How CIOs can please their CFOs with better IT Finance Management

How important are Finance Management & Cost Optimization Skills for a CIO ?

In short it is very important. Senior management and board members will always feel better about any IT budget if it falls within some reasonable industry standard. In today’s budget sensitive corporate world, CIOs that don’t proactively manage their IT budgets & costs will likely be losing their value with the C Suite and will be never considered for active presence in Board level interactions. So all along the way IT Budgeting & Cost Management has become one of the critical CIO success Pills as well an effective tool in managing IT Financial Risks.

A corporate budget, produced by the CFO, is a projection of the organization’s income statement for the next fiscal year. The IT budget is a subset of the overall corporate budget, and the CFO and other officers are relying on the CIO to contribute his or her part. The IT budget includes estimates of operating and capital expenditures for IT.The main difference between enterprise IT spending and the IT budget is total enterprise IT spending comprises all IT spending in the company whether managed or the responsibility of the IT department, and the IT budget comprises only the operational and capital budgets managed directly by the CIO.

The IT budget is composed of the following six key components:

? Hardware
? Software
? Staffing
? External Service Providers
? Communication Services
? Others (Office Supplies, Depreciation of Software & Hardware, Physical Equipments, Outside Services Procured, Travel, Entertainment, Miscellaneous and overheads such as Rent, Utilities)

To prepare IT Budget, CIOs need to collect in advance the following types of information to help streamline and improve accuracy of their IT budget:

? Actual operating, capital, and budget variance figures from the previous year.
? Initial statistics on employment growth or decline at the company.
? Initial statistics on profit and sales expectations for the company for the coming fiscal year.
? Any changes to company operating policies.
? Any changes to major applications in the past 12 months affecting support or development.
? Current approved IT project inventory and prioritization.
? Estimation of current peer spending
? Payroll statistics for the IT department.

The budgeting effort is typically kicked off by the finance department in preparation for the next fiscal year. Most often the CIOs will be given the following information to get started with their IT Budgeting process:

? Detailed accounting reports of the prior 12-month IT spending.
? Template spreadsheet with budget categories already included and calculation complete.
? Estimation of overhead line items to be allocated to the IT department.

Budgeting Methods

Zero-based budgeting

Zero-based budgeting is the method used to prepare a budget that starts with a “clean sheet” and builds from the ground up based on assumptions, required service levels, and projects. In a zero based budget, each activity or line item to be funded must be justified each year on the current merits for spending money on it. This method, while time consuming, ensures that the annual budgets do not carry forward any poor assumptions from the previous budget, and that the underlying assumptions are reconsidered each year. Zero-based budgeting works particularly well in companies that are experiencing rapid rates of change (business growth, major initiatives, acquisitions or divestitures).

The steps in developing a zero based budget are:

? Determine components of the budget that are fixed (e.g., facilities, infrastructure, application maintenance, data communications) and those that are variable (e.g., hardware purchases, staff labor, training, software upgrades, enhancements).
? Justify each fixed expense in the department. Is the expense reasonable given current market conditions? Can, and should, the expense be altered? Document assumptions and any actions that would contribute to cost reduction. Because these are fixed expenses, some creativity is necessary. For example, if IT leases its own office space, can the director go back to the realtor and negotiate a longer lease for a discount today? Does the expense change for any reason (step-up in vendor contract, annual increase in rate in contract, automatic fees tied to maintenance contracts)?
? Total all fixed items. This total of fixed costs is called the baseline budget.
? Document any potential cost reductions, and the associated reduction in service levels or project capabilities, and keep for presentation during the final budget review with the IT steering committee.
? Build up the budget for variable cost line items (e.g., outside contractors, new software licenses) by performing an item-by-item analysis. Understand the key drivers of cost in the variability (e.g., number of projects, employees, and transactions). Make assumptions for each line item and calculate the variable budget. Once again, document assumptions, as you will use them in the budget presentation and need them to answer budget questions.
? Fix the gaps (If any) and prepare first draft.

Run rate budgeting

Run rate budgeting is used to prepare a budget based on the current year and current time frame expenditures. For example, if rent is currently $25,000 per month, it is likely to run $25,000 next month. Run rate budgeting starts from the current average monthly rate of expenditure (the run rate) and are then refined from that baseline based on new assumptions (e.g., new project assumptions, new usage assumptions, service level changes). Each budget line item starts at its current level of spending and is adjusted upward or downward based on new or current information. Run rate budgeting can be completed relatively rapidly, because the list of current line items is readily available. The process also incorporates the best thinking on what the budget will be, as it is based on actual current amounts. Run rate budgeting works best in environments where there is relatively little business change expected year to year.

Steps of developing a run rate budget:

? Populate budget template given by Finance Department with current run rate spending or the last 12-month actual spending. Accounting can provide this information.
? Review each line item in the budget and document assumptions for why the spending should be at or near the current run rate, or will change. Modify the subsequent months based on assumptions. Add any new budget line items for known new categories of expense, along with amounts and assumptions.
? Prepare first draft budgets based on the current run rate and assumptions on any changes.

Growth Budgeting

Grow budgeting helps the organization in introducing new capabilities or improve existing ones. Growth initiatives could include the implementation of new software that makes operations more efficient, the purchase of a new firewall that provides additional protection from cyber threats or an upgrade of the organization’s website that improves interactivity with customers. Growth budget items should tie directly to the organization’s strategic initiatives. Growth initiatives usually are flexible in nature, which means that they support good growh initiatives when additional cash is available, or for deferral if cash is tight.

Transform Budgeting

Transform Budget items are research- and-development-type activities. These initiatives might seek to identify, for example, the right technologies for new organizational capabilities; fundamental changes to business processes; or a new product or service offering. Examples of Transform initiatives include proof of concepts, prototypes and small scale testing of new systems or business applications. When finances are tight, transform initiatives often are the first to be cut or deferred—unless they are associated with key strategic initiatives that the organization views as essential to its continued operation. Even if the organization doesn’t deem certain Transform initiatives immediately essential, care should be taken when considering cutting or deferring them. That’s because Transform initiatives often are key to the organization’s long-term health. Failure to provide adequate resources to Transformation initiatives can stunt an organization’s future success.

By looking at the percentages of the Zero Based, Run Rate, Growth and Transform components of an IT budget, CFOs can analyze the role that IT plays in the organization. An analysis on this can determine whether the IT budget properly reflects IT Department’s designated role in achieving the organization’s mission. Additionally, by classifying initiatives into each of these budget categories, CFOs can help guide adjustments to the timing of IT spending in response to changes in the organization’s cash position throughout the year.

It is advisable that CIOs give the senior management team (CFO, CEO) options for key budget decisions. For example, produce two budgets—one based on current level of service and one based on a reduced level of service. This allows senior management to assess the price of any cost cutting they would like to execute (e.g., lower level of service means one-day turnaround on help desk trouble tickets versus four hours). Another variable that can be adjusted is the number of projects that can be executed, providing options for executing the top 10 projects versus executing only the top 5 projects. Management can then make trade-offs of spending versus service. Even if management elects not to take advantage of these potential cost reductions, the IT team will enhance their reputation for thriftiness with the senior management team and IT steering committee.

Tracking the IT Budget During the year, Finance department will probably furnish monthly or quarterly reports of year-to-date spending. CIOs should look closely at these reports. It’s not uncommon for data entry errors to occur where another department’s purchase is charged to your cost center or for one of your own purchases to be charged to the wrong category. The report CIOs get from Finance Department will have several columns for each category such as:

? Budgeted amount
? Actual amount spent for the month
? Actual amount spent year to date
? Variance against budget (an over/under amount indicating how well you are doing compared to the expected amount based on your original budget)                 ? Variance against last year (an over/under amount indicating if you are spending more or less for the same items as last year)

During the year, CIOs may have one or two opportunities to revise the IT budget. These revisions are often referred to as forecasts, reforecasts, revised estimates, or updates. These revisions can be used to:

? Include projects that weren’t expected during the initial budgeting process. ? Eliminate or reduce costs for projects that were canceled or scaled down since the initial budget was proposed. 

? Update/refine projections based on actual spending and other changes (e.g., vendor pricing,expansion, size of projects).                                                              

? Demonstrate anticipated cost reduction as a result of belt tightening.

Each opportunity to revise the IT Budget is a chance to deliver a more accurate estimate.Initial IT Budget is essentially a 12-month projection. However, a midyear revision is 6 months of actual costs and only 6 months of projection.

Key Challenges in IT Budgeting

? Culture of cost control for IT
? Lack of ability to address new demands for business capabilities based on IT systems
? The impact of increasing mobile end user force on legacy networks and applications
? Inability of managing IT spending outside the 'formal' IT budget ? Ineffective IT Expenses Capitalization Practice
? Growth of Staffing
? Unexpected Growth of IT department’s workload
? Loose integration between IT and business units; infrequent communication of needs and priorities.
? Poor service levels delivered by IT, forcing business to seek alternatives.
? Slow decision making and purchasing processes in IT
? Poor adherence to corporate standards for technology (software, hardware, desktops).
? Loose corporate procurement processes and standards.
? Decentralized, geographically disparate business operations.                                 ? Disruptive Technological changes happening in Market 
? Ineffective Contract & Vendor Management Practices There is a wide variety of hidden expenses that should be considered as part of the IT budget to get an enterprise wide view of total IT spending.

A sampling of these includes:

? IT staff embedded in business units or functional departments (e.g., web developers working for the marketing department, report writers working in the finance department, desktop support staff within a business unit).
? Outside service vendors (e.g., IT contractors, web site hosting, technology consulting company implementing systems or software within a business unit or function with no reliance on IT).
? Software (e.g., sales force automation software purchased by the sales function and photo shop software and Apple computers purchased by the marketing group on credit cards and purchase orders).
? Hardware/IT fixed assets (e.g., vice president of manufacturing doesn't like the standard laptop and orders them via credit card or purchase orders).

Economies of Scale

Economies of Scale has a major impact on spending levels and are therefore an important consideration when estimating appropriate IT spend. Economies of scale occur when size provides  and purchasing power, which drive down costs. This is important to the IT spend estimating process for several reasons. First, when planning an IT budget, it is critical to know if and when the company will achieve economies of scale in spending. Second, company growth (and therefore IT growth) can help lower overall spending as a percentage of revenue, but it will likely increase overall spending. Efficiency and high productivity can help IT Departments in achieving Economies of Scale for the IT department. So every CIO should attempt to build the most efficient infrastructure, application deployment, and IT organization to achieve this. IT Cost Management High costs and the realization that IT can make or break a business have led business managers to bring IT under greater scrutiny. 

The following are some of the recommendations for CIOs for keeping costs low and while attempting to run an efficient IT operation:

? Develop baseline infrastructure costs. Attempt to reduce this baseline on a continual basis. Standardization can reduce IT baseline spending considerably. Every effort should be made to attain it. The average company spends 70 percent of IT Budget on baseline and maintenance, creating significant opportunity for identifying potential reductions.
? Undertake only those projects that the IT Department can complete on time. Working on more projects than the IT Department has capacity to execute causes whipsawing and makes the entire department less productive. Make sure no projects are started without proper business justification and ownership from one of the business units.
? Develop a review process to critically assess current projects. Each project should receive a status flag of green (going well), yellow (warning signs), or red (behind schedule or over budget). Bringing in such a review process will ensure that over budgeted projects are dealt with before they greatly impact the budget.
? Periodically renegotiate vendor contracts to obtain savings from company size. If the company is growing, the department can often save IT dollars by aggregating spending into fewer vendors and demanding volume discounts in return.
? Reexamine service levels. Make sure the service levels that the IT Department is delivering to the business are actually what the business wants. Often service levels are actually over specified—meaning the business could actually do with lower service levels, which would allow lower costs to deliver.
? Tighten asset management. Implement a sound process for managing IT assets, including their inventory and physical tracking. Critically assess requests for assets, and make sure that the assets are actually being used for high priority activities. Redeploy assets from low-return areas to highest return projects.

The following are some of the successful IT Cost Optimization Techniques adopted by global organizations in optimizing their IT Costs:

? Aligning IT Services with business requirements using IT Demand Management Practice
? Introducing Charge back mechanisms that will make the business units to share the IT Budget
? Leveraging Cloud Computing Services such as SAAS, PAAS, IAAS
? Embarking into right off shoring/outsourcing partnerships with strategic vendors
? Renegotiating contracts with vendors in a periodic basis
? Rationalization & consolidation of Data Centers, IT Infrastructure and IT Applications Portfolios
? Introducing IT Standardization
? Centralizing, consolidating and creating shared IT services
? Implementing IT Portfolio Management practices to track the IT Investments
? Conducting periodic IT Spend Analysis
? Reducing contract labor or cut staff via organic attrition
? Usage of Open-source desktop software
? Cancelling redundant, poorly performing IT Projects not yielding expected results over a period of time
? Virtualization of storage and servers
? Conducting Periodic IT Asset utilization & IT Performance Reviews
? Introduction of Teleworking & Videoconferencing to reduce space and travel costs
? Implementing IT process improvements (e.g. COBIT, CMMI) leading to IT Operational Excellence
? Benchmarking IT Budgeting & Cost Management Practices in periodic basis


Conclusion

The concept of running IT like a Business is emerging as the expectation of management teams and boards. This is better enabled by implementing effective IT Budgeting & Cost Management Practices in an intelligent manner. By implementing them, CIOs can transform their IT Organizations from the status of being a mere cost center into the status of becoming a value adding business partner who will be able to meet all the tactical needs and strategic goals of the organization. Failing to implement effective IT Budgeting & Cost Management Practices in a timely manner will not help the CIOs in pleasing their CFOs during annual budgeting cycle.