A Buyer's Guide to IT Value Methodologies
- 05 August, 2002 13:00
When a company buys a new fleet of delivery trucks, it can predict with reasonable accuracy how much more revenue it will generate by delivering more goods more quickly to more customers. That can make it easier to justify the investment. It's rare, however, to find a CIO who can produce similar numbers for IT investments.
"As recently as two years ago, companies made IT investments to reduce cost, enhance productivity or solve specific business challenges," says Thomas Pisello, president and CEO of valuation consultancy Alinean. "Now with today's economic climate, CIOs are under a lot of pressure to justify that budget and put a measure on value that may not be obvious."
One way to make the value of IT more obvious is to adopt a logical, repeatable framework - a valuation methodology. This framework helps identify and nurture those investments that ultimately contribute directly to the financial health of the organisation. CIOs who have adopted these models say that they help establish a clear connection between IT and business strategy, link technology initiatives to shareholder value, facilitate negotiations with the CFO, and ultimately help them get more money for IT and spend it where it does the most good.
IT managers have it especially difficult when the business discussion moves from the subjective to the objective. Technology investments are often more expensive than they first appear, and the value they deliver is more difficult to measure. "IT buying is fundamentally more complex because of the range and quantity of inherent hidden costs and soft benefits," says Pisello.
For sanity's sake, we've divided the major methodologies into three categories: traditional, qualitative (also called heuristic) and probabilistic. Some techniques, like Economic Value Added (EVA), are more akin to building blocks than methodologies. Others, like Balanced Scorecard, try to be full-blown performance-management systems that cover everything from goal setting to incentive compensation. Whatever methodology you choose, keep in mind that the overarching goal of valuation is simple - to draw a direct line between IT investments and the enterprise's bottom line.
Which One Is for You?
We've zeroed in on each plan as best we can, but it's simply not possible to make a statement like: Portfolio Management is best suited for Web-based pizza delivery businesses. Choosing a valuation plan has at least as much to do with the way you, your department and your organisation operate as it does with the individual merits of each approach, practitioners say.
Take a good look at how other functions in your organisation value their investments. Douglas Hubbard is one of several analysts who express frustration at IT's occasional lack of perspective. "You don't have to dummy your numbers down," Hubbard insists. "It's time for IT to catch up with the business side."
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Traditional Financial Methods
These methodologies have their roots in the world of financial measurements, with IT-specific metrics and attempts at risk assessments Economic Value Added (EVA) "Net profit minus the rent."
ECONOMIC VALUE ADDED (EVA)
"Net profit minus the rent."
Nuts and Bolts: As a metric, EVA equals net operating profit minus appropriate capital charges. Simply put, when managers employ capital, they have to pay for it, explains Gregory Milano, partner and management committee member in the EVA consulting practice of North America at Stern Stewart & Company, the New York City-based developer and promoter of EVA. By assessing a charge for the use of capital, EVA encourages managers to monitor assets as well as income, and keeps them aware of the trade-offs between the two, Milano says. If you're evaluating a new ERP system, for example, EVA requires that you factor in all investments, including initial cash outlays, maintenance, and internal and external training costs, and take those as a charge against anticipated benefits, which might be increased revenue or reduced costs.
Using EVA as a yardstick to assess the performance of individual departments, including IT, on a monthly, quarterly and yearly basis can help with decisions on new projects. Conflicting and confusing goals (like revenue growth, market share or cash flow) are replaced with a single financial measure for all activities.
BancorpSouth has had success in eliminating multiple goals. "In the past, we looked internally at growth goals, efficiency ratios, pricing margins, market share and of course, on the external side, earnings per share, but there were no capital considerations. People would make decisions to get growth volume and wind up losing their shirt," says Will Newcomer, senior vice president of MIS at BancorpSouth, a six-state bank with its headquarters in Tupelo, Mississippi. By putting Hyperion Solutions' EVA calculation tool on each branch manager's desk, BancorpSouth can tell branches that they need to hit income goals and make back the cost of their capital - but still give them the autonomy to do it their way.
Word of Mouth: EVA is a good way to gauge the top-level impact of IT, says Alinean's Pisello, but it's difficult for many IT organisations to connect that high-end view with something like the purchase of a new server without using intermediate measures. BancorpSouth may be in the minority by using EVA as a full-blown valuation framework. Other companies feel more comfortable using it as a single metric that plugs into another valuation methodology.
Time and Money: As little as three or four months for small companies with clear financial data; a few years for full implementation in large, complex companies. Cost is commensurate with the size of the company and project, says Milano.
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TOTAL COST OF OWNERSHIP(TCO)
If you're already too cost-focused, TCO will just dig you in deeper."
Nuts and Bolts: TCO is an efficiency measure best used for helping service-oriented departments like IT squeeze better price and performance ratios out of key business processes such as operations, disaster recovery, change management and tech support.
Responding to a client query in 1986, Gartner's Bill Kirwin and others set out to calculate the ongoing costs of procuring, administration, set-up, moves/adds/changes, tech support, maintenance, peer support, downtime and other hidden costs of owning a PC. "We said: let's take a holistic view of costs across enterprise boundaries and over time," says Kirwin, now vice president and research director at Gartner (US). "When we added it all up, it was pretty surprising. Nobody believed the numbers at first, not even internally at Gartner."
They do now. TCO has become a way of life for many technology managers who like its dispassionate analysis of new products and upgrades. Hardware manufacturers can increase sales by building TCO-reducing features into their products that reduce maintenance and support costs.
Word of Mouth: TCO does an excellent job of providing a current cost benchmark, and it works well for analysing a narrow function or series of functions. When combined with best practices benchmarks, it can make a good framework for assessing and controlling IT spending. TCO does not assess risk or provide a way to align technology with strategic and competitive business goals.
Even Gartner, which developed TCO, acknowledges it isn't a silver bullet, but rather an efficiency metric that works well when plugged into the financial perspective of a Balanced Scorecard or other qualitative methodologies. Gartner is working on a broader version of the methodology called Total Value of Opportunity (TVO) that has a greater emphasis on investment performance.
Time and Money: Between eight and 16 weeks; anywhere from $30,000 to $50,000 on the low end.
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TOTAL ECONOMIC IMPACT (TEI)
"It's better to build layers on top of an organisation's existing toolkit than to drop in something brand new."
Nuts and Bolts: Total Economic Impact is a decision-support methodology designed to accommodate risk and something Giga Information Group research fellow Chip Gliedman calls "flexibility" - deferred or potential benefits often left out of straight cost-benefit analyses.
In analysing expenditures, IT managers assess three key areas - cost, benefit and flexibility - and determine risk for each. Cost analysis takes a TCO-like approach in considering ongoing costs in addition to capital expenditures. This tends to be an internal IT measure. Benefit assessments look at the project's business value and strategic contribution outside IT.
TEI calculates flexibility using a futures-options methodology, such as Real Options Valuation or the Black-Scholes model, both of which attempt to value options to be exercised later. For IT investments, risk considerations include the availability and stability of vendors, products, architecture, corporate culture, and size and timing of the project.
It doesn't matter which calculations a company uses, provided it is analysing all three categories and assessing risk for each, says Gliedman. "It's better to build layers on top of an organisation than to drop in something brand new," he says.
Word of Mouth: TEI works best when analysing two distinct scenarios (build versus buy or Oracle versus Sybase), particularly when those two choices involve infrastructure or other enterprisewide projects whose benefits are notoriously hard to pin down. Some measurement experts, including Technology Decision Modeling's Don Hinds, aren't thrilled with the subjective, nonstatistical nature of TEI's risk-assessment component.
Time and Money: Five days to two months; $20,000 to $30,000 on the high end.
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RAPID ECONOMIC JUSTIFICATION(REJ)
"Truth and beauty of the numbers"
Nuts and Bolts: Like TEI, Microsoft's Rapid Economic Justification seeks to flesh out TCO by aligning IT expenditures with business priorities. The five-step process requires IT to: develop a business assessment road map identifying a project's key stakeholders, critical success factors and key performance indicators; work with stakeholders to identify how technology can influence success factors; perform a cost-benefit equation; profile potential risks representing probability and impact of each; and run standard financial metrics.
Brad Post, group marketing manager for Microsoft's business value group, swears REJ doesn't favour Microsoft products. "It's a church and state division. We're really after the truth and beauty of the numbers." To certify REJ as 100 per cent neutral, the Microsoft team sends its initial report to Gartner, Giga or KPMG for comment and authentication.
That touch appealed to Angelo Macchia, executive vice president and CIO at Aegis Communications Group. The Texas-based teleservices outsourcer, which has 10 call centres and some 8000 employees worldwide, was considering a move from Unix/Sun to an all-Microsoft platform. "Gartner did our audit, and they were tough on it," says Macchia. "They pushed back on comparisons that they thought weren't fair, and Microsoft went back and revamped some numbers."
Word of Mouth: REJ is best suited for managing single projects rather than an entire project portfolio. Analysts and users like REJ's business assessment phase, its TCO-like baseline and its inclusion of risk analysis, although that analysis is subjective. If the winds are blowing fair from Redmond, you could get the whole valuation for free, as Aegis did. However, despite the "rapid" in its name, the REJ process can be slow. Also, some organisations won't trust any vendor-sponsored findings.
Time and Money: Between 12 and 20 weeks; $20,000 to $80,000.
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Qualitative Methods
These methods, sometimes called heuristic, attempt to round out quantitative measures with subjective and qualitative inputs to assess the value of people and processesBalanced Scorecard "You can make it as hard or as soft and fluffy as you want."
BALANCED SCORECARD
"You can make it as hard or as soft and fluffy as you want."
Nuts and Bolts: Balanced Scorecard has been around long enough that it's hard to remember how radical the concept was when Robert Kaplan and David Norton first proposed it in a 1992 Harvard Business Review article. The two were looking to join traditional finance lag indicators with operational metrics and integrate them into a broader framework that accounted for intangibles like corporate innovation, employee satisfaction or effectiveness of applications. The Scorecard puts those measures into four perspectives - financial, customer satisfaction, internal processes, and growth and learning - then asks managers to evaluate each perspective against the business strategy.
Investors Group, a Manitoba-based conglomerate of three insurance firms, uses Balanced Scorecard to measure the effectiveness of its newly centralised IS organisation. The department inserts metrics and measures into the Scorecard's four perspectives to gauge every aspect of its performance, from the Information Systems Audit and Control Association's IT governance framework, which helps monitor governance effectiveness and process performance, to a series of touchy-feely questions aimed at determining employees' engagement in their jobs.
"You can make it as hard or as soft and fluffy as you want," says Investors Group senior vice president and CIO Ron Saull, of the Scorecard. "We make it harder because that's the nature of our executives, that's what they want to see, and because I like to manage with numbers."
Word of Mouth: Because the Balanced Scorecard is primarily a tool for managing strategy, it rarely works without top-level executive sponsorship. If companies skip the initial step of mapping out a business strategy with clear cause-and-effect relationships, they can wind up measuring factors that don't link to business performance. Critics who don't care for the Scorecard's softer sliding-scale side charge it's used as a way to justify behaviour rather than effect meaningful change. Even proponents acknowledge IT faces a special challenge in correctly mapping its activities to strategic corporate goals.
Time and Money: About three months; as high as $500,000 for a complex, enterprisewide Scorecard.
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INFORMATION ECONOMICS (IE)
"What's important is getting the senior people to agree on what's important to the business."
Nuts and Bolts: Information Economics aims to provide a neutral method of evaluating a portfolio of projects and allocating resources where they will be of greatest benefit. The idea is to force IT and business managers to articulate, agree on and rank priorities, and draw more objective conclusions about the strategic business worth of individual projects.
"The value of IT will be improved over time if you invest in high-value projects. The underlying philosophy is to spend your money where it's going to make the most impact," says Tom Bugnitz, president of The Beta Group, the consultancy that champions Information Economics.
Both IT and business managers first list 10 decision factors and evaluate each for its relative importance (positive) or risk (negative) to the business. Each line of business has different decision factors that can be added, deleted or changed as priorities change. Next, IT projects are evaluated against those decision factors. The result is a total relative value number for each project in IT's portfolio. With a master list of projects ranked by score, it's simple to determine which should be continued and which should be killed.
Lafarge Canada, a construction materials company in Montreal, had a good track record for IT project starts, but decisions were based more on the power of the business sponsor than on sound strategic principles, says Michel Therrien, director of IT planning and e-business. "Now we can argue around specific definitions. Each of our imperatives is mapped to [our] goal."
Word of Mouth: IE is a relatively fast way to prioritise spending and align IT projects with business goals. Its risk analysis is fairly detailed, if still subjective. This isn't designed to manage projects, and it won't unless IS and business managers are willing to participate and to possibly revamp current planning models to accommodate the process.
Time and Money: Six to eight weeks; plus or minus $75,000.
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PORTFOLIO MANAGEMENT
"Transforming the buisness tends to be a high-risk, high-yield activity."
Nuts and Bolts: Portfolio Management was built around a premise that many other valuation approaches have since borrowed. To contribute to a company's bottom line, organisations must view IT staff and projects not as costs but as assets managed by the same criteria a fund manager would apply to any other investment. That means CIOs should continuously monitor existing investments and evaluate new investments by cost, benefit and risk. Just as stock managers diversify risk in a stock portfolio, so too should IT managers assess risk of technology projects and diversify accordingly.
"You have investments to run the business, grow the business or transform the business," explains Howard Rubin, developer of Portfolio Management and research fellow at the Meta Group (US). "Run-the-business investments are low risk, low yield. Growth is medium on both sides. And transforming the business tends to be a high-risk, high-yield activity." The level of risk associated with a component should determine the tightness with which it is managed.
Walter Weir, CIO at the University of Nebraska in Lincoln, says adopting ProSight Portfolio software has helped clarify IT priorities - no small task for a department that services 50,000 students on four campuses and has responsibility for universitywide computing, administration, SAP, student information, budgeting, facilities and Internet initiatives. Weir now divides projects into four categories - administration, service, production and enhancement - then tries to emphasise the higher-level strategic activities as much as possible. "The first three I try to cut down on so we can add resources to the enhancement piece," he explains. "It's been a wonderful tool to help me say no when I need to and to help me get extra funding when I need that."
Word of Mouth: This is not to be undertaken lightly. If your organisation isn't willing to undergo a change of management processes to accompany its new asset philosophy, Portfolio Management won't be as effective. It can also take time to get the proper mind-set ingrained in the organisation.
Time and Money: Full implementation in three to six months; cost ranges from about $180,000 for companies in the annual revenue range of $US500 million to $2 billion, to $500,000 and up for large companies with revenue at the $US50 billion level.
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IT SCORECARD
"Why kill yourself developing financial scorecards when the discussion is just going to get pushed back down to operational issues?"
Nuts and Bolts: Michael Bitterman, a principal with the IT Performance Management Group, spent two years trying to fit IT into the Balanced Scorecard but found it just wouldn't fit to his standards. "The cause-and-effect linkages of the pure Balanced Scorecard don't work," he says. "Some of the [Balanced Scorecard] perspectives don't apply, for example, knowledge and growth. And pure Balanced Scorecard requires a strategy map, but IT organisations are for the most part tactical organisations whether they want to be or not."
For an antidote, he developed an IT-centric approach that emphasises moving IT toward a strategic involvement. In place of the Scorecard's four perspectives, Bitterman substitutes business growth, productivity, quality (both internal and external to IT) and decision making. "The idea is to build toward value but start with an internal view for IT to use," says Bitterman.
It's an approach that works for California-based Firemen's Fund Insurance. "One thing we faced was a dearth of information. We felt we had to build some credibility with basic measures and show how those fit [into the strategic objectives]," says Jon Cooper, project manager for the IT department.
Word of Mouth: If you like Bitterman's IT-centric, bottom-up philosophy, chances are you'll find stability in the program's highly specific, many-layered approach.
Time and Money: Between six and eight weeks; consultant's fees run from $75,000 to $250,000; software can be as little as $20,000 or as much as $150,000.
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Probabilistic Methods
These methods use statistical and mathematical models to calibrate risk within a range of probabilities
REAL OPTIONS VALUATION (ROV)
"What kind of investment do we make in technology to create flexibility?"
Nuts and Bolts: Taking its cue from the Nobel-prize-winning Black-Scholes model for valuing options, ROV aims to put a quantifiable value on flexibility. The technique was applied to leasing, mergers and acquisitions, and manufacturing. Around 1990, "it became a very natural question to say, What kind of investment do we make in technology to create that kind of flexibility?" says John Henderson, the Richard C Shipley professor of management at Boston University and chairman of that department. Thus began the movement to value infrastructure and other ground-floor technologies, because nearly all other technical innovations are built on top of those base decisions.
Word of Mouth: Academic and arcane, but valuable. Works best as a stand-in for standard capital-budgeting processes in markets and economies where uncertainty is high and the need to stay flexible is at a premium. Most companies use ROV as a building block alongside more traditional financial and productivity measures.
Time and Money: Not applicable, as ROV is most often used as one measure inside a larger valuation plan.
APPLIED INFORMATION ECONOMICS (AIE)
"If we can compute probability on a satellite that's never flown before, we can compute project success in IT."
Nuts and Bolts: Here's a method for people who mistrust TEI's sliding-scale "guesstimation" of risk analysis, feel uncomfortable with TCO's single-point outcomes, and wouldn't use a Balanced Scorecard to take a nap on. If you're looking for quantifiable, statistically valid risk-return analysis that would make an insurance executive drool, AIE should work.
AIE developer Douglas Hubbard combines options theory, modern portfolio theory, traditional accounting measures like NPV, ROI and IRR, and a raft of actuarial statistics to quantify uncertain outcomes and generate a bell curve of expected results that objectively incorporates both risk and return. "If we can compute probability on a satellite that's never flown before, we can compute project success in IT," Hubbard insists. "IT does have a repeatable history, and if you're not willing to include that in your analysis, you may as well just flip a coin."
Word of Mouth: This is the most numbers-heavy methodology covered here. Like the IT Scorecard, AIE is essentially a one-man show. Critics charge its myriad calculations eventually hit the law of diminishing returns. For costly and career-making projects, it's a thorough and statistically valid way to analyse risk.
Time and Money: Plus or minus eight weeks; costs are typically 1 per cent to 2 per cent of overall project budget.