A company is considering replacing a system which is operating without issues but is older technology. The new system will be an off-the-self outsourced process but will require some customization from time to time. Management is interested in the relevant costs that should be considered in the decision and whether the types of costs may affect the decision. IT staff would be re-deployed to other systems if the New System is selected. The annual estimated costs of both systems are provided below:

Old System	New System
IT Staff allocated Contract IT Staff Training – on-going Configuration Hardware depreciation Tech support Running costs Patch maintenance General maintenance Process changes User management Licenses Security Incident response *Support services contract Total Costs	F - $95,000 NA F - $35,000 NA F - $20,000 IT staff above F - $20,000 IT staff above IT staff above IT staff above F - $20,000 F - $10,000 F - $25,000 V - $25,000 NA ________________ $250,000	NA V - $60,000 V - $50,000 F - $30,000 V – $15,000 See below* See below* See below* See below* V - $20,000 See below* F- $10,000 F -$20,000 V - $30,000 F – $50,000 $285,000

F = Fixed cost

V = Variable cost

NA = Not applicable

The general manager feels the New System is very expensive. And adds no benefit to the company since it is $35,000 more expensive on an annual basis. The New System has certain provisions where costs will only be charged if work is completed. But, as well, could be increased as more work is completed.

There have been issues with incident responses and the related amount of follow up work. Also, training needs to be maintained for staff turnover as issues tend to be related to poor training. Training capacity has been limited in the past.

Questions for Part 1

1. What is your assessment of the cost of both systems?
2. Which is better as IT work goes up?
3. Which is better as IT work goes down?
4. Are there any New System features that will help improve the strategic operation of the company?
5. What is your recommendation (ignoring Part 2) and why?

See Part 2 below – the case including Part 2 is worth 20% of your grade.

Case Analysis - Part 2

The additional information to consider on the case is as follows:

• The general manager has been advised that the hardware cost that is in the New System costs via depreciation is $15,000 annually.
• The service provider is treating depreciation as a variable cost because the system provider will increase or decrease depreciation in service fees depending on system use. This has cost risks if the system is used more than expected.
• The general manager thinks the IT department can buy the new hardware equipment for $150,000 with a 10-year life and no residual value. The Old System hardware is being depreciated at $20,000 a year and has a net book value remaining of $100,000 with no salvage value.
• The company IT department charges a service fee to other internal departments. The company treats this fee like an outside sale for analytical and responsibility accounting purposes.
• The service fee would be $310,000 based on the total cost estimate of $285,000 – variable costs of $160,000 and fixed costs of $125,000 under the general manager’s proposal.
• The new service provider would do everything else except own the hardware and would use the hardware as required.
• The company Chief Financial Officer (CFO) treats then IT department as an Investment Center versus a Cost Center since there is limited funding for projects throughout the company.
• The company has a required return on net capital deployed of 15%, minimum for residual income (RI) purposes.
• The minimum required return on net assets is 15% for return on investment (ROI) purposes.

Questions:

1. What is the contribution margin for the New System under the proposal?
2. What is the return on investment for the first year of the new system?
3. Using the residual income method, should the company purchase the hardware? Show your calculations.
4. What is one advantage and one disadvantage of the general manager’s proposal.
5. Why is the residual income approach preferred over a cost center analysis?