ITEC Chapter 9

Net present value analysis

Method of calculating the expected net monetary gain or loss from a project by discounting all expected future cash inflows and outflows to the present point in time.

Positive NPV

Means that the return from a project exceeds the cost of capital - the return available from investing the capital elsewhere.

Discount rate

• The interest rate used to discount cash flows.

• Takes into account not just the time value of money but also the risk or uncertainty of future cash flows.

• The greater the uncertainty of future cash flows, the higher the discount rate.

• It is also called the capitalization rate or opportunity cost of capital. 

NPV calculations

• Determine estimated costs and benefits for the life of the project and the products it produces.

• Determine the discount rate 

• Calculate the net present value 

Internal rate of return (IRR)

can be calculated by finding the discount rate that makes NPV equal to zero.

Return on Investment (ROI)

Calculated by subtracting the project's costs from the benefits and then dividing by the costs.

• [Blank] = (Total discounted benefits - total discounted costs) / discounted costs

Payback period

Is the amount of time it will take to recoup, in the form of net cash inflows, the total dollars invested in a project.

• Determines how much time will elapse before accrued benefits overtake accrued and continuing costs 

• Payback occurs when the net cumulative discounted benefits equals the costs 

• Many organizations have requirements for the length of the payback period of an investment.

Cost overrun

Is the additional percentage or dollar amount by which actual costs exceed estimates

Cost

Is a resource sacrificed or foregone to achieve a specific objective or something given up in exchange.

Project cost management

Includes the process required to ensure that the project is completed within an approved budget.

• Planning cost management

• Estimating costs

• Determining the budget

• Controlling costs

Planning cost management

Determining the policies, procedures, and documentation that will be used for planning, executing, and controlling project cost.

Estimating costs

Developing an approximation or estimate of the costs of the resources needed to complete a project.

Determining the budget

Allocating the overall cost estimate to individual work items to establish a baseline for measure performance.

Controlling costs

Controlling changes to the project budget.

Basic principles of Cost Management

Most members of an executive board better understand and are more interested in financial terms than IT terms.

• They need to present and discuss project information in both

  • Profits

  • Profit margin

  • Life cycle costing

  • Cash flow analysis

Profits

Revenue minus expenditures

Profit margin

Ratio of profits to revenues

Life cycle costing

Considers total cost of ownership, or development plus support costs, for a project.

Cash flow analysis

Determines estimated annual costs and benefits for a project and resulting annual cash flow.

Types of costs

• Tangible

• Intangible

• Direct

• Indirect

• Sunk

Tangible costs

Costs or benefits that an organization can easily measure in dollars.

Intangible costs

costs or benefits that are difficult to measure in monetary terms

Direct costs

Are costs that can be directly related to producing the products and services of the project

Indirect costs

Are costs that are not directly related to the products or services of the project, but are indirectly related to performing the project.

Sunk cost

Is money that has been spent in the past; when deciding what projects to invest in or continue, you should not include sunk costs.

Learning curve theory

When many items are produced repetitively, the unit cost of those items decreases in a regular pattern as more units are produced.

Reserves

Are dollars included in a cost estimate to mitigate cost risk by allowing for future situations that are difficult to predict

Types of reserves

• Contingency

• Management

Contingency reserves

Allow for future situations that may be partially planned for (sometimes called known unknown) and are included in the project cost baseline

Management reserves

allow for future situations that are unpredictable (sometimes called unknown unknown)

Cost management plan includes

• Level of accuracy 

  • E.g. rounding guidelines, guidelines for the amount of contingency funds to include.
    

• Units of measure 

  • Each unit used in cost measurements e.g. labor hours or days should be defined 

• Organizational procedure links 

  • Work breakdown structure (WBS) component used for project cost accounting as the control account (CA)

• Control thresholds

  • A specified amount of variation allowed before action needs to be taken 

• Rules of performance measurement 

  • Cost measurement rules, e.g., how often actual costs will be tracked and to what level of detail.

 

• Reporting formats 

  • Format and frequency of cost reports required for the project. 

• Process descriptions 

  • Describe how to perform all of the cost management processes.

Cost estimation tools and techniques

• Analogous or top-down estimates

• Bottom-up estimates

• Three-point estimates

• Parametric estimating

Analogous or top-down estimates

Use the actual cost of a previous, similar project as the basis for estimating the cost of the current project.

Bottom-up estimates

Involve estimating individual work items or activities and summing them to get a project total

Three-point estimates

Involve estimating the most likely, optimistic and pessimistic costs for items

Parametric estimating

Uses project characteristics (parameters) in a mathematical model to estimate project costs

Function points

Are a means of measuring software size in terms that are meaningful to end users

User stories

Are a common way to describe requirements in a simple, concise way.

Budgeting

Involves allocating the project cost estimate to individual work items over time

• Material resources or work items are based on the activities in the WBS for the project.

Cost baseline

Time-phased budget that project managers use to measure and monitor cost performance.

Earned value Management (EVM)

Project performance measurement technique that integrates scope, time, and cost data

• Involves calculating three values for each activity or summary activity from a project’s WBS

  • Planned value (PV)

  • Actual cost (AC)

  • Earned value (EV)

Planned value (PV)

Authorized budget assigned to scheduled work

Actual Cost (AC)

Realized cost incurred for the work performed on an activity during a specific time period.

Earned Value (EV)

Measure of work performed expressed in terms of the budget authorized for that work

Cost variance (CV)

Is the earned value minus the actual cost

Schedule variance (SV)

Is the earned value minus the planned value

Cost performance index (CPI)

Is the ratio of earned value to actual cost

Schedule performance index (SPI)

Is the ratio of earned value to planned value

Estimate at completion (EAC)

is an estimated cost of completing a project based on performance to date

Budget at completion (BAC)

Is the original total budget for the project

To-complete performance index (TCPI)

is a measure of the cost performance that must be achieved with the remaining resources to meet a specific goal.

TCPI Equation to meet BAC

TCPI = (BAC - EV)/(BAC - AC)

TCPI Equation to meet EAC

TCPI = (BAC - EV)/(EAC - AC)