It’s budget season again – a time when companies are (among other things) determining how much money they will be spending on their IT departments. In our experience, there are many things wrong with how companies budget generally (see “Make IT Spending More Transparent”), and certainly in how they manage the finances of their IT budget. Since the end of the Y2K fiasco and the dot-com boom, companies have spent most of their time and attention on the capital spending portion of the IT budget. Most have implemented a strong governance process (or, at least, a stronger process) to ensure IT investment dollars are spent wisely. The problem is that they still have serious issues with the IT operating budget.
From the perspective of many IT departments, far too much of their budget is devoted to “keeping the lights on” (KTLO – it had to have an acronym, right?) and too little for real innovation and interesting stuff. One of the most important reasons why this happens in so many companies is they have no idea of what drives their IT spending so they cannot allocate the department’s costs in ways that managers can make rational, actionable decisions about the IT costs they are driving. Instead, expenses are allocated by some formula that is only indirectly related to IT spending, such as revenues, headcount or space occupied. Lacking that direct connection, the allocated IT spending is nothing more than a corporate tax. Since executives are unlikely to reduce headcount just to cut their IT allocation, they lobby for a lower “tax;” in other words, a smaller IT budget. This, in turn, creates a woefully sub-optimal IT budget. Too much money going to things that they business either doesn’t want or would give up if they had to pay the real cost and not enough going to activities that would improve the efficiency and effectiveness of the company as a whole. (See “IT Spending Effectiveness”).
From the standpoint of this discussion, there are three basic buckets of IT spending. One is the general IT expenses that are the necessary core of running the enterprise. Like the CEO’s salary and bonus, these are allocated without discussion to business units, period. A second are costs incurred by a budgetary unit (division, department or business unit) that can be assigned to it unambiguously (such as software licensed on a named user basis). It’s the third bucket that’s the problem: the costs that are not essential that are allocated by formula to the business units and a large portion of what is called 'Keeping the Lights On' budget. These are difficult to measure because it can be hard to accurately connect the dots between the activities going on in the IT department and the “things” delivered to the business units (reports or demand planning functionality consumed by multiple departments). Depending on the nature of the business, how it structures its business (centralized versus decentralized) and what it considers essential, these third-bucket costs typically account for 20-50 percent of IT operating expense. For many CIOs, being able to free up even 5 percent of their budget to more value-added, forward looking projects would be welcome.
Step one to fixing the problem is having the mechanism in place to determine the IT budget’s true cost drivers. This includes both activity based costing software, which is far easier and practical to use than ever as a means of calculating cost drivers, as well as IT asset/portfolio management software, which helps track the IT department costs. Step two (which should be run in parallel with step one) is determining the process for allocating and adjudicating shared IT costs. Giving managers the ability to exercise a ‘line item veto’ for a piece of their IT allocation will be a powerful incentive to get their cooperation in the process.
We believe that more than a few CIOs are reluctant to start the process of making their IT budgets more transparent because they don’t think there’s much in it for them. In fact, they may think that any savings will simply be used to cut the budget. However, our benchmark research finds this fear is probably misplaced. We find that companies that have greater visibility into how they are spending their IT budget and that manage IT spending processes more carefully consistently rated their spending effectiveness higher, grew their IT budget faster and spent a higher percentage of it on innovation rather than keeping the lights on. CIOs that have demonstrated their ability to deliver value to the business and shown they use their dollars wisely usually have the credibility to make the case for spending the money saved on efforts that will enhance the business.
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Robert D. Kugel - SVP Research