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Project EE/06/B/FPP-169000 Learning Materials for Information Technology Professionals (EUCIP-Mat)

SummaryEdit

  1. Number of study hours: 20
  2. Short description of the course: Course handles IT economic impact to organization behaviour. *There is given detailed overview of fields and methods of IT Economy
  3. Target groups: The employers of IT core level professionals are the target sector here. The first target group consists of IT students (vocational school basic level IT training and the first courses in colleges and universities) in the field of technology, and IT practitioners not having vocational certificates yet
  4. Prerequisites: There are no prerequisites for this course.
  5. Aim of the course - learning outcomes: After taking the course students have basic knowledge about measuring IT in the terms of economics.

ContentsEdit

A.3.1 The Concept of the ClientEdit

Every customer together with his/her specific requirements and needs can be defined in a specific background. In our case, the customer has to be defined in the IT system. System in a wider sense is a related set of indivisible elements. The integrity of a system is characterised by a unified function, goal, purpose, etc, allowing for defining a system as a whole on one hand and separate from the surrounding on the other hand.

Developing an information system is based on the system theory, assessing various ways of establishing a system. The most widely used starting points for developing an information system are the developer's level (conceptual basis of the system, developing the system) and the administrator's level (maintaining, organising). The most important aspects in making the above stated strategic decisions are the future field of application of the information system and the goals for its use. At the same time, optimum co-operation of both levels must be ensured when developing large systems. Evidently, a customer can be considered everybody who encounters the information system in the course of later use, or whose decisions are affected by the information system in some way.

Practically all employees in an organisation encounter information systems, although, as a rule, they have different levels of access rights. Due to this, an optimal structure of access rights needs to be developed, stating who and on what extent can change something in the system or just passively use the information in the system. As a rule, an IT system replaces an older system that still works but has become obsolete (morally, in the sense of information technology, etc.). In such a case, attention must always be paid to preserving the old system too, and keeping it functioning for a certain period. Usually, developing or implementing an information system is initiated by decisions made on the management level. If the relevant solution is purchased as-is, with a goal of adjusting it for the company, then the order is placed by the council, board or executive management of the company. Thus, the customer can only be a person authorised for that.

Figure A3.01 shows a scheme of implementing a sub-level information system (financial information, stock regulation, etc.) in an organisation, together with the various levels of responsibility.

In the following, we state some of the more important levels related to implementing or reorganising IT systems:

  1. Customer – owner of the specific IT solution (company as a legal person);
  2. Project managers – in case of larger projects, both the customer and the developer of the specific solution are represented. Thus, project managers from inside the company and from outside the company can work together. External project managers provide advice in developing the specific applications. The salary expenses of external project managers are covered according to relevant agreements (either by the customer or the developer of the solution);
  3. General manager of implementing the IT system, can be one of the project managers;
  4. Analysts, programmers and users of the IT system with higher levels of access rights, often also support persons of the information system, who are keeping both the old system and the new information system functioning. They update data, ensure access to the end consumers and, if necessary, change algorithms;
  5. End consumers are all persons using the information systems.

One of the most important stages in preparing an IT system is notifying all interested parties about the functioning of the new IT system as a whole, but the changes and/or updates related to the interests of a specific consumer are also very important. Evidently, just handing over the manual and letting the consumers learn all by themselves is not enough. The better the parties understand the new system, the more easily they will accept it and the more proponents the system will have. New things that are not understood make people fear them (usually this is unfounded fear) and there is only a small step from fear to counteractions. The more complex the new IT system, the more important it is to ensure a wide acceptance base among consumers.

Approaches centred on the manufacturer or on the top-level management, where the existence of the system per se was considered to be the value in implementing the information system or where technocratic ideas were tried to be implemented outside the consumers, have not proven themselves as viable. There are many good ideas that have been left unimplemented or even failed during implementation due to such approaches. Figure A3.02 shows the modern approach, stating also some business-related sides of the process.

The role of IT in companies has change in remarkably short time. All this has been enabled by changes in technology but more importantly also by changes in thinking. The stages shown above highlight certain continuity, as everything new has been developed on the basis of old, incorporating something from the old system but having a somewhat wider nature due to new technological opportunities, up to the global application of Internet.

By looking closer at these development stages, we can characterise these as follows.

  1. Computers being invented. Individual test versions of computers in 1940s to 1950s, analogue computers, developing radar systems;
  2. Expansion of the range of application of computers. This began in 1960s to year 1975, computers were began to be used in production, one of the fields of application being power stations, and also optimisation of energy systems;
  3. Local use of computers. This is characteristic of years 1975 to 1980, where computer technology was mainly used in two fields of application. There were computer centres in companies, with one field of application being automation of production and the other being accountancy, in some places only salary calculations. In automating production, computers were used for directing and optimising specific processes (energy systems, transport tasks) or for controlling machines, transporter belts, etc. Often it was easy to use analogue computers in these fields, mainly in energy production. In accountancy, information technology was used mainly for data processing. Development of plan calculation systems started in the former Soviet Union, but unfortunately ignoring the efficiency criteria (total denial of the demand and offer system and thus ignoring the market prices) on one hand and copying the manual calculation methods into information technology on other hand did not for allow reaching any significant results in this;
  4. "Automated" jobs. In 1980s, personal use computers started to appear. Although computer centres and IT departments continued their work and more complex computing operations were still performed there, new possibilities appeared for text processing and also in fields of design and engineering;
  5. Integration within the company. Personal use computers and availability of operation systems on decent level, together with relatively reliable communication channels, allowed for starting to implement multi-layer computer systems. As a result of this, relatively complex integrated information systems were established on the basis of information and communication technology, constituting also a basis for making the business environment more efficient, i.e. establishing a synergy of simultaneous and common use of information;
  6. Globalisation. Fast development of Internet and digital communication technology has been the basis for implementing new logic networks of relations. Computer technology has turned from local tool to essential element for activities in a global system. Thanks to new possibilities, we are talking about the so-called "new economy", where new business models (digital company vs. virtual company, working from home, e-business, etc.) are firmly rooted.

The new economy has also brought about a new approach to company structures, developed on the basis of information technology achievements. Companies have new requirements for investments into the IT field, as there are suitable means available for new business approaches. Companies have higher expectations, and this causes the strategic level of long-term planning to become as important as the tactical operative level. The strategic level affects the market position of the company in long term (see section A.1.3).

Such fast developments in the field of information technology also bring about higher and higher requirements for IT personnel. An increase of the number of IT specialists must be accompanied by an increase of their professional level, because there are more and more new IT systems needed and more and more requirements expressed for all kinds of support services and advice. In the following, some of the fields of development activities and support services are stated, the need for which will probably increase sharply in the near future.

Development activities:

  1. Setting and analysing goals;
  2. Analysis of specific actions and describing technical conditions;
  3. Developing and adjusting strategies for system implementation;
  4. Designing, implementation and testing ob sub-parts of the system;
  5. Creating user interfaces;
  6. Entering and/or migrating data;
  7. Adjusting systems according to the needs of consumers;
  8. Testing the compatibility of systems, etc.

Support services:

  1. Finding an optimum solution for a company;
  2. Active participation in the process of system start-up;
  3. Finding and involving external labour force with the necessary know-how, if necessary;
  4. Providing the required support service for implemented systems, in order to ensure secure functioning of the system;
  5. Establishing, providing and continually improving the help desk service;
  6. Continuing the process of developing the system.

The end goal of establishing any system is to ensure that the level of the service provided conforms to the level required by the customers. IT personnel who are both the developers of the systems and the advisors of the customers must know how the technical solutions offered by them will affect the economic decisions of their customers. Thus, basic knowledge of economy is very much necessary for information technology personnel.

By analysing the definition of customer again, we can add some important criteria to the definition.

Firstly, a customer can be fundamentally an internal or an external party for the organisation. In a wider sense, the service provided can be a business process in itself. Defining a service in such a wide range creates a situation where every service can have an own customer or consumer, and in case of a wide customer base the levels of satisfaction with the service can vary considerably. It could be assumed that the customers purchasing a service have higher expectations of the service, but in reality the quality expectations for a service are high also among the people in the same company who are not in any direct monetary relations in regard with the service. This allows for a conclusion that the same level of attention needs to be paid to internal consumers as to external consumers, because a negative opinion as a feedback from any kind of customer creates problems.

Secondly, the status of different customers can be entirely different. A customer can be a top-level manager of the company, a mediator or naturally also a basic end consumer. On the basis of such a hierarchy it can be said that the value of the opinions in feedback is also different according to the status of the customer. Criticism from a top-level manager is evidently more influential than evaluations from anonymous end consumers who can be numerous and whose needs and wishes, sometimes not very clearly expressed, can be difficult to take into account all at once.

Thirdly, this level of anonymity or the hierarchy of customers can be taken into account already while creating the product or service. The more specific the consumer, the more extensively and more precisely his/her needs can be taken into account. Figuratively peaking, this is a tailor-made solution. In providing a service to an anonymous consumer, the definition of an average consumer needs to be used as a basis for consumer needs. Figuratively speaking, this is a mass-produced solution. In case of a consumer between these extremes, some special wishes can be taken into account. Figure A3.03 shows the product differentiation levels from homogeneous to unique production.

Fourthly, it can be said that often a customer in the IT context means a sub-part of a system with two ore more levels, for which a service is provided by another part of the system (server) (see section C1).


Questions

  1. Who are the participants in business processes?
  2. What are the tasks of personnel in business activities?
  3. What are the different types of customers in IT field?

A.3.2. Business Plans and Feasibility StudiesEdit

A business plan is a well laid out activity plan for implementation of an idea (in this case, an information system), together with the list of possible expenses needed for implementing this business idea and the estimates for benefits of the implementing the idea. The availability of qualified labour force and, in view of assessing the salary level, also the overall situation at the labour market is very important to take into account in developing of information systems. Also, it has to be considered who the business plan is intended for. If the company is still in the establishing stage, then the benefits and advantages of the information systems must be proven to the developer him/herself and to the business partners. Of course, the developer must prepare a highly detailed business plan for him/herself that excludes the shopping window effect, otherwise the consequences can be grave, all the planned activities can fail, capital can be lost and a very good business idea can be useless.

Organisations already active are trying to achieve the specific goals set for them. Generally, there is not much difference in what purpose the business plan is being prepared for. The fundamental approach is similar, whether a new project is brought to the market or new technological solutions need to be implemented. Besides, information systems have an effect to all fields of a given company, from internal factors to customers and suppliers. In order to specify the possibilities for achieving goals in new conditions, to estimate the effect of fast-changing factors (markets, consumers) on economic activities of the company, and to assess all possible risks, a business plan is prepared. A business plan cannot be a set of dogmas; clearly the dynamic business environment has to be taken into account and thus, the business plan has to be continually improved and in some cases even changed. While the mission of a company provides a concentrated and generalised overview of the goal, implementing it needs a significantly more specific plan.

In order to achieve their goals, companies need to decide how to do it, taking into account all possible limitations and finding optimum values of the factors under their control. The factors that the management of a company can affect are as follows:

  • Personnel;
  • Roles of the personnel;
  • Partners;
  • Information flows;
  • Procedures;
  • Rules and means of functioning.

Personnel includes all employees of the company without an exception, both payroll and contractual employees.

Partners are considered to be all persons acting in the company's interests and thus helping the company to achieve its goals. This means that partners include external specialists, advisors, suppliers, sub-contractors and co-operating companies.

A role is considered to be a set of behaviour norms for a specific person as stated in procedure rules, with the purpose of ensuring the fulfilment of the person's tasks and via this also the existence and functioning of the entire organisational structure.

All organisations must have stated descriptions of procedures (job descriptions, descriptions of specific work processes), on the basis of which it is possible to prepare activity plans (tactical rules). When the general principles and procedures have been described, then the fundamental possibility arises for using an information system that includes all necessary operative and permanent information and the software needed for processing this information. Thus, a good information system conforms to the requirements of the company's economic activities, it needs to ensure the connection between the company and the outside world, and it must allow for finding optimum solutions in the changing economic environment.

A stable economic development (hopefully towards improvement) allows for establishing and using an information system on the basis of typical solutions, by implementing only minor changes. On the other hand, such an approach may not prove to be sustainable. Thus, companies having exceeded the "critical mass" may encounter the need to achieve new quality, where cosmetic corrections and adjustments made within the framework of the previous logic system are not effectual any more. In such a case, the conceptual basis for the information system must be changed and, of course, previous experiences must be put to use.

An example of this could be Nordea bank, where information technology solutions have been relatively permanent for many years, incorporating only minor changes. At the same time, customers can compare the solution utilised by Nordea bank to the analogous solutions of Hansapank and SEB bank that are clearly more customer-friendly. There is harsh competition in the banking market and the environment is definitely a fast-changing one, so there is a perceptible pressure on Nordea bank to implement organisational and technological changes. Some factors can be highlighted that, as a rule, bring about a need to reorganise business procedures and to develop new information system solutions.

The main factors that can be signals of a need to implement changes are as follows:

  • Mergers and takeovers of companies, especially so-called hostile takeovers;
  • Expanding into new industries;
  • Expanding to foreign markets;
  • Implementing new growth strategies;
  • Significant changes in target markets.

Development of information systems means a lot of work, especially if the previous basis is abandoned and new concepts are used. Also, the imprecision of estimates is bound to cause problems, thus developing only those support services that are stated in the business plans of the companies may not guarantee expected results in the end. Figure A3.04 shows the curves that present the "rosy", the "black" and the realistic development scenario, with the budget necessary for developing information systems. If the economic growth cannot be estimated reliably, then flexibility should be incorporated into the information systems being developed, in order to allow for fast reactions to any changes in the economic growth.

A development of an information system cannot be a goal per se; it is fundamentally a tool to better organise the business activities, analyse what has been done earlier, and prepare estimates for the future. In addition to its main tasks, an information system also needs to ensure security (see section A7.4) and reasonable productivity. In order to guarantee sufficient productivity of an information system, much attention needs to be paid to the capacity of hardware elements (processor, memory, disk space, network bandwidth, etc.) on one hand, and to optimum choice of software layers (operating system, database engine, applications, user interfaces, etc.) on the other hand. Evidently it is never possible to make choices within unlimited budget, thus imitations need to be taken into account and sensible choices need to be made. In real economic activities, problems with information systems may appear both due to lacklustre capabilities of the hardware and due to an excessive equipment park. If the hardware does not allow for performing all necessary operations, then the operations need to be ordered from outside or made by hand. Also, problems can be due to an excessive amount of hardware being ordered, because a bad ratio of price to productivity can bring about too high expenses on information processing and thus also a decrease of the profit of the company and a decline of trust towards the information system.

Low functional productivity can render an information system useless. For example, this is so in case of warehouse accounting systems where barcodes are used for registering the movement of goods. If the response time of the system is not fast enough, and becomes a bottleneck of the system, then it can happen that the movements of goods are not reflected operatively in the system any more. Such an information system is not fulfilling its tasks and one element with a low productivity makes the entire system unreliable, thus also useless. There have been problems in booking a plane ticket via an electronic booking system. The consumer can use the Internet to find a destination, view the flight plan, book a seat in the plane, and buy a virtual ticket (there is no paper-based ticket), and then a boarding card is issued for the customer. As Internet-based booking has relatively low expenses, the booking system should ensure a very good response time and the consumers should get an impression of a system that works well. Unfortunately, there are hang-ups or even errors in such systems from time to time, and while these are understandable from the viewpoint of technology, they are not acceptable from the viewpoint of the level of service provided.

One example of over-achieving is the electronic financial system used in trade enterprises, where the morally obsolete character-based but entirely functional system is replaced by a modern system that adds the need to use a mouse. It is generally not recommended to go overboard with the capacities of information systems; instead, it should be tried to limit them to optimum solutions. Over-achieving causes excess expenses on equipment, but can also bring about a decrease of efficiency of the system while used by the actual operator, as the operator in unable to use all possibilities of the system.

An information system must be made conformant to the wishes and needs of the specific company it is developed for. As mentioned earlier, an information system can be created by continual improvement of an existing system or by developing an entirely new system. Regardless of the approach, it is important to prepare a development plan for the information system, providing an overview of the strategic plan of the system and the practical choices that may need to be made, together with the necessary documentation.

Similar to a business plan, it is also reasonable to perform a SWOT analysis for assessing and comparing different IT solutions in planning an IT system. Problems can crop up in cases where different information technology solutions are tried to be integrated together if this is impossible to be implemented without a mediator interface, for example if a company, out of a need to save expenses, decides to use an obsolete CAD system solution and to integrate it with a modern financial system. Evidently, SWOT analysis is just the tool that should be used before implementing such solutions. In this example, it should be analysed whether it is best to make an interface between the CAD system and the financial system or to buy a new CAD system that can be interfaced directly with the financial system. The benefit of using a mediator interface would be lower personnel training expenses, and the possibility to use familiar solutions is also more comfortable for the developers. On the other hand, using a mediator interface can cause problems later, as the possible errors in the interface may not be apparent immediately and can thus cause a long period of adjusting the interface while the interface can still be incomplete, so that the efficiency of the entire system decreases. Using a new CAD system will probably give a more modern and more reliable solution, but the investment is larger and the level of the team dealing with development and setup of the system during the planning stage needs to be higher.

Feasibility of the system is always a great concern when planning an IT system. Very different kinds of problems need to be addressed when planning large-scale IT systems, and such problems can be in different fields of economy, technology and organisation.

In developing IT systems, it is important to assess the economic aspects, to calculate the possible operating expenses, to assess risks, benefits and also disadvantages if such exist. The main expenses affecting the cost of the entire system are as follows:

  • Expenses related to establishing the system, including feasibility analysis, planning, development, testing and implementation;
  • Operating expenses, including maintenance expenses of the operating system, etc., expenses for reconstruction, improvements, etc.;
  • Assessment of potential risks like changes in needs, excess complexity of the IT system with the expected volume and thus also excess cost of the system, elimination of the initial needs before the system pays off;
  • Benefits of an IT system can be short-term and long-term. One of the positive effects is a more efficient functioning of the entire organisation; this would be evident both inside and outside the organisation. Increase of the company's efficiency means also a decrease of expenses, better use of special skills of partners, less routine work as this becomes the task of the information system.

Analysis of economic feasibility has set only one limit on implementation of IT plans, and this is the limit of financial resources. Evidently, more financial resources being spent means that significantly better results can be achieved, and the user-friendliness of the system can be increased. At the same time, it must be assessed where the reasonable balance is between user-friendliness and expenses for purchasing, installation and operating of the IT system, i.e. what risks can be taken. The question is whether the achieved result is worth all the expenses.

Sometimes, the best of ideas remain unimplemented because of the issue of technical feasibility. Sometimes the developers of IT systems are so committed to the IT system itself that they do not pay sufficient attention to correct assessment of all expenses. Often, those who pay for ideas are not those who offer them. Also, the technical complexity of a solution is not always adequately assessed and works are started with assumptions that prove to be shallow or even completely wrong. Sometimes ideas have such a high level that technical problems become the deciding hindrances. If, after a shallow assessment is given to the prospective ideas, a decision is made to continue the development of a project although serious hindrances have already cropped up in implementation of it, then big problems can ensue. Such a situation is often caused by a high need for an IT system and a lack of reasonable alternatives. Evidently, a feasibility study should preclude the implementation of such large projects, as this can highlight possible significant problems more clearly. Well-established traditions and good practices dictate that pilot projects should be started first, instead of initiating a development of an IT system encompassing the entire company while there is limited initial information available. To summarise what has been stated above – a feasibility study of an IT system should provide an answer to the question of whether the offered IT system can be implemented in the offered way and with the estimated expenses.

And last but not least – the organisational problems of developing IT systems. Although technical problems are a big aspect in developing IT systems, it is still a rare occasion where these turn out to be the main cause of a failure. Usually, the failure is caused by a low consistency of the project managers in implementing the IT project and their insufficient level of responsibility in solving organisational problems. In order to achieve good results, the company needs to be prepared for the changes; the company must want to implement the IT system as soon as possible. It is difficult to achieve any reasonable results if the preparation work in the company has been insufficient, the potential users are not familiar with the changes, they do not know the benefits of using the new system, and they are forced to familiarise themselves with the possibilities of the new IT system on their own, while experiencing difficulties and encountering big problems. Thus, all changes must be managed in order to avoid organisational problems (see section A6.4), and also answers must be found to the following questions:

  • Are the expected positive results realistically achievable?
  • Is it possible to implement the new system in the organisation?
  • What changes need to be made in the organisation or in the system?
  • Which changes actually improve the real situation?

Questions N/A for this section.


A.3.3 Costs and BenefitsEdit

As a rule, all investments made into a company should pay off within a reasonable time. The economic ratio of ROI (Return on Investment) is used or assessing the profitability of an investment. Such an assessment is made more difficult if the measurable results from the investment are indirect. The benefits from use of an information system arte certainly difficult to assess, because the benefits are mainly impossible to measure, as the more organised archiving of information or an increase of the work quality cannot be specifically measured. In addition to the relatively abstract nature of measuring benefits from an information system, the contents of the economic activities of the company also affect the possible benefits:

  • Types of products in the field of activity (raw materials, consumer goods and services, mental work);
  • Nature of the market (developing, stable, diminishing);
  • Geographical location and participation in a business network;
  • Consumer expectations;
  • Production volume of the company;
  • Market structure (monopoly, oligopoly, etc.) and market position (leader or the market, etc.);
  • Share of employees performing the main activity of the company, structure of the company;
  • Logistic solutions, expectations of trade partners.

It must be noted that although the effect of using IT systems is difficult to assess, the results of follow-up analyses can be used as a basis for stating the effect of information systems on the growth of sales revenues and on efficiency activities in different industries (see figure A3.05). •

As a rule, companies cannot be indifferent towards the efficiency of their activities, and without a doubt IT systems provide good opportunities for increasing this efficiency. Although nobody denies the possibilities of increasing the efficiency with the help of IT systems, the following problems often crop up in relation with IT systems:

  • Economic results are difficult to be measured, because these are not visible results and indirect assessment of results may not conform to the generally accepted methods, causing disputes;
  • Favourable economic results are not always guaranteed, because a project needs to be implemented in order to achieve them and this may involve many unforeseeable situations and additional expenses. Goals set in the project may be achieved only partially and thus some part of the system may turn out to be inefficient;
  • In order to minimise failures, the company as a whole, starting from the top-level management, needs to be seriously dealing with the project, so that the nature of the changes planned and the benefits expected from these changes are understood on all levels of the organisation. A capable project manager should be assigned to manage the project, who would be a able to plan, direct and manage the activities, to ensure the right balance between ambitious plans and realistic possibilities. The project manager must be able to choose the IT system with the suitable proportions and to determine the maximum level of flexibility in the system, in order to ensure a co-operation of the company and the IT system.

Undoubtedly, the companies having good and modern information systems have advantages, but unfortunately it is difficult to assess the economic effects of these advantages. If the volume of revenues and expenses is known, then the profit, i.e. net revenues can be determined:

Failed to parse (lexing error): Profit = Total~revenues -– Total~expenses


Figure A3.06 shows the dynamics of static expenses, dynamic expenses and total expenses of a company.

The production volume where revenues are equal to total expenses ensures a zero profit and this level of total expenses is called the breakeven point, because from this production volume onwards the company starts earning profit. The minimum necessary production volume (Qmin), from which onwards that would the company would earn profit can be determined from the following formula:

Failed to parse (lexing error): Q<sub>min</sub> = \frac{TFC}{p -– AVC}


where TFC – Total fixed cost; p – Price for unit of production; AVC – Average variable cost.

Thus, production volume is important for earning profit, because the more a company produces the more profit it can earn. Naturally, there are limits here, because starting from a certain production volume the profit can start decreasing due to organisational problems logistics problems, information noise, etc. related to large production volumes. Estimates of production volume can also used for approximate assessment of return on investment (ROIi), to be determined from the following formula:

Failed to parse (lexing error): ROI_i = \frac{TR –- TC}{TC}


where TR – Total revenue; TC – Total cost, i.e. investments made.

With all investments, the present value and the future value of money need to be taken into account. In the real world, the price of money always needs to be considered; this means interest rates that can be largely different at different times. Thus, a certain amount of money is not comparable to the same amount of money after a year. Contrasting factors like inflation on other hand and expected revenue on the other hand give the money an entirely other value in the course of that time. Money not being invested will decrease in value due to inflation and will also not earn the owner any revenues in the form of interests. In order to assess the feasibility of an investment, the possible revenue is calculated for the present day and then compared to the amount of the investment. If the expected profit in its present value exceeds the investment, then the investment should be feasible. Of course, the expected rate of return needs to be taken into account; if the estimated rate of return exceeds the wishers of the investor, then the investment really should be made.

The present value (PV) of money is determined from the following commonly used formula:

PV = \frac{FV}{1+r_i}

where PV – Present value of the money; FV – Future value of the money, i.e. the expected revenue from the investment; r – Interest rate for the accounting period; i – Number of periods.

If the money is received periodically and at the same time there can be expenses, then the present value of the money can be calculated from the following formula:

PV = \frac{FV_1}{1+r_1} + \frac{FV_2}{(1+r_2)^2} + \frac{FV_3}{(1+r_3)^3} + ... + \frac{FV_n}{(1+r_n)^n}

The present value of the money can be used as a basis for determining the net present value of the investment:

Failed to parse (lexing error): NPV = PV -– TC


where TC – Initial expenses (investment).

If the NPV > 0, then the project can be deemed acceptable.

Also, the internal rate of return can be calculated in order to assess the project. Internal rate of return is fundamentally an interest rate that equalises the initial expenses of the project with the sum of future revenues. Thus, applying this criterion assumes that the cash flows added by the project are reinvested with the interest rate equal to the internal rate of return. Internal rate of return is determined from the following formula:

NPV = \sum_{i=1}^N \frac{NCF_i}{(1 + IRR)^i}

where NCFi means the added cash flows for the period of "i". Internal rate of return is the actual profit margin of the project.











Figure A3.07. Diagram showing the profitability of investments.

In order to illustrate the information provided above, the investment diagram shown in figure A3.07 can be used. This shows relatively high initial expenses that exceed the revenues in the beginning. Thereafter the revenues begin to dominate and the sine curve of revenues reaches the profit side only in the second quarter of the fourth year.

This example allows comparing the difference in considering and not considering the time factor. From the viewpoint of the stability of the project, it would be psychologically very reasonable to consider the time factor, because the continually changing inflation and interest rates should be taken into account.

Example 1. If 500 units (EEK or Euro; this is not important for this example) of expenses are made for the entire period and the total revenue is 1,000 units, then the profit would be 500 units. If the length of the period is not important, then the rate of return would be 100%.

At the same time, it would be reasonable to take into account the fact that the cash flow is distributed over five years and the rate or return should be calculated via the present value formula as follows:

The present value (PV) is 500 units; in five years this turns into 1,000 units, so the average interest rate for achieving this result should be determined.

PV = \frac{FV}{(1+r)^5}

By putting actual values into the formula, the result is 500 = \frac{1000}{(1+r)^5} the average interest rate r is calculated as follows:

(1+r)^5 = 2

Failed to parse (lexing error): r = \sqrt[5]{2} -– 1 = 0.1486


in percentage, this is 14.86%.

Presentation of revenues and expenses as cash flows for a period of time allows calculating various ratios characterising economic activities, but it does not characterise the nature of the revenues and expenses. A somewhat better overall picture is achieved by dividing expenses into two groups according to their causes of incurrence:

  1. Fixed costs, incurred by purchasing and implementing the necessary information technology solutions (hardware, software licenses, implementation project, etc.);
  2. Variable costs, incurred by operating and improving the system and calculated in advance for a definite period of time, usually one year (expenses related to development and maintenance contract, auxiliary materials, etc.).

The most problems seem to be encountered in assessing revenues. Another example can be used for illustrating the nature of revenues.

This example states that a company has a sales volume (turnover) of 100 million EUR and a profit of 10% of the turnover. The company intends to expand and wishes to open a sub-unit dealing with sales via Internet. The estimated time needed for preparations of the opening are approx. 3 months, because the preliminary agreement for purchasing the necessary software component is already signed. This component is supplied by a n enterprise that has also sold the company a financial information system. Thus, there should be no problems regarding software compatibility. The example assumes that the following information is known:

  • The new system would allow the company to expand its customer base so extensively that the sales volume would increase by 8 million EUR per year (this is an 8% increase when compared to the previous turnover) and the profit would increase by 4% per year;
  • In addition to that, it is estimated that 20% of the existing customers would use the new possibility for making purchases. Thus, part of the sales hall personnel would not be needed any more and this personnel resource can be used for marketing activities wit the goal of finding new customers preferring the traditional way of making purchases. It is estimated that this would allow increasing the turnover by approx. 500,000 EUR per year without increasing the number of sales personnel (an increase of turnover by 0.5%);
  • The expenses related to receiving orders from customers and processing these orders are estimated to be equal to 6% of the turnover, and it is expected that the electronic order processing system would decrease the expenses by approx. 60%, i.e. by 1 million EUR;
  • Presently, the expenses of the customer service related to verification of orders and to other necessary operations are equal to 2%; these expenses are expected to be decreased by 10% due to the increase of the self-service share, i.e. by 56,000 EUR;
  • The total cost of the E-sales system, together with the necessary hardware, software, project management and time resources of the company's own personnel are estimated to be approx. 350,000 EUR.

On the basis of the initial information stated above, the return on investment (ROI) for the first year of activity can be calculated as 172%, the present value of the cash flow would be 500,000 EUR, and the internal rate of return would exceed 150%. These calculations do not take into account the continuous increase of efficiency over the next years (people are learning to use the system better), a slight decrease of expenses in the future, and the continually better use of the capabilities of the system.

This example shows that making assessments about revenues requires a rather good background in financial management.

Intellectual capital is a record in the balance sheet of a company that belongs among immaterial assets. Such a record cannot be added to the balance sheet of every company, because intellectual assets are a clear sign that the company has a development potential, know-how of some kind. Evidently, such a company should take investment opportunities seriously, because new solutions may have a very favourable effect on the increase of the company's competitive edge in the future. Intellectual capital can be viewed as a preserved asset, not as expense that loses its effect during the accounting year.

Intellectual capital is a value for the company, and it should ensure a know-how, skill or brand of some kind for the owners of the company. Intellectual property can be considered to be a technical solution developed by the company, an invention, a useful model or a trademark used for marketing a product. Intellectual capital can also be purchased (as patents, technologies, etc.); this approach was very successfully used by Japanese companies in a certain period. Intellectual property can also ensure a state of monopoly for the company for a certain period ands in a certain field. At the same time, such a mental asset is relatively difficult to protect, because good ideas are always copied, an analogue or a close replacement for the product can be developed. Although it is difficult for a company to protect its intellectual property rights, there are certain possibilities to do that.

Many lawyer's offices are active in protection of intellectual property, and significant amounts of money are used for that purpose. Section A.7.1 deals with some of the forms of protection of intellectual property. The best known protection method is copyright legislation that is applied to texts, visual art, musical works, scientific and study means, and also software. Technical solutions are protected by registering a patent or a useful model, and the main business identification of a company, i.e. a logo or a trademark, is also protected by registering it.

Often, some form of protection of intellectual property is disputed, accusing this approach of being fundamentally an activity against the interests of the public. Intellectual property protection measures are tried to be avoided also by using new information technology possibilities, by trying to find loopholes in legislation that have failed to foresee the developments of IT. At the same time, the interest of producers and authors in protecting their products must be understood, because money has been spent on creating these solutions or for making these discoveries and the creators want to turn this into a source of revenue in order to pay off these expenses in some time.

Besides protected intellectual property, there is also unprotected intellectual property, and this has received high praise from consumers. There are such examples of the author or owner leaving their property unprotected in all fields of activity, but this approach is most well-known in software development where developers grant public access to their products via freeware, shareware or open-source methods. As a rule, such an approach is not violating the protection of intellectual property because it is not forbidden for the owner of the protected intellectual property to allow free-of-charge use of the results of his/her work. In any case, it is up to the owner to state the conditions of use of his/her software, whereas the interested parties are forced to accept the rules stated by the owner.

If a free distribution of the intellectual property is not desired, then it can be quite a problem to determine the value of the intellectual property. In case of material assets, one of the approaches that can be used is analytic evaluation, whereby the labour resources and material resources expended are calculated and this is used for determining the approximate value of the product. On the other hand, this approach doesn't always reflect the absolute truth even in case of material assets because the market has a significant role here. Determining the value of intellectual property is by far more complex, although the fundamental basis would still be an evaluation of the expenses made and of the market value of the property. A comparison of these approaches yields the following conclusions:

  1. Calculations on the basis of investments made earlier are considered to be more objective, although there are problems with this, too. For example, the price can become too high when compared to the revenue generated by the product, due to unchecked and not purposeful expenses. In such a case, the ratio of price to quality is not balanced and the potential buyers may not be interested in the product;
  2. Determining the market value of the product can yield a result that is relatively close to the actual demand, but this process can become quite expensive (market studies are not cheap). Results of a market study are dependent on the target group and may thus be subjective.

Trademark is somewhat different from other forms of intellectual property, because its value increases together with the goodwill of the company and is also highly dependent on marketing work being performed. Often it is the image created via marketing investments that reaches the consumer as slogans and logos. Still, a trademark cannot be established on an entirely empty place; there must be a somewhat unique product, the lack of which was not felt by the consumers previously but which they cannot do without after the product has entered the market

Often the Coca-Cola phenomenon is used as an example of a trademark, because this trademark is well known in the entire world and there are many documented facts, and also urban legends, about the establishing of the main product of this company:

  • The uniqueness of Coca-cola is ensured by its secret, but unprotected recipe. Although the main components are well known, no manufacturer has had success in developing a similar refreshing drink on a comparative level. On one hand, it is amazing that no person possessing the manufacturing secrets could be bought off in today's environment, and on the second hand, it is also amazing that the company has such confidence as to leave this kind of product unprotected by patents. At the same time, the latter can also be considered a stroke of genius, because in USA, a patent becomes obsolete in 17 years and after that all interested parties could learn the recipe of Coca-Cola. The effect is precisely that patenting would make this recipe public and others could start using it after the end of the patent's validity period. As it is, the manufacturer of Coca-Cola can well start planning for the jubilee of a hundred years while no serious replacement products have entered the market yet;
  • Also, the design of the Coca-Cola bottle has been the subject of many discussions, because its original shape turns heads even today, while the payment for the person coming up with it is told to have been about 1 USD;
  • At the same time, the trademark of Coca-Cola has a very serious protection, whereby even the use of similar graphical solutions is forbidden. If the lawyers can prove that someone has violated the Coca-Cola trademark rights, then the party at fault can expect to get a hefty penalty request. There was such a case in Estonia some years go, when the organisers of the Arvo Pärt festival had problems because the designer of the festival's logo had used recognisable curves of the Coca-Cola letter C in the festival's logo letter P;
  • The value of the Coca-Cola trademark is estimated to be approx. 35 billion EUR.

Expensive trademarks can be encountered in other industries as well: General Motors, Shell, and in the IT field there's definitely IBM; the value of the latter trademark is estimated to be approx. 20 billion EUR.

A.3.4 Evaluation of IT SolutionsEdit

The above sections presented a short summary of economical aspects of IT and highlighted the efficiency of using technical solutions in certain fields:

  • The implemented technical solution must be in conformance with the internal and external consumers of the information system (see section A.3.1);
  • Modernising, updating, merging with another information system, expanding or delimiting an information system must be in conformance with the information system adjustment plans, stating evaluations of profitability of all possible activities (see section A.3.2.) and assessments of these activities in regard with their conformance to the business plan;
  • Hardware is not always compatible and thus it would be reasonable to determine the causes for the specific IT solutions having emerged – can these solutions be used in the changed conditions or in some entirely other situation? Example: if a large-scale farm produces meat for one meat processing establishment only, then there is really no need for a customer management system in this farm;
  • In addition to availability of correct technical and conceptual solutions and the highlighting of the advantages of the offered solution, an analysis must be performed about the economic ratios of the entire information system. Certainly, return on investment (ROI), return on equity (ROE), internal rate of return (IRR), nominal present value of investment (NPV), etc. must be determined;
  • Also, the effect of implementing the new information system on users must be assessed. The risk related to using new solutions must be offset by the emerging competitive advantage on the basis of the new knowledge, solutions and skills that would be an intellectual capital for the company.

In order to get a more objective economic overview of the activities of the information system, a calculation of operating expenses and operating revenues across different articles of expenses and revenues should be performed. Analyses have shown that tailor-made information systems can cause problems in usage because of the system not supporting the main activity of the organisation or turning out to be too expensive to operate. The benefits of operating such information systems is less than the expenses needed for operating them, although the solutions are technically correct.

Also, the value of immaterial assets, additional benefits from information technology solutions, and problems in assessing their value have been described above. In addition to revenues and expenses that are difficult to be determined, there are also a number of easily calculated revenues and expenses:

  • As a result of modernising the production process, the average total costs (cost price) can decrease;
  • Decrease of variable costs (less labour force needed);
  • Expenses on purchasing hardware and software licenses;
  • Service fees for product updates and support services;
  • Purchases of all kinds of additional services in addition to the existing solution.

If it is impossible to make precise calculations, then expert assessments should be made for the relevant expenses and revenues. Even if risks increase as a result of such expert assessments, the results should not be considered insignificant. Also, assessments based on experience and intuition are valuable for the company, because computers cannot be used for getting such results and generally, assessments are needed about the increase of responsibility in regard with quality and efficiency of end results. Evidently, the fields of intellectual work where computers cannot be used will be performed by people in the future, too. Thus, there will also be fields where it is impossible to determine the exact economic figures:

  • Expenses related to the customer's employees involved in development of IT projects;
  • Development and training expenses, decrease of efficiency in the course of implementation;
  • All kinds of unforeseen expenses;
  • Expanding the range of services offered to consumers or increasing the service level;
  • Benefits from an improvement of the company's image;
  • Employee satisfaction and benefits from the increase of work quality resulting from this,
  • Benefits from a co-operation of different systems, etc.

Objective approach to the economic aspect of information systems requires that all revenues and expenses are taken into account, regardless of the level of difficulty in determining these.

One of the possibilities for determining these expenses is the method of total cost of ownership. This means that all expenses are determined from the planning stage to the operating stage (see section A.2.6). It would be tactically better to start with smaller parts of the entire economic analysis of the information system, thus a pilot project with a limited data volume should be implemented first within a sub-unit of the organisation, and then, gradually, the entire organisation would be involved. Regardless of limited volumes, such approach allows for determining the majority of possible shortcomings and for clearly highlighting the benefits of the system. This also provides initial information for evaluating the possible expenses of the entire system in real environment.

The assessment of profitability of the information system is needed before making the decision to purchase the information system or to establish it in the course of development work. More specific results about the possible total costs and potential benefits can be achieved on the basis of a functioning system.

In order to compare different financial figures of economic analysis, the methods for calculating the relevant ratios need to be known. The approaches most often used internationally are stated below:

  • One of the easiest ways to provide an assessment about the system is to determine the payoff time of the system, i.e. the time after which the investment starts to earn profit. Evidently, a shorter payoff time is a better result here. The revenues to be received after the payoff time are considered additional revenues that are not calculated at this point;
  • The annual revenue of the investment is determined as the ratio of the average annual revenue to the invested capital (initial or average value) and expressed in percentage. Additionally, the return on investment (ROI), the accounting rate of return (ARR), and the return on capital employed (ROCE) are determined;
  • The nominal present value of the investment (NPV) and the internal rate of return (IRR) are determined. These figures take into account the change of the value of the money in time;
  • The rest of the methods are based on discounted cash flows.

QuestionsEdit

  1. Which of the following is considered to be the customer in the sense of IT economics?
    1. A company using computer technology
    2. A person purchasing a computer from a retail store;
    3. A project manager;
    4. The manager of a company using computer technology.
  2. What does a business plan describe?
    1. Possibilities and ways of achieving the business goals of the company;
    2. Ways of getting new customers;
    3. Ways of improving the technical parameters of computers;
    4. Long-term plans of the management of the company.
  3. Which of the following are considered to be static costs?
    1. Production costs depending on production volume;
    2. Costs with an unknown precise amount;
    3. Expenses for office personnel, not dependent on production volume.
  4. Which of the following is considered to be the breakeven point?
    1. The production volume where revenues and expenses are in balance;
    2. The point of achieving 100% profit;
    3. An increase of sales volume of products after implementing new technology in production.
  5. Which of the following is a part of the Skype intellectual capital, among other things?
    1. A well-known trademark;
    2. 10 million users in year 2007;
    3. Positions of the owners among dividend millionaires.
  6. Which of the following is the basis for determining return on investment?
    1. Payoff time;
    2. Amount of money spent;
    3. Average number of employees made redundant;
    4. Preservation of goodwill of the company during economic crisis.

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