THE RIGHT LEVEL OF IT EXPENSE

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1 INFORMATION MANAGEMENT: STRATEGY, SYSTEMS, AND TECHNOLOGIES THE RIGHT LEVEL OF IT EXPENSE John P. Murray INSIDE Industry Averages; IT Performance and Funding; Approaches to IT Budgeting; Effect of Legacy Systems; The Funding Process There has been considerable debate about organizations information technology (IT) expense. Senior management often contends that IT expense is too high, while the IT department tends to consider the expense level too low. Of course, the battle for funding between senior management and department managers is not limited to IT functions. Any good manager will attempt to increase his or her departmental funding in order to add organizational value. Adding organizational value through IT services is at the crux of any debate concerning the IT budget, and the topic should be considered in a broad context. It should include an organization s movement to new, more sophisticated technical approaches; moving to higher levels of IT service to internal customers; and raising the existing levels of IT performance. In turn, the latter leads to newer, more productive technical approaches, or to improving IT customer service levels. There is no one right answer to an organization s level of IT funding. Rather, the funding level should depend on the organization s IT goals. If there are no clear IT goals or expectations, the right funding level is probably whatever the organization is currently spending on the function. In other cases, to determine whether IT funding is too high or too low, the organization should objectively analyze the function s current value and future role. It should compare current value of IT to the organization whether actual or perceived to what that value should be in the future. PAYOFF IDEA This article illustrates how underfunding can hamper progress of the IT function, and shows how new methods of IT budget development can correct IT problems. In rethinking the IT budget process, organizations must understand that IT work is expensive, and concede that adequate, long-term IT funding is needed for competitive advantage. In funding IT, organizations would also be wise to deal with their legacy systems, to admit that disposable applications are an expensive reality, and to realize that funding delays will cost more in the long run. Auerbach Publications

2 INDUSTRY AVERAGES Instead, organizations commonly base the right level of IT funding on an arbitrary rule of thumb, often using an industry average. For example, an organization might use a percentage of the organization s gross sales, basing the funding on the average for a given industry. This provides an easy, consistent guideline for IT funding. However, industry averages do not effectively measure the value returned by IT for the money invested. Determining what an organization will spend for IT, based on average IT expenditure for an industry as X percent of gross sales, is not a businesslike way to address the issues of IT goods and services delivery. Such an approach assumes that all IT installations within a particular industry are essentially the same, as are all organizations needs within that industry. If that were true, it would be appropriate to base IT funding on an industry average. In reality, however, while individual IT installations have the same basic issues, they all also face unique issues to be resolved. Therefore, a one-size-fits-all approach to IT funding is clearly incorrect. Within any given organization, the current level of IT spending might be too high or too low. But basing the IT budget on some average bears little relation to what the level of IT expense should be, how the organization should determine the correct level, or what the result would be of moving to that level. IT PERFORMANCE AND FUNDING Many organizations have been traditionally beset with IT difficulties, which have not become less serious, despite advances in technology, and reductions in the cost of hardware processing power. In fact, many IT installations are finding that their problems are growing. The level of IT funding is one reason why IT departments fail to deliver high-quality products to their customers. While it is not usually considered, funding can figure significantly when organizations consider IT performance delivery. There is a correlation between poor IT performance and the organization s belief in some quarters that the IT funding level is too high. When senior management continually faces concerns about IT performance, and perceives little IT-related progress, the organization will question the value of IT. As IT becomes increasingly more expensive, yet performance remains poor, some will naturally find IT expense too high. Still, organizations seldom consider the appropriate level of IT funding when dealing with poor IT performance, because of more prominent issues that are easier to understand. More obvious reasons for IT difficulties include the effective uses of technology, poor planning, a lack of focus, high employee turnover, project failures, and the failure of ven-

3 dors to deliver as promised. While all these factors and others do play a part in IT-based difficulties, many are linked to IT funding. Therefore, any analysis of IT performance must consider funding. IT BUDGET APPROACHES The process used to determine IT budgets is generally based on other factors than good business planning, or analyzing IT potential. When setting budgets, few organizations relate the causes of IT failures to funding, or consider how new methods of IT budget development might correct IT problems. Instead, IT budgets will be based on invalid assumptions if they are determined via industry averages, or as an emotional response to the IT department s work. Organizations will erroneously assume that the levels of IT need and performance are similar throughout the industry, or that it would not be worthwhile to consider the current state of the organization s IT function. In fact, some organizations have such a poor IT history that they treat the department with resignation. Therefore, no high-level manager will seriously consider new approaches. In organizations with little confidence in the IT department, the function is simply ignored. While people may worry about IT performance, the organization makes little effort at change because IT improvement is viewed as an intractable, or high-risk, problem. When the problems with IT become highly obvious, such organizations will sometimes take severe action, which might produce the desired results. However, it would be far more effective to take a measured, carefully thought-out approach to correction before the IT situation becomes untenable. Evolutionary change is better than revolutionary change. The most effective approach leading to a well-run IT installation is to understand what has gone wrong, why it has gone wrong, and how it can be repaired with minimal disruption. It might create additional difficulty if an organization overreacts, or moves too aggressively in the absence of really understanding the problems. Those responsible for approving the IT budget often use some type of industry average to set IT funding levels. These people seldom understand the needs of the function, or the potential of a well-managed IT department. In these cases, the most popular funding approach will seem to be the most prudent. Certainly, organizations that have underfunded their IT function for a long time are accustomed to budgetary constraints, and will not likely understand how IT can assist in moving the organization forward. In fact, underfunding so hampers the progress of the IT function that IT can at best be expected to simply hold its own. Such organizations will likely believe, based on their experience, that IT potential is limited.

4 It takes time and effort to understand the needs and potential of the organization s IT function. Admittedly, the issue is compounded by arcane IT environment. Because IT uses so much technical jargon, those outside the department will perceive its techniques and processes as overly esoteric. IT employees may compound the perception by failing to relate IT work to business needs. This background helps explain why many organizations employ averages for IT funding. Averages not only provide a baseline for IT funding, but they offer a rationale if the organization s approach to funding is challenged. Another factor that works against effective IT funding is the perception that IT is constantly campaigning for more money. True, the management costs of the function continue to grow, along with increased demands for IT service. However, IT managers seldom present their requests for additional funding appropriately. Because few such requests are well thought out, or linked to assisting the business, they are often considered unrealistic if not unreasonable. Several other negative factors affect the determination of IT funding. One is the assumption that because IT is out of control, the IT department budget is being wasted. This may result from comparing the existing IT budget to the industry average, whereby the budget figure may be higher than deemed appropriate relative to the industry average. Although viewing the department as out of control might be an emotional reaction rather than a fact, it will nevertheless constrain the IT budget. In fact, the budget might even be reduced in an attempt to bring IT back under control. The level of IT spending might also be affected by a general dissatisfaction with IT performance. The organization might even allocate some IT department funds to business units for developing their own IT-related solutions to business problems. The organization might believe that the money will be better used with this approach, and produce an improved return. While allocating IT funds to individual departments may be a good approach for some organizations, it may prove futile, unless the organizations clearly understands the issues within the IT department, and can objectively analyze IT performance levels. The organization may simply shift the ineffective use of money from the IT department to some other section, which will continue to use it inappropriately. HOW LEGACY SYSTEMS AFFECT IT BUDGETS Legacy systems present another factor significantly affecting IT budgets, by their number and quality. It is always difficult and expensive for IT installations to support the continued use of legacy systems, depending on

5 the number of systems, the level of the systems use, and the quality of the applications. Many organizations spend a lot of money on keeping existing systems operating in essentially the same way as they have for years, but that money is not being very well spent. None of the money spent on the continuing support of legacy systems will provide the organization with any long-term benefit in terms of new approaches or functions. Sooner or later, the organization must address the support costs associated with legacy systems, and how to reduce or eliminate those expenses. The IT department should consider legacy system support expenses as one of its baseline costs. Since those organizations with a large legacy system portfolio must dedicate a considerable portion of their IT budget to maintaining and operating these systems, they should ask, How much are we spending on our legacy systems? A good follow-on question would be, Would replacing these systems be more cost effective in delivering the IT services they provide? A final related question would be, What would it cost to move away from the legacy systems? When an organization has asked these questions and investigated the answers, it will be closer to determining the right IT funding level. First, it will realize that the potential liabilities associated with the continued use of legacy systems must be addressed. Second, as the organization starts dealing with the legacy system issue, it will realize that it is spending too much money on these systems. The expense is too high because the organization is doing little more than retaining the status quo. In fact, when legacy system support consumes more than 40 percent of the total IT budget, it should be considered too high. Nevertheless, in some organizations, lowering the support level for legacy systems to below 50 percent of the IT budget would be a significant improvement. Beyond the expense of legacy systems, organizations should recognize two important legacy system issues that are not related to cost. The first is the inability of the business to effectively compete, due to the technology and processing constraints associated with legacy systems, when compared to newer, more flexible systems that the organization s competition may be using. The second issue relates to the organization s risks in continuing to rely on aging legacy systems. One risk factor is related to the constraints of legacy systems, which deter the organization from moving to more effective ways of meeting customer needs. The organization also faces the risk that something will occur within the aging legacy systems, rendering them inoperable and causing serious business consequences. The issue of legacy systems helps fuel the contention that IT expenses are too high, and that not enough IT function is being delivered for the funding provided. Because there are better overall methods to do the work of the legacy systems, the expense may indeed be too high.

6 In addition, legacy systems present expenses beyond routine maintenance and operation. Because those systems often form an integral part of the organization s business applications, they will likely require constant code changes to meet changing business needs. And making these changes can be expensive. In the first place, legacy systems are seldom well documented. Because the systems are old, code changes will require lots of trial and error before the new or changed code will work correctly. In addition to poor documentation, the code itself may be poorly written, requiring a considerable amount of rework and testing, with a high associated cost. In addition, changes made to one area of code may well create problems in other areas of the application. Some organizations that require business changes rely so heavily on legacy systems that they do not dare risk making the needed changes. Instead, they devise some type of subsystem to provide the required information outside the legacy system. However, while such an approach can work, it represents a jerry-built solution, adding one more step to the process, requiring additional controls, and opening up the system to an increased possibility of error. Changes to legacy systems open the organization to another potential vulnerability. Despite an organization s care and testing when making corrections, it can introduce errors that show up at a later date, perhaps somewhere downstream from the applications where the changes occurred. Realistically, however, business demands will require that changes be made. Certainly, if a legacy system fails, bringing it back into production can be very costly, when measured in both hard and soft dollars. The hard dollars relate to the salaries of those getting the application back into production. While the employees are already on the payroll, and may not therefore be seen as requiring additional expense, there is also the cost issue associated with lost business opportunity. If the employees were not required to address the legacy system problems, they could have produced more value to the organization. It is also possible that the organization cannot support the failed legacy system because no employee has experience with the system s technology. In this situation, the organization must go outside for help, requiring a high hard-dollar expense. An additional expense here will be ensuring good documentation for the work done. Soft-dollar expenses associated with the failure of a legacy system can easily cost more than hard-dollar costs. Since the legacy system is probably important to the organization s business operation, its failure will adversely affect business functions. As the problems associated with legacy system failure move outside the organization and begin affecting customers, the problems can grow rapidly. Soft-dollar items that can rapidly injure an organization s reputa-

7 tion include incorrect billings, orders that are improperly entered into the system, or the failure to ship goods. Such a situation offers considerable competitive advantages to competitors. Sometimes, an organization will argue that the continued use of legacy systems represents a sound financial approach to IT expense because the longer the system is used, the higher the return on the original system investment. Because IT systems represent a high expense, it does make sense to maximize the use of those systems. The key is recognizing when to replace the systems. An organization that sets appropriate levels of IT funding can best determine when that time has come. Those organizations addressing IT funding may be facing a serious reduction in business, and need to cut expenses across the entire enterprise. In this case, the IT department can expect the same budget reduction level as other areas of the organization. And the business units may well turn to IT for automation to compensate for a headcount reduction. For IT, this may signal an opportunity to improve the performance and value of the department, but it may also require additional IT funding, or at least forestall a reduction in the IT budget. RETHINKING THE PROCESS While dealing with the IT funding level will be different in every organization, some general assumptions can be made about improving the process, and a set of criteria can be developed as a baseline. As the organization begins the process, it must determine what it wants from the IT function, and decide what it will cost to get to that level. If the cost is greater than the organization is willing or able to afford, it must develop priorities the same as it would for any other business issue. In addition, it will take considerable time and careful thought for an organization to develop an IT budget in this way. SETTING REALISTIC EXPECTATIONS When IT funding is considered too low, it might be that the service expectations of internal IT customers exceed the department s funding level. It is not unusual for people in other departments to want new or expanded services from IT, which IT management should not view as entirely negative. Rather, in attempting to increase the IT department s funding, it helps to identify and tie costs to these demands. However, when an IT organization is underfunded, unfulfilled expectations of IT customers tend to be seen as IT failures. The problem here is not inadequate funding; it relates instead to unrealistic customer expectations. In this area, IT managers and people in the business units can work together to improve their respective functions. The IT manager can request more money to meet the demands of IT customers. For their part,

8 people in the business units who have requested additional IT services, can explain why these services are needed, and should justify additional costs as due to increased benefits. In some IT installations, while the funding level is very low, the organization is pleased with the performance of the function. It may be that the low IT budget is adequate because the department is exceptionally well managed. Alternatively, the organization s senior managers may not have high expectations of IT. DEVELOPING AN IT VISION In order to derive the greatest benefit from their IT function, organizations must develop an understanding, or vision, ofvalue and role of IT in the organization. In this context, several issues should be recognized: 1. The organization must understand that IT work is expensive, and will be so for the foreseeable future. Although hardware and software costs are declining, the lower prices are offset by growing demands for business services, be they increased functions or new applications. Meeting those demands requires more powerful hardware and more sophisticated software. In turn, higher levels of IT sophistication mean higher training expenses. 2. As IT technology grows and changes, organizations that use the technology for competitive advantage must increase their competence level accordingly. This requires adequate, long-term IT funding. 3. Sooner or later, the organization must address its legacy systems, taking appropriate actions to deal with them. 4. Disposable applications are becoming a reality, with the era of 15- or 20-year-old legacy systems rapidly drawing to a close. Soon, organizations will consider five-year-old systems as having a long production life. Rapidly replacing major IT applications with in-house or packaged software will become increasingly expensive, which will in turn affect IT funding. 5. Unfortunately, while IT investment can be deferred, it cannot be deferred indefinitely. At some point, the money will have to be spent. When organizations delay the appropriate level of IT funding, the cost will rise appreciably. CONCLUSION This article has addressed the way in which organizations can and do develop IT budgets. Although there is no one right way to determine these budgets, IT performance will improve if organizations think about the process, and move toward approaches that better fit the particular organization. If the current IT budgeting process does not suit the organization, changing it will benefit everyone. It is also critical for senior management

9 to have realistic expectations of the IT function, and to understand the relationship between IT funding and fulfilling these expectations. John P. Murray has more than 35 years of experience in the IS field. The author of more than 150 articles, he is currently a consultant in Madison, WI.