainties: Risk Analysis and Chapter 20 Statistical Decision Theory: The Value of Information
[16] "Pareto analysis," Wikipedia, Mar. 3, 2009. [Online]. Available: [Accessed: Apr. 22, 2009].
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