IT Costs Vs. Revenues

Source: Tech Update/ZDnet
by Mike Sisco, TechRepublic
Date: 28/10/2002


Strike up a conversation with a successful CEO and you will quickly find a person with an excellent grasp on the makeup of the company's profit and loss (P&L) statement and the revenues and expenses that contribute to them.

In the early '90s, I was a CIO (chief information officer) for a healthcare billing company that was in a significant acquisition and growth mode. Watching Randy, our CEO, was a very interesting exercise. He would quiz operational VPs about the cause and effects of their P&L performance within the areas that they controlled. Randy always seemed to have a better grasp of the Memphis operation or the Philadelphia operation than the manager in charge of a region. It gave me a sense of urgency to understand the financial dynamics of the IT organization.

For me, that experience reinforced what all CIOs know--if they want to communicate with CEOs, and hope to have any leverage with the person in the corner office, then they must learn how to speak in financial terms. It's always helpful to learn a new financial metric to add to the tools CIOs are already using. One of those tools is the ability to calculate IT as a percent of revenue. The calculation is an effective way to illustrate the effectiveness of the IT department to the CEOs and CFOs in your organization.

CEOs like to relate to an IT department's costs--especially how much the IT department spends as a percentage of revenue. However, most CEOs are strategic thinkers who do not necessarily get into the details of how a CIO is spending the company's money. Yet they usually have a picture of how much the company can afford for corporate services (sometimes called corporate overhead) to support the revenue generating operations of the company.

To present IT expense as a percent of revenue, use this:

IT expense as a % of revenue = Total IT expense/Company revenue

Download this spreadsheet to automate the calculations and produce a graph to illustrate the results, which will help you position and manage IT financial expectations. The spreadsheet is also an excellent tool for CIOs when it comes to obtaining the next investment needed in technology to help your company achieve greater success.

How to calculate IT expenses

Astute CEOs want to know how their IT department compares with IT departments in similar companies. So using the IT expense as a percent of revenue figure lets CEOs compare one IT shop to another.

For example, if the CEO heads up a healthcare company, the CEO will want to look at the percent of revenue figure for IT departments in other healthcare companies. Perhaps the industry typically has a technology expense of 2.5 percent to 3 percent. If the IT department has a percentage much larger than that, perhaps the CEO will need to understand why the IT shop is not functioning as efficiently as others in the industry. The CEO will also want to know how the company can beat the industry averages.

You can use the expense-as-a-percentage-of-revenue discussion to help you build a case to actually spend more in technology to benefit the company. The key here is that the expenditure must be an investment that provides quantifiable and tangible benefits to the company. Financial upside is usually the criteria that your CEO and CFO are looking for.

How to use the spreadsheet

This spreadsheet can be used to help track and forecast your IT department's expense as a percent of company revenues.

To use the spreadsheet:

• Fill in the two rows for company revenue and IT expense. In the company revenue row, use the entire company's revenue numbers or the revenues of the division of the company that IT supports. (For example, if IT supports a wholly owned subsidiary of the parent company that makes up only 15 percent of the company's revenues, you should use the revenues just for that division, i.e., the revenue that is appropriate for the part of the company your IT organization supports.)
  
  
• For the IT expense row, include the entire IT budget and/or actual P&L expense numbers for your IT organization. Be sure to include all expenses that are related to the technology of the company to get a true picture, even if it is not included as part of your IT budget.

For example, I would include all WAN costs even if the company allocates WAN costs out to the remote operations that use the WAN circuits. Different companies look at technology costs differently. The key is to be consistent with how your industry looks at them if you plan to compare your numbers to industry averages, which may be difficult to obtain. In some cases, I have had to resort to asking companies with similar business models about their technology spending trends to create a comparison.

How IT helps reduce expenses

Assume that you are the CIO of a $100 million healthcare provider. Your company spends $6 million, or 6 percent of revenue, in the corporate billing department to support the medical provider operations, and $2 million, or 2 percent of revenue, is spent annually for technology support.

There is considerable upside for such a company in automating its billing processes. A CIO can use the expense as a percentage of revenue dynamic to encourage the CEO to make additional investments in technology that improves billing automation. For example, a $1 million technology investment to eliminate the manual efforts of billing results in a 20 percent to 30 percent reduction in billing department expenses. The great thing about this strategy is that the increase in technology is predominately a one-time cost while the savings is a benefit that provides ongoing improvements to the company's performance.

If you put these numbers in terms of the expense as a percent of revenue, the technology percentage jumps by 50 percent. Because of that million-dollar technology investment, the IT expense is now up to 3 percent of revenue, but it has improved the percent of revenue number for the billing department.

The bottom line here is that the company achieves a lower expense overall to run the company after the technology investment is made. Most CEOs will make $1 million investments that will reduce ongoing operating expenses by $1.2 to $2 million.

How to use the equation in your argument

I've used the technology expense-as-a-percentage-of-revenue argument several times to help CEOs and CFOs understand the investment needed to turn around a problematic IT organization or to make the technology investments that position the company for major growth. Use the same numbers as above, IT running at 2 percent of company revenue, and assume a situation that requires an investment to improve IT performance.

Meet with the senior managers of the company and lay out your high-level strategy. Position them to accept the estimated costs by showing the changes that will occur with IT spending as a percent of revenue. It might go something like this:

Today we are spending 2 percent of revenue for the technology support of the company. That's a reasonable expenditure to provide basic support services, but it does not allow us to make investments that will have a material effect on reducing the company's cost structure or that positions our company for the significant growth we have talked about.

"My recommendation is that we will need to increase technology spending by two to three times (4 percent to 6 percent of revenue) for nine to 12 months in order to make the technology investments that will accomplish these objectives. Over time, the technology expense as a percentage of revenue will decline to a level slightly below our current percent of revenue spending."

The challenge will be to manage through what is sometimes called the "bubble effect period." (See the accompanying figure.) This period requires the company to invest more money, meaning that there's an initial operating expense. You must argue that the benefits down the road are well worth the investment today, which will also provide ongoing savings from increased employee productivity derived from the technology investments.

The ultimate outcome

I have found this simple message to be an excellent way to begin positioning senior managers to accept the expense ramifications of what will happen.

I have used this scenario effectively several times with different CEOs. They relate quickly to the expense-as-a-percent-of-revenue, and the "bubble effect" allows them to visualize the implications. You must remind them of the long-term benefits during the higher spending months and keep them focused on where you are going, not where you are.