Is IT Worth it?

RISK in IT Capital Budgeting

RISK is by far another misused term after ROI in IT.  It is often used to describe "the probability of the unknown" - maybe I am giving too much credit to the ones who use it!  It is also used to make IT decisions most ambiguous.  Lastly, it is a great CYA term - "what is the RISK of this decision?" - was never sure what people mean by these statements.

Anyways, let us define RISK in more real-life terms.  RISK is the probability of an unknown event that may lead to a LOSS (a non-deterministic behavior or Stochastic process).  It is driven by two factors - unknown outcome of a decision - attributed to lack of Information , and randomness of the assumptions used in making a decision - attributed to lack of Statistical rigor in evaluating assumptions used in a decision.  We can minimize RISK by minimizing these two factors that drive RISK

IT decisions are mostly centered around investments in new technology and/or in new talent.  These are usually to address new business automation needs to accelerate the speed to do business.  In this context there are basically two factors that define the value of the business opportunity:

1. The "expected" cash-flow arising from the new business opportunity
2. The "risk" associated with the business opportunity arising from:

• The impact of "chance" in the decision or randomness in decision-making
• The impact of the "unknown" in the decision - or the impact of "Information Asymmetry" (lack of information) on the decision

Hence, the problem centers around identifying the "unknowns" in the decision so that appropriate steps may be taken to "mitigate" their occurrence because "randomness" cannot be foreseen or mitigated.  Rest is up to the "Marketing Einsteins" to forecast the expected cash-flow from the business opportunity.  The pursuit to "attempt to know the unknowns" is an oxymoron.    The question is how should executives make the decision in the "right" way rather than how to make the "right decision". 

Enter IT Finance...

The traditional way to ascertain the value of the IT decision would be to do a Discounted Cash Flow on the current state and compare it against the "expected future state" and then do a NPV (Net Present Value) of the expected net savings to demonstrate the value of the decision.  If the NPV is a "large positive number" then it is a good proposition.  Subsequently "expected future state" is compared to the "expected revenue forecasts" made by the Marketing Einsteins to demonstrate that it is a great opportunity and they must immediately embark upon it to make the "expected" millions...
A few things are ignored in this type of a valuation - the company's cost of capital is treated as "constant" over the period of the valuation, the expected cash flow is "expected" and the assumptions are all held constant over the duration of the valuation.  Once the project is undertaken, new nuances are discovered and the "loss" portion of the project starts creeping in.  Managers are blamed, Vendors are chastised, a few senior heads roll and the project is ultimately scrapped ... the death of a "potential" value-creation opportunity.  Sometimes proof of concepts are initiated, however very rarely is the outcome taken to re-calibrate the "expected future state" of the project.

However...
IT Capital projects can be broken into small investments each consisting of a "proof-of-concept" or "try-out" phases where the assumptions may be re-visited to re-calibrate the expected future state.  In other words, these "proof of concepts" serve as the opportunity to mitigate the Information Asymmetry of the decision leading to reducing that portion of the Risk and re-calibrating the "expected future state" at a lower level of Risk.  Using simple simulation models and with the use of simple real-options concept the executives may be able to re-visit their decision at periodic intervals to ensure whether the project is still a "positive return" investment.

In a nutshell...
Remove the Information Asymmetry by giving importance to "proof of concepts" and gathering the data to revisit the financial impact of the project. This reduces the Risk (I can now define Risk as the Standard Deviation of the Net Present Value or the Strategic Value of the project) and provides transparency to IT finance to advise the IT executive to make the right decision at the right time.

Doing IT the ROIt way...

The term ROI is the most misled and misused term when evaluating the true potential of a given technology.  Vendors use ROI as the "silver" bullet to prove how good the investment is if made in their offering, CIOs use it to look smart in front of the vendors, Corporate Finance uses yet another method to calculate the "true financial impact" of technology investments. The main issue is ROI is a point in time metric i.e. it only tells us the Net Gains from an Investment.  Let us take an example to illustrate how this works.

Example:  We need to invest $500K in some new piece of software that automates the billing department.  By investing in this we can free up 2 billing clerks who are annually paid $50K each.  The cost of training the other people in the department is $50K and is a one time expense. The annual maintenance on the software (charged from year 2) is 10% of the price

ROI (Year 1) = ( ( 2*100) - (500+50) ) / (500+50) = -64%

This is misleading as from the second year, there is a Net Savings of (2 * 100)- (10% of 500K), which $150K on an ongoing basis.  Hence, by just looking at the ROI of the project, it does not look like something that we should invest in.  However the NPV for a 5-year period (Net Present Value) of the project is $76K (assuming a 14% Cost of Capital), and an IRR (Internal Rate of Return) of 26%.

Hence, from a pure Corporate Finance 101 perspective, this is a project that we should embark if we look at the NPV and IRR, however this project is a "no-go" if we just look at the ROI.

To summarize, we need to look at stronger long-term metrics such as NPV and IRR rather than just the ROI of the project.  It is important for IT organizations to see the impact of a Capital Investment on their long-term operating structure and to explore "value-creation" opportunities rather than look at a "point-of-time" measurement - Return on Investment (ROI)

IT Organizations or Second Class Citizens...

Corporate America treats IT organizations as "Cost Centers" better known as second class citizens.  This goes back to my previous post on "Corporate Finance for Techies...".  Most of corporate IT comprises professionals from an architecture, application development and IT operations background with the "degree in eliteness" in descending order.  Architects think they drive technology in the enterprise, Application Development Teams (if there are any - mostly the architects are embedded in these teams.  They still consider themeselves the elites) think they do the "Real Work" and IT Operations laugh at the other two and think "if it were not for us...you guys would be nowhere".

On a more serious note, I often think why is this the case?  Firstly, why is a department that is the latest addition to the other more conventional ones such as Finance, Sales and Marketing, perceived as a "Cost Center".  Simple answer - CIOs don't do a good job of two things.  Firstly - they do a poor job of correlating the value of their organization's output to the Enterprise Value of the firm.  This is because they are incapable or going after the "quick wins" and "low hanging fruits" - which are tactical and mostly do not add or augment Enterprise Value of the firm.  Secondly - they are not "forward looking".  In other words, they do not "think" about using "IT as a Revenue Generating" catalyst as much as a "Cost cutting tool".  Those that do, come up with disruptive and Killer Apps - Internet Retail Banking, Online Payments, Online Trading...I can go on.  One can argue whether these ideas originated from the business or from the technology community.  I would argue - they orginated from technologists who were interested in making their firms "earn more money" than "save more money".  They were thinking of what Gary Hamel terms as the "Opportunity Share" of a market that is non-existent at that point of time.

So why are IT organizations second class citizens?  Finance does not bring in revenue - but does not have a reputation like IT.  I think it is due to this inherent nature of technologist to experiment, perfect and be proud to flaunt a "cool new gadget" or "solution" and NOT focus on trying to help their firms generate more revenue.  It also due to their nature about trying to solve the 20% of the problems which have insignificant or a very low impact (positive or negative) on the firm's bottom line.  Basically it is also due to the "Capex heavy" and "Opex bleeding" nature of the department.  Every business case for a new IT project has a "Hardware", "Software" and "Professional Services" sections.  All this adds up to a VERY LARGE NUMBER which DOES NOT TRANSLATE to ENTERPRISE VALUE" - I am just a stickler for Enterprise Value.  Every department's existence in Corporate America or any other economy must be contingent about their ability to add "value" to their firm.

IT Organizations (comprising architects, developers, testers and operations personnel) have to think "Revenue" NOT "Cost".  It is not a paradigm shift - it is just trying to figure out a way to extend their thought-process to transform the "coolness factor" of a "new gadget or solution" to "add value" to the firm.  Putting it simply - they have to get out of the "solution mode" and start their thought process from "What business problem am I solving" or better still "How can the coolness of this new technology add value by generating more Revenue for my firm".  Believe me if they just start thinking on these lines - we would have more killer apps.  Killer apps are an after thought - though technologists think they know what is a killer app.  Suppliers of IT products and services consider their products no less than a killer app.  However, it is the problem that these apps finally solve makes them a killer app.  On the demand-side of IT, the CTO organization is rarely thinking of "value" or "revenue".  They think in terms of "cost", "process automation", "reduction in manual processes" - all geared towards automating manual business process with the use of technology.  Why is it that they do not learn from the examples of Online Banking and Online Payments that IT can be also be used to generate revenue...

What is really tragic is the mypoic perspective of CIOs and CTOs.  They are there to "fix" a problem.  But they are fixing the symptoms or saving their jobs.  Hence the short life span - 18-24 months on an average.  I think they are to be blamed for turning the IT Organization into a second-class citizen.  CIOs and CTOs assume that their job is to cut costs by automating business processes (which is not a bad beginnning) and "keep the lights on" - as they say.  As more CIOs/CTOs try and introduce visionary and breakthrough solutions to existing and anticipated business problems, this trend may change.  Companies with those kinds of CIOs/CTOs fall in the top 10% of the leading companies in any industry vertical - Schwab in Financial Services, DELL in Online Hardware Retail, Amazon in Online Retail Aggregation to name a few...Others are mediocre companies that do not believe in IT as a differentiator - or I would say that there CIOs/CTOs do not have the courage to think so as they "assume" too much about their job responsibilities and do not want to make a difference...