It is nearly 20 years since Harvard professor Michael
Porter wrote, "Firms will not ultimately succeed unless they base
their strategies on improvement and innovation, a willingness to
compete and a realistic understanding of their national environment
and how to improve it."
It is a message largely ignored by CIOs and accountants. IT
professionals have failed to produce a standard, recognised and
widely applied system for accounting for the value of intangible
assets such as knowledge, know-how, innovation and
competitiveness.
As a result, many IT managers are stuck with tools that are
unfit to assess investment in systems intended to create greater
customer insight, improve the effectiveness of products and service
delivery and deliver a sustainable competitive edge, all of which
lead to profit, and hence survival.
Michael Blackstaff is the author of
British Computer Society book,
Finance for IT Decision Makers, and is a frequent lecturer on the
topic. "In my 40 years' experience, I have found that many people
who make or influence IT decisions do not really understand the
standard financial evaluation methods, let alone the fancier ones,"
he says.
These standard tools are typically
return on
investment,
net present
value,
internal rate
of return and
payback period.
By and large, these are effective in analysing the hoped-for
returns from a project or capital asset and for comparing one
project with another. But they have little to say about what is
probably the most valuable part of an IT project, namely the
data.
That is not to say that businesses are unaware of the importance
of IT to their operations. Tesco, the UK's biggest retailer, notes
in its annual report, "We recognise the essential role that IT
plays across the group in allowing us to trade efficiently, and
that we can also achieve commercial advantage through implementing
IT innovations that improve the shopping trip for customers and
make things easier for employees."
Tesco.com is just one example of how integral IT is to Tesco's
success. The online shopping service now has 750,000 regular
customers who place more than 200,000 orders a week, which is
almost 3% of total sales. Last year this was worth £56.2m (3.54% of
total profit) on sales of nearly £1bn.
Many sectors are so dependent on IT that there is no business
without it. However, efforts to measure the return on investment on
IT often end up measuring the return on capital spent on the
business as a whole.
Make, buy or rent IT?
Every enterprise faced with a potential IT investment must
decide whether it is better to make, buy or rent the system.
Authors such as Nicholas Carr argue that IT is now a service much
like electricity, and that it should be acquired on a pay-per-use
basis.
Since many applications such as payroll and accounting are
common, they should be outsourced to more efficient specialist
utility firms, Carr argues. This should result in better process
efficiency.
McKinsey consultants David Craig and Ranjit Tinaiker, writing in
Divide and Conquer: Rethinking IT Strategy, acknowledge that for
many CIOs, "The job is simply to keep the e-mail working and
deliver narrowly focused projects, not to champion investments in
innovation. But focusing exclusively on bottom-line costs limits
the top-line potential."
Craig and Tinaiker argue that companies should adopt a portfolio
approach to IT systems, in the same way that they would segregate
investments in financial or product development.
They suggest that as much as 60% of the IT budget should go
towards "staying in the race", meaning maintaining and enhancing
core services, meeting compliance rules, e-mail and websites.
Another 10%-30% should go to "winning the race", meaning lowering
costs or improving productivity compared with competitors.
"More difficult to manage is a small category of high-risk,
high-reward investments that focus on changing the race:
innovations that open new markets or make it possible to offer new
products or services that are substantially different from and more
desirable than those of competitors."
This approach allows IT managers to trade risk and required, or
"hurdle", rates of return. It also provides a potentially deeper
insight into the make-buy-rent decision.
Intangible assets
IT and the business must agree ways to value knowledge and other
intangible assets, according to Karl-Erik Sveiby, professor of
knowledge management at the Hanken Business School in Helsinki. He
argues that for information to be valuable, it requires context,
timing and someone capable of acting on it.
"Information is meaningless in itself. Each piece of information
has to be interpreted by the reader. My argument about the value of
information is not that it is wrong to regard information as
valuable, merely that we should reconsider our mindsets about the
value.
"I would suggest that a lot of money is wasted because we allow
unreflected notions about this fundamental concept to guide our
actions."
Typically, the value of brands and intellectual property such as
patents, licences and know-how seldom make it on to the balance
sheet, even though the cost of creating them passes through the
profit and loss account. Their true value is reflected in the share
price, Sveiby argues, but remains uncounted in unlisted
companies.
Pin down the value
In a Forrester paper, Measuring the Business Value of IT, Craig
Symons identifies four ways of pinning this value down. "The key is
to adopt one method and begin using it," he says.
The four methodologies Symons identifies are the Business Value
Index, Total Economic Impact, Val IT, and Applied Information
Economics.
Intel developed the
Business Value Index and has used it to evaluate several
billion dollars' worth of IT projects since 2002. It is also freely
available over the internet.
The Total Economic Impact methodology adds a way to quantify
risk and incorporate the value of flexibility to the Business Value
Index.
Val IT was developed by the
IT Governance Institute, which
also developed the Cobit governance regulatory and compliance
framework. Val IT uses a highly structured analysis of the business
case for the proposed IT investment and requires ongoing updates
totalling "three key processes containing 41 key management
practices".
Although used extensively by the Dutch ING Bank, Val IT remains
a work in progress, says Symons.
Applied Information Economics, which was developed by Douglas
Hubbard, is the most rigorous of the four, in Symons' opinion.
"Applied Information Economics uses a 'clarify, measure, optimise'
approach to assessing IT investment alternatives, even when they
are 'intangible'," he says. "Its strength lies in its ability to
conduct a true risk-return analysis based on proven methods that
have a known statistical validity."
Symons argues that "There are no IT projects, only IT-enabled
business changes", and in saying this he ties IT back into the
business. Indeed, the business case is the fulcrum about which
everything - including return on investment estimates - turns.
Symons adds, "At each review a decision must be made to continue,
accelerate, reduce or eliminate the funding for the
investment."
Manage uncertainty
Hubbard's number-intensive Applied Information Economics
methodology helps pin down the costs and benefits of projects where
the outcome is uncertain. Projects that use Applied Information
Economics range from a new PC replacement policy, to software
development, to estimating the fuel required by US Marines in
Iraq.
"Some people are good at judging odds - bookmakers are good,
medical doctors are very bad. IT managers are in the top tier of
optimists, but their track record is bad," Hubbard says.
He says it is partly to do with the increasing complexity of the
world they manage. "Complexity increases uncertainty, but
information decreases complexity, which leads to better decisions,
which leads to better outcomes that we can measure."
So, what is the value of information? Hubbard's answer: the cost
of being wrong multiplied by the uncertainty of being wrong.
"Information is not an intangible," Hubbard says. "In fact, all
intangibles can be reduced to a dollar value if you work on the
risk/reward ratio and are content to deal with range values."
And pretty much everyone except, it seems, CIOs and accountants,
manages to deal daily with range values rather than what Hubbard
calls point values. "IT managers are decades behind in terms of
dealing with uncertainty," he says.
According to Hubbard, the best guesses or "gut feel" of
experienced people dealing with familiar problems are often
remarkably accurate. But they fare no better than average when
taken out of their comfort zones. Hubbard claims people can learn
to be better guessers using calibration techniques such as Monte
Carlo simulations, weighted scores and Modern Portfolio
Management.
"People may still go with their gut feel, but we can show
empirically how much more accurate they can be, and more
importantly, what the real trade-offs are and where the real value
lies. And when you start seeing things through an actuary's eyes,
it is amazing how different the world looks."
Hubbard says a comprehensive project evaluation using Applied
Information Economics typically costs less than 2% of the project
budget, subject to a £500,000 minimum. "Of course Applied
Information Economics works for smaller systems, but I would argue
that if you are going to spend more than £500,000, a properly
quantified risk/reward assessment should be mandatory," he says.
This is because a big enough system is likely to have 80 to 100
variables.
If IT managers do test for variables, most IT projects will pick
one or two key ones, he says. "This probably leads to a lower
economic value delivered over the long term."
Of the many variables, which is the best predictor of a high
return on investment? "User adoption rates have a very high
correlation with high economic value returned," Hubbard says. "It
leverages highly all other benefits as well."
Hubbard's research site
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