"We've got to manage clients' expectations." I hear that phrase from executives in service-provider organizations (like CIOs) all the time, and I hate it. It evokes the image of manipulating others' feelings.

But the problem is real. Clients generally expect more of an internal service provider like IT than the organization can deliver with its limited resources.

Will, the CIO in a not-for-profit health-care provider, got through the budget planning process, and as usual, the watch-word was "cut!" He ended up with fewer resources and even more "keep the lights on" operational work (thanks to last year's projects). That left less than ever for new projects.

But, of course this reality didn't stop clients from wanting new things. And lots of them! Thus, the gap between clients' demands and available resources was larger than ever.

Will figured this was a good time to think about managing clients' expectations.

Source of Unrealistic Expectations

Where do unrealistic expectations come from?

It's simple: Like the proverbial kid in a candy story, clients want everything because they don't have to pay for anything. When price is zero, demand approaches infinity.

So the kids clamor for everything. Daddy says no because he knows the limit of his checkbook and is aware of other competing demands. And of course when Daddy says no, Daddy is the villain.

Similarly, Will knew the limit of his IT organization's resources. And whenever he said no, IT was the villain.

Realizing this, Will set up a governance process, foisting the villain role off on a committee of executives.

What did this accomplish? Clients still wanted more than IT could deliver, and all the executive committee could say was, "Here's our sense of priorities. Now do all the high-priority items."

Thanks to the committee, IT was now looking bureaucratic and unresponsive, and Will still found himself grumbling about managing expectations.

The Simple Solution

The key to solving the "managing expectations" problem is found in market economics.

Essentially, give the kid in the candy store an allowance and let them buy whatever they want. In corporate terms, clients need a sense of how much is in their checkbooks and what everything costs.

I'm not talking about chargebacks. A fee-for-service internal economy is the most advanced and most challenging form. But chargebacks aren't necessary to make market economics work within corporations.

Two ingredients are necessary: a defined checkbook which clients own and manage; and prices for everything the organization sells.

With these two ingredients, the service-provider organization can establish a non-bureaucratic, client-driven portfolio-management process. Then, clients will never expect more than they can afford to buy.

Sure, they'll want more. We all want more than we can afford. But we don't blame the store when we can't afford everything in it. Clients will come to understand that the limit is the corporation's spending power, not in the service-provider organization.

Client Checkbooks

The first ingredient in this systematic solution is a well-defined checkbook, handed over to clients to manage.

By "checkbook," I don't mean cash. Clients only get real money if the organization has implemented chargebacks.

If you don't charge fees for services, the checkbook represents a claim on the service provider's resources. Think of the organization's budget as a "pre-paid account" -- money put on deposit by the corporation in order to buy things from the organization all year long.

Some of that budget should be managed by the service provider itself. The rest goes in the clients' checkbook.

Specifically, there are two subsets of the budget which should be managed by the organization itself rather than clients.

One subset is funding for "corporate good" activities, which pays for services that the organization does for the corporation as a whole which competitors (like outsourcing vendors and decentralized counterparts) don't have to do. It includes things like policy coordination, architectural standards, "consumers report" style research like on vendor products like PCs, and participating in unrelated tasks like corporate committees and community-action programs. (It does not include mass-market commodities like desktops, interconnectivity, and email, which are services to clients.)

The other subset of the budget which the organization should manage by itself is one-time funding for improvements in the organization. This includes both capital and operating expense to fund infrastructure (anything that's capitalized and depreciated), start-ups of new lines of business, and other major organizational improvements. Think of it like a loan from the bank, paid back (in some cases) through depreciation.

The rest of the organization's budget belongs to clients. It covers all their ongoing operational services (the "keeps the lights on" activities) plus new projects. This portion of the budget must be isolated, and then turned over to clients to manage. There are various types of client-driven demand-management processes. Clients may manage their checkbook with a corporatewide committee, or it may be divided among the business units and managed locally.

Prices

Once clients own a checkbook, they need to know what everything costs -- the second ingredient in systematically managing expectations.

Clients need to know the full cost of ongoing services, so they understand where much of their checkbook is going and have an incentive to shut down less-valuable services to free up resources for new things. And they need to know the cost of all the new projects and services they might want.

It's critically important that prices represent the true, full cost to shareholders/taxpayers/donors of each purchase decision. Anything less will cause clients to buy more than is economic.

Worse, with marginal-cost pricing, internal support functions won't be able to grow as the organization's business grows, and the "managing expectations" problem will crop up again in a different spot in the organization. (The pitfalls of marginal-cost pricing are described in detail in my book, The Internal Economy.)

Every product and service should be priced at a rate that includes all direct costs plus a fair share of indirect costs. Indirect costs include:

• The cost of staff's "unbillable" time for sustenance activities like their own training, new-product research, and client relations.

• External-indirect expenses to train and equip staff and to support the infrastructure.

• Internal-indirect expenses when one group within the organization "sells" its services to another group; for example, infrastructure engineers sell upgrades to the operations group, a cost which is spread over all the services sold by the operations group.

• Overhead that's spread across the entire organization.

Some would call this activity-based budgeting. In fact, it's more.

There are two key challenges to understanding the full cost of your products/services: First, to define each group's products and services, both those sold to clients and those sold internally. Second, to get all the indirect costs spread in the right places, without circularity (A sells to B, who sells to C, who in turn sells to A).

Single Solution

The challenge of managing expectations comes down to two fundamental financial processes: budgeting, and pricing. The budget must sort out how much goes in the clients' checkbook(s) versus resources to be managed by the organization itself. And prices must represent the true, full cost of everything clients might buy.

These are not really two separate things. You wouldn't want to quote a cost in the budget and then charge a rate during the year that adds up to a different number! Both budgets and prices should be developed by a single, integrated operational planning process.

The planning process begins by identifying the lines of business within the service-provider organization.

Then, each manager lists all the deliverables (products and services) he/she might sell (internally and to clients) in the year ahead. This becomes the basis for a service catalog designed around clients' purchase decisions.

These deliverables are prioritized, leading to a "keep the lights on" pessimistic forecast and an optimistic growth forecast.

Analysis includes the types of staff (employees and contractors) to be utilized, the billable-time ratios for each, the costs of each, and of course direct and indirect expenses.

In this process, managers agree on what they'll sell to one another and what overhead services they'll build into their prices.

All indirect costs are carefully scrutinized by the organization's senior management. Then a budget is presented for deliverables instead of for cost-factors like compensation, travel, and training. This leads to a rational discussion of what the corporation will and won't buy from the service provider in the year ahead.

Already, clients know what to expect of the organization. Furthermore, knowing what the budget is meant to pay for allows you to sort funds into the various checkbooks, which is the basis for an ongoing, dynamic portfolio-management process.

Finally, prices are extracted from this data-cube.

This integrated operational planning, budgeting, and pricing process is the first step in a systematic approach to managing expectations.

This process can be done either to prepare for the next budget cycle, or mid-year to reverse-engineer the current budget and set up the process ahead of the next cycle. In either case, expectations and resources will snap into alignment once results are communicated to clients.

The Systematic Approach

The "managing expectations" problem can't be solved by lectures on the organization's limits, nor by bureaucratic committees and approval processes. Only a systematic approach solves the problem in the right way, once and for all.

The systematic solution is found in market economics and an integrated business planning, investment-based budgeting, and rate-setting process.

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