An Analytical Framework for Capital Planning and Investment Control for Information Technology
Foreward
This publication presents an analysis of a framework for capital planning in support of major acquisitions and has been prepared for governmentwide use.
It is becoming increasingly important that agencies think of their Information Technology (IT) projects as investments. With the emphasis on outcome-oriented performance measures, the contribution of IT to achieving business goals and objectives is increasingly being emphasized, and recognized. In an environment of cutting costs and downsizing, IRM projects have to clearly communicate their payoff to justify the investments in IT. The framework provided here will provide assistance in incorporating capital planning and investment techniques in agency management and control decision-making processes.
The emphasis provided in this publication is on the financial analysis involved in capital planning. There are also significant other non-quantifiable factors that should also be addressed when preparing a capital plan (pg. 13) for projects. However, the financial analysis forms the foundation for good management decision-making regarding investments for information technology.
If you have any questions regarding this document, please contact Rich Kellett at rich.kellett@gsa.gov or at
(202) 501-1650.
G. Martin Wagner
Associate Administrator
Policy, Planning and Evaluation (M)
TABLE OF CONTENTS
Capital Planning and Investment Control Model
Key Financial Criteria Used in the Capital Planning Process
Revenue and Profit/Benefits
Resources
Convert to Dollars and Post to a Program Management Model
Capital Budget
Capital Plan (Business Plan)
Strategic Portfolio
Conclusion
CAPITAL PLANNING AND INVESTMENT CONTROL MODEL
With the increasing emphasis on outcome-oriented performance measures, Information Technology (IT) is increasingly being recognized as a key enabler to achieve business goals and objectives. This paper describes a Capital Planning and Investment Control Model and addresses key issues involved in IT capital analysis. The Capital Planning and Investment Control Model presented in this paper outlines an analytical framework for linking IT investment decisions to strategic goals and objectives. IT is an asset that contributes to the achievement of an agency's mission and should be managed to maximize the use of limited funds to accomplish the agency's mission. The information provided here highlights the investment issues addressed in managing IT projects, and assumes some understanding of program management principles and the development of project plans.
The model mirrors the commercial market place process for developing business plans. Since it is the corporate perspective that frames the analysis of investments in IT in the Federal government, the Capital Planning and Investment Control Model will be presented primarily using corporate financial statements. Similar principles can be used in the Federal government context. The model consist of six layers, starting from the top:
- Determine Revenue (or Benefits)
- Identify all Required Resources/Costs
- Convert Benefits and Resources to Dollars
- Develop Capital Budget (Project Analysis Worksheet)
- Develop Capital Plan ( or Business Plan)
- Evaluate Capital Plans to form Strategic portfolio
Each investment factor is built from and incorporates the previous layer. Once a capital plan is developed a project committee will evaluate and prioritize projects. The resulting strategic portfolio may in turn be reviewed by Agency level oversight organizations and/or a governmentwide oversight bodies. Exhibit (1) is a schematic overview of the Capital Planning Model.
KEY FINANCIAL CRITERIA USED IN THE CAPITAL PLANNING PROCESS
In the commercial environment, the flow of an organization's funds can be thought of as being divided into three areas. These are financing decisions (selling stock or borrowing money), operations (operating revenues and expenses), and investments (fixed assets and other new capabilities). Capital planning is concerned primarily with making investment decisions. Making an investment decision implies making choices, that is, allocating limited funds to new investments by conducting an analysis of individual investments and setting priorities among investments. Although the term "capital planning" has been expanding to include many management methodologies and principles, the focus of capital planning is on making investment decisions. The current reengineering and reinvention environment encourages the Federal agencies to study and adopt a capital planning process. The following illustrates the analytical framework of the commercial process for capital planning.
To make investment-based decisions requires an understanding of profit/loss statements, cash flow statements, and financial measures. Financial measures generally include, at a minimum, calculating the net present value of a project. Profit is an important financial measure of a project, but due to certain accounting conventions the profit/loss statement distorts the actual flow of cash in and out of a project. It is important to recognize that profit/loss statements do not correctly state the flow of cash in and out of a project. The profit/loss statements must be adjusted by backing out accounting entries that distort actual cash flow. This adjusted profit/loss statement is called the cash flow statement. Analysis of the actual cash flow provides the basis for comparing multiple projects. The cash flow statement is used to calculate financial measures, such as net present value, and provide a common basis for comparing projects using financial measures. This is best explained by examining a sample spreadsheet for a hypothetical corporation.
The first spreadsheet, Exhibit (2), provides an example of a profit and loss statement. Basically, revenue minus operating expenses and taxes equals profit. The profit/loss statement does not state the cash flow. There are distortions to the cash flow due to accounting entries.
The easiest adjustment to understand for correcting profit/loss statements to reflect true cash flow is depreciation. Depreciation is an accounting entry that reduces the tax liability of the organization by overstating expenses. The greater the depreciation, the greater the expenses and the less tax the corporation has to pay. In this case, the depreciation entry causes cash into the project to be understated, since the depreciation entry is used to "overstate" expenses.
Another distortion to cash flow is accounts receivable. Usually corporations will sell products on credit with receipt of payment due 30 to 90 days after delivery. Corporations report the sale as revenue even though the sale is added to the accounts receivable. The effect is that as accounts receivable grows, revenue is overstated.
Since there is a delay in payment for products or services sold, corporations require working capital primarily to support operations pending actual receipt of revenue. Bills must continue to be paid pending actual receipt of cash from the sale of products. Working capital provides this "cushion." An adjustment is needed to the profit/loss statement to indicate the addition of cash for working capital.
Other accounts that might require adjustments to capture cash flow in the Federal government context might include the timing of appropriations, delays involved in transferring funds, etc.
PROFIT AND LOSS SPREADSHEET
HYPOTHETICAL CORPORATION
| ANNUAL CASH FLOWS | 0 | 1 | 2 | 3 | ||
|---|---|---|---|---|---|---|
| REVENUE | 50 | 100 | 100 | |||
| EXPENSES | ||||||
| Operating Expenses | 30 | 70 | 70 | |||
| Depreciation | 10 | 5 | 5 | |||
| Other | 6 | 9 | 9 | |||
| TOTAL EXPENSES | 46 | 84 | 84 | |||
| PRE-TAX PROFIT | 4 | 16 | 16 | |||
| TAXES @ 25% | 1 | 4 | 4 | |||
| PROFIT/LOSS | 3 | 12 | 12 | |||
_____________________________________________________________________________________
Exhibit (2)The second spreadsheet, Exhibit (3), provides an example of cash flow. To determine cash flow add back or subtract, as appropriate, all accounting distortions to the profit and loss statement. Include adjustments for payments made for assets needed in the project and working capital. These adjustments correct the profit/loss statement to obtain the actual cash flow. For purposes of this example the investments for assets are assumed to be made at the beginning of the project. Often assets are purchased throughout the life of the project. The spreadsheet in Exhibit (3) summarizes the basic difference between profit/loss and cash flow statements.
It should be noted that a corporation can have a positive profit, but be on the verge of bankruptcy. For instance, the accounts receivable is growing; therefore, making revenue appear positive. However, if customers do not pay their debts (accounts receivable) the business will go bankrupt. Eventually the corporation will run out of cash to pay employees and creditors which will force the corporation into bankruptcy. This is just one example of how profit/loss statements can differ from the analysis that the cash flow provides. Generally, corporations (and projects) must have both a positive profit and a positive cash flow.
CASH FLOW SPREADSHEET
HYPOTHETICAL CORPORATION
| ANNUAL CASH FLOWS | ||||||||
|---|---|---|---|---|---|---|---|---|
| 0 | 1 | 2 | 3 | |||||
| REVENUE | 50 | 100 | 100 | |||||
| EXPENSES | ||||||||
| Operating Expenses | 30 | 70 | 70 | |||||
| Depreciation | 10 | 5 | 5 | |||||
| Other | 6 | 9 | 9 | |||||
| TOTAL EXPENSES | 46 | 84 | 84 | |||||
| PRE-TAX PROFIT | 4 | 16 | 16 | |||||
| TAXES @ 25% | 1 | 4 | 4 | |||||
| PROFIT/LOSS | 3 | 12 | 12 | |||||
| ADJUSTMENTS TO | ||||||||
| CASH FLOW | ||||||||
| Depreciation | 10 | 5 | 5 | |||||
| Other | ||||||||
| OPERATING CASH | 13 | 17 | 17 | |||||
| FLOW | ||||||||
| INVESTMENTS | ||||||||
| Assets | 10 | |||||||
| Tax Credits | 1 | |||||||
| Working Capital | 5 | |||||||
| Other | ||||||||
| NET CASH FLOW | (16) | 13 | 17 | 17 | ||||
_____________________________________________________________________________________
Exhibit (3)Once the net cash flow (Exhibit 3) has been determined, the flow of cash in and out of the project can be used to calculate financial measures such as net present value.
Exhibit (4) is a summary of net present value. $1.00 today is only worth $1.00 today, but by investing wisely $1.00 today is worth more in the future. In one year, at 10% interest rates, $1.00 today is worth $1.10, in two years $1.21 and in three years $1.33. The same analysis can be conducted in reverse. $1.33 in three years is only worth $1.00 today. Said another way, $1.00 in three years is only worth $0.75 today. This process of "looking backward" on future cash flows to determine the present value of future money is called discounting. When applying discounting to the cash flow stated in the spreadsheet example for the hypothetical corporation, it is called discounted cash flow analysis. The interest rate is called the "discount rate". The discount rate is the rate used to calculate the present value of future cash flows. By calculating the cash flow for projects and using the cash flow to calculate financial measures, such as net present value, there is a common basis upon which to compare projects free of distorting accounting entries. Ultimately, the cash flow into an organization and the timing of this cash flow determines the "value" of a particular project. Alternatively, similar analysis could be used to determine the least cost in the absence of revenue or the most benefit.
NET PRESENT VALUE
| Looking Forward | Value | Time | |||
|---|---|---|---|---|---|
| $1.00 Today | $`1.00 | 0 Year | |||
| $1.00 | $1.10 | +1 Year | |||
| $1.10 | $1.21 | +2 Years | |||
| $1.21 | $1.33 | +3 Years |
- In other words $1.00 today is worth $1.33 in three years.
- The 10% value is called the discount rate
- Looking backward (called discounting), $1.00 Three years from now is
- only worth $0.75 today. (The same analysis as above in reverse.)
NET PRESENT VALUE OR DISCOUNTED CASH FLOW ANALYSIS
| Present Value | Future Time | |||||||||||
| 0 | 1 | 2 | 3 | |||||||||
| ( $1.00) | $1.00 | $1.00 | $1.00 | |||||||||
| ($1.00) | ||||||||||||
| $0.91 | ||||||||||||
| $0.83 | ||||||||||||
| $0.75 | ||||||||||||
| $1.49 |
- Net present value for this project @ 10% = $1.49
- By investing $1.00 today I can obtain a revenue stream of $1.00 for the
- next three years. This revenue stream is worth $2.49 today. I will have
- increased the value of the corporation by $1.49 ($2.49 minus the $1.00 of
- principle that was invested). The net present value for this project is $1.49.
- Use a business calculator that has a button for this formula:
- Future value = present value (1+i)n
- where n=number of periods
_____________________________________________________________________________________
Exhibit (4)
The next spreadsheet, Exhibit (5), shows the net present value for the example of the hypothetical corporation. By discounting the cash flow back to present dollars, the net present value of the project can be determined. The purpose of determining the net present value of projects is to arrive at a number that provides a basis for comparing projects. Projects can be ranked based, at least in part, by their net present value. Obviously, projects that have a negative net present value should not be done since the corporation is loosing money as opposed to making other investments. Projects that have a positive net present value can be ranked and prioritized based on their net present values from largest to smallest.
PROJECT ANALYSIS WORKSHEET
NET PRESENT VALUE
HYPOTHETICAL CORPORATION
ANNUAL CASH FLOWS
__________________________________________________________________________________________________________________________________________________________________________
| 0 | 1 | 2 | 3 | |
| REVENUE | 50 | 100 | 100 | |
| EXPENSES | ||||
| Operating Expenses | 30 | 70 | 70 | |
| Depreciation | 10 | 5 | 5 | |
| Other | 6 | 9 | 9 | |
| TOTAL EXPENSES | 46 | 84 | 84 | |
| PRE-TAX PROFITS | 4 | 16 | 16 | |
| TAXES @ 25% | 1 | 4 | 4 | |
| PROFIT/LOSS | 3 | 12 | 12 | |
| ADJUSTMENTS TO CASH FLOW | ||||
| Depreciation | 10 | 5 | 5 | |
| Other | ||||
| OPERATING CASH FLOW | 13 | 17 | 17 | |
| INVESTMENTS | ||||
| Assets | 10 | |||
| Tax Credits | 1 | |||
| Working Capital | 5 | |||
| Other | ||||
| NET CASH FLOW | ||||
| (16) | 13 | 17 | 17 | |
| PRESENT VALUE @ 10% | (16) | 12 | 14 | 13 |
| NET PRESENT VALUE | 23 |
_____________________________________________________________________________________
Exhibit (5)Exhibit (5) is also an example of a Project Analysis Worksheet. The Project Analysis Worksheet should be completed for all projects including initiating, expanding, replacing or eliminating new projects/businesses. As can be seen from the Project Analysis Worksheet, the profit/loss statement, cash flow calculations and financial measures such as the net present value analysis form the core of the investment analysis for projects. Following the same basic format as Exhibit (5) additional entries can be added or expanded.
Now that the terms profit/loss statements, cash flow and net present value have been defined, we can move into defining a model for capital planning that can be used as the basis for developing an implementation plan for a capital planning process. However, the core analysis in a Capital Plan is based on the investment analysis which should contain as a minimum the elementsprovided in the Project Analysis Worksheet (Exhibit 5).
Capital Planning is much more than a financial analysis for purchasing fixed assets. Capital Planning involves capturing all costs for a project of which the fixed assets are usually only one component. In the application of information technology fixed assets are usually not the largest component of costs for the total project. In any new acquisition of information technology the costs for services in the form of internal or external Full Time Equivalents (FTEs) usually is the largest component of costs for the total project. A Capital Plan should include all direct and indirect revenues and costs.
The Capital Planning model presented in Exhibit (1) will now be explored by each layer, starting from the core (revenue and profit) and to the outer most layer (the strategic portfolio).
REVENUE AND PROFIT/BENEFITS
Calculating revenue can be a difficult step, particularly for the Federal government in situations where revenue cannot be calculated and estimates for the value of the benefit must be used. Generally, in order to determine the revenue stream (or value of the benefit) for a project, the analysis of the Revenue and Profit/Benefits should include the following:
PRODUCT OR SERVICE - Define the product or service including, as
- appropriate, the following:
- Mission analysis should be substituted where it is not appropriate
to conduct a traditional "product" analysis.
- Performance measures that would be of value to the customer.
-Threshold questions that address: Should the government be doing this work? Should this agency be doing this work? What is the mix of government and contractor support?
- MARKET/BENEFIT ANALYSIS
-What are typical charges for this product or service outside of government?
- What would be a reasonable charge that customers might be willing to pay if required to do so?
-Did it pass a reasonableness test? Conduct an analysis to assess the extent to which costs, benefits and risks are sensitive to changes in the following key factors
--systems life
--volume
--mix or patterns of workload
--requirements
--configuration of equipment or software
- SOURCES OF FUNDS
-Shared acquisitions for multiple agencies.
--Should the participating agencies be treated as a customer (cost plus fees)?
-- Should the participating agencies contribute only to costs?
Combination of the two?
--Legal structure defining the relationship of the participating agencies to the overall project.
--Financial strategy for transferring funds.
RESOURCES
Project managers should determine all resources required to implement a project and to estimate the true cost and the timing of these resources. As can be seen from the Project Analysis Worksheet, the timing of funds has a significant impact on the financial analysis of individual projects. Resource categories should include but are not limited to:
- Management
- Labor
- Space
- Assets
- Energy
Generally off-the-shelf products will provide greater cost advantages due to economies of scale in the marketplace as opposed to in-house development.
Also, in this step, a program management software package should be obtained. Data on revenue, cost categories and the type of effort should drive the development of a program/project management model (life cycle model) appropriate for the project using an automated program management software package for assistance.
PROJECT MANAGEMENT SOFTWARE
PROGRAM MANAGEMENT MODEL
CONVERT TO DOLLARS AND POST TO A PROGRAM MANAGEMENT MODEL
To be able to obtain a true cost picture, all revenue/benefits and resources/costs should be converted to numerical dollar values. Estimates of charges for "invisible" or "free" resources must be accounted for in the program management model. Some examples for invisible or free resources are:
- Market rate for owned building space
- All labor/salaries - any "hidden" IT FTEs
- A percentage for central office overhead support
Federal agencies should note that there are competitive cost advantages that are not readily available to their commercial counterparts, such as:
- No taxes
- Lower insurance - direct liability often less
- Buying power - size
- Interest charges on money (appropriations vs. loans)
- Not for profit usually - no stockholders
In evaluating and comparing projects between the Federal government and private sectors, consideration should be given to some of the cost advantages the Federal government has.
CAPITAL BUDGET
(NUMERIC MODEL - NET PRESENT VALUE OF CASH FLOW)
Using the information on revenue and the cost of resources stated above, the agency should develop a Project Analysis Worksheet that has the appropriate level of detail for the goals and objectives of the project. The detail will also vary depending on the complexity of the project. Additional measures can be used (payback period, internal rate of return, etc.); however, the profit/loss, cash flow and net present value should be calculated for each project. The program management software chosen (as stated above) should provide automated summaries of the accounting entries needed for the Project Analysis Worksheet. The Program Management Model and the Project Analysis Worksheet become the Capital Budget for the project.
Using the information provided from the Capital Budget (the Program Management Model and Project Analysis Worksheet), additional financial measures can be calculated such as:
- A discount rate
- Pay back period
- Internal rate of return
- Break even analysis
The next step is to develop a Capital Plan. The Capital Budget (or Project Analysis Worksheet) and the investment analysis derived from the Capital Budget form the core of the Capital Plan. By using commercial off-the-shelf program management software, the agency can also complete appropriate alternatives analysis and develop a Project Analysis Worksheet for each alternative. These alternatives can also be incorporated into the Capital Plan.
CAPITAL PLAN
(BUSINESS PLAN)
The Capital Plan outlines the strategy for managing and implementing a viable project relying heavily on the investment analysis provided by the Capital Budget. The Capital Budget is a key component of the Capital Plan. The Capital Budget is used, in turn, to develop the broader Financial Plan which includes additional analyses as noted below. The Capital Plan should address at least the following areas:
Identify and define a project strategy, including:
- Scope of the project and problems
- Measurable objectives
- Existing systems
- Proposed systems concept
- Process reengineering and integration opportunities
Products and services, including:
- Product or service definition
- Performance metrics
- Market research on market size, segments, trends, customers, and competition including competitor's cost advantages and disadvantages
Sale forecast
Marketing plan (In government referred to as Program Development.)
- Channels of distribution
- Sales force
- Advertising and promotion,
- Warranties
- Compliance with agency strategic and tactical IT plans
Operations
Organization and management
Financial plan
- Capital Budget
-- Project Analysis Worksheet
--- Profit and loss
--- Cash flow
--- Financial measures such as net present value
-- Project management plan with milestones
- Sources of funds and transfer mechanisms
- Cost/benefit analysis in accordance with OMB Circular A-94
- Balance sheet
Risks consideration
- Nature and extent of vulnerabilities
- Management (new or similar project)
-Project size (small to large)
-Project length (short to long)
-Annual Loss Expectancies (ALEs)
STRATEGIC PORTFOLIO
The strategic portfolio consists of assembling all Capital Plans. An analysis should be conducted of each Capital Plan. Each Capital Plan should be evaluated for inclusion into the strategic portfolio. The entire portfolio of projects should be evaluated and prioritized with high risk and low returns being eliminated from the portfolio of projects.
IT Projects are often categorized according to the following common areas:
- Legacy
- In development
- New projects
- Shared systems
- "Commodity purchases" - off-the shelf
CONCLUSION
The investment goal of every IT acquisition project is to maximize the value (revenue or benefits), minimize costs and manage the risks. Revenue (or benefits) must be balanced with costs and risks. In addition, the investments should be aligned with strategic and tactical IT goals of the Agency over the long term. The Capital Planning and Investment Control Model provided here should provide for the best selection of projects by incorporating key investment criteria in the analysis of individual projects and in comparing projects. The emphasis of this paper has been to highlight the key investment criteria used and to provide an analytical framework as to how the investment analysis relates to the planning and selection processes.
The effectiveness of implementing the Capital Planning and Investment Model will be dependent upon the quality of the accounting and financial information provided in the Capital Budget. As previously stated many accounting organizations do not consider IT to be an asset, but an overhead expense. This must change. There is a strong need for improved understanding in program management methodologies and financial management principles in considering the investment aspects for IT projects. In order to foster this understanding, the agency's training should concentrate in the areas of program management, accounting, financial management and strategic marketing.
REFERENCES
Koskinen, John A., Evaluating Information Technology Investments, A Practical Guide, Version 1.0, Information Policy and Technology Branch, Office of Information and Regulatory Affairs, Office of Management and Budget, Executive Office of the President, November 1995
Keen, Peter G.W., Shaping The Future, Business Design through Information Technology, Harvard Business School Press, 1991
Information Strategies Group, OMB Circular A-94: New Complexity in Present-Value Discounting, IDC Government Publication Number W1625, 1993
