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IT Budgeting Dynamic Allocation, Change is afoot..

November 24, 2008

Dynamic IT Baseline Budget Model

In my opinion, the most critical issue in managing the IT budget and liberating funds for new IT investments is a deep and thorough understanding the makeup of that IT budget.

Organizations that rely primarily on the judgment of the finance department for next year’s IT budget are not being proactive. The IT budget ought to use a dynamic baseline model. The Working Council of CIOs details that a dynamic baseline budget model consists of the following elements:

New budget = Initial baseline
+ Impact of previous investments
+ Uncontrollable increases
+ New investments
Cost savings
+/- Target for expansion/reduction
  • Initial baseline is the prior year’s budget.
  • The impact of previous investments will be primarily year-two depreciation of capital assets, operating costs, and maintenance costs.
  • Uncontrollable increases includes items such as necessary maintenance or uncontrollable increases in software license fees, or changes due to regulatory, legal or safety requirements. Higher staff salaries due to skills shortages may contribute as well.

·         Proposed new investments comprise the startup costs of investments and the first year depreciation of capital assets.

  • Cost savings is the sum of all cost reduction activities across the IT organization and environment, including recovered costs from retired applications and modified service level agreements.
  • Finally, most IT organizations are issued an annual target for expansion or reduction of the budget by the CFO or CEO.

While CIOs can influence CEOs and CFOs and argue for larger target increases by demonstrating a track record of increasing and accumulating business value from their IT investments, the two variables in the dynamic baseline budget equation that are most controllable from a CIO’s perspective are proposed new investments and cost savings.

Most IT executives would agree that failing to make some proposed new investments each year is the beginning of a death spiral. And, the single biggest lever that the CIO has is the cost saving variable. The level of focus and success in achieving costs savings through taking advantage of lower cost technology (i.e. the effects of Moore’s Law) and other actions directly affects the ability of funds in the IT organizations to make the investments that will sustain IT’s future and, indeed, the business’s future.

Capital Expenditure versus Operational Expenditure

The balance between capital expenditure and operating expenditure is a key trade-off that CIOs need to make. Too much capital investment may mean overinvestment in IT assets. Overspend builds a backlog of future problems when depreciation eats up a significant share of future operational expenditures. Too little capital investment means IT asset life is over-extended, leading to excessive future maintenance costs and future operational expenditure. Getting the balance in expenditure right and investing predictably according to the plan is important in terms of optimizing IT expenditure.

Delta Air Lines identified a phenomenon that they call the bow wave of deferred expenditure. Deferring planned capital expenditure from one year to the next creates two problems. First, deferring expenditures is likely to increase operational expenditures due to increased maintenance and support costs for older IT assets. Second, deferring necessary expenditures triggers an accumulation of expense that will demand increased capital spending in future years. The budget consequences of deferred IT capital investment set enterprises on a path that is difficult to recover from. The challenge during difficult economic times is to determine what minimum level of capital expenditure is required to refresh computing assets and not create significant budget problems in the future.

Fixed Versus Variable Spending

Any IT budget consists of both fixed and variable spending. Monies budgeted for a three-year network contract with a telecommunication provider would be considered a fixed cost because it is difficult to change such a cost without incurring a penalty. Monies budgeted for short-term contractors are variable costs that can be increased or decreased as business conditions and demand for services change. CIOs and finance managers need to determine the right balance of fixed and variable spending in their budgets to provide the right level of flexibility and responsiveness while also minimizing cost as much as possible.

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