There are 2 reasons why IT cost cost reduction strategies are so difficult: Firstly, many of the benefits of ICT are intangible and it is difficult to trace their origin. It is hard to determine the value of increased customer service or the increase in productivity from better search and retrieval of information. Secondly, many of the inputs which actually make IT systems work are left unaccounted for and unaccountable. The management glue which implements the systems (often poorly and contrary to the architecture) and the project tools, systems and methods which build/customise the system (because IT, unlike standard captital goods, is often maintained as a going concern under constant development, e.g. upgrades, customisation, workflows etc) are very difficult to cost.
Standard IT cost models only account for the hard costs of the goods and services necessary to implement and maintain the infrastructure, applications and ancillary services. Anything more is believed to be a project cost needed to be funded by the overhead.
This is unsatisfactory.
The value of technology systems – embedded systems excluded – is in the ability of information workers to apply their knowledge by communicating with the relevant experts (customers, suppliers etc) within a structured workflow (process) in order to achieve a corporate goal.
Capturing the dependencies of knowledge and process within the cost model, therefore, is critical. Showing how the IT system enables the relevant capability is the critical factor. A system is more valuable when used by employees who are trained than less trained. A system is more valuable when workers can operate, with flexibility, from different locations. A system is more valuable where workers can collaborate to solve problems and bring their knowledge to bear on relevant problems. So how much is knowledge management worth?
The full cost of a system – the way they are traditionally modelled – assumes 100% (at least!) effectiveness. Cost models such as COSYSMO and COSYSMOR account for internal capability with statistical coefficients. Modelling soft costs such as information effectiveness and technology performance helps the business define the root causes of poor performance rather than subjective self-analysis. If a firm makes the wrong assessment of capability scores in COSYSMO the projected cost of an IT system could be out by tens of millions.
Financial models for IT should therefore focus less on the cost of technology and more on the cost of capability. The answer to this is in modelling soft costs (management costs), indirect costs and project costs as well as the hard costs of the system’s infrastructure, apps and services.
In our last blog we recounted that most ICT cost reduction programs fail. More to the point, we noted how they fail in larger businesses through a vicious cycle following increased overhead from poor process analysis. All this stems from a limited view of direct and indirect ICT spend.
In summ, the answer is detailed cost modelling of ICT which analyses the firm’s technology in its place as a business capability enabler. This is vital in the current economic climate otherwise businesses will simply benchmark their costs against similar firms rather than try to pare ICT costs to the bone.
The results of traditional IT programs?
- ICT cost reduction programs usually only attack the easy and obvious. For sustained cost management in ICT the cost reduction program needs to attack: (i) soft costs (indirect spend), (ii) managerial costs and (iii) program costs as well as all the standard hard costs.
- Cost cutting reduces capability. Traditional approach is to cut applications and services as well as heads but capability will eventually suffer. Senior people are often made redundant was work is pushed from higher to lower paybands. With them also goes much of the firm knowledge capital and goodwill of the firm. If we want to quantify this cost of lost knowledge it is the difference between the market value and the book value of a business.
The problem is that IT is usually seen as a black box. Few senior executives understand the subtle dependencies which stretch from technology throughout the business. More importantly, few understand that actual capex and opex of ICT just represents the hard costs of ICT. In addition to the hard costs are the soft costs, the management costs and the program costs of ICT. In more detail:
- Soft Costs relate to all the indirect spend which flows from ICT procurement. This may include travel for non-IT personnel involved in change, training and customisation or process change etc.
- Managerial Costs is the accumulated cost of decision making from management. This is pure overhead and is not accounted for in the Cost of Goods Sold but rather shows up in bloated Sales, General & Administrative (SGA) accounts.
- Program Costs are the costs of running ICT programs beyond the costs accounted for in the various cost allocation systems. These can be the cost of running distributed teams, the cost of low development capability etc. Such cost coefficients are statistically generated.
On top of all these are the hard costs of ICT.
Borrowing diagrams from Accenture the solution is to run a 3-tiered cost reduction strategy:
After the easy stuff is done, the business must ultimately streamline its processes (and align cost structures accordingly) and then lower it non-discretionary spend. The key is to (i) see the whole process, (ii) understand the dependencies, and (iii) engage locally.
- Minimise (Hard Costs) – Tactical Cost Reduction. Grab the low hanging fruit and take out the obvious costs; the costs in plain sight. Engage locally with account managers and business unit leaders to reduce headcount but understand and model the dependencies by seeing the whole capability. The Boston Consulting Group advise that managers proceed on third of a third rule, ie 1/3 of all FTEs are non customer facing and 1/3 of those can be removed without adverse impact on the business.
- Optimise (Soft & Program Costs) – Proactive Cost Governance. This involves detailed spend analysis and process optimisation. Indirect process costs grow like barnacles on a ship. The longer they are there the more they are accepted but ultimately they increase the financial drag on a business. Remove all the invented tasks by modelling the firm’s value chain and seeing where the processes fit into larger business capabilities. Once this is done executives can optimise the key cost drivers and their inputs. This improves the delivery model for ICT and enables better demand management. Accompanying these operational actions the business should improve cost governance. It can achieve this by removing the management structures around excessive process governance. This requires a more active and dynamic GRC system but ultimately the business feels a lighter GRC touch. Most importantly, simplify processes and remove the ‘cost of complexity‘ ie vertical integration and convoluted workflows which increase process time and transactional costs.
- Re-design (Program & Managerial Costs) – Strategic Cost Management. In order to achieve significant and lasting cost reduction benefits the business must lower its discretionary spend. However, managerial cost structures (which are significant) can only be made redundant when the overall complexity is reduced. Once this happens shared services may be implemented and rationalised. The ICT offering can be standardised and the business can create re-usable technology components. Then the business can change its transfer pricing models and look towards offering the customer-facing SBUs a more sophisticated multi-channel mix of capabilities, ie give them the agility to increase their high-end customer offerings. Only once this is achieved can the business look towards modernising and streamline technical architectures.
The key is to look at ICT as a capability enabler and not as a business unit in its own right. ICT should have to justify its very existence. However, once it does and develops full cost transparency then and only then can it move forward in real partnership with the business.
In a crisis the company P&L statement can be a useful starting point for cost reduction programs. Over the long term, however, general ledger entries do not have the required level of detail to garner the requisite per unit analysis (McKinsey, May 2010). Unfortunately, few companies do not have systems which can analyse the complexity of cost and spend in order to make accurate and detailed changes.
In the following series of blogs we will highlight the problems with standard ICT cost reduction & management programs and detail how to structure and run one effectively.
The key to an effective ICT cost reduction & management program is detailed cost modelling. Most financial systems do not capture costs at the right level of detail for businesses to perform accurate and detailed cost reductions. Businesses need to perform intricate spend analyses and build up intricate cost models for ICT which highlight the following:
- The capabilities which various ICT components support (and where in the Value Chain they lie). Only through this level of visibility can the business consolidate their ICT spend.
- The HR and process dependencies which are indirectly attributed to various ICT elements. Only with this level of detail can ICT remove duplication and redundancy.
In the absence of this granularity, cost reduction programs invariably fail or fail to stick. In fact, McKinsey & Co note that 90% of cost reduction programs fail. Only 10% of these programs actually succeed in realising sustained cost management three years on.
In a typical IT cost reduction cycle the following happens:
- Headcount is reduced. The remaining people then have to work harder (but with fewer skills, because tasks are pushed to the lower pay bands) to achieve the same amount of work.
- Many, often unique, soft skills are also removed (from experienced people in the higher pay bands) in the redundancies.
- Overall service levels decrease.
- Further cost reductions are then required and some applications and services are axed.
In simple businesses this is not a problem. In large and complex businesses the outcome usually follows a vicious cycle, namely:
- The firm still needs to retain a significant management overhead in order to deal with complexity.
- In these cases, poor transfer pricing and high overhead allocations mean that perfectly good, competitive core business process seem cost-ineffective.
- Critically, Kaplan notes in his seminal work “Relevance Lost: The Rise and Fall of Management Accounting” that the increased costs of processes leads to outsourcing of perfectly good processes.
- Capability suffers and the business loses competitive advantage.
- The business is no longer able to deal with the level of complexity and complexity reaches an inflection point. The business outsources the whole problem (eg, large ERM programs with much customisation), getting locked into horrific terms and conditions.
- Core business is lost and competitive advantage is reduced. Remaining managers pad out their budgets with excessive risk and contingency in order to shield themselves from further cost reductions.
- Overheads increase again and the business eventually prices itself out of the market.
In a recent (2010) Accenture survey on general cost reduction effectiveness in the banking industry, 40% of respondents noted that the program has reduced overall ICT effectiveness and impacted adversely on both customer service and general management.
in order to reduce costs effectively without impinging on capability as well as making new costs stick, it is essential to view costs and spend at the most granular level possible.
In our next blogs we will go into detail how to structure and run an effective ICT cost reduction and cost management program including effective ICT cost modelling.