IT Valuation Techniques

Assessing the Value of Software

Projects

Objectives
At the end of this session, you will be able
to
Understand and apply traditional valuation
techniques to software projects viz:
ROI/Payback & NPV/IRR
Discuss the use of value models to estimate
future market value for software products
Understand the concepts of newer valuation
techniques such as: Sensitivity Analysis; Monte
Carlo Simulation; Real Options
Understand and Apply Earned-Value-Analysis
to software projects

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 Perceptions of Value?

Value of an object is based on the

need for it
Aristotle 384-322 BC
Cost-Plus value as a function of the
amount of work that had gone into
producing something
Industrial economy
Value depends entirely on utility -
"marginal analysis" theory
Carl Menger (1840-1921)

SW Economics Costs v Benefits

COCOMO II: Effort = (Size) (Quality)
(Personnel) (Environment) (Process)
Effort: person-months required to complete the project
Size: number of human-generated source instructions
composing the end product
Quality: factors considering the required product quality
Personnel: factors considering the abilities of the team
Environment: factors considering tools, techniques, platform
Process: Effectiveness of the process used to produce the end
product

Benefits Realization: Benefits = (Outcomes)

(Initiatives) (Contributions) (Assumptions)
Linkage between IT investment and other aspects of the
business
Reach: extent to which an IT-enabled change impacts on and
requires other changes in the organization
People must commit to a desired transformational change
Time: Estimating time frame within which a change is made is
critical to success

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Project Valuation Techniques

Traditional Methods
Return on Investment/Payback (ROI)
Net Present Value (NPV)
Internal Rate of Return (IRR)
Value Models
Sensitivity Analysis
Monte Carlo Simulation.
Real Options

Return on Investment (ROI/Payback)

Metric
how much time is required (the payback period) to
recover the original investment.

Advantages
Easy to calculate & Use; readily Understood by many
business executives
Problems
Ignores benefits that may occur after the payback period,
and so does not measure longer term profitability.
Ignores the time value of money -- the discount rate.
Does not factor in risk, when risk of failure in project work
of any kind may exceed 50 percent
Applicability
Best for short-term utility investments; Not recommended
when project is risky, complex, long-lived or competing
with alternative investment opportunities

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 ROI Example
An IT Investment project is estimated to cost forty million (J$40M) and
take twelve (12) months to implement. The new system is expected
to generate employee productivity savings of J$6M per year
immediately after installation. One year after the new system is
implemented the company expects to realize Improved Inventory turn
contributing an additional J$5M annually, and incremental revenues
estimated at J$12M annually based on a projected market share
growth of 15% per annum. Calculate the Return on Investment
(ROI/Payback) for this project

Cost = $40M
Annual inflows = J$6M (after Yr1)
Annual savings (Inventory Turns) = $5M (after Yr2)
Incremental revenues = $12M (after Yr2)
Total annual inflows = $6M after Yr1 and $23M after Yr 2

Not a straight application of the formula due to

separately delayed benefits
6M of Investment recovered after 1 year
34M remains to be recovered beyond Yr1
ROI =1 + 34/23 = 2.5yrs
The company uses a nominal project
selection criterion of Payback < 2years.
Should they approve this project?

Net Present Value (NPV/IRR)

Metric
Present value of cash inflows minus the present value of
cash outflows.
Future cashflow streams are discounted back at a
required rate of return (IRR)

Advantages
Accounts for future cash flows and time value of money
(inflation, internal cost of capital, etc.);
Problems
Does not explicitly model risk, although the IRR can be
set based on project/organization risk profile
Sensitive to uncertainty/reliability in future cash inflows

Applicability
Useful for all categories of investments; More suitable
when project benefits are explicit and tangible and include
hard savings; More applicable for internal software
projects, than for competitive market projects

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BUSINESS BENEFIT and VALUE ANALYSIS
Tangible benefits
Improved productivity Error reduction in order taking
Improved Sales Planning/Forecasting

Improved data integrity Error reduction in order taking

Expense reduction
Increased revenue
Cost avoidance
Intangible Benefits
Improved customer
satisfaction
Improved Collaboration
Better tracking of Orders Increased supply chain visibility,
Eliminate data entry staff
Reduced Order cycle time (10->4 wks)
Reduced Inventory carrying costs (Turn 45 ->
30days)
Increased Sales/Profitability
Eliminate district management / increased
Salesforce
Enhanced demand forecasting/planning functions,
fresher beer, and improved relationship
management
Supply chain collaboration between distributors,
salesforce, US HeadOffice and Production centers

Project Benefits / Valuation

Tangible Benefit 1996 1997 1998 1999 2000
($000)
Investment -950
Employee Productivity
Savings 83 279 279 279
Inventory Carrying
Costs Benefit 56 490 286 61
Net Profit Benefit 0 3,300 6,633 9,999
See valuation spreadsheet for assumptions and valuation
calculations
Valuation Measures 139 4,069 7,197 10,338
Payback 2.2 years
Net Present Value (NPV) = $18.7M
Internal Rate of Return (IRR) = 193% 1996 1997 1998 1999 2000

Notes to Valuation 950

Extremely high-value project
Increase in Net Income is biggest contributor to Valuation profile
Payback does not account for significant benefits in Years 2 & 3
Valuation based on Hard Benefits only, does not factor intangible benefits

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 Software Valuation Model
Typically applicable to software projects that
target a competitive marketplace;

Estimation of:
The value of the market for the product
The market share that the product can capture

Value Model computes license sales/revenue as a

function of:
Market Parameters
size, growth rate, industry pricing, discounts,
competition, advertising
Product Factors
Quality, price, performance, Time-to-market
Contextual factors
macroeconomic factors, competitive and regulatory
requirements, pricing (discounts), culture, etc.

Monte Carlo Simulation / Sensitivity Analysis

Monte Carlo Simulation
Use Random variables to model uncertainty in specific Model
inputs (eg.Demand, Inflation, Competitor pricing)
Sensitivity Analysis
Technique to determine which uncertainties in the inputs to
a value model will produce the greatest effects on output --
software product value
REV(t) = F(Market) * F(Product) * F(Context)
Market Parameters: size, growth rate, industry
pricing, discounts, competition, advertising
Advantages
Product Factors: Quality, price, performance, Time-to-
Quantify / Assess the impact of uncertainty in specific inputs
market
Contextual factors: macroeconomic factors,
and assumptions
competitive and regulatory requirements, pricing
Facilitates Risk assessment
(discounts), culture, etc. & control
Increase business confidence in the model
Problems
More complex and costly valuation models to develop &
interpret; Greater modeling expertise
Applicability
More complex valuation models; particularly well suited to
technology / capability investments as well as for
competitive market projects

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Real Options Perspective
Refers to the application of options pricing theory to
the valuation of Software investments.

Benefits of Delayed Investment Decisions

Time Value of money
Holds that pool of capital until it can be sunk into the best
possible design features

Risk of Delayed Investments

Missed market opportunity
Delayed project implementation/benefits

Applicability
estimate the present value of the flexibility that
modularity in software design confers
Associate a value with iterative development methods
which brings the benefits of delay while managing its
associated risk of missing a market opportunity
Options have value (e.g. Amazon.com)

Real Options Example

Software vendor has option to make product OS-
portable
Costs: more effort; slower performance; later time
to market
Benefits: option to sell product in more OS market
sectors
What is the net present value(NPV) of the option?
NPV = PV(Benefit flows) - PV(Cost Flows)
Key challenge: estimating PV(Benefit flows) for
various OS options
Windows, Mac, Unix,
Real options approach
Can approximate PV(Benefit flows) by relative
present market value of OS supplier firms
Used successfully in electronic components
industry

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Earned Value Analysis
Earned Value Analysis is:
an industry standard way to:
measure a projects progress,
forecast its completion date and final cost,
and
provide schedule and budget variances along
the way.

By integrating three measurements, it

provides consistent, numerical indicators
with which you can evaluate and compare
projects.

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 Standard EVA Terms
BCWS - Budgeted Cost of Work Scheduled
Planned cost of the total amount of work scheduled
to be performed by the milestone date.

ACWP - Actual Cost of Work Performed

Cost incurred to accomplish the work that has been
done to date.

BCWP - Budgeted Cost of Work Performed

The planned (not actual) cost to complete the work
that has been done.

Some Derived Metrics

SV: Schedule Variance (BCWP-BCWS)

A comparison of amount of work performed during a
given period of time to what was scheduled to be
performed.
A negative variance means the project is behind
schedule

CV: Cost Variance (BCWP-ACWP)

A comparison of the budgeted cost of work
performed with actual cost.
A negative variance means the project is over
budget.

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 Some More Derived Metrics

SPI: Schedule Performance Index

SPI=BCWP/BCWS
SPI<1 means project is behind schedule
CPI: Cost Performance Index
CPI= BCWP/ACWP
CPI<1 means project is over budget

CSI: Cost Schedule Index (CSI=CPI x

SPI)
The further CSI is from 1.0, the less likely project
recovery becomes.

Earned Value Analysis Example

In a software project it is estimated that the completion of prototypes will take
two months and $15,000, the analyses one month and $10,000, the plans one
month and another $10,000, and the specs two months and $15,000.
The Table represents the findings from a review performed at the end of the
fourth month to assess the projects status and actual cost.

Project TasksProject Tasks Time (Months)

Time (Months)
Budget 4 month
Budget
status
4 month status
BCWS BCWP ACWP
1 2 13 24 35 4 5%ge Cost %ge Cost
Prototypes Prototypes 15,000 100%
15,000
14,000 100%
15,000
14,000
15,000 14,000

Analyses Analyses 10,000 100%

10,0006,000100%
10,0006,000
10,000 6,000

Plans Plans 10,000 30%

10,000
5,000 30%
10,0005,0003,000 5,000

Specifications Specifications 15,000 20%

15,000
10,000 20%
7,500
10,0003,000 10,000

TOTAL TOTAL 50,000 50,000

35,000 42,500
35,000
31,000 35,000

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 Schedule Variance & Cost Variance

Schedule Variance = BCWP-BCWS

$31,000
- 42,500
SV = - $ 11,500

Cost Variance = BCWP-ACWP

$31,000
35,000
CV = - $4,000

Performance Metrics

SPI: BCWP/BCWS
31,000/42,500 = 0.73

CPI: BCWP/ACWP
31,000/35,000 = 0.89

CSI: SPI x CPI

.73 x .89 = 0.65

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 Earned Value Analysis Example
Project Tasks Time (Months) Budget 4 month status
BCWS BCWP ACWP
1 2 3 4 5 %ge Cost
Prototypes 15,000 100% 14,000 15,000 15,000 14,000

Analyses 10,000 100% 6,000 10,000 10,000 6,000

Plans 10,000 30% 5,000 10,000 3,000 5,000

Specifications 15,000 20% 10,000 7,500 3,000 10,000

TOTAL 50,000 35,000 42,500 31,000 35,000

Earned Value Analysis (EVA)

SV: Schedule Variance (BCWP-BCWS) - 11,500
CV: Cost Variance (BCWP-ACWP) - 4,000
SPI: Schedule Performance Index 0.73
CPI: Cost Performance Index 0.89
CSI: Cost Schedule Index 0.65

What Does this Picture Tell?

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 Making Projections
Once a project is 10% complete, the
overrun at completion will not be less
than the current overrun.

Once a project is 20% complete,

the CPI does not vary from its current
value by more
than 10%.

The CPI and SPI are statistically accurate indicators of

final cost results.

Source: Defense Acquisition University

Earned Value Analysis

Traditional Project Monitoring / Control

Value-Based
Software
Engineering

Whats wrong with this picture?

Value = Cost?
Emphasis only on traditional project constraints
Schedule, Cost, Scope?
Dynamic value assessment?
What about Risk?

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Value-Based Software Engineering (Review)
Program Design/Execution: Some Tools:
Requires understanding of Linkages, and Results Chain
Organizational Reach, People issues. Logical Framework Analysis
Dynamic management of the benefits
realization process over time
(Activist Accountability / Full-Cycle Governance /
Measurement / Change management)
Value Assessment:
Supports validation and selection of Return on
programs; Investment/Payback (ROI)
Assess alignment and integration Net Present Value (NPV)
Assess cost and benefits Internal Rate of Return
(IRR)
Assess capability/efficiency
Software Valuation Model
Supports ongoing management of the
portfolio, including dynamic adjustments to Earned Value Analysis
the programs in it. Risk Management

Value-Based Software Engineering:

Two Case Studies

Value-Based Software
Engineering: A Case Study
Boehm, B. L. G. H. (2003). Value-based software
engineering: A case study. Computer, 36(3), 33-41.

Heineken USA: Reengineering

Distribution with HOPS
Gyeung-min, K. P., John. (2003). Heineken USA:
Reengineering distribution with HOPS. Journal of Cases
on Information Technology, 5, 88-97.

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