Chapter 3 project life cycle phases process of project mannagement june2011

CHAPTER3: – THE PROCESS OF PROJECT MANAGEMENT- PROJECT LIFE
CYCLE PHASES
Introduction
– Traditional approaches to project management have emphasized the procedures involved. This
reflects an idea of project management which has emphasized physical resources and the use of
analytical techniques such as network analysis.
– Another approach which has been found to be effective is much more people and organization
oriented and can be broken down into a series of steps/stages/phases:
Project life Cycle:- A collection of project phases
Stages, Phases
• Projects are rarely tackled as a single, monolithic job.
What will you do to break up long projects?
Do they need to be long?
How long can a long Project Last?
If you want to shorten a project, what can you do?
Can you split a project into several smaller projects?
Why have Stages?
Break a large problem down into smaller, more manageable problems
What is Project Phasing?
Phasing may be used:
➢ To break up a long project into smaller, more manageable ones(Mini projects)
Or
➢ To deliver some working parts of an application while other parts are still under development (or
will be done later)
➢ “Phased implementation”
Or
➢ To run pilot system before committing system to wide scale use
➢ Unlike prototyping, the pilot system is a finished, working system in a useable state
➢ Experimentation is more likely to be concerned with related clerical procedures
Projects are systems and have a definite life Cycle
– Total project management is a change process that starts with a concept and finishes with use of
the output from the project(product)
– A useful method of examining project life cycle is to examine the management actions required
at each phase.
– Not only do actions change but so too does the mix on personnel involved in the project
– The parameters of cost, time and performance however apply over the whole cycle.
– ALL life cycle stages have their own level of uncertainty. Management anticipates the effect of
these uncertainties and be able to adapt.
– It is this process of learning to adapt that characterizes the ability of project management to
function where many process management systems have failed.
Breaking up large projects Stages of a Project life/ Project phases
Mostly, all projects have to pass through the following five phases:
1. Conception phase:-Clarifying the nature of the project
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2. Definition phase :- Defining goals and objectives – Feasibility studies
3. Planning and organizing phase:- Detailed organization of the project:
• Project definition
• Planning and scheduling
4. Implementation phase:- Project implementation and control
5. Project clean-up phase
While ideally these phases should follow one another in sequence, this rarely happens in real life. Not
only do the succeeding phases overlap with the preceding ones, it is also not too uncommon to find
complete overlap of all the phases.
We can have a look at these in turn.
1. Conception phase/ initiation:-Clarifying the nature of the project
– This is the phase during which project idea germinated.
➢ The idea may first come to the mind when one is seriously trying to overcome
certain problems.
– This phase begins when the user perceives a problem, need or opportunity.
➢ This can arise anywhere in an organization, some areas are corporate planning,
marketing, engineering, manufacturing sections etc.
As part of this phase, it is also necessary that the idea has merit and should be pursued. This
requires investigation that usually follows the following sequence:
✓ Fact finding where data is collected from interview, background research or review of
existing documentation.
✓ Definition of the problems statement where objectives are defined.
✓ Determination of possible solutions without detailed investigation of the alternative but
the elements of the problem. Preliminary order of magnitude estimates are often made at
this stage.
✓ Determination of screening criteria to evaluate the most promising of alternatives.
✓ Selection of solutions worth undertaking a detailed analysis.
The problems may be non-utilisation of the available funds, plant capacity, expertise or simply
unfulfilled aspirations. The following need to be established at the planning stage of the project:
• Resourcing,
• management support,
• nature of team working; the balance, for example, between creativity and
implementation skills,
• clarity of objectives.
E.g. when one is seized with the problems, he looks in and around to find out ways of overcoming them.
It may so happen that an idea will suddenly come to his mind as he surveys the environment. It is also
possible that ideas will be put to him by his well wishers or those working on the problems for him.
Example An operating cement plant may be having low capacity utilisation, high power consumption
and consequently higher cost of production. In such a situation it might be a good idea to introduce new
technology, replace some critical items selectively or scrap the plant altogether. There may be financial
constraints, the existing staff may need to be on roll, limestone deposits may last for limited number of
years and so on. The ideas need to be examined in light of objectives and constraints and what finally
becomes acceptable may form the future project. All projects are usually conceived this way.
A well-conceived project will go a long way for successful implementation and operation of a project. It
is quite possible that ideas may undergo some changes as the project progresses. This is understandable
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since at the conception stage all pertinent data are not available and also the real life scenario may
undergo considerable change compared to what may have been assumed initially.
2)
Definition Phase
The definition phase of the project will develop the idea generated during the conception phase and
produce a document describing the project in sufficient details covering all aspects necessary for the
customer and/or financial institutions to make up their minds on the project idea. It may include the
following stages:The success criteria for the project need to be defined. We have already seen that there could be hard
or soft.
a) Project feasibility
This stage is undertaken to determine if the solution is economically viable and worth pursuing. This
stage requires a lot of information and is often undertaken in the following sequence:
• Pre-feasibility study that is an initial screening process using information available inside the
users company.
• Solicitation of information from contractors to assess project’s viability (Request for Proposal).
• Analysis of the viability of the project.
The provision of information from the contract is not without cost to both parties. Contractor’s
undertake the risk of incurring this cost and will assess:
• is the risk worth getting a head start on competitors,
• Whether the contractor has sufficient resources to continue with the project.
• If undertaking the project will be consistent for the contractors reputation.
• The probability and ability of the client to implement the project.
Sometimes contractors will submit a proposal with little chance of undertaking the work to be
maintained on the clients bidders list for other work.
Proposals may be prepared by the contractor without the users soliciting proposals. This occurs
when a contractor feels that it has a solution that may be of benefit to the user.
Feasibility Studies
The basic questions to be asked are:
• Is the project feasible?
• How feasible are the alternatives under consideration?
The aim of the study would be to carry out a preliminary investigation which should help to
determine whether the project should proceed further and how it should proceed.
The relevance of this approach will vary with the nature of the project itself. The more concrete the
project is, the more likely that there will be established procedures in relation to feasibility. At the
other end of the scale there will be less need for a feasibility study for an open project.
The project manager responsible for conducting the feasibility study would normally consider:
i) Cost: is this within the budget set by the organisation or within the capabilities of the
organisation to finance it? How do the alternatives compare?
ii) Timing: are there specific constraints on timing and is it possible to complete the project within
these constraints?
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iii) Performance: will the project satisfy performance criteria which have been determined?
Basically this means will it do the job it is designed to do?
iv) Effect on the organisation: is it feasible in the context of the organisation and the effect which
it will have upon it?
We should have a look at these factors in a little more detail.
I)
Cost factors will be looked at through a financial appraisal. This should be related to financial
criteria which have been determined. You need to consider whether the following criteria are
relevant.
i) Capital expenditure implications:
• What are the costs of the project?
• If there are alternatives, what are the relative figures?
• What effects will this have upon the organisation’s finances particularly the capital
budget?
• How will it fit with controls imposed upon the organisation by central government.
• How will the expenditure be financed? What are the alternatives?
ii) Revenue implications:
• How much will this cost both in the current year and in subsequent years?
• What are the likely gains in terms of income?
• What effect will this have upon the revenue budget?
The answers to these questions will determine the financial criteria upon which the feasibility
will be judged.
II) Timing: the project schedule may need to comply with specific criteria which have been laid
down. Timing can be important:
• to comply with legal or governmental requirements. For example, new legislation or new
requirements may need to be implemented by a certain date;
• for operational reasons. A new system may be required as a matter of organisational policy
or to fit in with existing procedures and deadlines;
• to assist with financing arrangements. Grants or borrowing approvals may need to be spent
within a specific period;
• to give the organisation an edge over its competitors.
II) Performance specifications: these may be:
• technical
• service based
• resulting from external regulations
• required by clients and customers
IV) Organisational context:
• What is the policy of the organisation?
• Organisational culture; does the project fit in with the general values and beliefs of the
organisation?
• How will it affect resourcing? (Are the skills, technology and physical space available?)
• How will the project fit in with existing procedures? What effect will it have upon systems?
The actual questions asked and the shape of the study and the consequent report will depend upon
the type of project being investigated.
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Student Activity
– Examine a live project in your own organisation. Make a list of questions that should be
asked in relation to feasibility.
Feasibility Report
The project manager will be responsible for reporting on feasibility to the sponsoring decision
makers or stakeholders/project steering committee/project board.
This may be done in a variety of ways and with different degrees of formality. Typical contents
would include:
➢ project definition covering goals and objectives
➢ general background and introduction with an outline description of the options
➢ a clear definition of success criteria or feasibility criteria
➢ findings of the feasibility study
➢ financial appraisal
➢ preliminary compliance
➢ organisational suitability
➢ the plan for the management of the project including implementation
b) Proposal Preparation(see the attached sample content of a project proposal)
Proposals prepared by the contractor are separate mini projects. As time and money are expended,
top management authorisation is usually required for this process.
▪ A proposal manager is appointed and reviews the users requirements. From these
requirements it is often advisable to prepare a detailed summary of the project.
▪ The proposal team may be involved in further defining the user’s requirements to enable a
proposal to be prepared. This further development often occurs with input from the user.
▪ Once the requirements are fully determined, a statement of work or methodology is prepared.
This outlines the activities in broad terms that are required to satisfy the user’s requirements.
▪ The contractor will then prepare a structure for presentation and collation of information. The
proposal team must think through the entire project and a Work Breakdown Structure is
devised to facilitate this process.
The contractor will then review information in the proposal and make final adjustments before
submitting the document to the user for consideration.
c) Project evaluation and selection
The selection of a model is subject to a number of criteria:
➢ Realism and consistency of comparison across multiple projects. The realities that a selection model
should consider are:
✓ Resource constraints.
✓ Financial Constraint: – capital or borrowing capacity of the company.
✓ Personnel Constraint: – personnel available to supervise the project and many others.
➢ To have an effective selection model a company needs to compare “apples with apples”. This
requirement often causes companies to compare on a cost/benefit basis usually expressed in dollar
terms.
➢ Capability of being able to simulate both internal and external conditions and optimize the solution.
➢ Flexibility to cater for a range of conditions that may affect the decision.
✓ Ease of use.
✓ Cost effective, particularly being consistent with the risks of the project.
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Project selection is the first step in initiating a project. It is a systematic process of comparison of
alternatives to achieve organisational objectives.
In many methods, figures will be used to select the projects worth pursuing. If numerical analysis is not
possible, the principles will often still apply. It is worth going behind the formulas and understanding the
logic and philosophy to fully apply these techniques. These methods generally use three parameters:
✓ Cost
✓ Benefit
✓ Risk.
Understanding these processes although the project manager is often appointed after selection has been
made is important to allow project personnel to understand the client or parent organisation’s objectives.
3)
Planning and Organizing Phase/ Project Planning and Scheduling
➢ This phase can effectively start only after definition phase but in practice it starts much
earlier, almost immediately after the conception phase.
➢ This phase overlaps so much with the definition and also with implementation phases that no
formal recognition is given to this by most organizations.
➢ Some organisations, however, prepare documents such as Project Execution Plan to mark this
phase.
Project Planning involves:- Identifying the products to be delivered, developing estimates for the work to be
performed, establishing the necessary commitments, and defining a schedule to perform
the work
– Planning begins with a statement of the work to be performed and other constraints and
other constraints and goals that define and bound the project.
– The planning process takes estimates produced by the estimation process and use these to
produce a schedule, identify and asses risks and negotiate commitments.
Project Planning begins as soon as Definition allows. The process involves planning subprojects first and hence Definition must at least have identified the sub-projects and the major
tasks involved in them.
From this point, Planning and Definition tend to continue in parallel as a series of iterations,
gradually refining and hardening both Definition and Plans.
The purpose of the Project Plan at this stage, is to provide detailed realistic estimates of time,
duration, resource and cost, and planning should be carried out only in sufficient detail to allow
this to be achieved. Detailed planning for allocation of tasks to individuals is carried out
progressively as the work proceeds.
Where there are sub-projects these should be planned first and then combined to produce the
overall project plan. Produce a plan for each sub-project, or for the total project if there are no
sub-projects as follows:
a). Identify Major Activities
Break the work down into activities of the order of 20-50 days of effort, ensuring that
milestones correspond to completion of one or more of these. In practice the achievement of
a milestone is usually a good basis for identifying an activity e.g. ‘prepare and perform user
training’.
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b) Identify and Chart Dependencies
Produce a network chart for the sub-project showing dependencies between the major
activities and dependencies on other sub-projects or external events.
c)
Estimate Effort and Duration
Estimate effort and duration of each major activity.
d) Provide Contingency
At this stage estimates are likely to be ‘soft’ and probably expressed in ranges, because
precise details of the work are not settled. Contingency needs to be allowed both on the
estimated effort and elapsed time because of:
• the likelihood of unforeseen work arising,
• the likelihood that tasks will take longer than expected,
• the likelihood of changes to requirements or plans before publication. (Subsequent
changes should be processed through Change Control).
Contingency provision should remain evident in plans (probably as one or more contingency
‘tasks’). This provision should then progressively be removed from plans during Tracking
and Control as a result of either:
• being used up by e.g. tasks taking longer than planned,
• or reaching a point where uncertainty is reduced such that a part of contingency
provision can safely be deleted. This usually means the deletion of contingency allowed,
but not used, on tasks now completed.
e) Schedule Major Activities
Determine start and end dates for each major activity and produce a bar chart or other
diagram, showing relationships between activities.
f) Calculate Resource Requirements
Calculate requirements for each time period. Identify needs for each resource type (e.g.
systems analyst, user staff) and identify needs for special skills or scarce resources.
g) Calculate Costs
Calculate costs for the sub-project. This should include ‘hardening up’ items such as
cabling, training etc., for which an order of costs had been produced previously.
h) Determine Overall Costs and Benefits of the Project
The cost/benefit justification should have already been stated in the feasibility study. This
stage provides the opportunity to review the case in the light of more detailed information.
i)
Document the Project Plan
Once a viable plan has emerged (i.e. conflicts have been resolved, resource availability has
been confirmed etc.) the Project Manager should produce the Project Plan covering:
➢ Project Schedule. This should show major activities by sub-project on a bar chart or
other diagram. The chart should also show project milestones and target dates. Show
contingency as a single provision at the end. Include an overall project network showing
the critical path. Narrative explanation may be included for clarification.
➢ Major Checkpoints and Reviews. List the dates of Checkpoint Reports, Checkpoint
Meetings, Steering Group Meeting and the Post-Implementation Review.
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➢ Deliverables. List the major products of the project with delivery dates and acceptance
procedures.
➢ Resources. Summarise the resource needs from the sub-project plans.
➢ Costs and Benefits figures. Revise and refine as a result of completion of Definition and
Planning.
➢ Potential Problems. List any risks, problems or assumptions which may jeopardise the
Plan, together with actions needed to correct the situation.
➢ Appendices. Any useful supporting information including Sub-project Plans may be
included.
j) Ensure Management Systems are in place.
4)
Project Implementation and Control Phase
It is during this period that something starts growing in the field and people for the ‘first time can see the
project. Preparation of specifications for equipment and machinery, ordering of equipment, lining up
software developer contractors, System analysis, designing of system, software development/coding,
testing, checking, trial run and commissioning of the software take place during this phase. As far as the
volume of work is concerned, 80 – 85% of project work is done in this phase only.
This phase itself being more or less the whole project, every attempt is made to fast track, i.e., overlap
the various sub-phases such as engineering, procurement, construction and commissioning to the
maximum extent. This is besides starting the implementation stage itself in parallel with the earlier
phases of the project life cycle. Hardly any project can afford the luxury of completing one
implementation sub-phase fully before moving on to the next.
The amount of fast tracking will, however, depend on who is doing the project. If design is done by one
agency and construction by another, then the scope for fast-tracking becomes very limited. If, on the
other hand, design, supply and construction is contracted out as a total package, then the contractor is in
a position to use fast-tracking to the maximum extent possible. It is this and many such requirements of
this phase that have given birth to what is considered modern project management.
Figure 1.3 lists the sub-phases and shows the extent of fast tracking in this phase of project life.
SUB
SUB-PHASE
PHASE DESCRPTION
NO
I
software Analysis
II
Hardware Selection
III
Software Design
IV
Hardware testing
V
Software
testing/implementation
1
2
3
4
5
MONTHS
6
7
8
9
10
11
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The role of the project manager falls into three areas:
i) Management of stakeholders
ii) Management of the project life cycle
iii) Management of performance
An approach needs to be developed for each of these. Control and monitoring procedures need to be put in place
and appropriate information systems developed.
The procedures which are put into place can only be successful if:
• there is satisfactory information to enable the team to manage the project effectively;
• they are simple and easy to operate and understand;
• they have the full support of the project team.
How should this relate to the three categories referred to above?
i)
Management of stakeholders:
Stakeholders’ interest must be monitored to ensure that:
• their interest and support is maintained;
• their views and ideas are being adequately reflected in the project development;
• their personal success criteria are being pursued and achieved;
• environmental change is fully taken into account.
ii)
Management of the project life cycle:
This is probably the most conventional view of project control. Feedback systems need to be set up to monitor
key areas.
Activity
For a project that is already underway in your organisation, identify the key areas requiring monitoring and
suggest the kind of information and procedures that would be involved.
Suggested Answer
The key areas would be as follows:
• The project timetable, with particular reference to critical event times and potential bottlenecks. There
should be feedback on activity times achieved and their effect on the whole project. If network analysis is
used, then it is vital that the network is reworked and updated to take into account the actual performance
achieved.
• The project budget; budgetary control procedures can be used as in respect of any other form of budget.
• Quality and performance standards; these need to be monitored against the original project specification
subject to changes agreed with stakeholders in the course of project development.
Where possible this should all be done through positive reporting which will required action to be taken.
iii) Management of performance:
This is the least tangible but possibly the most important of the three categories. How it is tackled will depend
upon what kind of project is being carried out.
It is unlikely that the project team will spend all of their working time together in close proximity and under the
direct supervision of the project manager. It is much more likely that they will work apart most of the time, only
meeting up occasionally and only meeting with the project manager from time to time. Control issues that need
to be considered therefore would be:
• How to get the best out of the team when they are together. If you are holding meetings then they should be
purposeful and effective. They should not simply be part of the routine. Having said that, they may be an
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•
•
•
•
important element in binding the team together and in developing a team approach to planning and
monitoring of performance.
Ensuring people work when the team is apart. You need to set people realistic deadlines and ensure that
they see the importance of their contribution and that their contribution is fully valued.
Communications are important in terms of disseminating information and keeping everyone informed.
There are views that team members should be given information on a need to know basis but this approach
can cause problems.
Ensuring continuing commitment by the team and adherence to the values and beliefs being pursued by the
team.
Change, in particular, needs to be communicated to team members quickly and effectively.
It is important to stress once again the need to look at the team and also for the project leader to look inwards at
his or her own performance.
Funding the Project
This will be determined by:
a) The nature of the project
b) The nature of the organisation
i)
The nature of the Project
A major capital scheme will call for a large injection of new finance into the organisation. A management
project can often be managed by using existing staffing resources. However it should not be forgotten that there
is an opportunity cost to this.
ii)
The nature of the organisation
Companies can use a variety of resources for capital projects.
• Share issues
• Long term loans
• Leasing
The ability of companies to raise finance will depend upon the perceptions of lenders of money. Public Sector
organisations are often restricted in their sources of finance by government regulations.
5)
Project Clean-up Phase/project close up
➢ This is a transition phase in which the hardware built with the active involvement of
various agencies is physically handed over for production to a different agency who was
not so involved earlier. For project personnel this phase is basically a clean-up task.
➢ Drawing, documents, files, operation and maintenance manuals are catalogued and
handed over to the customer.
➢ The customer has to be satisfied with guarantee-test runs.
➢ Any change required at the last minute for fulfillment of contractual obligations in
respect of performance has, therefore, to be completed during this phase to the
satisfaction of the customer.
➢ Project accounts are closed, materials reconciliation carried out, outstanding payments
made, and dues collected during this phase.
The most important issue during this phase is planning of the staff and workers involved in
execution of the project. All project personnel cannot be suddenly asked to go.
Summary
Project management concepts
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The peculiarities described so far about a project require a special approach to ensure the success of the
project. We may term this special approach as project management. Now success for a project means
1. It must get completed
2. It must be completed within budget
3. It must get completed within allocated time
4. It must perform to satisfaction
Project management meets these demands.
The success, however, can be achieved only through people. To that extent the principles of general
management must apply to project management also. What makes project management different is its
approach to task which besides its specification, is fully bound by time, cost and performance targets.
Steps in Project Management
Project management approach basically consists of the following five steps:
1. Grouping work into packages which acquires the properties of a project. This means that the works
so grouped are related to each other, contribute to the same goal(s) and can be bound by definite
time, cost and performance targets.
2. Entrusting the whole project to a single responsibility centre known as the project manager, for
coordinating, directing and controlling the project.
3. Supporting and servicing the project internally within the organisation by matrixing or through total
projectisation, and externally through vendors and contractors.
4. Building up commitment through negotiations, coordinating and directing towards goals through
schedules, budgets and contracts.
5. Ensuring adherence’ to goals through continuous monitoring and control using schedule, budgets
and contracts as the basis.
To use project management the first step needed is to create a project. This is possible even in a routine
situation. To exemplify when a maintenance organisation involved in routine maintenance decides to go
for scheduled maintenance, a scope for using the project management approach is created.
The organisation can install a project manager who may take the following steps
1. Projectise maintenance work as much as possible, i.e. create a number of projects such as daily,
weekly, monthly, quarterly, biannual and annual maintenance of the entire plant.
2. Set cost and time targets for each of these projects, i.e. daily, weekly, monthly maintenance, etc.
3. Mathx with the maintenance department which will now provide maintenance still including labour
and supervision. The maintenance department may be responsible for breakdown and running
maintenance.
4. Line-up vendors and contractors for supply of materials and erection skills.
5. Matrix and coordinate with other departments for preparation of drawings, specifications and
procurement of materials.
6. Monitor and control these projects using schedules, budgets and contracts.
The benefits of such an approach are immediately apparent. Total plant shutdown time as also the
maintenance cost will be minimum. This is because:
1. The project manager will be wholly concerned with completing the projectized maintenance work
within the budget and schedule. Unlike the maintenance manager he is not concerned with the day-
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to-day maintenance-related problems. Also, since his performance will be evaluated in terms of
schedule and budget, he will ensure the best possible adherence to the same.
2. All maintenance work will be accommodated within the longest maintenance cycle time known as
critical path (usually the maintenance time of the critical equipment), thus reducing the total plant
down-time to minimum.
3. Each agency will have definite time and cost targets to work to. The work of these agencies will be
continuously monitored and, therefore, problems will be reviewed and re solved even before they
cause any damage.
4. A project manager manages what he projects. He is, therefore, concerned with how to achieve the
next target and not to make a fuss as to why the previous targets have not been achieved.
5. Since the project manager will have the necessary authority to take most of the decisions relating to
his project, decisions will be made faster.
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CHAPTER 4: CAPITAL BUDGETING MODELS FURTHER READING
It is essential to evaluate the process of selection in regard to other measures of objective
attainment. The most effective modelling systems should examine the attainment of a weighted
set of objectives.
It will then be necessary to determine the criteria for acceptance or rejection of a project. A
number of factors are covered in the text. These factors may occur once or reoccur.
A number of items have to be considered when selecting and using these criteria. These include:
o
o
o
Range of uncertainty.
Timing.
Threshold or hurdle values.
TYPES OF MODELS
These are one of several techniques used to evaluate the value of investing in long term capital
investment projects in this case the information systems. The process of analysing and selecting various
proposals is called the capital budgeting. Alternative methods are available to compare different
projects and to make a decision about the investment. The three that are most widely used are:
•
•
•
•
•
Cost Benefit Ratio (from CBA seen earlier)
Pay Back Analysis
Net Present Value
Accounting Rate of Return on Investment (ROI)
Internal Rate of Return
1. Cost Benefit Ratio
This is simple method of calculating the returns from a capital expenditure and is the ratio of benefits to
costs. The formula is as follows:
Total benefits / Total Costs = Cost-Benefit ratio
This method mainly deal with tangible costs and benefits that can be quantified in monetary terms.
Some firms may establish a minimum cost-benefit ratio that must be attained by any capital project,
looking primarily at the tangible benefits.
2. Pay-back period:
This is calculated as Original investment over Net annual cash inflow and this gives the No. of years for
payback.
3. Net Present Value (NPV)
Evaluating a capital project requires that the cost of an investment be compared with the net cash
inflows that occur many years later as the investment produces the returns. But these two kinds of
inflows are not directly comparable because of the time value of money. Money to be received in the
future is not worth as much as money received today due to the time factor of inflation et al. Thus
money to be received has to be discounted by some appropriate percentage rate, usually the prevailing
interest rate or sometimes the cost of capital.
Present value is the value in current shillings of a payment or stream of payments to be received in the
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future. It can be calculated using the following formula:
n
Payment X (1 – (1 + interest) /interest = Present Value
Thus in order to compare the investment (made in today’s shillings) with future savings or earnings, one
needs to discount the earnings to their present value and then calculate the net present value of the
investment. The net present value is the amount of money an investment is worth taking into account
its cost, earnings, and the time value of money. The formula is as follows:
Present value of expected cash flows – initial investment cost = Net Present Value
4. Accounting Rate Of Return On Investment (ROI)
This calculates the rate of return from an investment by adjusting the cash inflows produced by
the investment over depreciation.
Firms make capital investments to earn a satisfactory rate of return. In the long run the desired rate of
return must equal or exceed the cost of borrowing money in the market place. ROI calculates the rate of
return on an investment by adjusting the cash inflows produced by the investment for depreciation. It
gives an approximation of the accounting income earned by the project.
To find the ROI first calculate the average net benefit as follows: (Total benefits – Total
cost- Depreciation) / Useful Life = Net Benefit
This net benefit is divided by the total initial investment to arrive at ROI as follows:
Net Benefit / Total Initial Investment = ROI
Limitations to financial methods
1.
They assume that all relevant alternatives have been examined, that all costs an benefits are known
and that these costs and benefits can be expressed in common metrics specifically money.
2.
They do not express the risks and uncertainties in their own cost benefits estimates. Costs and
benefits do not occur in the same time frame – costs tend to be up front and tangible while benefits tend
to be back-loaded and intangible Inflation may affect the costs and benefits differentially. Technology
especially IT can change during the course of the project, causing estimates to vary greatly. Intangible
benefits are difficult to quantify.
Cost–benefit analysis of an IS
The basic stages of CBA as applied to IS development include:
(i) Identification of the cost of acquisition and operation of the proposed system
Some of the expenses incurred will be fixed costs, one time cost of acquiring systems resources,
including the cost of systems development. These expenditures need to be made before the system
becomes operational.
Operating costs, on the other hand, will be borne on a recurring basis (e.g. annually) after systems
implementation. Operating costs and benefits start only following system implementation.
System costs:
Fixed costs (one time resource acquisition)
H/w acquisition: s/w– purchase and development, establishment of dbases,
establishment of new procedures training and hiring of personnel
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Operating costs (e.g. annually)
Labour (operation and maintenance) Facilities Supplies Leases
(ii) Identification of benefits that will be derived from the use of the system
Benefits fall into two categories:
Tangible benefits that are easy to quantify and intangible benefits that are
difficult to quantify.
Tangible benefits include cost savings and revenue increases.
Tangible benefits saving (e.g. reduced labour costs, reduced h/w costs, reduced
purchasing costs, inventory reduction) Revenue +ces induced sales in existing
units, market expansion.
Intangible benefits are often of a riding importance in case of MIS Important intangible benefits of IS
a) Improved customer service.]
b) Achieving specific strategic advantage in the market place
c) Availability of higher quality information
d) Higher utilisation of assets.
e) Improved work co-ordination
f) Improved planning g) Improved resource control
h) Assimilation of promising new technology
i) Improved working environment
j) Induced organisation flexibility
k) Streamlined operations
l) Induced reliability and security of IS operations
m) Satisfying legal rafts
(iii) Comparison of costs with benefits
After the costs, tangible benefits, and those aspects of intangible benefits that can be detained are
quantified, a cost-benefit evaluation technique is applied. The most commonly used CBA technique is
the
Net Present Value Approach.
Using this method, the NPV of a system is computed by subtracting the present value (PV) of the costs
from the PV of the benefits calculated over the lifetime of a system. If a positive value is obtained, the
project has merit. For example. it’s estimated that the development time of the IS will be 18 months. The
system will remain in operation for 4 1/2 years. After the costs and tangible benefits have been listed
and quantified the full schedule of costs and benefits is obtained:
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Costs (Ksh.)
Fixed
Year 1
Year 2
Operating
50000
30000
10000
20000
Year 3 – 6
Benefits
Year 1
Year 2
0
30000
60000
Year 3 – 6
The discount rate as used by the finance dept of the firm is 12%. Calculate NP
Solution:
Year
effective
Costs $
Benefits
Net value
1
2
3
4
5
6
50000
-5000
40000
30000
-10000
20000
60000
40000
20000
60000
40000
20000
60000
40000
20000
60000
40000
Present value
factor
PV
1
0.893
0.7117
0.7971
0.6355
0.5674
-50000
-8930
318880
28480
25440
22680
After adding the PV, the NPV= 49580
Note: Figures can be replaced with desirable ones
As an alternative CBA technique, some firms use the break-even method also known the pay-back
technique. In this technique, the graphs for annual benefits and costs (their present values) would be
charted for the lifetime of the project. The point where they intercept shows when the system becomes
profitable.
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