The Chief Operating Officer and Chief Financial Officer of a Fortune-1000 company faced a challenge: Revenues were growing, but profits weren't. They had to get a handle on costs, especially corporate overhead (G&A).

One really visible part of corporate overhead was IT. The IT budget was growing even faster than was total overhead, and it was a big number. The COO and CFO weren't clear on the benefits they were getting from their investments in IT, so they decided to put a stop to its budget expansion.

However, they didn't want to target IT's vendor costs. These were less controllable because they were negotiated deals (like infrastructure licenses and the off-shore applications development relationship), and they already had their "strategic sourcing" procurement staff helping with vendor negotiations. Plus, they didn't want to discourage outsourcing, which they believed saved them money.

Thus, they issued the following edict: No growth in IT headcount (employees).

Why Caps Backfire

The CIO and her leadership team respected the cap, and only hired staff to fill existing open positions. But IT costs didn't come down.

Why?

Clients in the various business units understood the return on IT investments far better than the COO and CFO, who they privately considered out of touch in the ivory tower of corporate headquarters. These business leaders knew they needed to buy more IT to stay competitive and grow.

When the corporate IT budget wasn't sufficient, the business units transfered incremental money to IT to get what they needed. IT used this money to hire contractors to get the job done.

Of course, the contractors were more expensive than employees. So the net result of the cap was an increase in IT costs, not a decrease!

When the CFO saw what was occuring, he was very upset. But he couldn't tell the CIO to refuse client projects they were willing to pay for -- at least not directly. To do so would be counter to the corporatewide customer-focus program.

So he modified the edict: No growth in IT headcount, including contractors.

And then he added another edict, just to be sure: No growth in the IT budget (total spending).

The business units still needed more IT. But no edict can magically make IT more productive (the old "do more with less" delusion). When the corporate IT department couldn't satisfy the business units demands, clients did the obvious. They hired their own IT staff (many of whom were hidden under other titles), and they went directly to outsourcing vendors.

In other words, the cap didn't reduce IT spending. All it did was cap the "market share" of the corporate IT department.

Decentralization inevitably drove costs up as economies of scale were lost, and as little pockets of generalists attempted to do work formerly done by teams of specialists. And a lot of little outsourcing deals drove costs up too. Furthermore, corporate synergies were lost, the pace of innovation slowed, and quality suffered.

Again, the net effect of the cap was to increase, not decrease, IT costs.

The lesson here is straightforward: You can't control spending by controlling supply. The only effective way to contain costs is by limiting clients' spending power.

Bureaucratic Governance Processes

How can executives constrain the amount that business units spend on IT?

Some people advocate a "governance" process that imposes bureaucratic hurdles in an IT project-approval process -- ROI threshholds, committee and CIO approvals, and piles of paperwork. Their theory is that the committee or the CIO are smarter about investing than clients, and they'll stop business leaders who try to buy something that's a poor investment.

In their cynical moments, advocates of bureaucracy might admit that simply making it difficult to do business with the corporate IT department will reduce demand since people won't make the effort to run the gauntlet for any but the really important projects.

While these hurdles may, in fact, dampen demand, they certainly don't engender optimal resource governance. Some people make up ROIs. Others may not bother with projects that are really good investments. People break up their requirements into small "enhancements" to circumvent the committee. No doubt you know all the games people play.

Furthermore, bureaucratic hurdles chase business to the competition (decentralization and outsourcing), where clients are treated as customers (not like children in a candy store who need to be controlled) and where it's easy to get what they need. Like caps, bureaucratic project-approval hurdles drive costs up.

Market Economics

The alternative to bureaucracy is market economics. In a market economy, your spending isn't limited by the size of the store. It's limited by your checkbook.

Similarly, within corporations cost containment is best achieved by limiting the size of the business units' checkbooks, not by limiting the size of an internal service provider like IT.

In other words, the corporation must constrain demand, not supply.

Then, the business units can be free to spend whatever they have on whatever they see fit. They'll naturally use their limited funds to buy what's most important to them and skip the rest, without time-consuming hurdles. Resources will automatically flow to the best investments.

I call this a market-based internal economy.

There are three things required to make this marketplace work: business units who care about their bottom lines, a limit to their checkbooks, and the information they need to make good investment decisions.

As to the first requirement, most business unit leaders already care about their bottom line. If this concern doesn't ripple down through their ranks, then they have a management problem -- one that will affect spending on everything, not just IT. There's nothing IT can do about this.

So presuming that clients want to spend their resources wisely, the two remaining challenges are to limit their checkbooks for IT, and then to provide the information they need to make good spending decisions.

Limiting the Checkbook

If IT charges for its products and services, then spending on IT is limited by clients' budgets. With chargebacks, IT costs can only be contained by managing business units' budgets -- eg, by setting appropriate profit targets.

However, if IT gets a budget directly (or through allocations) rather than through chargebacks, then IT sees the limits of this spending power but clients do not. Even if they understand the limits of the IT budget, they might not care; they may feel that IT is tasked with meeting its budget and this is not their problem.

The solution is to treat the portion of the IT budget intended to benefit clients (the bulk of it) as a "prepaid" account -- money put on deposit with IT at the beginning of the year, but owned by clients rather than by IT.

Then, clients can be given the power to write checks within the limits of this checkbook. Decisions may be made by a single committee, or the checkbook may be divided among the business units. In either case, clients must live within their means; and there's no need to cap IT headcount or spending.

Thus, even without chargebacks, a market effect can be created. And since clients cannot buy more than their checkbook permits, IT costs are fully controlled with no need for caps on headcount or expenses.

Information for Decision-making

For clients to make decisions on which checks to write, and for IT to decrement the checkbook when work is delivered, IT must calculate the fully-burdened cost of all its products and services.

Using concepts of product/service costing, it must forecast its budget in terms of the cost of deliverables (not just expense codes by manager). This is the only way to know what its budget does and doesn't include.

In addition, it must calculate rates (prices) consistent with its budget, and use these rates to decrement the checkbook as work is completed.

The fully burdened cost includes direct costs plus a fair share of all indirect (so-called "fixed") costs. This is a critical concept.

If the indirect costs are paid by IT or put in a pool and allocated to the business units, and the checkbook given to the purser only covers direct costs, the market will not work properly. It misleads clients into thinking things are less expensive than their true cost to shareholders, so they tend to buy more than is economic.

Furthermore, the indirect costs do not expand or contract as the IT business grows or shrinks. Indeed, they become a target for arbitrary cuts. Soon, IT will find it cannot deliver on its committments for lack of needed internal support services.

Bottom Line

Markets work. And caps don't. It's that simple.

The only practical way to manage IT spending is to effect a marketplace where clients' demand is constrained by the limits to their checkbooks.

Implementing a market without chargebacks takes a bit of thought and effort, but the mechanics and the process are well understood. All it takes is a commitment to control costs systemically, rather than through ineffective caps and budget cuts.

We all believe in market economics outside the office. Let's apply the same dynamics within corporations to govern resources effectively with minimal bureaucracy.

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