Establishing the ROI on Software through Examination of Total Ownership Costs Daniel D. Galorath Founder and CEO of Galorath, Incorporated

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1 Establishing the ROI on Software through Examination of Total Ownership Costs Daniel D. Galorath Founder and CEO of Galorath, Incorporated Abstract: Software and IT systems can provide a positive Return On Investment (ROI) and contribute significantly to business value. Unfortunately many systems never do, due to overoptimistic benefit assumptions and underestimating costs. Total ownership cost, not just development or project cost must be considered to understand the cost side of the equation. Unfortunately software economics has long been considered just the estimation of software development costs, missing the bulk of the total ownership costs such as: software maintenance, IT Infrastructure, and IT services. This paper discusses estimation of total ownership costs and benefits so the most viable portfolio decisions can be made and IT can become a profit center. The following topics are discussed: The Software Business Case Total Ownership Costs Development Cost Contribution Process For Estimating Development Process for Business Case / Return on Investment Analysis Including Risk in the Analysis 1 ITMPI005

2 Daniel D Galorath Founder & CEO Galorath, Inc. dgalorath@galorath.com Michael Milutis Director of Marketing Computer Aid, Inc. (CAI) Michael_milutis@compaid.com 2

3 About Galorath Galorath began as a consulting firm in 1979, committed to assisting government and industry to improve their software and hardware development products and program management. SEER by Galorath was initially envisioned by a veteran project engineer and a team of senior scientists and analysts who experienced first hand the shortcomings of manual estimation processes: Information gaps, inconsistent processes, changing requirements, competing demands, and outside pressure borne of wishful thinking. Galorath has invested over two decades of research and development helping organizations better plan and control project costs, quality, duration and risk. Leveraging sophisticated modeling technology and project-applicable knowledge bases, SEER solutions are proven to accurately replicate realworld project outcomes more quickly and with much greater accuracy than any traditional estimating methodologies. 3

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7 Scope: We Will Cover Principals Software Economics is a complex topic We will address the principals not details Engineers you may think this is too much detail on value If you are a finance person you will see much more can be done (e.g. pre vs. post tax considerations) Many books on ROI and cost are available 2009 Copyright Galorath Incorporated

8 ROI On Software High Level Overview Determine & Quantify Benefits over time Determine total ownership costs against schedule Determine if project worthwhile on its own or as part of a portfolio 2009 Copyright Galorath Incorporated 8

9 Software & IT Systems Are About Business Value Value Return on investment Internal rate of return Net present value Intangibles Cost Development Maintenance IT infrastructure IT services Other direct costs 2009 Copyright Galorath Incorporated 9

10 Introduction: Software Projects Must Return Business Value Economics is primarily a science of choice software economics should provide methods for analyzing the choices software projects must make. Leon Levy Base choices on those providing the maximum business value to the organization Eli Goldratt Some say business value is not our problem While others generally need to perform benefit analysis We need to start building systems that optimize the business Make IT part of the solution 2009 Copyright Galorath Incorporated 10

11 Cutter Consortium Software Project Survey: 62% overran original schedule by more than 50% 64% more than 50% over budget; 70% had critical product quality defects after release Standish Group CHAOS Report 46% challenged 19% failed 35% successful BUT SUCCESS DID NOT INCLUDE RETURNING BUSINESS VALUE ~$875 billion spent on IT ~$300 billion spent on IT projects ~$57 billion wasted annually ~22% of IT Budget WITHOUT CONSIDERING PROJECTS THAT DON T RETURN BUSINESS VALUE 2009 Copyright Galorath Incorporated Run IT Like a Business

12 TOC Core Metric: Value Provided By Software Concept: Spend where you obta in the most value Value = savings to company or additional revenue due to the software Software Fails to add value much too often Users enamored with concept Concept deployed Little to no value contributed to company Many reasons often no changes in business rules MRP is a classic example of software hyped but which did not provide value Many Organizations May Not Be Mature Enough To Consider Value From the Software Team 2009 Copyright Galorath Incorporated

13 Human Nature: Don t say No HBR Article explains this Phenomenon: Problem: Humans seem hardwired to be optimists We routinely exaggerate benefits and discount costs Reference: Delusions of Success: How Optimism Undermines Executives' Decisions (Source: HBR Articles Dan Lovallo, Daniel Kahneman Jul 01, 2003) It Is Hard To Just Say No Due To Optimism When pessimistic opinions are suppressed, while optimistic ones are rewarded, an organizations ability to think critically is undermined (HBR Article) 13

14 Engineering Business Case Process 1. ID Scope of business case analysis 6. Estimate value / value Risk 7. Determine if project ROI justifies it 2. Understand problem & problem uncertainty 5. Estimate cost / cost risk 8. Select solution with best ROI or path to ROI 3. Define groundrules & assumptions 4. Establish technical baseline 9. Collect Information Ongoing to confirm and improve process 2008 Copyright Galorath Incorporated

15 Generating the Business Value Side of the Equation (Benefits) The business owns benefit calculations IT should participate Exception: projects solely improving internal IT Beware of subjectivity when translating soft benefits (e.g. improved customer satisfaction) into dollars Use Probability and risk Cost Reduction Reduction in ongoing operating costs: people, processes, cash outflows Increased Revenue Increased Profit Recommend: 2009 Copyright Galorath Incorporated How To Measure Anything, D. Hubbard

16 Return on Investment (ROI) Basic assessment of projects value Does not capture Time value of money (A dollar today is worth more than a dollar tomorrow) Rate at which business value (total return) is achieved Be sure to consider risk on investment and return 2009 Copyright Galorath Incorporated 16

17 Net Present Value of A Cash Stream PV = Net Present Value of future cash I t = Future value of period t R t = interest rate in period t Simplified equation should be iterated per period Normalizes $ over time (Discounted cash flow) Highest NPV brings the most value to the company Theoretically if NPV > 0 project is worth doing 2009 Copyright Galorath Incorporated 17

18 Internal Rate of Return (IRR) Accesses financial viability of projects (Internal value) Used in conjunction with NPV IRR =Measure & compare profitability 2008 Copyright Galorath Incorporated 18

19 Other Considerations Capitalization Vs Expensing Before and after tax returns Breakeven Economic life how long will it last. Degrading maintained software Reasons for replacement.. Deteriation versus obsolescence Sunk cost Depreciation vs. expensing 2009 Copyright Galorath Incorporated

20 Watch Total System Requirements: IT Systems Total Ownership Costs; 60+% Can Be Infrastructure & Services Software Development Software Maintenance IT Infrastructure IT Services Other

21 An Estimate Defined An estimate is the most knowledgeable statement you can make at a particular point in time regarding: Effort / Cost Schedule Staffing Risk Reliability Estimates more precise with progress A WELL FORMED ESTIMATE IS A DISTRIBUTION 21

22 10 Step Software Estimation Process: Consistent Processes = Reliable Estimates 1. Establish Estimate Scope 10. Track Project Throughout Development 2. Establish Technical Baseline, Ground Rules, Assumptions 9. Document Estimate and Lessons Learned 8. Generate a Project Plan 3. Collect Data 7. Quantify Risks and Risk Analysis 4. Estimate and Validate Software Size 6. Review, Verify and Validate Estimate Prepare Baseline Estimates

23 Manual Estimates: Human Reasons For Error (Metrics Can Help) Desire for credibility motivates overestimate behavior (80% probability?) So must spend all the time to be reliable Better approach force 50% probability & have buffer for overruns Technical pride causes underestimates Buy-in causes underestimates 23

24 Minimum Time Balancing Resources & Schedule Is A Science Minimum Time To Complete (Effort Increases to Reduce Schedule) Work Expands To Fill Time (Effort Increases due to lack of pressure) Effort Increase due to Longer Schedule Effort Months Optimal Effort (Lower Effort for Longer Schedule) For a given Size, Complexity and Technology Calendar Time 24

25 Staff Level (FTE people) Cost & Time Penalty SEER-SEM: Avoid Death Marches & Failed Projects By Applying Brooks Law Unaccomplished Work Planned Delivery Schedule or Cost Optimal Staffing Schedule Slip Elapsed Calendar Time (months) Level Staffing Actual Delivery Effective Staffing Staffing Beyond Plan Overstaffed Understaffed 25

26 Example Benchmark Versus an Estimate.. Why Are We So Expensive? 2009 Copyright Galorath Incorporated

27 Maintenance: 75% of Software Costs Dictionary: "The work of keeping something in proper order Generally about 75% of software total ownership cost Different from hardware maintenance because: Software doesn't physically wear out, but... Software often gets less useful with age and... It may be delivered with undiscovered flaws Software maintenance is: "The process of modifying existing operational software while leaving its primary functions intact. IEEE 1219, The modification of a software product after delivery to correct faults, to improve performance or other attributes, or to adapt the product to a modified environment 27

28 Development Defects Analysis Is a Clue to Maintenance Issues 28

29 Maintenance Growth Over Life Anticipated size growth from the point immediately after the software is turned over to maintenance to the end of the maintenance cycle May include additions of new functionality Rating Description 100%Major updates adding many new functions 35% Moderate updates adding some new functions 20% Minor updates & enhancements to existing functions 5% No updates expected, some minor enhancements 0% Sustaining engineering only 100% growth over 5 years Initial 27 mo development Nov-06 Feb-07 Hours By Month 0 vs 100% growth over 5 years May-07 Aug-07 Nov-07 Feb-08 May-08 Aug-08 Nov-08 Feb-09 May-09 Development Aug-09 Nov-09 Maintenance Feb-10 May-10 Aug-10 Nov-10 Feb-11 May-11 Aug-11 Nov-11 Feb-12 May-12 Aug-12 Nov Nov-06 Feb-07 Hours By Month 0% growth over 5 years Initial 27 mo development May-07 Aug-07 Nov-07 Feb-08 May-08 Aug-08 Nov-08 Feb-09 May-09 Development Aug-09 Nov Feb-10 May-10 Maintenance Aug-10 Nov-10 Feb-11 May-11 Aug-11 Nov-11 Feb-12 May-12 Aug-12 Nov-12

30 Key Driver: Maintenance Level (Rigor) Most Projects Spend Low During Maintenance Staff Vs Maintenance Rigor staff hours per month develop Rigor vhi+ Rigor nom Rigor vlo Time 30 Be Sure to include system degradation & potential reimplementation costs if maintenance rigor is insufficient

31 The IT Debt Gartner says $500 billion and going to $1 Trillion Cast Software says average cost of the IT debt is Technical Debt of an average-sized application of 374,000 lines of code is $1,055,000. Future cost of replacement of decaying software Software Entropy Either evolution & innovation is managed & effort invested or Software / system become less useful to the point where it needs replacing 2009 Copyright Galorath Incorporated 31

32 Be Sure to Include IT Infrastructure IT Services In Total Ownership Costs 2009 Copyright Galorath Incorporated

33 Benefit Types Tangible Benefits Intangible Benefits Intangible Quantified Benefits Actual benefit that can be measured (e.g. reduced headcount) Contribute to quality & performance (e.g. improved employee morale, better customer satisfaction) Numbers applied to intangibles when one will happen 2009 Copyright Galorath Incorporated

34 Bayesian Analysis To Quantify Intangible Benefits Assumes that 1 of several possible events will occur Uses expert opinion to identify events and probability of each The sum of these probabilities = 1 Assign value of each possible event & likelihood of occurring Example: Intangible benefit: improved brand awareness Possible increase in gross sales Revenue based on occurence Probability of occurence Expected return 34 0% $ $0 1% $750, $375,000 3% $2,250, $562,500 5% $3,750, $562, $1,500,000

35 NPV = discounted cash flow 400 Net or Discounted Value (200) Net and Discounted Cash Flow Year 1 Year 2 Year 3 Year 4 Year 5 Analysis Period Year Net Cash Flow (50) (100) (150) Incremental Cash Flow Incremental Cash Flow Projections Proposal scenario less Business as Usual Year 1 Year 2 Year 3 Year 4 Year 5 Analysis Period Year Cumulative Incremental Cash Flow Proposal scenario Less Business as Usual Cumulative Incremental CF (100) (200) 2009 Copyright Galorath Incorporated Year 1 Year 2 Year 3 Year 4 Year 5 Analysis Period Year

36 Investment Summary Initial Investment Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Total life cycle Hardware $ - Software 500,000 $ 500, Initial Installation $ - Misc. $ - Ongoing Expenses Hardware 10,000 10,000 10,000 12,000 12,000 15,000 15,000 $ 84, Software 20,000 20,000 20,000 10,000 12,000 12,000 12,000 $ 106, Maintenance Contracts 5,000 5,000 5,000 5,000 5,000 5,000 6,000 $ 36, Internal Development Staff 25,000 5,000 5,000 5,000 5,000 5,000 5,000 $ 55, Internal Admin/Maintenance Staff $ - Help Desk Staff 10,000 10,000 10,000 10,000 10,000 10,000 10,000 $ 70, Line-of-business Staff $ - Consulting Fees $ - Outsourced Services 40,000 40,000 40,000 $ 120, Hosting Fees $ - Hard Materials (printing, CDs, etc.) $ - Misc. $ - Totals $ 500, ,000 90,000 90,000 42,000 44,000 47,000 48,000 0 $ 971, Ongoing Expenses Hardware $ - Software 20,000 20,000 20,000 20,000 20,000 20,000 20,000 $ 140,000 Maintenance Contracts $ - Internal Development Staff $ - Internal Admin/Maintenance Staff $ - Help Desk Staff $ - Line-of-business Staff $ - Consulting Fees $ - Outsourced Services $ - Hosting Fees $ - Hard Materials (printing, CDs, etc.) $ - Misc. $ - Totals $ - 20,000 20,000 20,000 20,000 20,000 20,000 20,000 0 $ 140, Copyright Galorath Incorporated

37 The RISK Problem "It's tough to make predictions, especially about the future." -- Yogi Berra. 37

38 An ROI Analysis of A New System Cost of capital 8.0% Total Ownership Initial Investment Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Investment $100,000 $100,000 Increase/(dec.) in revenue ($40,000) $60,000 $110,000 $100,000 $100,000 $150,000 $150,000 $630,000 Increase/(dec.) in op. exp. $90,000 $70,000 $70,000 $22,000 $24,000 $27,000 $28,000 $331,000 Cash Flow ($100,000) ($130,000) ($10,000) $40,000 $78,000 $76,000 $123,000 $122,000 $199,000 PV of Cash Flow ($100,000) ($120,370) ($8,573) $31,753 $57,332 $51,724 $77,511 $71,186 $60,563 NPV 60,563 $60,563 IRR 13.5% 13.5% ROI 121% 121.1% 2008 Copyright Galorath Incorporated

39 Revenue Summary [proposed alternative] Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Total life cycle Direct Revenue - 100, , , , , ,000 $ 950,000 Indirect Revenue (leads, contacts, etc.) 10,000 10,000 10,000 $ 30,000 Totals $ 10,000 $ 110,000 $ 160,000 $ 150,000 $ 150, , ,000 0 $ 980,000 [current operations] Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Total life cycle Direct Revenue 50,000 50,000 50,000 50,000 50,000 50,000 50,000 $ 350,000 Indirect Revenue (leads, contacts, etc.) $ - Totals $ 50,000 $ 50,000 $ 50,000 $ 50,000 $ 50,000 $50,000 $50,000 $0 $ 350,000 Net Increase/(decrease) in revenue $ (40,000) $ 60,000 $ 110,000 $ 100,000 $ 100,000 $150,000 $150,000 $ - $ 630, Copyright Galorath Incorporated

40 SEER-SEM Basic Math Effort & Duration Simplified (Copyright Galorath Incorporated) K= D 0.4 (S e / C te ) 1.2 Simplified Basic Effort t d = D -0.2 (S e /C te ).04 Simplified Basic Schedule K is effort Se is effective size S g is size growth Reuse rit is amount of reuse T d is schedule Cte is effective technology People, Process, Technology D is staffing complexity - Inherent difficulty in terms of the rate at which staff are added to a project in min time Staff a is actual staffing Q is quality as defects inserted and removed Requirements & Integration computed separately Numerous adjustments based on constraints, staffing availability, etc. Productivity & schedule penalties applied as shown to right 40

41 Beware the Optimistic Benefit For example if a 10,000 person organization installs a new timecard system Ad that system saves every employee 1 minute per day People generally work a day each day 1 minute wont help That is not a 10,000 minute per day saved 2009 Copyright Galorath Incorporated

42 Internal Rate of Return Versus Net Present Value Project Cash flows ($) NPV at IRR t=0 t=1 10% A -10, , ,182 B -20, , ,818 NPV(A) and NPV(B) as function of the discount rate NPV at 10% IRR Project A Project B Copyright Galorath Incorporated Source: MIT Engineering Economics

43 Quantify Soft Software Benefits & Costs When you Can But Be Realistic; Examples Improved Customer Satisfaction may yield Improved Customer Retention Higher Quality Product may yield lower rework and higher customer satisfaction Improved Decision Making may yield many things Improved win ratio yields additional revenue Reduced time to market costs If system will yield business value $100,000 per month then every month is not available costs $100,000 THIS IS ONE REASON WHY SCHEDULE ESTIMATION IS AS IMPORTANT AS COST ESTIMATION Can be used to evaluate new tools, practices, ec. Assess slippage 2009 Copyright Galorath Incorporated

44 Conclusions Software purpose is to provide business value to the organization Success definition needs to include business value Quantify both costs and anticipated benefits Software maintenance can be 75% of software costs IT infrastructure / IT services can be 60+% of the total ownership costs Understand ROI, IRR, NPV, etc. But get finance involved or use tools to compute the numbers Communicating in language of executives can make more projects successful 2009 Copyright Galorath Incorporated

45 Questions? 45

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