Of late, there is a lot of emphasis on IT ROI. While this is commendable, extending this argument to convert the IT Organization into a profit center is taking it to another extreme. For example, are HR, finance, and marketing profit centers? Why not?
The model of the "internal" IT Organization as a profit center just does not work. The concept of profit centers is built around profitability, which in turn requires an unwavering focus on the business model. Consequently, profit centers must meet certain minimum criteria:
- Revenues and costs: Accurately quantify revenues and costs
- Market: Focus on customer relationships that are generating higher profits and either discontinue or deemphasize those that aren't
- Product Mix: Create a portfolio of products and services driven by market demand. For example, a profit center will not introduce products that the market does not need. It will discontinue a product if it is not profitable. Sometimes, it will introduce loss leaders to build brand loyalty which in turn will translate into revenues through the sale of higher margin products.
- Product pricing: Price products and services to maximize profits. Pricing can be done on a cost plus basis or, more accurately, on market conditions i.e. what the market will bear. The latter usually results in substantially higher profits, even though, sometimes, the reverse is also true. For example, the cost of construction has almost tripled in Florida after the hurricane season. In other words, in a free market system, a market eventually determines the value of a product or the "price" a customer is willing to pay for it.
- Timing: It is often said that in business timing is everything. Profit centers are profitable when they can quickly respond to market opportunity. This is by no means an exhaustive list but it should be sufficient to provide an idea of the general focus and direction of "profit driven" enterprise.
Companies also have expectations of their IT Capability. IT is supposed to work, hand in glove, with the business to create shareholder value. Hence, the more closely an IT capability is aligned with business requirements the more the shareholder value generated by the enterprise. There is also an expectation that IT Capability should come at an increasingly lower cost. The discussion, of whether IT Organizations should operate as a profit center, then boils down to answering these key questions:
- Does an "internal" IT Organization meet the criteria of a profit center?
- If it were to operate as one, can it still meet the expectations of alignment and value?
For starters, we cannot determine the revenues and cost associated with the IT Department with a high degree of certainty or accuracy.
- How do we allocate the company's revenues to a department, say marketing or IT?
- In what proportion did they contribute to creating those revenues? Some have approached this problem from the other end i.e. determining the value generated by IT.
Theoretically, each IT project creates value in some form, say, increased revenues or cost savings. Adding all these would give us the value generated by the IT Organization as a whole. However, there are obvious flaws in this approach. Can IT generate this value without the other functions? Then, how do we separate IT's revenue contribution from their's?
Having been involved in many project portfolio rationalization efforts, I have learnt that adding the "projected" value generated by individual IT projects exceeds the total value generated by the entire organization! If there is a difference between the total value generated by IT and the enterprise, how will we adjust IT's revenues to account for this discrepancy? We just do not have an accurate way of allocating enterprise revenues to individual functions.
The cost side of this equation is somewhat easier because we have departmental budgets. However, budgets do not account for all the costs associated with a function nor do they accurately reflect the "cost of doing business." Many organizations, especially larger ones, have "shadow" IT organizations - IT resources, outside of the IT organization, deployed by business functions. The expenditure on "shadow" IT, which can be upwards of 10 percent of the IT budget, is not included in it. Additionally, a department's "cost of doing business" is affected by two key factors; Organizational friction and harmony.
- Friction: Any interaction between two entities has a degree of friction - the higher the friction the more dysfunctional the relationship. This friction affects the efficiency and effectiveness of one or both entities. To give a sport analogy, the same player will perform differently on two different teams. In the corporate world, this friction between departments has an impact on their individual performance. For example a department, say IT, might theoretically do "better" or "worse" if not for its relationship with another department, say marketing. Not any marketing department but that marketing department. The impact of organizational friction is impossible to ascertain in a meaningful way. Hence any allocation of revenues or costs to individual departments will be inaccurate.
- Harmony: Is the exact opposite of friction. Two departments might perform better because of their relationship. How much better? What is the impact on each others' revenues and costs?
Till we can answer these questions our allocations are meaningless. Revenue and cost allocation issue is just the tip of the iceberg.
An "internal" IT Organization cannot work as a "profit center" because it does not meet the other criteria outlined above. An internal IT department has a captive relationship with its "customers", the other business functions. IT is obliged to service all its customers and treat them equally. These "customers" do not have the freedom to "bid" the work out to other providers. This relationship precludes any discussion of profitability as free market forces are not at play.
Market: IT does not have the freedom to focus on its more profitable "customers" and perhaps, downgrade the service to or drop its unprofitable ones. How can it be profit driven then?
Product Mix: An internal IT Organization does not have the freedom to manage its product mix for profitability. For example, it cannot reject projects or discontinue services because they are not profitable. Often, business requirements, especially those related to competitive differentiation, dictate investment in "unprofitable" initiatives. These could be requests for one of a kind or custom tailored products and services which do not provide economies of scale or require specialized resources and invariably cost more.
Pricing: IT cannot price its services to market conditions. Remember, sometimes, it is market inefficiencies that determine price and consequently, profitability. If there is a one of a kind request from a business unit, should IT engage in price increases, just like any "profit driven" business would? If there is a need for express delivery, can the charge be different? Competitive positioning also drives price - can IT charge higher for the same service in bids to different business functions? If it is the sole provider of a service or system, can it demand premium pricing? In the absence of the ability to price products and services to market conditions, the discussion on IT as a profit center is moot. A profit center's profitability is determined by using all levers at its disposal. For example:
- Innovation can generate substantial profits. New and improved products are priced at higher margins. However, this also means creating a market for those products. IT cannot introduce new products that its internal market does not need. Consequently, it cannot reap the benefits from innovation, to the extent real profit centers can.
- Financial management can impact profits as well. For example, loans at a lower than IRR rates or strategic investments or risk management. IT does not have the freedom to invest its spare cash and generate higher returns.
- Creatively use distribution channels and partnerships for profits. Profit driven companies take advantage of their competitive advantage in their channels. IT cannot leverage its channels to deliver other providers products for a profit.
If an internal IT Organization overcame all these issues and considered operating as a profit center it would not meet the expectations of alignment and value placed on it. The internal IT Organization is created to address business needs - a specific business' needs. Hence, the more IT hones in to its business customers' requirements, the more shareholder value the enterprise generates. Moreover, over time this will also result in increasingly lower costs as the logical benefit of climbing the learning curve. However, this alignment will also invariably result in an IT Capability so custom tailored to the specific needs of a business that it cannot be of use to another business - without costly modifications of course.
Some have argued that for IT to succeed as a profit center it must become an independent entity. While the extent of "independence" varies the underlying concept is similar. This organization is profit driven and serves both internal and external clients. It also competes for business with other providers even for internal clients' projects. This model is market driven and hence fulfills the premise of profitability driven enterprise. However, this model fails on the alignment and value criteria outlined above and will also not result in the desired benefits to the enterprise.
IT will create less shareholder value: It is almost universally accepted that aligning business with IT creates higher shareholder value. An external provider is not motivated to align its capability to one business' requirements as it will loose other customers. It is nearly impossible for any provider to align themselves with all or most of their customers. An open market model also dictates that companies have multiple suppliers. It would be impossible for them to align themselves will all these suppliers either. Consequently, in the absence of this alignment between business and IT, will this model produce lower shareholder value?
Strategic advantage from IT comes when it is tailored to the specific business' needs. By definition, profit driven providers focus on economies of scale. Hence, they will create generic products that are of use to many customers. Customizing these products to meet specific needs of a particular business will, in the least, cost extra. This lesson was learnt by many companies, some the hard way, when they implemented off the shelf ERP packages. The package did not cost a fraction of what it took to implement it! But there is an even bigger problem. Over time, the vendor will incorporate the customer features into the generic product as it will make the product more marketable. If a companys competitors also have this product, where is the competitive advantage?
IT will cost more: A market driven company will price its products and services to market conditions. Invariably, these prices are higher than those charged on a "cost plus" basis. Hence, IT products and services will cost more than they do with the internal organization. There are other considerations that will adversely impact costs. The total cost of the two entities will be higher as they cannot leverage the synergies of their relationship. For example, they will have two separate marketing, legal, procurement departments. An open procurement model will also increase transaction costs of vendor selection and relationship management.
Sometimes we forget that just because we can get it done cheaper outside does not mean that is what it "cost" to get it done! Using financial measures and placing "profit" expectations are unreasonable and unproductive. The goal is to ascertain and assure that IT is efficient and effective there are many more accurate and reliable ways of accomplishing this.
About the Author: Sourabh Hajela is a management consultant and trainer with over 20 years of experience creating shareholder value for his Fortune 50 clients. His consulting practice is focused on IT Strategy - alignment and ROI. For more information, please visit StartSmart Consulting Please feel free to contact him.