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The Case for Changing the IT Funding Model

By Kathryn Krolopp and John Hillery

This article is from the Q3 2017 issue of Fi|r|st: The CEB Journal of Finance|Risk|Strategy

 

As digitalization becomes more strategically important, how the IT function invests in technologies becomes more of a concern for Finance leaders. Most CIOs know their functions must become faster and more flexible to support digital opportunities. However, key changes to IT’s operations require Finance leaders’ support to steer the requisite transformation in IT’s funding model—moving from a focus on projects to a focus on IT product lines.

A funding model based on IT product lines allows CIOs to support business goals more quickly and flexibly. To harness this ability, CIOs allocate funding to IT product lines, which are organized around business capabilities. This model enables CIOs to explain more clearly how IT investments affect a business- or enterprise-level capability.

While this model is not new, it has recently become more widespread. In 2016, about 33% of IT organizations reported having some kind of IT product lines. In 2017, the percentage of organizations reporting IT product lines jumped to more than 50%. IT product line adopters can, from our estimates, reduce IT spending by 15% annually.

The transition to this model is often gradual and may take several years to fully implement; CFOs will have a significant role to play in the process. If your CIO has not already addressed operating and funding model changes, reach out and start the conversation.

Challenges of the Current IT Funding Models

Most companies today fund IT groups as cost centers, often allocating funds as a percentage of total revenue. Perspectives differ on IT funding (figure 1). While Finance leaders may think of the IT budget in capex and opex terms, or as budget-allocation items (e.g., hardware and software, staffing) many IT leaders think of a run budget, a grow budget, and a transformation/innovation budget.

Regardless of the perspective, IT funding models tend to share two drawbacks:

  1. Alignment of funding to business capabilities is opaque and inefficient

    Because of digitalization, an expanding share of technology spending happens outside of IT. Formerly known as “shadow IT,” this spending is no longer incidental: shadow IT spending, or business-led IT spending, comprises at least one-third of enterprise technology spending. In fact, technology spend outside of IT is growing at a faster pace than the CIO’s budget. This business-led IT spending causes disparate and potentially duplicative investments. Moreover, such spending creates unplanned maintenance or “run costs” for IT to support and scale, often without much advanced visibility. Some CIOs refer to this situation as the “baby on the doorstep.” When technology spending does take the form of an IT project, it is often unclear how it ties back to enterprise capabilities or how it relates to other technology spending happening outside of IT.

  2. Prioritization by projects inhibits speed and flexibility.

    Project-based funding locks in all the required costs. This reality makes it difficult to move money around if a project’s design or objective changes. Over the past five years, many companies have created digital technologies through iterative development. The mismatch between the funding process and how IT actually works leads to waste (resources flow to projects that may not be as valuable as other activities) and often makes IT unable to respond to a shift in business needs.

For a successful IT funding model (figure 2), organizations must make the following changes.

Fund product lines to ensure flexibility and alignment to business capabilities.

In this model, each IT product line receives its own block funding. Funding IT product lines individually prioritizes business capabilities. This step allows business leaders to disproportionally invest in product lines (and therefore business capabilities) that best help realize enterprise   strategy.   Unlike  project-based funding, block funding for IT product lines ensures value discovery, continual enhancement, and a learning mind-set. In addition, IT personnel are pulled to support IT product lines as needed, enabling CIOs to use resources more efficiently and effectively.

IT product lines are not to be confused with product lines in the business (figure 3).

For example, a billing management product line would include invoicing and billing history capabilities; the technologies that support them would be managed by a product line manager to support his or her consumers’ needs (figure 4). However, to fully realize the benefits of the IT product line model, IT product line managers should run their IT product lines like a product manager would.

Therefore, Finance leaders must update IT cost allocation and reporting systems to reflect IT product line activities. Funding IT product lines promises to help circumnavigate the traditional cost and ROI tension between administrative and revenue- generating systems. Instead, organizations can understand how well IT product lines are delivering new and enhanced business capabilities.

Budget separately for technology foundations and digital experimentation.

Technology foundations are IT’s recurring expenses. This part of the budget keeps the lights on. However, CIOs know software is never finished and today’s innovation is tomorrow’s foundation. So over time, run costs start to reflect new projects.

The separation of a foundations budget from a new capabilities budget allows CIOs to better track and articulate the value of those investments. This model helps IT show why it’s necessary to invest in both.

These digital foundations include older technologies, such as an ERP system, and emerging capabilities, such as data lakes or advanced automation tools. Ideally, old and new foundations should be funded separately to reinforce the message that while IT is squeezing efficiencies from transforming old foundations, investment in new foundations is money well spent.

Furthermore, IT budgets should have innovation funds allocated to concepts and experiments that fall outside of an existing product line. Some companies take a venture capital approach, which involves giving seed funding to a broad portfolio of ideas and then investing more in the resulting capabilities that show the most promise. Other companies see business-led IT as an important source of this initial experimentation and are careful not to rein it in. In either case, the most successful experiments eventually reach a scale at which they can be set up as a new product line or merged into an existing one, and the approach to funding switches accordingly.

The Benefits for Finance and the Entire Enterprise

The new model helps CFOs assess if business performance is achieved from funds allocated to IT and if IT is appropriately stewarding its budget to enable digital progress.

In addition, this model moves IT away from its historically technology- centric perspective. Instead of investing in technology and hoping the investments support business needs, CFOs determine spending in the context of the specific business outcomes the technology supports. The ties between the two are therefore explicit.

Some CFOs are comfortable with the current funding model because they can “keep a line of sight on IT spending,” as one CFO put it, “and if a project goes haywire, I know how to kill it.”

However, using business capability– aligned IT product lines as the basis for funding improves a CIO’s ability to explain how IT investments affect an enterprise-level objective. This model also helps CIOs articulate to their CFOs and the rest of the business what their maintenance and upgrade costs are and why those expenses are necessary.

Implementing this funding model “strengthens the relationships between IT and the business,” according to the CFO, who heads Finance at a large Canadian firm.

Starting the Conversation

CFOs should ask their CIOs:

  • What sort of requirements should be used to propose investments or initiatives?
  • How will performance metrics change in this model?
  • How will value be tracked for experimental initiatives?
  • What kind of documentation will Agile delivery teams produce at each stage of the value delivery process?

Early discussions are important. As this transition is underway, companies may need to operate in a hybrid-funding environment. “CFOs have to explain to the broader business why IT costs are what they are during this transition,” the CFO noted. It requires the CFO and CIO sit down and work out what will change and when.

Another CFO concern is that prioritizing spending between products rather than projects could open a stark divide between “winners” and “losers.” With fewer products—in place of hundreds of IT projects—CFOs struggle to fund each business leader’s top technology priority, and therefore, struggle to keep everyone happy.

At the enterprise level, this outcome is positive, as it means more money spent in areas that directly support enterprise strategy. But some business leaders, especially those from support functions, may resist. CIOs who have made the move successfully report it was important to be upfront about how allocations may change and to tie this to the need to accelerate digital strategy.

 

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