How to profit from technology

To make IT a source of business value you have to get to grips with financial metrics and risk. Ian Grant looks at the different methods

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." 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 >>

IT investment value at Intel >>

Do Gateway reviews produce results? >>

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