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IT's new math

IT's new math

For many CIOs, the budget story has not been a happy one these last several years. The economic downturn that followed the dotcom meltdown, 9/11 and the high-profile accounting scandals that led to the Sarbanes-Oxley Act negatively affected IT budgets -- a shock to IT leaders after the go-go, profligate nineties.

Now IT budgets are beginning to grow again...but under intense scrutiny by management that wants proof that all those IT dollars actually redound to the bottom line. But while CIOs provide business with proof of IT's value -- and its fiscal responsibility -- they may cut through any remaining fat in their budgets right into the bones that support their enterprise's enabling technologies.

This risk, and the fear that comes with it, brings back bad memories of the days when IT was regarded as a mere cost to contain, notes Howard Rubin, president of the consultancy Rubin Systems and a research associate at MIT's Center for Information Systems Research. That cost focus changed in the 1980s when IT became part of business strategy and the fiscal discipline imposed on IT investments was somewhat reduced. "Then, in the 1990s, companies became technology day traders -- profits were rising and it was very easy [to] buy stuff," Rubin says. "But when the bubble burst in 2000, companies said that those investments had done nothing for them, so they cleaned up their portfolios. Technology," Rubin suggests, "is once again viewed as a cost."

If true, that puts CIOs in a difficult position. "If IT is just a cost, you want to cut it," notes Rubin. But that thinking forces CIOs to slash costs while at the same time responding to another demand coming from the executive suites: to innovate and thereby grow the business.

Out of the Budgetary Death Spiral

Getting that balance wrong could result in a race to the bottom, says Bob Zukis, a partner at PricewaterhouseCoopers. "It becomes a death spiral," he says. Cutting costs can impair the CIO's ability to deliver technology's benefits to the enterprise, which makes the enterprise question the value of technology, which leads to more cuts, fewer benefits and less value.

It's the CIO who needs to make the case that IT should not be regarded as a cost to be contained.

"The average C-level executive doesn't know how to evaluate if a technology investment is doing what it's supposed to do," says Richard Chang, CEO of the consultancy Richard Chang Associates. Thus, these executives focus solely on cost, looking for some easy metric such as tying IT spending to a percentage of revenue or benchmarking your IT spend against your industry.

But "that's a reductio ad absurdum," argues Bernard 'Bud' Mathaisel, CIO of IT outsourcer Achievo and former CIO of Solectron, Ford and Walt Disney. "Spending needs to be in context. If you're in investment mode, your IT spend will be higher than for your industry as a whole," he says.

The trick is to change the terms of the discussion. If IT is a cost, Rubin points out, it needs to be contained. If, however, IT is an investment, "you want to manage it." The key is to make the argument convincing.

"The holy grail is to understand the inflection point of how much to invest in technology," says Jim Noble, MD of global infrastructure solutions at Merrill Lynch.

Rubin says he has found a way to help CIOs permanently alter the nature of technology's conversation with the business. Based on 25 years of industry benchmarking and research as an executive at the Meta Group, IBM and PwC, plus direct consulting with dozens of large enterprises, Rubin now believes he can show which spending metrics correlate to real business value and how individual companies compare to peers within specific aspects of their technology portfolios. It will allow CIOs to focus their spending assessments more deeply.

"This research will turn up the heat significantly on CIOs who can't prove their value creation," says PwC's Zukis, since now there is a way for them to do so. "The days of 'trust me' are over," concurs David Howe, North American vice president for benchmarking at Gartner.

New Math: The Theory

Rubin's research reveals two key concepts that can enable CIOs to see whether their IT investments are returning real business value:

Measuring IT spend against two factors -- operating expense and net revenue -- is a more accurate gauge of IT effectiveness than the traditional metric of measuring solely against net revenue.

Enterprises that spend slightly more than their peers tend to have better business results. But after a certain point, that extra spending does no good. Rubin calls the sweet spot of extra but not exorbitant spending 'optimal IT intensity.' He calculates IT intensity by comparing the IT spend to both the operating expense and net revenue, and has developed IT intensity curves that help CIOs see if they are underinvesting, investing an optimal amount or overinvesting. (Rubin compares the IT intensity number to profit to determine what the optimal amount is for a given industry. See The IT Intensity Curve)

Although Rubin's research is based on more than two decades of work, his key conclusions have crystallized only in the last year. But he is now working with several CIOs to put his theory to the test. Intuitively, his findings make sense, they say.

"Now we can understand in an actionable way where we are underinvesting and [where we're] perhaps overinvesting," says Merrill Lynch's Noble.

"We realized we needed a better comparison to be able to evaluate [IT spending] on a more holistic basis," says John Comisky, VP of services operations at Verizon.

"The discipline of going through something like this provides a great deal of credibility with the senior management and at the board level," notes Rob Leeming, chief administrative officer for IT infrastructure at financial services provider UBS.

These IT leaders note, however, that it will be a few years before they know how well Rubin's theories play out in practice. And the numbers don't provide insight on how to get the most bang for your IT buck, just that slightly higher spending correlates to better business results. "It's not clear if [IT intensity] is a cause or an effect," says Scott Abbey, CTO of UBS. There is, it seems, still an art to IT investment, not just math.

New Math: The Practice

Benchmarking yourself against previous investments and the investments of your peers is nothing new. But the available data was hard to use for anything more than the highest-level comparisons. "Even then, the benchmarks were pretty worthless," says Merrill Lynch's Noble. And the data was insufficiently detailed to allow companies to compare specific aspects of their IT spending versus that of other companies. "There was a danger of comparing apples to oranges," Noble says.

But Noble believes that Rubin's two decades of benchmarking has created a database for the financial services sector that allows finer grained comparisons, a key step to understanding real trends over time and distinctions between competitors.

Rubin's own analysis of IT spending compared to a company's financial performance made him question the traditional measure of IT ROI, typically arrived at by dividing the IT spend into net revenue. The assumption behind that measurement was that net revenue should rise proportionally to the IT spend. Consequently, if revenue did not rise with a higher spend, the investment should be adjusted accordingly. Or more simply, the IT spend should be limited to a set percentage of net revenue. But this calculation, in Rubin's view, ignores periods of investment and market change.

Rubin began experimenting and found that IT spending as a measure of business success correlated much better to another factor: operating expenses. He believes that comparing the IT spend to operating expenses better accounts for shifts in corporate realities: entering new markets, making previously deferred upgrades to the IT infrastructure and other capital improvements to competitiveness and efficiency, not to mention reacting to market shifts. While Rubin can't prove that this is the reason for the better correlation to business results that he derived from comparing IT spending to operating expenses rather than net revenue, the prima facie evidence comes from calculations across hundreds of companies in more than a dozen industries. So for companies looking for a yardstick to measure normalized IT spending trends over time, Rubin says his metric does a better job, especially because it employs two factors a business can control: operating expenses and IT spending. But enterprises still need to track the IT spend against net revenue, Rubin notes, even though revenue is, ultimately, not something anyone can control. "You don't want to spend money you don't have, so you have to be aware of that figure," he says.

IT Intensity: How to Find the Sweet Spot

Further research showed Rubin that comparing IT spending to operating expense to measure IT's impact on business performance was not the answer to determining whether the right amount of money was being invested in IT. It turns out that calculating the relationship between the IT spend as a percentage of operating expenses and the spend as a percentage of net revenue is what a CIO needs to do to arrive at an optimal IT investment. Rubin believes this because the triangulation that occurs when these two calculations are used can better account for the interplay between IT investment (operational expenses) and fiscal reality (net revenue). This helps the CIO make sufficient investments when there's revenue but throttle back when it isn't.

That triangulation led to Rubin's IT intensity concept: there is a sweet spot for IT spending. For most enterprises, that means spending more as both a percentage of operating expenses and of net revenue than they are now doing. "The objective analysis shows that spending wisely and applying IT intensity analysis can get you more return," says Gartner's Howe.

But the research does not mean the sky's the limit. Rubin's calculations show that technology investments hit a saturation point after which no further business value is obtained. For example, he found no examples of any type of financial institution outperforming its peers by spending more than 14.1 percent of operating expenses on technology -- essentially demonstrating that for banks there's a ceiling for IT investments. For the subcategory of investment banks, that ceiling was 13.1 percent.

Rubin has created IT intensity charts for more than a dozen industries based on historical IT spending and their financial results. All show the same basic IT intensity curve and the sweet spot at its apex, although the curve itself differs from industry to industry. That makes sense, says Gartner's Howe, because business models and degree of dependence on IT to deliver business functions vary across industries.

There are also variances within industries. This means that you can't just pick the IT intensity curve for your industry and automatically align your spending to it, Howe says. "People don't spend their dollars equally wisely," he explains.

But the pattern holds despite these variances because the variables to factor in -- labor rates, multiplicity of platforms, geographic dispersion and market volatility, for example -- are still finite.

Art of IT Investing

While Rubin's research provides a way for CIOs to calibrate their spending to optimize the chances for business success, it doesn't guarantee that success. That's because, Rubin notes, the wise selection of technology initiatives (IT strategy) and good execution are always critical to gaining positive results. And that's where the art comes in. CIOs who can do the math but flunk the art will not be able to use any extra money they pry out of their CEOs to improve business performance or create new value.

Even artful CIOs will get different results from similar spending. "Companies will drive to different results based on how they answer the questions the data poses," says Grande Bucca, MD for investment banking, research, legal and compliance technology at Merrill Lynch. "We look at our investments against our business goals, and we can change the order of them or their emphasis based on that assessment." That metrics-driven approach is key, says Accenture CIO Frank Modruson. "The top-performing companies manage by metrics," he notes, giving them both detailed data to validate their IT decisions and early warning signals when those judgments are off.

At Verizon "we now have a more in-depth viewpoint about our spend that lets us lower the cost of maintenance and infrastructure while at the same time improving the quality of services," says Comisky. "This lets you spend your dollars on the efforts you think are better for productivity."

At UBS, Abbey says, "We start with a view of the desired outcomes for each of the businesses, then derive from that an overall technology strategy that we can test with benchmarks to see if we've got out of it what we expected." Even if Rubin's research improves a CIO's ability to understand his spending's impact on business performance, achieving efficiency should not be ignored, says Gartner's Howe. "Finding each dollar through increased efficiency is still a worthy cause," he says. "You can spend those dollars for whatever has the best return, whether that's in IT or not."

Separate research at the BTM Institute, an industry think tank, reinforces the idea that smart technology management is essential to getting the desired ROI. Its research shows that companies that treat IT as a driver of business growth get better financial performance and "that doesn't necessarily mean they're spending more on technology," says Faisal Hoque, the institute's chairman.

Other research shows that companies that have managed the complexity of their IT by building well-conceived systems rather than throwing a lot of technology at the wall to see what sticks get higher value from their IT spend, notes PwC's Zukis.

At the end of the day, there's no magic formula to justify IT budgets, no wand to wave that guarantees that real business value will pop out of the technology investment hat. But good CIOs shouldn't be looking for magic, says Rubin. They should be using their skills in the science and art of IT to manage technology as the critical investment it is.

"The CIO," concludes Rubin, "is a fund manager who needs to get the right return on his investment for the risk assumed -- and who must make sure his portfolio is managed well."

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