SEN2022 · Week 2 · Systems Analysis and Design for Information Systems

System request and feasibility: ROI, NPV, payback

The system request that states why a project will be done, and technical, economic and organizational feasibility. The calculation question on the exam is usually NPV, ROI and break-even.

system requestbusiness needbusiness valuetangible benefitintangible benefitfeasibility analysistechnical feasibilityeconomic feasibilityorganizational feasibilityreturn on investment (ROI)net present value (NPV)break-even pointpayback periodchampionstakeholder analysis

A project passes through two gates before any code is written. The first is the system request: a short document from a business unit saying “we need this system, because…”. The second is feasibility analysis: the answer to “can we do it, should we do it, will it be used if we do it?”. On the exam two types of question come from this week: definitions (the types of feasibility, the parts of a system request) and calculations (NPV, ROI, payback). The calculation question is almost guaranteed and carries high marks.

Golden rules:

  1. Three feasibilities, three questions: technical = Can we build it? economic = Should we build it? organizational = If we build it, will they come?
  2. Money has a time value. 1 TL today is worth more than 1 TL in 3 years. NPV takes this into account.
  3. Build a table. Years in the columns; benefits, costs, net, PV, cumulative in the rows. Most calculation errors come from not building a table.
  4. Write the unit: NPV is money (TL), ROI is a percentage, payback is years.

System request

A project idea usually comes from the business side: a manager, a department. This idea is put in writing with a system request and presented to the approval committee.

PartContentCampus library example
Project sponsorThe person who wants and owns the projectThe library director
Business needWhy it is needed (in business language)The lending queue is long, late-return tracking is done by hand
Business requirementsWhat the system should do (high level)Online reservation, automatic overdue reminders
Business valueWhat it gains (tangible and intangible)2 staff hours saved per year, student satisfaction
Special issuesConstraints, datesMust be ready by the start of the fall semester

Business value is of two kinds. Tangible value can be measured and converted into money: “a 20% increase in collection of late fees”. Intangible value is real but cannot be converted into money: “a better student experience”. The point that gets mixed up on the exam: “customer satisfaction” is intangible, “15 minutes less staff time per customer complaint” is tangible.

Technical feasibility

“Can we build this system?” The answer is really a risk assessment. Four factors raise the risk:

FactorExplanation
Familiarity with functional areaHow well do users and analysts know the business area? If they don’t, the requirements will be misunderstood.
Familiarity with technologyHas the team used this technology before? New technology = high risk.
Project sizeRisk rises as team size, duration and number of features grow.
CompatibilityWill the new system be able to integrate with existing systems (database, network, other software)?

Economic feasibility

“Should we do it?” This is a cost-benefit analysis. Four steps:

  1. Identify the costs and benefits.
  2. Assign values (give each one a monetary equivalent).
  3. Spread the cash flow over the years.
  4. Compute the financial measures: ROI, NPV, break-even point.

Costs are of two kinds. Development costs are one-time (software license, developer pay, hardware, training). Operational costs repeat every year (maintenance, cloud bill, support staff).

Formulas

Present value: the present equivalent of an amount FF to be received tt years from now, with discount rate rr:

PV=F(1+r)tPV = \frac{F}{(1+r)^t}

Net present value:

NPV=∑t=0nBt−Ct(1+r)tNPV = \sum_{t=0}^{n} \frac{B_t - C_t}{(1+r)^t}

Here BtB_t is the benefit and CtC_t is the cost. Year 0 (today) is not discounted. If NPV > 0, the project is economically acceptable.

Return on investment:

ROI=total benefits−total coststotal costsROI = \frac{\text{total benefits} - \text{total costs}}{\text{total costs}}

Payback period (break-even point): the moment the cumulative cash flow passes zero. Within a year the flow is assumed to arrive evenly:

payback=(last negative year)+shortfall at the end of that yearnext year’s flow\text{payback} = (\text{last negative year}) + \frac{\text{shortfall at the end of that year}}{\text{next year's flow}}

Worked example: the FitHub membership system

A gym chain is considering an online membership and door access system.

  • Development cost (year 0): 150,000 TL
  • Operating cost: 20,000 TL per year (years 1-5)
  • Benefit (staff savings + fewer lost memberships): 70,000 TL per year (years 1-5)
  • Discount rate: 8%

Step 1: Net cash flow. Each year 70,000 − 20,000 = 50,000 TL. In year 0, −150,000.

Step 2: PV of each year.

Year Net flow    1.08^t    PV
 0   -150,000    1.0000   -150,000.00
 1     50,000    1.0800     46,296.30
 2     50,000    1.1664     42,866.94
 3     50,000    1.2597     39,691.61
 4     50,000    1.3605     36,751.49
 5     50,000    1.4693     34,029.16

Step 3: NPV. Add them all:

46,296.30 + 42,866.94 + 39,691.61
 + 36,751.49 + 34,029.16 = 199,635.50
NPV = 199,635.50 - 150,000 = 49,635.50 TL

NPV is positive: the project is economically feasible.

Step 4: ROI (nominal). Total benefit 5 × 70,000 = 350,000. Total cost 150,000 + 5 × 20,000 = 250,000.

ROI=350000−250000250000=0.40=40%ROI = \frac{350000 - 250000}{250000} = 0.40 = 40\%

Some sources compute ROI with PVs. Then the PV of benefits is 279,489.70, the PV of costs is 229,854.20, and ROI comes out as 21.59%. Use whichever one the question asks for; if it is not specified, state your method.

Step 5: Payback. Simple (undiscounted) cumulative: −100,000, −50,000, 0. It breaks even exactly at the end of year 3: 3.00 years.

Discounted (with PVs) cumulative:

Year PV          Cumulative
 0  -150,000.00  -150,000.00
 1    46,296.30  -103,703.70
 2    42,866.94   -60,836.76
 3    39,691.61   -21,145.15
 4    36,751.49    15,606.34   <- sign changed

Payback = 3 + 21,145.15 / 36,751.49 = 3 + 0.575 = 3.58 years. The discounted payback is always longer than the simple one, because future money is scaled down.

PITFALL · discounting year 0. Money spent today is already today’s money: 1.080=11.08^0 = 1. A student who divides year 0 by 1.08 inflates the NPV.

TIP · shortcut for equal flows. If the same amount comes every year, instead of adding the PVs one by one you can add the factors: for 5 years at 8%, ∑1/1.08t=3.9927\sum 1/1.08^t = 3.9927. 50,000 × 3.9927 = 199,635.50.

Second example: uneven flows

A campus food-ordering app costs 100,000 TL, with net flows of 20,000, 30,000, 70,000, 50,000 TL.

Year Flow      Cumulative
 0  -100,000  -100,000
 1    20,000   -80,000
 2    30,000   -50,000
 3    70,000   +20,000   <- crossover in year 3
payback = 2 + 50,000 / 70,000 = 2.71 years

In the division, put the crossover year’s own flow (70,000) in the denominator, not the average flow.

Organizational feasibility

“If we build it, will they use it?” Two views:

Strategic alignment. How well does the project match the organization’s goals? A project that directly serves a strategic goal has low risk.

Stakeholder analysis. Everyone affected by the project:

StakeholderRoleTo raise it
ChampionInitiates and defends the project, senior, usually outside ISGive them regular progress reports
Organizational managementKnows and approves the project, allocates resourcesExplain the benefit in business language
System usersThe people who will use the systemInvolve them in the process, listen to their needs

Resistance arises in a project where users are excluded: even the best system has zero value if it isn’t used.

Project selection

The feasibility result goes to the approval committee. The committee evaluates the project within the organization’s project portfolio: it balances risky and low-risk, short and long, strategic and operational projects. The feasibility study is updated throughout the project; it is reviewed again at the end of analysis and design.

Common mistakes

Wrong ideaThe truth
Technical feasibility = “can we write the code”A risk assessment: functional area, technology, size, compatibility
Discount year 0 as wellYear 0 is today, the factor is 1
If the nominal total > the investment, NPV is positiveThe time value of money can reverse the result
Divide by the average flow in paybackDivide by the crossover year’s own flow
Satisfaction is a tangible benefitIt is intangible; if it can’t be converted to money, it is intangible
Write ROI as moneyROI is a ratio, write it as a percentage
Champion = project managerThe champion is the senior manager who supports the project
Forget the operating costDevelopment + operational, both are costs

Test yourself

Exam-style questions. Solve them on paper first, then reveal the answer.

Question 1easy

Which part of a system request explains why the system should be built, in business terms?

  1. Project sponsor
  2. Business need
  3. Business requirements
  4. Special issues
Show answer
B) Business need

A system request has five parts: project sponsor, business need (why), business requirements (what the system should do), business value (what it will gain), special issues/constraints (constraints). The business need answers the "why" question.

Question 2easy

Classify each benefit as tangible or intangible: (a) 15% fewer paper forms printed, (b) improved student satisfaction, (c) 2 fewer clerks needed.

Show answer
(a) tangible, (b) intangible, (c) tangible

A tangible benefit can be converted into money: savings in paper and staff can be measured. An intangible benefit is real but cannot be directly converted into money: satisfaction, image, decision quality.

Question 3medium

A project costs 80,000 TL now and returns a net cash flow of 30,000 TL per year for 4 years. With a discount rate of 10%, what is the NPV (nearest TL)?

Show answer
15,096 TL

The present value of each year: PV=300001.10tPV = \frac{30000}{1.10^t}.
Year 1: 27,272.73. Year 2: 24,793.39. Year 3: 22,539.44. Year 4: 20,490.40.
Total 95,095.96. NPV = 95,095.96 − 80,000 = 15,095.96 ≈ 15,096 TL. Positive, so the project is economically acceptable.

Question 4medium

Using the same project (80,000 TL investment, 30,000 TL net per year), what is the simple (undiscounted) payback period?

Show answer
2.67 years

Cumulative cash: −50,000 at the end of year 1, −20,000 at the end of year 2. In year 3, 30,000 will come, and 20,000 of it is enough: 20,000 / 30,000 = 0.67. Payback is 2 + 0.67 = 2.67 years.

Question 5easy

Total benefits of a project over its life are 300,000 TL and total costs are 240,000 TL. What is the ROI?

Show answer
25%

ROI=total benefits−total coststotal costs=300000−240000240000=0.25ROI = \frac{\text{total benefits} - \text{total costs}}{\text{total costs}} = \frac{300000-240000}{240000} = 0.25, that is 25%.

Question 6medium

What is the present value of 55,000 TL received 3 years from now if the discount rate is 6%?

Show answer
46,179 TL

PV=550001.063=550001.191016=46179.06PV = \frac{55000}{1.06^3} = \frac{55000}{1.191016} = 46179.06 TL. Money in the future is worth less than money today.

Question 7hard

A system costs 100,000 TL and its net cash flows for years 1 to 4 are 20,000, 30,000, 70,000 and 50,000 TL. What is the simple payback period?

Show answer
2.71 years

Cumulative: year 1 −80,000, year 2 −50,000. Year 3 brings 70,000, and 50,000 is enough: 50,000 / 70,000 = 0.714. Payback is 2 + 0.71 = 2.71 years. With uneven flows, do the division with that year's own flow.

Question 8hard

An investment of 200,000 TL returns 45,000 TL net per year for 5 years. The discount rate is 9%. Compute the NPV and decide.

Show answer
NPV ≈ −24,966 TL, reject on economic grounds

For 5 years at 9%, the sum of the present values of 1 TL per year is 3.88965. 45,000 × 3.88965 = 175,034.31. NPV = 175,034.31 − 200,000 = −24,965.69. Even though the nominal total (225,000) is greater than the investment, once the time value of money is taken into account the project loses money.

Question 9easy

Which question does organizational feasibility answer?

  1. Can we build it with the technology we have?
  2. Should we build it, will it pay off?
  3. If we build it, will users accept and use it?
  4. How many function points does it have?
Show answer
C) If we build it, will users accept and use it?

Technical feasibility: "Can we build it?". Economic feasibility: "Should we build it, is it worth it?". Organizational feasibility: "If we build it, will they come?". Strategic alignment and stakeholder analysis go here.

Question 10medium

Name three sources of technical risk in a project.

Show answer
Unfamiliarity with the functional area, unfamiliarity with the technology, and large project size (also compatibility with existing systems).

What raises technical risk: users and analysts not knowing the functional area, the team not knowing the technology, the size of the project (team, duration, number of modules) and compatibility with existing systems.

Question 11medium

In stakeholder analysis, what is a champion?

  1. The developer who writes the most code
  2. A high-level, non-IS executive who initiates and promotes the project
  3. The end user who tests the system
  4. The vendor of the software
Show answer
B) A high-level, non-IS executive who initiates and promotes the project

The champion is the senior manager (usually from outside IT) who initiates and supports the project and commits time and resources. Organizational management also gives support but does not follow it day by day. System users are the people who will use the system.

Question 12hard

Why is NPV usually preferred over simple ROI when comparing two projects with different lifetimes?

Show answer
NPV accounts for the time value of money by discounting future cash flows.

Simple ROI treats 1 TL in year 5 and 1 TL today as the same. NPV brings each year's cash flow to today with the discount rate, so a project whose benefits come early correctly looks more valuable.

Verification: All NPV, ROI, present value and payback figures were computed with node (verify/SEN2022/02.mjs, shared functions in lib.mjs). Conceptual questions were compared with the standard definitions.

Review card

System request: sponsor, business need, business requirements, business value, special issues Technical: Can we build it? Economic: Should we build it? Organizational: Will they use it? Technical risk: unfamiliar functional area, unfamiliar technology, project size, compatibility Tangible = convertible to money; intangible = satisfaction, image Costs: development (one-time) + operational (every year) PV = future amount / (1 + r)^t NPV = total PV(benefits) - total PV(costs); accept if NPV > 0 ROI = (total benefits - total costs) / total costs Payback: the year the cumulative goes from negative to positive + (remaining / that year's flow) Discounted payback: the same process, with PVs; always longer than the simple one Stakeholders: champion, organizational management, system users PITFALL: ROI is a percentage, payback is years, NPV is money. Write the unit.