Amalgamated Widgets, a fictitious manufacturing company with $500 million in annual revenues, was under pressure from its shareholders and from Wall Street to increase its profitability. One possibility top management considered was to install an online procurement system to cut purchasing costs for just about everything the company buys, from raw materials for its widgets to such commoditized items as safety helmets, work gloves, and office supplies, on which the company spends about $225 million a year. There has been a lot of hype surrounding e-purchasing, and the company's executives, ordinarily a pretty conservative bunch, were uneasy about making a significant investment in a new—and, in their minds, unproven—technology. So they asked their CIO and CFO a simple question: How much actual value might such a system bring to Amalgamated's shareholders?
To answer that question, Amalgamated's CIO and CFO began by estimating the life of such an online purchasing system to be about four years, given the rapid advance of such information technology. In addition, Amalgamated's new system would not be up and running for a year because of the time it would take to build and install the system, train the company's purchasing employees, connect the system to suppliers, and educate them in its use.
The goal of the system was to boost Amalgamated's ability to drive higher discounts on bulk purchases. Although the company spends about $225 million on such buys, in reality, the team estimated, it would save just 3 to 5 percent of the total spent using the system, significantly lower than the amount estimated by Amalgamated's potential IT vendors, who assumed 100 percent adoption by both employees and suppliers.
On the upside, the system would give Amalgamated new data about its buying patterns, which would give it more negotiating leverage over its suppliers. However, the savings wouldn't start until Amalgamated could cut new purchasing contracts, so there would be a lag in realizing the benefits. The result: Amalgamated felt it would realize no savings in the first year, $850,000 in year 2, $3.5 million in year 3, and $7.4 million in year 4.
Amalgamated decided to outsource the system to an application service provider (ASP), a move it felt would minimize the investment costs for the system to $1.2 million. The ASP quoted the operating costs at about $610,000 per year, a sure figure since the contract was written so that the ASP had to assume all other costs, including any incurred after year 4, such as exit and migration costs.
Amalgamated's corporate tax rate is 32 percent of earnings, and the company can take a tax break of approximately $96,000 each year of the life of the project from the noncash charges generated from its investment costs. This assumes that Amalgamated spreads out the deduction it can take for the investment costs evenly over the four years.
The cash flows Amalgamated's team expected from the system were adjusted using a discount rate of 20 percent based on a 10 percent benchmark (cost of capital) plus a 10 percent premium reflecting their analysis of the project's risk. The premium was selected because the history has been that only one in two IT projects at Amalgamated results in a return. The major risk: Would Amalgamated's employees and suppliers adopt the new system?
Amalgamated's team calculated the value of the proposed e-procurement system by adding up the discounted cash flows for each year of the project, for a total of $2,382,686. With
23.5 million shares outstanding, the figure represented an increase of ten cents per share or a 1 percent increase on a single share price of ten dollars. Management therefore decided to approve this project.
Ray Trotta, a partner and cofounder of iValue, an IT strategy firm based in New York, teaches, speaks, and consults on technology and finance topics. Ray recently published Translating Strategy into Shareholder Value: A Companywide Approach to Value Creation (2003). He is also a member of the graduate school faculty of the Walter E. Heller College of Business Administration at Roosevelt University.
Christopher Gardner is a partner and cofounder of iValue and the author of The Valuation of Information Technology: A Guide for Strategy Development, Valuation and Financial Planning (2000).
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