Monday, February 11, 2008
So What Is It Really Worth
Your ERP implementation is finally done. Y2K is history. Time now to tackle that backlog of applications, starting with e-commerce. Speed to market is the name of the game, so you'd better act fast. No time to spend on measurement and valuation? Oh well, your CEO won't care, as long as you get the new stuff rolled out. Right? Wrong. It may be true that the pressure to implement quickly is fierce in this internet era, but that doesn't mean it's any less important to assess the value contribution of your IT investments. In fact, a number of forces are combining to make valuation more important than ever, and the net may even be one of them. First, the post-Y2K backlog means companies must be especially selective in prioritizing and choosing among new IT investments. Most larger companies have now also completed their ERP implementations, and for many the payoff doesn't look good. That tends to make CEOs sit up and take notice. Similarly, just about everyone is now online, thanks to what originally looked like a no-brainer decision: Competitive necessity combined with what promised to be a relatively small investment. But today, the ongoing costs of hastily built e-commerce systems can add up faster than the payoff, causing upper management to wonder what happened. It all creates extra pressure on the CIO to prove the value of IT—both for individual investments and, on a higher level, for the IS organization as a whole. In this CIO Special Report, we've done our best to help you sort through and make sense of the challenges, methods and possible actions. Because when you're asked "What's IT worth?" you'd better have an answer. And a good one.
Proof/Notes
Answers to the questions "How much value does our IT department produce?" and "What is the return on my IT investments (ROI)?" will likely vary, depending on perspective. While IT management may answer the question "a lot," top management may take a different view. Answers such as "not enough," and "what ROI?" and "IT is a necessary evil" are far more typical from corporate management. In fact, the truth is probably closer to the IT view. However, the lack of agreement on the answers identifies a gap in perception that the IT manager must overcome in order to succeed.
If one defines "value" as the cumulative increase in direct benefits, indirect benefits or flexibility increases, and risk reduction, we estimate the typical IT organization delivers an ROI, or incremental increase in value, of between 15 percent and 40 percent. However, most IT organizations do not even have clear ways to calculate and communicate the direct benefits produced. Though these estimates are obviously not predictive, nor are they specific to any type of organization, the process by which we calculate this return can provide a framework an individual organization can use to better quantify and communicate the value of IT and begin to bridge the perception gap.
If one defines "value" as the cumulative increase in direct benefits, indirect benefits or flexibility increases, and risk reduction, we estimate the typical IT organization delivers an ROI, or incremental increase in value, of between 15 percent and 40 percent. However, most IT organizations do not even have clear ways to calculate and communicate the direct benefits produced. Though these estimates are obviously not predictive, nor are they specific to any type of organization, the process by which we calculate this return can provide a framework an individual organization can use to better quantify and communicate the value of IT and begin to bridge the perception gap.
Alternative View
Claiming that the overall return on the IT investment is sufficient is an exercise in double-speak. The goal of IT management is to produce business benefit from 100 percent of the IT budget. While some returns may be higher than others, all major budget expenditures must be evaluated in terms of business benefit. Allowing one the comfort of thinking that support for a system should be continued because it was running last year may result in inefficient spending. All systems and investments need to be evaluated on a regular basis and those whose ongoing value is not increasing should be considered fodder for cancellation and the funds saved or earmarked to new projects with increased ROI. Likewise, assuming a 66 percent failure rate in new projects should not be tolerated. While all projects may not succeed, all should serve as learning tools to improve the success/failure rate over time. The root cause for the poor perception of IT value is less rooted in communication and more a result of poor execution of initiatives.
Communicating the Hidden Return on IT Investment
If IT initiatives are producing positive returns to the organization, but business management is unaware of these returns, a communications gap is clearly present. This gap may be the result of a number of problems:
Problem: IT is unable to calculate the return on investment of its initiatives.Solution: Implement a program of metrics where each major initiative has defined goals and metrics to indicate these goals have been obtained. Translate these metrics into financial terms using standard conversion factors, such as the cost to the company of each employee saved, the value of time saved, increased revenue per customer or transaction, or the savings in time and money from fewer defects. Communicate these financially oriented results on a regular basis.
Problem: There is no standard conversion rate for translating most metrics into financial terms.Solution: Develop a set of standard conversion rates. When in doubt, use either the cost of the resource (e.g., employees, servers, time) or the market value of the services provides (e.g., what the organization would have to pay to have someone else provide equivalent services).
Problem: There is no vehicle to communicate the benefits of IT to management.Solution: Establish such a vehicle that regularly communicates recent initiatives and their results. In an environment of rapid change, quarterly reports may be appropriate. In very few cases should such reports be less frequent than semi-annual. One potential format for such a communication would show the cumulative benefits received (DBenefit), the changes to the IT spending rate (DCost) and any changes to customer satisfaction (DSat) in IT services (see Figure 2). After a defined interval, such as one year, the return on the IT portfolio can then be calculated. Problem: The business only wants to hear about the reduction in IT spending.Solution: Begin to calculate and communicate business-oriented metrics anyway. Eventually, the business will become accustomed to seeing such reports and will question their absence. Credibility cannot be built overnight. One must begin to show fiscal responsibility and use the pattern of calculation and communication to build credibility.
Problem: IT is unable to calculate the return on investment of its initiatives.Solution: Implement a program of metrics where each major initiative has defined goals and metrics to indicate these goals have been obtained. Translate these metrics into financial terms using standard conversion factors, such as the cost to the company of each employee saved, the value of time saved, increased revenue per customer or transaction, or the savings in time and money from fewer defects. Communicate these financially oriented results on a regular basis.
Problem: There is no standard conversion rate for translating most metrics into financial terms.Solution: Develop a set of standard conversion rates. When in doubt, use either the cost of the resource (e.g., employees, servers, time) or the market value of the services provides (e.g., what the organization would have to pay to have someone else provide equivalent services).
Problem: There is no vehicle to communicate the benefits of IT to management.Solution: Establish such a vehicle that regularly communicates recent initiatives and their results. In an environment of rapid change, quarterly reports may be appropriate. In very few cases should such reports be less frequent than semi-annual. One potential format for such a communication would show the cumulative benefits received (DBenefit), the changes to the IT spending rate (DCost) and any changes to customer satisfaction (DSat) in IT services (see Figure 2). After a defined interval, such as one year, the return on the IT portfolio can then be calculated. Problem: The business only wants to hear about the reduction in IT spending.Solution: Begin to calculate and communicate business-oriented metrics anyway. Eventually, the business will become accustomed to seeing such reports and will question their absence. Credibility cannot be built overnight. One must begin to show fiscal responsibility and use the pattern of calculation and communication to build credibility.
The Hidden Return on IT Investment
No IT organization is perfect. On the other hand, IT is likely not getting sufficient credit with management for the value it is actually delivering. Similar to the old question: "If a tree falls in the forest and there is no one there to hear it, does it make any noise?" one could ask, "If IT undertakes an initiative, and fails to help management understand its value, does it have any value?" A deeper analysis of the IT portfolio finds a significant contribution to the corporate health and well-being that should be calculated and communicated.
Within the largest segment of the IT budget, maintenance and operations, many changes may take place during the course of a year. Older systems are phased out and new ones move from the new application category to the maintenance category. Some applications are routinely upgraded, increasing their usability or availability. Additionally, systems grow in size and number, such as computers, networks, storage, etc. Much of this change in number and size is masked by concurrent increases in efficiency so that there may be a minimal net change to the spending rate of this budget segment during the period of analysis. However, when one steps in and compares the contents of this segment over the period, it is clear that IT is now delivering more services to the organization than it was at the beginning. Quantifying the size of this increase in services over a year, we estimate that the 75 cents of each IT dollar spent in this segment is supporting five cents to 10 cents of new services.
Moving to the new applications category, there is little that we can do to justify an increase in value for a cancelled project. Though steps should be taken to decrease the number of such applications, methods for this are beyond the scope of this Planning Assumption. The ROI for the 10 cents spent on cancelled projects is zero.
Within the delivered but negative return category, the category itself points us to the ROI. The approximately seven cents spent in this budget segment must be returning between zero and seven cents (we will hope that there are a minimum of systems that decrease the value of the organization).
Moving to the value-positive systems, as with the previous category, the title points us to the likely returns. As a minimum, this eight cents of spending should deliver eight cents or more of return. Estimating the top end of return estimates at a 250 percent ROI (2.5 times the spending), we come up with an estimate of 20 cents.
Within the largest segment of the IT budget, maintenance and operations, many changes may take place during the course of a year. Older systems are phased out and new ones move from the new application category to the maintenance category. Some applications are routinely upgraded, increasing their usability or availability. Additionally, systems grow in size and number, such as computers, networks, storage, etc. Much of this change in number and size is masked by concurrent increases in efficiency so that there may be a minimal net change to the spending rate of this budget segment during the period of analysis. However, when one steps in and compares the contents of this segment over the period, it is clear that IT is now delivering more services to the organization than it was at the beginning. Quantifying the size of this increase in services over a year, we estimate that the 75 cents of each IT dollar spent in this segment is supporting five cents to 10 cents of new services.
Moving to the new applications category, there is little that we can do to justify an increase in value for a cancelled project. Though steps should be taken to decrease the number of such applications, methods for this are beyond the scope of this Planning Assumption. The ROI for the 10 cents spent on cancelled projects is zero.
Within the delivered but negative return category, the category itself points us to the ROI. The approximately seven cents spent in this budget segment must be returning between zero and seven cents (we will hope that there are a minimum of systems that decrease the value of the organization).
Moving to the value-positive systems, as with the previous category, the title points us to the likely returns. As a minimum, this eight cents of spending should deliver eight cents or more of return. Estimating the top end of return estimates at a 250 percent ROI (2.5 times the spending), we come up with an estimate of 20 cents.
Management's View of the Return on IT Investments
In our conversations with both IT and top business management, it is clear that, in most organizations, there is often a difference of opinion regarding the contribution of IT to the overall growth, or increase in value, of the organization. Deconstructing the IT budget and segmenting spending into discrete categories allows us to attempt to quantify these differing perceptions of IT. To estimate the ROI of IT, as management views it, we first segment the IT budget into "maintenance and operations" (M&O) and "new applications." This split is frequently noted and reported in many organizations. Such segmentation is also often the basis of the IT budgeting and reporting structure.
All business processes incur both maintenance and new investment expenses. When segmenting the IT budget at a typical organization in this way, approximately 75 percent of the budget is spent maintaining and operating existing infrastructure, systems, and technologies. For most, this budget segment is perceived not to create new value to the organization. This is not to say that the systems being supported do not provide any value to the organization. Rather, the year-to-year change in value is minimal, if any. An analogous situation would be to look at year-to-year corporate revenue. While all revenue (and IT value) may be significant, the corporation will likely emphasize increases in annual or quarterly revenue when discussing results. In fact, as with corporate revenue, there can be significant turnover within this base. However, reaching the level of last year is assumed, regardless of the changes within the installed customer or infrastructure base. A large percentage of maintenance is, in fact, new investment or would be treated as new investment in most other contexts. Major among these are support for the prior year's new investments that become this year's new maintenance projects. There is, however, a general blindness to this, since traditional notions of maintenance versus new investment tend to assimilate this dichotomy to recurring revenue versus net new revenue, and the latter typically implies competitive differentiation. Therefore, when viewed by management, the perceived increase in value of this segment is zero, since the major changes to the M&O suite are "last year's" differentiators.
All business processes incur both maintenance and new investment expenses. When segmenting the IT budget at a typical organization in this way, approximately 75 percent of the budget is spent maintaining and operating existing infrastructure, systems, and technologies. For most, this budget segment is perceived not to create new value to the organization. This is not to say that the systems being supported do not provide any value to the organization. Rather, the year-to-year change in value is minimal, if any. An analogous situation would be to look at year-to-year corporate revenue. While all revenue (and IT value) may be significant, the corporation will likely emphasize increases in annual or quarterly revenue when discussing results. In fact, as with corporate revenue, there can be significant turnover within this base. However, reaching the level of last year is assumed, regardless of the changes within the installed customer or infrastructure base. A large percentage of maintenance is, in fact, new investment or would be treated as new investment in most other contexts. Major among these are support for the prior year's new investments that become this year's new maintenance projects. There is, however, a general blindness to this, since traditional notions of maintenance versus new investment tend to assimilate this dichotomy to recurring revenue versus net new revenue, and the latter typically implies competitive differentiation. Therefore, when viewed by management, the perceived increase in value of this segment is zero, since the major changes to the M&O suite are "last year's" differentiators.
Giga: Measure Business Value Created by IT Spending to Fight Perceptions of Little Benefit
An examination of IT budgets shows typical organizations devote approximately 75 percent to maintenance and operations and about 25 percent to new projects and initiatives. Most organizations rely on the 25 percent segment to create the systems that will allow the organization to change business processes, enter new markets, or restructure the way they do business. Unfortunately, only one-third of these new initiatives can be considered successful, in that they return a business value greater than their cost. Therefore, only 33 percent of the 25 percent segment of the IT budget, or 8.33 percent, creates additional business value. Organizations where the split between maintenance and operations and new projects is 80 percent and 20 percent, respectively, fair even worse. In these organizations, only 6.67 percent of IT budgets return incremental business value to the organization.
Such is the environment into which IT managers must make their budget proposals and stake their careers. In fact, with the hurdle rate for IT investments hovering at 30 percent to 50 percent, the eight cents of the IT dollar that result in successful projects will create eight cents to 20 cents of business value. Combined with the approximately zero to six cents of value created by projects that deliver some, but not "profitable" value, and the five cents to 15 cents from additions and enhancements to existing systems, and the net result is an overall return on investment of approximately 13 cents to 41 cents of business value. Such returns are actually quite respectable. The problem, therefore, is less of return on investment (ROI) and more of measurement and communications.
Such is the environment into which IT managers must make their budget proposals and stake their careers. In fact, with the hurdle rate for IT investments hovering at 30 percent to 50 percent, the eight cents of the IT dollar that result in successful projects will create eight cents to 20 cents of business value. Combined with the approximately zero to six cents of value created by projects that deliver some, but not "profitable" value, and the five cents to 15 cents from additions and enhancements to existing systems, and the net result is an overall return on investment of approximately 13 cents to 41 cents of business value. Such returns are actually quite respectable. The problem, therefore, is less of return on investment (ROI) and more of measurement and communications.
Subscribe to:
Posts (Atom)