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Software Engineering Economics

Software Engineering Economics. SE 361 By Muhammad Waseem. Word of Wisdom. The most excellent Jihad is that for the conquest of self." (Bukhari). Inflation and Deflation. Think about : Year ago you bought some ordinary thing, such as a movie ticket or a gallon of gasoline.

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Software Engineering Economics

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  1. Software Engineering Economics SE 361 By Muhammad Waseem

  2. Word of Wisdom • The most excellent Jihad is that for the conquest of self." (Bukhari)

  3. Inflation and Deflation • Think about : Year ago you bought some ordinary thing, such as a movie ticket or a gallon of gasoline. • How much did you pay for it? • Now think back to the first time you can remember buying that same kind of thing. • How much did you pay then The terms inflation and deflation describe long-term trends in prices

  4. Inflation/ Deflation What is it? an increase in the price level a decrease in price level How is it determined? by comparing the CPI in different years and noting the change CPI is higher=inflation CPI is lower=deflation CPI= Consumer Price Index

  5. Inflation and Deflation Inflation can be caused by an increase in aggregate demand • Under what conditions would you expect to see deflation (fall in price level)? Typical causes for inflation include government price support policies (subsidies) and deficit spending. Less price of oil and grain Deflation can be caused by a decrease in aggregate demand • Deflation can be caused by more efficient production methods (which lowers production cost) or higher availability of resources

  6. Price Indices:Measuring Inflation and Deflation • Inflation (or, deflation) is measured using a price index. • A price index is the ratio (expressed as a percentage) of the historical price of goods or services at some point in time to the price of the same goods or services at another point in time.

  7. Steps involve in Developing Price Index • Make Market Basket • House Hold Market Basket • Corporation Market Basket • Pick Up Reference Date • Reference Date is Arbitrary • Cost on the Reference Date • Denominator in Price Index • Cost on the Current Date • Nominator of Price index

  8. Price Index Formula

  9. Popular Price Indices • There are two popular price indices that are used for measuring inflation and deflation • Consumer Price Index [CPI] • Producers Price Index [PPI] • More information about CPI and PPI you can find the following site • www.bls.gov/home .htm • http://www.tradingeconomics.com/pakistan/inflation-cpi

  10. Consumer Price Index • Measure price change from the retail purchaser’s perspective • Based on the spending habits of the average household consumer • Buyers perspective • Market basket include • Housing • Food and drinks • Clothing • Transportation • Medical care • Recreation • Education

  11. Producer Price Index • PPI is the Family of price indices that measure the changes in selling price for domestic goods and services before they reach the retail consumer. • Seller perspective • For Example • Manufacturing • Agriculture • Forestry • Finance • Business services • Health

  12. The Inflation Rate • The inflation rate measures the rate of increase of the corresponding price index and is usually stated as an annual percentage (for example, 2.3%). • The deflation rate is the negative of the inflation rate,. • Inflation rate can be measured in • SINGLE-YEAR ANNUAL INFLATION RATE • AVERAGE ANNUAL INFLATION RATES

  13. SINGLE-YEAR ANNUAL INFLATION RATE • The inflation rate in any single year can be calculated by dividing the difference between the price index at the end of that year and beginning of that year (which is the price index at the end of the previous year) by the price index at the beginning of that year, as follows:

  14. AVERAGE ANNUAL INFLATION RATES • Inflation will almost always span more than one year • There can be variation in the annual inflation rate • Average annual inflation rate can be calculated from price indices

  15. Home work • AVERAGE ANNUAL INFLATION RATES • Purchasing Power and Inflation

  16. Interesting links • Purchasing Power Calculator • http://buyupside.com/calculators/purchasepowerjan08.htm • Inflation Calculator - Save Enough to Account for Inflation • http://buyupside.com/calculators/inflationjan08.htm • inflation Rate in Percent for Jan 2000-Present • http://inflationdata.com/Inflation/Inflation_Rate/CurrentInflation.asp • Current Unemployment Rate • http://unemploymentdata.com/charts/current-unemployment-rate-chart/ • Pakistan national statistical data • http://www.tradingeconomics.com/pakistan/indicators

  17. ` • Question /Answer

  18. Depreciation • Depreciation addresses • How investments in capital assets are charged off against income over several years • Software itself typically isn't depreciated • but if you're working on proposals with a planning horizon longer than one year, the proposals involve capital assets (such as buildings and equipment) • then depreciation will be an important factor to include in the analysis

  19. Introduction to Depreciation • The word depreciation has two different meanings in business decisions • First, it refers to how an asset will lose value over time due to effects such as wear and tear[damage or loss resulting from ordinary use] • This will be called actual depreciation • Second, it refers to how the organization accounts for that loss in value. • This will be called depreciation accounting

  20. Actual Depreciation • There are two general causes for actual depreciation, physical depreciation and functional depreciation • Both can happen at the same timeor they may happen separately. • Physical depreciation • literally means that the asset is wearing out and it cant do its job as well as it used to. • For example, wear and tear • The more it's used, the more it wears out. • Physical depreciation also includes natural fall such as • rust, corrosion, decomposing,, and so on. • Rust =Become destroyed by water, air, or a corrosive such as an acid • Corrosion= Wearing away by chemical action • Software isn't a physical thing, so it can't be affected by physical depreciation • On the other hand, • software professionals are sometimes responsible for, or have influence on, decisions about computer hardware, peripherals, and computing facilities

  21. Actual Depreciation • There are two general causes for actual depreciation, physical depreciation and functional depreciation • Both can happen at the same timeor they may happen separately. Functional Depreciation • Functional depreciation means that the environment where the asset is operating has changed, and the asset isn't well matched to that new environment • One kind of functional depreciation is obsolescence[The process of becoming obsolete; falling into neglect or becoming out of date] • Another type of functional depreciation is when the demand on the asset increases to the point where the asset can't meet that demand.

  22. Depreciation Accounting • The key idea in depreciation accounting is that corporations are taxed on profit (net income), not gross income: Profit = Gross income – Expenses • Depreciation accounting effectively treats the original cost of an asset as a prepaid expense • Instead of charging the entire cost as an expense when that asset is bought, depreciation accounting spreads the cost over the life of the asset • It's important to recognize that the depreciation amounts in depreciation accounting are not actual cash-flow instances • The actual cash-flow instance happens when the company buys the asset.

  23. Depreciation Accounting • One theoretical alternative to depreciation accounting would be to allow the company to write off the entire expense in the year an asset was bought • This would make the income taxes for that year unrealistically low, whereas the income taxes for the remainder of the asset's life would be unrealistically high • Depreciation accounting is the tax authorities' attempt to make each year's income taxes as realistic as possible. • Any asset that • Is used in a business or trade • Is used for producing income • Has a known lifespan that is more than 1 year

  24. Value-Time Functions • A value-time function is a mathematical function that models how an asset loses value over time. • The simplest value-time function is known as • straight-line. • The straight-line value-time function assumes that the asset loses value at a constant rate (i.e., as a fixed percentage of the asset's original value) over its lifetime.

  25. Value-Time Functions • Example • An asset that originally cost $10,000 and has a 10-year expected life is assumed to have a value of $3,000 7 years after it was bought.

  26. Value-Time Functions • Another value-time function is called • declining-balance. • The declining-balance value-time function assumes that the asset loses value as a fixed percentage of its remaining value over its lifetime • (e.g., it's worth 20% less than it was the year before). Using an 80% declining-balance value-time function, a $10,000 asset would be assumed to be worth $8,000 after 1 year, $6,400 after 2, $5,120 after 3, etc.

  27. Book Value • The book value of an asset is the tax authorities' best estimate, based on depreciation accounting, of that asset's actual value • Another way of looking at book value is that it's the part of the asset's acquisition cost that hasn't been charged off by depreciation accounting. • Book value may not be the asset’s actual value

  28. Book Value • The book value in any year can be calculated by subtracting the depreciation amount in one year from the book value from the previous year. • BookValueyear(t) = BookValueyear(t–1) – Depreciationyear(t–1)

  29. Depreciation Methods • The U.S. tax code has defined different depreciation methods three times in the recent past: • Before 1981 • 1981 through 1986 • 1987 and beyond • The Next lecture explains each of the depreciation methods prescribed during these times.

  30. Depreciation Methods Before 1981 • Before 1981, the organization could choose any one of four different methods for depreciating any asset: • Straight-line depreciation • Declining-balance depreciation • Declining-balance switching to straight-line depreciation • Sum-of-the-years-digits depreciation

  31. Why Before 1981 • First, and most important, looking at each of these methods gives a broad survey of different approaches to depreciation accounting. • Second, the earlier depreciation methods are a good foundation for understanding the method used today. • Finally, the tax laws could certainly change again in the future, and one of the earlier methods may become prescribed again.

  32. STRAIGHT-LINE DEPRECIATION • Straight-line depreciation assumes that the value of the asset decreases at a constant rate over its useful life • The asset loses a fixed percentage of its original value each year. • Formula • Depreciation=(Accusation Cost – Salvage value)/life in years • Straight-line depreciation is the only method that uses the same depreciation amount each year

  33. BookValue • The book value of an asset is the value of that asset on the "books" (balance sheet) of the company. • The book value is not necessarily the same as the fair market value (the amount the asset could be sold\buy for on the open market). • The book value is calculated as the purchase price of the depreciable asset minus accumulated depreciation on that asset

  34. Declining-Balance Depreciation • Declining-balance depreciation assumes that the value of the asset decreases faster earlier in its life and slower later in its life. • Under declining-balance depreciation, the asset loses a fixed percentage of its remaining value over time.

  35. Declining-Balance Depreciation • The depreciation amount is a fixed percentage, α* of the book value of the asset at the beginning of that year • The formula for calculating the declining-balance depreciation amount in year t is as follows: • Depreciationyear(t) = α* BookValueyear(t–1)

  36. DECLINING-BALANCE SWITCHING TO STRAIGHT-LINE DEPRECIATION • In this method, the declining-balance formula is used in the early part of the asset's life and the straight-line method is used for the rest • The switch from declining-balance to straight-line happens when the declining-balance depreciation amount becomes less than the straight-line amount • Depreciationyear(t) = max(DecliningBalanceyear(t), StraightLineyear(t))

  37. SUM-OF-THE-YEARS-DIGITS DEPRECIATION • The depreciation factor in any given year is determined by a fraction, • where the numerator is found by counting down from the useful life, and • the denominator is the sum of the numbers from 1 to the useful life.

  38. SUM-OF-THE-YEARS-DIGITS DEPRECIATION

  39. Accelerated Cost Recovery System (ACRS), 1981–1986 • The accelerated cost recovery system (ACRS) [IRS95] was the defined depreciation method from 1981 through 1986. • All depreciable assets put into service during these years used the ACRS method. • There are two variants of the ACRS method, the • prescribed method and the • alternative method. Coming Lecture

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