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Years ago my grandfather shared his financial wisdom while we were pruning blackberry bushes on his mini-farm. I have applied one of these thoughts to Information Technology (IT) departments and describe it as `scaling expenses.' The principle is simple; set up expenses so that they automatically adjust up or down based on business conditions. When times are good, needs imposed on IT can grow correspondingly. Executives are usually more tolerate when IT expenses creep up along with a company's increased sales. When times are tough and sales decrease it would be awesome to have an IT infrastructure whose costs drift down corresponding to the business slowdown. This can be done as addressed in this article.
It is generally easier to increase expenses than it is to reduce them. Therefore, the big challenge is setting up an IT environment where expenses can self-adjust down when business conditions deteriorate. For the sake of this article let's call them friends and foes; policies which facilitate flexibility and those which tend to reduce flexibility and the ability to scale-down expenses. Starting with foes, here are some policy decisions which can inhibit financial control during tough times, which many companies have experienced these last several years.Foe #1 - Depreciation
When procuring large IT projects and capitalizing them, it locks in the expense profile for the next several years. I have been a part of three companies now where my role was to push through completion of their Enterprise Resource Planning (ERP) system implementations. These tend to be larger IT projects and thus are ripe to illustrate.
The common pattern is that the immediate years after ERP implementation the IT department is forced to reduce headcount and the IT Director often can't avoid it. Even though the ERP system has been implemented it is not yet completely effective or fully utilized (there is an important distinction between implemented and effective). Because of accelerated depreciation schedules, IT departments are forced to cut key staff at the exact same time when they are needed to crank up the ERP system to generate new business and profits. This is, obviously, counter-productive. The lesson-learned is to anticipate this phenomenon and to determine if another approach will provide more flexibility.
Instead of a major capitalized project for the software, hardware, and the set-up time of your staff, this is another reason to consider SaaS (Software-as-a-Service) where the per-seat fees are expensed when people start using it and there is no discrete hardware or licensing cost at all. While staff time, and likely a few consultants, might still be capitalized to make the conversion, the other costs are normalized to hit the income statement as the users actually begin to use the ERP system. This is a profound change in the cost structure for IT. I have attempted to depict this typical expense profile in Figure 1.Figure 1 - Loss of control over IT expenses due to rise in depreciation expense
Unfortunately, this same expense profile applies to all types of IT projects. Let's imagine that your company is going to perform a major IT infrastructure upgrade; servers, network equipment, PCs, etc. The profile is the same. You are locked into several years of above normal expenses because of an accelerated depreciation hit. But what if your company were to rent the ERP software, or to rent servers in the cloud, or to rent e-mail, and to rent the Spam filter? Under these scenarios the cost profile changes dramatically as actual expenses more closely reflects what you are actually using at the time.
As a result, our first foe as far as allowing flexibility in IT expenses goes, is capitalizing IT projects using an accelerated depreciation method. An objective could be to expense as much as possible and to capitalize as little as possible. Expenses are easier to control.Foe #2 - Chunky IT Spending
A second situation where IT locks in future costs, whether the underlying equipment and software are needed or not, has to do with the pattern of buying IT components. Consider for example when the IT Director makes a request to spend a significant amount of money because the current IT systems are hitting their limits. This can take the form of;
- out of disc space,
- no available software licenses for new staff,
- PC's or servers are too slow, or
- unable to support staff who are trying to perform what-if analyzes to help grow the business.
Due to the chunky nature of capitalization, your IT Director's proposal not only addresses the immediate need but also anticipates needs for several years into the future. This means that the IT Department is asking to spend money today for systems that won't be entirely leveraged until years in the future. This is depicted graphically in Figure 2 below. Note the graph section marked as Waste signifies cost inefficiencies.Figure 2 - Waste Inherent is Chunky IT UpgradesFoe #3 - Data Center
Whether your business is booming or struggling, your data center is always there, consuming electricity, valuable building space, air conditioner and power supply maintenance contracts, etc. You can't easily adjust these expenses. There are many fine companies that offer co-location services, as they have been commonly known. Also, consider a hybrid solution where the servers that contain your most mission critical and sensitive information are outsourced to a top-quality co-location data center and your remaining servers are placed into a convenient converted broom-closet in your offices.
So far I have identified three forces that can lead to inefficient IT spend, otherwise called foes. Let's now turn the corner to identify some approaches that can help streamline IT expenses, making them more closely aligned to the needs and growth patterns of business. I call these friends as they provide flexibility. Friend #1 - E-Mail in the Cloud
E-mail has hidden costs; such as big servers, server operating systems, per-seat licensing costs often charged at intervals of 25 people at a time, SPAM filtering, Virus/Malware filtering, records retention systems for potential Legal Holds or other litigation, and the list goes on. This is a great opportunity for a fresh approach to reduce the disadvantages in the aforementioned sections on depreciation, chunky IT spending, and data center costs. Outsourcing e-mail requires no capital expenditure today and provides more control over the costs.
Also, most e-mail services have addressed records management needs as an optional retention feature can be purchased for directors and key executives. Typically, you would only purchase this optional records retention service for the e-mail boxes of a select few executives whose messages have legal implications (i.e.: persons with contract authority, fiduciary responsibilities, company spokespersons, etc.).Friend #2 - Storage in the Cloud
Like e-Mail; there are several costs associated with simple storage of files; such as, the hardware server, licenses for the server operating system, block purchase of anti-virus software, and maybe some application software (e.g., advanced SharePoint functions). We are seeing growth in what is known as `cloud storage.' The big advantage of these technologies is that they allow companies to pay for only what it needs at the current time. This is in contrast to spending for big servers with their own storage, whose utilization will drift from perhaps 30% up to 100% over the next five years.Friend #3 - NAS or SAN
Network Attached Storage (NAS) or Storage Attached to the Network (SAN) are two acronyms for essentially the same technology that provides for a given amount of storage space to be shared among multiple servers. This has obvious advantages as the NAS/SAN can grow at a finer level of granularity than if each server had its own storage.Friend #4 - Server Virtualization
Virtual servers trick software to think that a certain function is running on its own server when it is really using the idle time of another server. I can't think of anything more efficient and effective than using otherwise idle time on servers. Buy one server and use it for many functions. Or even better, mesh several servers together into one massive IT server farm and then slice out portions based on the needs of the particular function. That is the goal of virtualization, which can smooth capital expenditures. Actual expenditures are naturally going to more-closely track to actual needs.Friend #5 - Consultants
Hire them when you need them, let them go when they are no longer needed. Summary
If I had to summarize these suggestions into one, it would be to make sure your IT leader has a thorough understanding of the complete array of expense versus capitalization accounting issue. Knowledge of the flow and timing of expenses will cause them to think out-of-the-box and more-easily consider new approaches to IT. Take advice from Charlie Szews, who is now the CEO of Oshkosh Corporation, who forced staff to model the expense impact of IT projects for several years into the future and also to express their impact on earnings-per-share. What a radical thought. Have your eye on the bottom line by procuring what you need today while deferring tomorrow's expenses until tomorrow. As your business situation changes you should be in a position of great flexibility to enable both cost accelerations and cost reductions.
Jerry D. Norton is a Partner with Candela Solutions. He leads our IT practice. Jerry can be reached at jnorton@CandelaSolutions.com
This is an article reprint from the Governance Issues™ Newsletter, Volume 2012, Number 1, published on March 28, 2012. To automatically receive the newsletter, go to www.candelasolutions/newsletter
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Author acknowledges that straight-line depreciation will reduce this effect. However, the issue with the loss of control over the depreciation amount remains and can't be adjusted based on market conditions.
The opinions expressed herein or statements made in the above column are solely those of the author, and do not necessarily reflect the views of WTN Media, LLC.
WTN accepts no legal liability or responsibility for any claims made or opinions expressed herein.