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Feb 1993

Cost and operational considerations in assessing alternative computer options. (The CPA in Industry)

by Weissman, Ira

    Abstract- A company's choice of a data processing system is often based on several financial and operating factors. Among the cost considerations that serve as bases for purchasing decisions are specific one-time costs, unpredictable one-time expenses, recurring fixed expenses and recurring costs. The operational variables that should be factored in when constructing the total cost of ownership model include evaluation and selection, pre-installation, and acquisition. Also to be considered are the costs of adding new capabilities to the system, such as those incurred for enhancement or upgrades, migration/conversion, hardware maintenance, software development and integration, software maintenance, operation of new systems, training of users and disposal of out-of-date machines. Putting all these expenses in an electronic spreadsheet may help accountants and financial officers understand them better.

The hardware options available to companies today include proprietary systems, e.g, the IBM AS-400, open systems for Unix, or a totally integrated PC network. The specific nuances of the system hardware alternatives would be gathered by dealing with an appropriate licensed vendor representative. In many cases the final choice on hardware implementation will be based on software alternatives which are available on a specific industry basis. In assessing the hardware alternatives, many complex financial and operating variables must be considered.

The following information may simplify the task of the financial executive or the outside accountant in advising his or her respective management or client in analyzing the proper course of action which should be pursued in choosing the computer installation which best serves the needs of the company.

The cost considerations which will influence the choice of the appropriate system alternatives will involve the following:

Specific One-Time Costs. These costs are incurred once during ownership. Typical are the actual acquisition costs of hardware, software, installation, packaged software customization, site preparation, etc. One method for creating comparable estimates across different vendors' offerings is to compare leases with comparable terms and conditions using the monthly lease fee as the basis for comparison. If the lease is a true fair market value lease, the lessors must compute their estimates of residual value at termination.

Unpredictable One-Time Costs. Indeterminate one-time costs are primarily for items such as loss on disposal of present equipment, lease termination charges, etc. These costs can vary greatly depending on timing. For example, early termination charges on a lease may not be known until the lessor disposes of the system.

Specific one-time costs are to be expected in evaluating system alternatives; whereas unpredictable one-time costs should be considered but based on the facts at hand they may not be a significant factor.

Recurring Fixed Costs. Recurring specific costs are for items such as hardware and software maintenance, monthly charges for leased communications lines, software support charges, etc. Many of these cost elements are fixed over the life of the equipment. Others can be escalated. Maximum escalation factors should be used.

Recurring Variable Costs. Variable costs are usually the single largest element of cost in the equation. They include factors such as--

Operations (systems programmers, console/peripheral operators, data entry staff);

* Program development (analysts, programmers);

* Maintenance;

* Consumables (tape, paper, ribbons, toner, etc.);

Outside purchased services (contractors, package customization, integration services, etc.); and

* Utilities (electrical power).

The operational factors which are necessary in order to build the total cost of ownership model will include the following considerations:

Evaluation and Selection. When purchasing a system, a number of choices must be made. These selections include--

* Application package vendors

* System software

* Integrator (if necessary)

* Manufacturer

* Utilities

Maturity in the applications and system software industry means less effort will be required to evaluate integration of utilities, performance claims, etc. Site visits are more easily arranged and claims of various vendors can be more easily verified.

In order to maximize your performance, the ultimate decision as to which hardware to choose is usually based on what software is available on an industrywide basis.

The choice of software alternatives should be based on what package will answer the basic needs of your company and require only a moderate amount of customization. In selecting a software alternative, it would be prudent to choose a package which will in effect answer at least 80% of your basic corporate needs. This will therefore reduce the need for a substantial amount of costly and time consuming customization.

Once the software package is chosen, the need to employ an outside integrator as well as which hardware to purchase can be decided upon.

Pre-Installation. Several pre-installation requirements must be met before the arrival of the new system. These requirements include--

* Site preparation;

* Dispose of obsolescent hardware; and

* Settle lease termination fees (if appropriate).

The pre-installation phase would involve the costs of rewiring and other site work. All existing hardware should be reevaluated for its potential use in the new system configuration.

Acquisition. The initial hardware configuration is critical to the selection process. A mistake made here is multiplied in many ways. It is apparent that the acquisition of an incorrectly sized processor can result in significant "hidden" future costs.

In considering the selection sizing of the hardware the following should be considered:

* Speed--expressed in terms of MIPS for processors.

* User counts--represents the number of work stations that can be concurrently attached and supported by a processor complex.

* Response time--represents the time the user consumes in entering and receiving a response.

* Benchmark--a variety of standardized and/or custom-designed tests that purport to measure the overall comparative performance of different configurations.

The initial costs of operating software vary widely both by cost and capability. In addition, most manufacturers tier costs based upon the size of the processor or number of users. Factors to be considered include capabilities needed that are not included, and the cost of adding the needed capabilities from the vendor or a third party.

Migration/Conversion. Factors to be considered are--

* Need to run parallel operations

* Availability and effectiveness of conversion programs

* Ability to continue operations of old system.

Continued operation of the system being replaced can be a significant cost that should be factored into any acquisition analysis. The length of operation of dual environments can be a major cost factor which must be considered when choosing from various system alternatives.

Upgrades/Enhancements. The potential for enhancing the system should be considered, including such matters as--

* Add-ons;

* Upgrades; and

* Trade-outs.

Most systems go through a series of upgrades during their ownership. Vendor pricing policies and packaging largely determine the impact of upgrades. When acquiring a system, one of the factors that should be included is the cost of upgrading components at various levels of growth. Factors analyzed should include separate estimates for memory, disk capacity, work station attachments, communications facilities, etc.

Hardware Maintenance. Both hardware and peripherals maintenance should be priced. Hardware maintenance can be a major on-going cost. Rapid escalation is a risk that can be managed. Selecting the level of maintenance and the source can cause recurring costs to vary significantly. When considering maintenance, the quality, consistency of response, and escalation procedures must be considered.

Software Development and Integration. The factors to be considered are--

* New development; * Integration testing; * Compatibility testing; * Package customization; * Performance tuning; and * Problem determination.

The high level of integration at both the hardware and software levels should be a major consideration in choosing among system alternatives; evaluating, testing, integrating, and paying for the comparable tools can be a major, on-going cost of ownership.

Software Maintenance. Software maintenance must be factored in for the--

* Operating system support; * Application package support; and * Outside purchased services.

The costs of operating and supporting the system and application programs will generally be the largest single category of cost in any TCO calculation.

Operations. Finally, the cost of operating the new system must be factored in.

This includes--

* System programmers; * Operators; * Data entry; and * Data communications.

The choice of software and hardware options will also be evaluated by considering the amount and experience level needed by the personnel required to monitor the operations of the selected system.

Personnel/Training. The system will require a properly trained staff to operate. To get there, the following costs may have to be incurred:

* Recruiting fees; * Termination expenses; * Course charges; * Travel expenses; * Materials; * Lost labor during training; and * Loss of productivity after training.

All direct costs of training should be considered including fees to the vendor of the system and application solution providers, and expenses for travel. Training costs are tricky to estimate. Two factors to consider are turnover and availability of trained personnel in the marketplace. If turnover has been a significant factor in the employee positions that need to be trained, then a continuing budget for training should be established. If there is a large pool of candidates who are trained and knowledgeable about the system being acquired, whether operations, development, and maintenance, then the education budget can be adjusted accordingly.

When employees are being trained they are not working. The lost productivity, cost of temporary help, overtime, etc., should all be computed as a cost of acquisition. There are also productivity losses while employees begin to apply newly learned techniques and skills.

The greater the change in operating environments, the higher the likelihood the incumbent staff will need to be replaced. It is therefore critical to recognize that any major change will create turnover. Turnover creates costs for recruitment, agency fees, interview time, etc.

Disposal. The costs to dispose of the obsolete equipment will include--

* Lease termination costs, if any; and * Residual value

Residual values on disposing of an old system may add to your system alternative criteria. Independent lessors must factor in the anticipated residual values when quoting the financing arrangements for the acquisition of a new system.

Total the Spreadsheet

A useful exercise in this process is to set forth all the costs in an electronic spreadsheet. When the total is entered, "sticker shock" is inevitable, but constructive. Automating or upgrading an existing computer installation has a significant price tag which management is better off facing up front. Your summary analysis will indicate that the equipment cost is but a small element of total cost. The temptation will be to try and eliminate or significantly reduce some of the activities set forth in your analysis. For example, you may think your staff doesn't require extensive training and can learn on the fly. Or you may think it is not necessary to run both the old and new systems on a parallel basis during a test period. Such short-term thinking may result in disastrous consequences. In any installation or upgrade, it is most cost effective to do it right the first time. The time and effort to recover from mistakes made in the beginning are many times the savings that may have been realized from short-cutting the initial efforts. You will have done your job as a manager or advisor in realistically analyzing the costs that will likely be incurred.

Mr. Weissman is also an instructor in the Person-Wolinsky CPA Review program and an adjunct professor at Long Island University, Hunter College of the City University of New York, and Rutgers University.

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