Six rules for finding IT value

Paul Strassman has a relatively older article that has a rather frank discussion on finding value in IT projects. Given my interest in the enterprise application software, which could be classified as one gigantic IT project which has nothing much to do with IT, this article certainly had my antennae up.
Paul begins:

So far - to my best knowledge - nobody has been able to demonstrate that there is a positive correlation between money spent on IT and sustainable profits.

Alright, that's one swing from the bat but let's see if it is on target...

Sure there are articles about the positive contributions of IT. But the proof could be applied to justify greater IT spending as a sure cure for poor for poor financial numbers is still missing. The quest for demonstrating the directly measurable value of IT can be added to the list of fascinating but hitherto unfulfilled ambitions to attract academic fame or consulting contracts.

And quite importantly...

What is always missing is a repeatable technique for performing the calculations that would satisfy a firm's methods for making investment decisions

Alright, Paul is not denying that IT investments contribute/create value for the firm but that a direct measurement of that value created/contributed is so far lacking and when provided is not repeatable in other contexts. I would hazard a guess that demanding controlled repeatability in the real world is an idealistic requirement which is more to be found in the scientific world than the business world.
He continues:

Nevertheless, there are ways of finding IT value - it's just that they are all indirect.

He has outlined 6 key rules that might direct an investigator as to where to look for IT value:

Rule #1: Follow the money - The decisive contribution to an enterprise's profitability is its capacity to manage purchases. Ergo, that is where the contribution of IT should be maximized as that is where the greatest opportunities are - primarily in improving the management of the firm's purchases and in simplifying transaction costs. The relationship between purchasing, transaction costs and profits has not been adequately exploited.

According to Paul Strassmann, purchases account for 54%, transaction costs account for 23% and COGS (Cost of Goods Sold) account for 17% of corporate costs which together account for 94% of corporate costs.

Rule #2: Do not let accountants measure value - The greatest obstacle to the demonstration of IT value can be found in conventional accounting methods. Accounting practices deal exclusively with tangible assets, which explain only 20% of the shareholder worth of profitable firms.

I would tend to agree that the above is so true because while accounting measures a firm's assets, it should actually be in the practice of measuring value for internal reporting purposes and that is a request to deal with the intangibles of running a firm.

The worth of the accumulated knowledge of employees, of software, of databases, of organizational capabilities, and of customer relationships does not show up on the general ledger, even though the worth of IT is best reflected in what it contributes to the capacity of people to deliver greater value to customers. Consequently, much of the potential of IT is lost when projects that would increase knowledge capital are said to contribute only to "intangible benefits."

I came across precisely this conundrum while consulting with a manufacturing firm and bringing in Quick Response Methodology in order to improve their manufacturing processes and specifically the lead times on the. The accounting specialist had the idea that the development of new processes and specifically new improved tooling, jigs and fixtures would mean lower manufacturing costs for the firm. I disagreed by pointing out to him that it would mean increased manufacturing and maintenance costs but would dramatically reduce the lead times that the firm was experiencing. That was a dead-end and we beat around the bush for close to an hour and I couldn't convince him. Of course, the problem was the accounting is about tangible assets - what exactly is the worth of reduced lead times - in some cases, we had projected lead time reductions of 60% or so by putting in QRM cells. On the ledger, reduced lead times equalled precisely zero value and increased maintenance costs accounted for net increase in costs.

Rule #3: Focus on shareholder's value - A shareholder perspective will reflect the reality of all financial decision making: you cannot determine the worth of past decisions without the benefit of perfect (and unbiased) hindsight. It follows then that it is not possible to state what share of profits today are attributable to IT decisions made in the past. Therefore, proving rigorously what is todays value of IT as a percentage of current profits cannot be known.

Paul's stress on shareholder value is rather enligtening and his method of comparison roughly breaks down as a comparison of the two branches of making a decision of a particular IT investment:
1. Calculated the discounted present value of cash (using shareholder's cost of capital) as if the firm was making not making the proposed IT investment
2. Calculate the discounted present value of cash as if the firm was making the proposed IT investment assuming some profit plan going forward
The difference of the two should give the value of deploying that particular IT project.

All you are left to do then, in the quest for valuation of IT, is to evaluate the best decision you can make at the time when you commit to a credible plan. The logic of such reasoning propels you to the most obvious conclusion: making no changes to IT as it is presently can be the only valid basis from which all other options can be assessed. If your budget inquisitors can accept such reasoning, you may be able to claim (and get away with it) that the value of IT can indeed be calculated using conventional methods of financial analysis.

Rule #4 - Commit to value after discounting for risks -

Here Paul suggests coming up with various scenarios that reflect the degree of risk and consequent expected payoffs in order to communicate to the various parties the impact that risks bear on the forecasted profit plan and the expected value derived from the investment under these conditions.

Are they [risks] technological (even though that is nowadays a rare occurrence)? How much of the risk is managerial (recognizing that this is the primary culprit in every failed IT venture)? The implicit purpose of early risk recognition is to initiate early risk-containment countermeasures. One of the principles of generating value is to focus not on winning - a compulsion of all technologists - but on making sure that you do not lose - a characteristic of all prudent investors.

Further more,

The benefit of any risk management approach to making IT investments will be to reduce the discount factor used in the calculation of the present worth from a high-risk to a lower-risk premium. This will allow shareholders to accept even seemingly risky IT proposals.

Rule #5 - Keep away from revenue ratios -

Here, I can only plead fuzziness (or ignorance). I can glean from Paul's illustrations and figures that revenue/employee ratios are a less reliable indicator of the effect that investments in IT have on generating additional revenues. Perhaps, one should take away from this suggestion that making revenue ratio comparisons across firms in similar industries or disparate industries is not such a great idea when it comes to comparing the value added by IT at these companies. However, I think that I will need to do some more research about this in order to be convinced. Or if somebody else were kind enough to guide me along...

Rule #6 - Justify the infrastructure -

Paul offers some helpful advice on how to present a well-reasoned case to justify IT investments and he elaborates on three steps that are necesary to demonstrate the value of investing in such IT infrastructure. They are:
1. Demonstrate ongoing cost reductions - Paul demonstrates this in his article by showing the discounted ROI made for IT projects
2. Demonstrate the effect that IT investments have on operational effectiveness - Paul demonstrates this by alluding to the greater productivity/efficiencies that are gained by deploying IT in other functional areas such as Logistics, Planning etc
3. Demonstrate strategic gains - Paul demonstrates this by calculating the discounted ROI extracted from all the IT projects under consideration.

In conclusion, perusing this article was quite an eye-opener for me because it was instructive about how to make a reasoned case for justifying IT investments specifically in areas such as SCM. There are other articles by Paul Strassman at this site and I'm sure that they will be worth your while to sift through.

Tags: IT Investment, Discounted Cash, IT value, IT Risk Management Paul Strassmann

posted by AJ @ 1:35 PM