Value Made Visible

Value Made Visible

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* How various valuation methodologies differ* Which methodologies work best for specific projectsSo you've finally finished rolling out that new ERP system. Can you say by how many thousands it will increase the bottom line in FY 2004? How about your Web initiative - you just had to have it, of course, but is there any way to state specifically and accurately how it increases shareholder value?

For that matter, just what is information technology worth to your organisation? Some CIOs and technology champions say a question that broad is flat-out preposterous, but others aren't so sure anymore.

For an increasing number of executive and financial officers, vague promises of productivity enhancements and cost cutting are no longer enough to justify IT's ever more voracious budgets. Suspicious over the Y2K doomsday that wasn't and bowled over by the costs of CRM, SFA and other multiyear, multimillion-dollar systems, executives want to know not just what they're getting for their IT dollar but why they should care - two questions that technology valuation programs aim to answer.

IT organisations have not done a good job of quantifying what they're able to deliver, says Michael Mah, managing partner at QSM Associates, a Massachusetts-based, measurement and consulting company, and editor of the IT Metrics Strategies newsletter published by Cutter Information, also in Massachusetts. "Most projects overrun, and most people aren't able to estimate correctly," he explains. "That drives [executives] to say, ‘If you guys are always late and always coming back to the well for more money, what's the value of IT? What's the outcome here?'."

To be sure, the IT landscape is already cluttered with metrics that micromonitor any number of traditional technology activities - frames, megs, MIPS, objects, uptime and the like. But because they're internal programming measures that aren't linked to business strategy, they don't matter to the executives holding the purse strings or driving the company's corporate vision. "Function points per work month has been a nightmare," says Mah of one such popular metric. "Even CIOs don't understand a function point from a sausage; it's a dated metric for output."

When it comes time to talk to the CFO, IT departments often fall back on efficiency measurements to prove their worth. "There is a lot of concern about maintaining the [IT] asset and doing a good job of managing IT resources, but you're never going to save your way to prosperity," points out Bob Cawly, senior vice president at Meta Group (US), and developer of the Economic Value Sourced (EVS) valuation plan. Companies need a way to measure effectiveness as well as efficiency, Cawly says, to know not just how a resource is managed, but to quantify how effectively it was applied.

But by anyone's lights, it's not easy to measure how a new data warehouse contributes to the bottom line or specify the role that IT plays in achieving business strategy. "When you had a new mainframe program that replaced 30 workers, the benefit was obvious," says Douglas Hubbard, a principal at Hubbard Ross in Illinois. "But with e-business, groupware and expert systems, you're not doing a head-count reduction, you're communicating better."

How do you value improved communication, increased organisational flexibility or streamlined knowledge sharing? Some CIOs would rather not. "When I tell people I believe there are no intangibles, their knuckles get white around their pens," says Hubbard. "It's almost like a religion. People have made a career out of saying that IT is the exception, that they're the only ones who can't do a [cost-benefit analysis]."

A whole school of valuation methodologies has cropped up to try to nail down those intangibles, make a real and measurable link between technology and strategy, and define and quantify risk in a meaningful way. Most approaches are borrowed from the world of finance and business strategy, but some are tailor-made for IT. So whether you want to quantify your IT assets before a merger, justify that data warehouse, benchmark your technology function against that of another organisation or link your new call centre software to that increase in fourth-quarter revenue, there's a methodology you can follow to get the answers you desire.

Make that several methodologies. Or maybe even dozens of methodologies. In fact, with business valuation in vogue, it seems like every consultant to hang out a shingle has developed his or her unique approach to determining value. Finding the one discipline that's right for your needs can be like trying to find the definitive recipe for chicken soup: everybody claims to love it, everyone looks to it as a magic cure and everybody claims to know the secret ingredient that makes their version just a tiny bit better than the rest.

Fortunately, just as most soup recipes do share a minimum list of common ingredients (say, chicken, broth and noodles), so valuation approaches share a few basic tenets: They aim to forge and enforce an alignment between the IT function and business strategy; they require all parties to articulate what their goals and expectations are for a given IT project (or for the function as a whole); and they seek to help business executives map out a clear hierarchy of priorities.

If those sound like the kind of touchy-feely talking points more appropriate at a weekend offsite than in the CFO's office, rest assured that the majority of valuation plans have numbers to back up their philosophies, in some cases many numbers. "Strategy is often just a set of hypotheses about what's going to be successful," says Randall Hancock, senior vice president of e-strategy for consulting firm Mainspring in the US, which is currently at work on an e-business version of the balanced scorecard performance measurement system. A balanced-scorecard-based performance measurement system allows executives to test those strategic hypotheses against not only traditional "lag" indicators, such as typical quarterly financial results, but also against a range of less-easily-quantified "lead" indicators, such as customer satisfaction or employee preparedness, and to then make adjustments as necessary.

Valuation's most crucial contribution to IT might very well be that it maps a clear cause-and-effect relationship between technology and the bottom line. "There isn't a first-order relationship between IT investment and financial outcome," points out David Norton, one of the two original developers of the balanced scorecard and president of the Balanced Scorecard Collaborative, a US-based research and training organisation. "Investment in IT typically has a third-order financial effect," he explains, where, for example, technology improves some intermediate valuation, like customer service, which in turn boosts customer confidence, which finally results in increased sales for the company. What the balanced scorecard and other methods try to do is make visible those intermediate steps, in ways that can be quantified, measured and tracked.

With the need for speed paramount in every sector of business, can any company afford to step out of the stream long enough to undergo a formal valuation process? One valuation company claims it can evaluate an individual project in a day or two; another can install its methodology as a default across an enterprise in about seven weeks. "I can facilitate a scorecard in a matter of days with a client team if the knowledge level and understanding of the project are fairly sound," says Andrew de Lannoy, principal with Renaissance Worldwide, a management consulting group founded by Norton.

That "if" can be something of a sticking point. When valuation takes up too much time, practitioners say, it's because companies find themselves struggling over basic issues regarding project scope, business strategy, market climate, departmental alignment and so on. In that case, consultants say, "wasting" days, weeks or even months is infinitely preferable to pushing forward with an ill-conceived or poorly structured plan that faces a high risk of failure down the line.

To make IT valuation work, advocates say, it has to be embraced outside the IT department. "Sixty per cent of tech spending is outside the tech department, so putting this [valuation] mind-set only on the CIO is not enough," says Howard Rubin, CEO of Rubin Systems and a Meta Group research fellow based in New York, who has done extensive work in the area of IT portfolio management. Portfolio management treats technology as if it were an investment fund with risks, yields, benefits and so on. "You have to manage technology wherever it is. Ideally, you manage it from the top down, with a business management team that includes the technology director," says Rubin.

Likewise, companies should avoid adopting stovepipe valuation systems, where every function uses a different set of measures to further different goals. The result can be an organisational cacophony. "Local, narrow metrics can give you diminishing returns," warns David Glassman, partner in charge of strategic initiatives at Stern Stewart & Co in New York, which developed the economic value-added methodology. For example, someone in procurement trying to minimise the cost-per-unit of an item may sign a huge purchasing contract to meet his goal. But if the company has to shoulder unnecessary inventory costs, the procurement savings are negated, and the employee's actions wind up being counterproductive to the wider business goals.

More than one valuation expert warned IT executives to be wary of vendors bearing metrics. As business valuation gains popularity, some vendors are throwing in valuation as a freebie - that is, adding in a set of measures that can allegedly prove their product is worth its price tag and will help CIOs sell the purchase internally.

Like many other business trends, valuation can be misleading when misapplied and costly and time-consuming when applied for no reason at all. Prices vary widely depending on what methodology you're considering, what consultancy you choose and how deep you want to delve: A one-time analysis can cost as low as $US25,000 to $US40,000, but the majority of firms charge in the $US250,000 to $US400,000 range to value projects with price tags roughly 100 times that dollar figure on up. At the highest end of the market, a global corporation can find itself dropping a cool $US3 million to institutionalise a method across the entire enterprise.

If you're considering a $US100 million global upgrade, spending up to several hundred thousand dollars on valuation makes sense, particularly if it saves you from making critical mistakes, points out Hubbard. But if you're simply signing up for valuation to placate the powers that be or to justify IT in some vague big-picture sense, it's time and money that many feel could be better spent elsewhere.

First and foremost, then, CIOs should know exactly why they're valuing a project or department, or being asked to do so, says Greg Smith, executive consultant for Compass America, a consultancy that doesn't champion one method over another.

"If the CIO just does this as an exercise without having a business impetus, the numbers are just numbers," he says. At the very minimum, the CIO should be able to say exactly what he or she is trying to derive from a valuation system. Is it the cost of e-commerce? The justification for new hires? Building a defence against budget cuts? "There has to be a business driver for valuation," Smith says. "Before you begin, you need a reason to quantify, you need to understand why you're doing it."

Ready to jump in? It's a jungle out there, but we've managed to winnow out a few of the more established approaches, add in a couple of custom-built methods for IT and throw in one baby-in-the-making just right for e-business. What follows are thumbnail synopses of each approach; for more details, contact the individual practitioners, who will in an instant supply more white-paper information than any one person's desk can reasonably accommodate.

Applied information economics (AIE): Developed by Douglas Hubbard, principal of Hubbard Ross, AIE prides itself on being more scientific than its counterparts. AIE assigns units of measure to traditional intangibles, such as customer satisfaction and strategic alignment, then applies various tools borrowed from actuarial science, portfolio theory and statistics to calculate the value of information. The approach relies on the tenets of decision theory to accommodate multiple strategies with uncertain outcomes, as is frequently the case with IT investments.

"We're familiarising IT decision makers with methods that have already been developed to put economic value on flexibility, improved communication and infrastructure," says Hubbard, who acknowledges that AIE's range of esoteric calculations may initially be intimidating. "It's a lot of work, but actuarial science is heavy. IT investments are big, risky things, and you really ought to be willing to do the math."

Balanced scorecard: Downplayed by some as a squishy 1980s leftover, the balanced scorecard and its various permutations (there's a subset for finance, human resources, IT, employee competency and, coming up, one for e-business) is nevertheless the methodology business people most frequently think of when someone says "valuation".

At its essence, the scorecard seeks to articulate a direct link between business strategy and financial performance by monitoring four different areas of activity. The traditional lag indicators of standard financial performance are "balanced" out by also measuring three more fluid activities: customer relationships, operational excellence, and learning and growth infrastructure, that is, the organisation's ability to learn and improve.

Companies must first establish a cause and effect between financial outcome and strategy at the highest levels of the organisation, says David Norton, who developed the balanced scorecard along with Robert Kaplan and is now president of the Balanced Scorecard Collaborative. The next step is to define and monitor the internal processes - including the technology drivers - to help you achieve those outcomes, he explains.

The IT scorecard tightens the link between business strategy and the use of technology by insisting that every IT action be answerable to the company's stated strategic goals, explains Andrew de Lannoy, principal with Renaissance Worldwide, a US-based management consulting group. The scorecard can help CIOs shift from a mind-set that simply supports business processes to a forward-looking, more nimble organisation that articulates its activities around the centralised business strategy. "We need to leapfrog those long development cycles we see in information technology," he says. "We can't wait for applications to evolve anymore; we need to deliver things in weeks and months."

Dotcoms and other e-business companies that can't wait even that long will soon be able to tap into a balanced scorecard specifically designed for Internet initiatives. Mainspring is working with the Balanced Scorecard Collaborative and executives from 25 companies to tailor the scorecard to the needs of online initiatives. The e-strategy balanced scorecard should be available this month.

Customer index: Andersen Consulting's customer index approach, initially developed for mortgage, banking and other financial sectors, urges companies to determine the true economic value of its customers by tracking revenue, cost and profit on a per-customer basis. While it's often difficult to make a direct connection between IT investments and customer retention or acquisition, Rainer Famulla, a partner in Andersen Consulting's US financial services practice, says organisations can derive decision-making perspective from determining how such purchases will influence the customer base.

"If you compute your current costs and profitability on a per-customer basis, you can then ask, What will future technology investments do to those numbers?" says Famulla. This approach isn't relevant to companies with few customers - say, a global construction giant that builds one or two desalinisation plants a year - but it's particularly appropriate for dotcoms like where customer numbers drive every aspect of the business, Famulla says.

Economic value added (EVA): As a financial measure, EVA dictates that profit be computed simply by subtracting all costs, including the cost of capital. When managers, including IT managers, employ capital, they must "pay" for it, just as if it were a wage, explains David Glassman, partner in charge of strategic initiatives at Stern Stewart & Company in New York. Factoring in capital gives IT fuller credit for its contributions to the company and ensures business units economise on assets as well as on operating and other costs.

As a mind-set - what Stern Stewart refers to as "EVA governance" - the approach advises corporations to establish IT as a value centre rather than a cost centre, which requires IT to market its skills internally and articulate the ways in which they add to shareholder value. Business units in turn must compensate IT at rates roughly equivalent to the external market, which allows the company to track IT revenue as well as costs. Finally, Stern Stewart strongly advises adding an incentive component to give the program some teeth. "If you link EVA measures with incentives that reinforce those measures, you're going to get a much higher level of accountability," says Glassman. "You see better behaviour and more people thinking directly about shareholder value."

Economic value sourced (EVS): EVS posits that there are four and only four ways IT creates value for an organisation: by increasing revenue, improving productivity, decreasing cycle time and decreasing risk, explains Bob Cawly, developer of EVS, which is marketed as part of the Meta Group's Business Value Framework. While EVS extends the use of such valuation tools as EVA, internal rate of return (IRR) and return on investment (ROI) to help define IT in economic terms, the methodology goes a step further by trying to express the values of time and risk and add them into the equation.

EVS advises organisations to take a risk-management approach to high-profile projects. "Most companies don't believe the probability of the [calculated] risk will ever happen to them," says Cawly, "but there is much more value lost over technology than anyone acknowledges." EVS asks companies to calculate exactly the risk they might incur in being even one or two days late to market with a new system or, on the flip side, the benefits to be gained in removing just a day or two per month from their existing value chain.

Portfolio management: Taking a page from the red-hot stock market of the past decade, the portfolio management approach suggests that companies manage IT as they would a stock fund, with the CIO or another senior-level executive acting as a fund manager. "The organisation has to be wired with the mind-set that technology is an investment that has to be worked as frequently as the financial markets," says Howard Rubin, CEO of Rubin Systems and a Meta Group research fellow who promulgates the plan.

From a value-centric rather than cost-centric outlook, a company needs to manage its IT portfolio, looking at the amount, size, age, performance and risk of each investment. On the cost side of the equation, Rubin says, "Once you get an understanding of the size of your asset base - the people, networks and so on - you need to manage the unit costs of commodity services like processing transactions or Internet sales." On the yield side, companies should watch carefully the growth of the asset base and its performance.

Because the annual technology cycle doesn't work for this level of attention, companies need to shorten the budget cycle and install and develop management processes that allow them to fine-tune the technology portfolio every time they spend.

Real option valuation (ROV): At the backbone of ROV is one key concept: flexibility for the future. Like other valuation methodologies, ROV advises companies to approach IT as if it were a portfolio of options; the difference is ROV insists on a much deeper level of granularity - or, as some call it, complexity.

"Companies are struggling to determine which [IT] investment returns value, but the techniques aren't very useful," says Adam Borison, a principal at PricewaterhouseCoopers in the US, and leader of its ROV practice. "People ask, How do I figure out some rigorous, meaningful approach that lets us know what to do or not to do?"

First taking hold in the world of mergers and acquisitions, where previously unvalued or undervalued entities must suddenly be counted, ROV is gaining adherents in technology, research and development, and e-business - all areas traditionally viewed as cost centres. "Tech investments are like options. You look at what you're doing, you're not quite sure how it's going to play out, but you manage it over time to create value," says Borison.

One way to make that right decision is to look at a much wider array of indicators and consider a wider array of outcomes or future scenarios, which ROV depicts as a "dynamic road map" of management decisions and future events. The goal is to achieve the maximum level of flexibility, which in turn allows organisations to fine-tune or alter their IT course in the shortest order. "We try to make sure we've correctly looked at whether there is downstream flexibility. If you can ask, What are the milestones? How can I adjust my strategy?, then you're getting a more accurate picture of reality," Borison says.

Methods to the Madness

How to get more information on value methodologies Applied information economicsUses scientific and mathematical methods to evaluate the IT investment process. Balanced scorecardIntegrates traditional financial measures with three other key performance indicators: customer perspectives, internal business processes and organisational growth, learning and innovation., www.rens.comEconomic value addedCalculates "true" economic profit by subtracting the cost of all capital invested in an enterprise - including technology - from net operating profit. www.sternstewart.comEconomic value sourcedQuantifies the dollar values of risk and time and adds these into the valuation equation. (Select the products and services page and then Initiatives - Business Value Consulting.) Portfolio managementManages IT assets from an investment perspective by calculating risks, yields and benefits., www.metagroup.comReal option valuationValues corporate flexibility above all else; tracks "assets in place" and "growth options" to present the widest array of future possibilities. (Enter "real option valuation" in the search field.)

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