The 'Right' Spending

by Paul A. Strassmann

Computerworld
January 7, 2002

In 1986, General Motors' top management became alarmed about escalating IT costs. To benchmark IT spending against Ford, GM hired me as a consultant to deliver an IT-to-revenue ratio comparable to Ford's, whose IT budget was reportedly smaller than GM's. It took me a while to convince GM that overall revenue wasn't a reliable basis for reaching valid conclusions as to whether GM was overspending or underspending on IT compared with Ford. In those days, Ford, with less revenue, was outsourcing more of its production costs than GM was. Therefore, Ford would theoretically require fewer employees to make a car and consume fewer IT resources to support its workforce. After adjusting for each company's employment, salaries, the amount of outsourcing and total assets under management, I delivered a report that was used to realign some of GM's IT spending.

During the current economic downturn and IT budget crunch, some executive will likely come up with a consultant's average IT-to-revenue ratio for your industry, then ask you to match it. In the chart below, I have included numbers from the year 2000 for Ford and GM to illustrate how you might want to deal with such a simplistic challenge.

Ford vs. GM: In 2000, here's how much revenue Ford and GM took in, how many they employed, and what they spent in comparison to revenues. Also shown are their profits from 1991 to 2000.
Revenues (in millions of dollars) Employees (in thousands) Purchases as percentage of revenue Information costs as percentage of cost of goods sold Total profits from 1991 to 2000 (in millions of dollars)
FORD $170,064 346 64.4% 5.6% $46,474
GM $178,763 357 73.7% 12.5% $11,367

As the chart shows, Ford's and GM's revenues and employment are alike, and therefore, their IT spending should be close if you apply either a revenue- or spending-per-employee ratio. But their IT budgets are different because their financial and employment structures are different. GM's estimated IT expenditures are approximately twice those of Ford's!

In 2000, GM purchased a larger share of its subassemblies, parts, components and IT than Ford did. Therefore, GM ought to employ fewer IT resources to manage operations. But that didn't happen because GM's estimated information costs - such as sales, general and administrative expenses - relative to its costs of goods sold are much larger than Ford's. This difference is important because IT budgets can be best explained not by corporate revenues but by other factors, such as total information costs (which include IT spending), plus the salaries of all IT users. Information costs include the purchase of services from consultants, outsourcing contractors, advertising agencies, law firms and accountants to support the internal information workforce. GM's presumed advantage from its greater reliance on outsourcing is overwhelmed by a larger information workforce that almost certainly will generate more demand for IT.

There are other indicators to consider. For instance, what are the differences in growth rates? Here, GM is at a disadvantage. Ford's 1991-2000 revenue growth was twice that of GM's, but Ford's information cost to value-added ratio remained level, while GM's grew 34%. What matters is the difference in profits. As the chart shows, the automakers reported starkly different profits over a decade.

Taking into account all the relevant financial indicators, GM's much higher IT spending is about what I would expect. What is, then, the "right" IT budget for GM, or any corporation? That can't be answered by having GM match Ford's spending. The answer is to define a corporate structure that delivers superior profits, then realigning IT spending to support that.

Implications

CIOs will be pressed to produce credible benchmarks to prove that IT costs are either in line with or lower than those of competitors. The "expected" level of IT expenditures is determined by factors such as the ratio of information workers to the total workforce; the composition of the information workforce (such as clerical vs. professional workers); growth in corporate profits; dependency on purchases from suppliers; the value of assets under management; and the number of PC users supported. The "right" IT budget, then, is one that's less than those of your chief competitors, while your firm delivers superior shareholder returns.

Strassmann has had to defend IT budgets many times in his career. Contact him at paul@strassmann.com.