Innovation Capital: Beyond “Last year + x%” IT Budgeting

Innovation Consultant

Preparing the annual budget is an exercise many tech leaders dread. There is tedious work required to inventory needs, project growth, and gather quotes for those costs, even in a delta% approach based on the previous year. In a zero-base “bottom up” approach, the work effort is even larger! And all of this is added on the plate of IT leaders already busy operating their organization’s tech platform and executing on the current year’s projects…

But the annual IT budgeting project offers a unique opportunity too. At least this one time each year, business leaders are looking at IT dollars at the same time as they’re projecting revenue and expenses across the enterprise. We counsel our clients not to look at the technology component of their organization as just “IT spend” , but as a combination of two very different uses of funds:

  • Expenses to keep the lights on – which should be optimized in an enterprise-wise balance of costs and service levels, AND…
  • Innovation Capital: investments in technology to help accelerate results across the entire organization.

Two Different Types of IT costs call for Two Different Mindsets

Just as capital is put to work acquiring complementary companies, expanding to new markets, developing new products and services, acquiring and upgrading equipment and tools, etc… capital investments in innovation & technology are key to real growth, especially top line growth. Business leaders are accustomed to thinking in these terms, and are usually more open to these kinds of conversations and proposals than most IT leaders realize. The challenge for many is that IT leaders aren’t trained in surfacing ideas of this kind, evaluating their benefits, and presenting a compelling business case for these investments. On the whole, we’re far more comfortable speaking to the first bullet above than the second; unfortunately it’s the second topic which is far more likely to draw the interest and energy from the rest of the C-suite.

Surfacing Ideas for Innovation Capital

There are myriad articles and entire books written on the topic of driving efficiency with technology solutions, and new technologies like Robotic Process Automation (RPA) have opened up possibilities for desktop automation across disparate systems without the need for custom programming projects.

More challenging for most tech leaders is the identification and analysis of projects to drive sales. There are many challenges to answering questions on this front:

  • How does one know what new/enhanced capabilities would “move the needle” on market-share of existing products & services to existing customers?
  • How does one know which new capabilities might make commercial sense as new revenue streams on their own?
  • How does one know which new markets might be appealing and worthwhile for expansion via technology investments vs. M&A and other means?

Each organization’s strategy, culture, and industry positioning are unique and those differences are critical to finding answers to the questions above, but generally our approach is to have the right data (sales process, competitors, deep customer analysis, etc.) and the right trust & collaboration with leadership to understand the data and allow it to inform our innovation strategy.

Including Proposals for Innovation Capital in an IT Budget

We suggest treating the two different categories of IT costs as completely separate in budget discussions in order to separate the “comparison with last year” conversation from the “investing for the future” conversation.

There is a natural tendency among business leaders (particularly among CFOs) to measure IT budgets vs. the previous year; this is appropriate and a reasonable validation of their cash-flow & margin model, but a few caveats apply:

  • Measuring “lights on costs per supported employee” is more informative than overall total costs, particularly in growing organizations.
  • At times “the right answer” may lead to higher costs for platform capabilities and/or positioning for the future; this moves the comparison from cost of apples/apples. We suggest adopting an enterprise-wide Total Cost of Operation (TCO) perspective, to offset service efficiencies in business groups OR savings in future years against increased IT costs which enable those efficiencies.
  • Business leaders should avoid applying budget pressure which incentivizes cost cutting on “hidden” platform services e.g. cybersecurity, infrastructure redundancy, or disaster preparedness. We suggest a periodic external IT assessment, and a discipline within the budget cycle to inventory not just proposed costs/services but any removals from previous years.

The format and presentation of these “lights on” budget components can and should remain fairly static year to year. This is in full contrast to Innovation Capital project proposals, which by their nature will likely be different in number, scale, type, &/or impact each year. For this reason, they should also be outside of “IT budget vs. last year” comparisons, although they do need their own discipline and organized accountability.

  • Either in conjunction with the budget cycle, or in its own cadence, previously approved investments should have an accounting of their status, costs, and benefits. Credibility to this overall approach to technology budgeting requires that projects have realistic benefits articulated in collaboration with appropriate business subject matter experts (SMEs), and that these bear fruit in a way that makes leadership comfortable making similar investments in the future.
  • Likewise, the current year’s proposals should have sufficient analysis completed on the effort, costs, staffing plan, vendor selection(s) if any, benefits, and plan of action to have confidence in the range of the estimates provided. ROI or ROIC (Return on Invested Capital) thresholds will differ depending on an organization’s Cost of Capital (CoC) and other potential uses of that capital in the given timeframe.
  • Tech leaders should be aware that their project concepts are competing in this venue with business investment projects, most of which will be more “comfortable” to business leadership due to their training/knowledge about those parts of the business. We suggest building a “coalition of support” well ahead of any formal proposal – not just to gather the needed details to estimate the impact of new capabilities, but to ensure the appropriate business leaders are ready to support the proposal as an intelligent use of the company’s capital.
  • These project discussions and approvals may work well on a quarterly or as-needed basis rather than as part of the annual budget cycle. If this cadence is preferred, we suggest that tech leaders spend time with the CFO annually for an in-depth projection of the upcoming year’s potential Innovation Capital proposals for the purpose of cash-flow planning.

Understanding % Revenue Averages

Gartner and others publish industry averages of “technology spend as a % of enterprise revenue”, about which our consultants are often asked. In short, we believe these are interesting but may lead to the wrong kind of “top-down” thought process unless taken in the right context.

Whether in the “lights on” budget category or the Innovation Capital projects discussed above, we strongly prefer a “bottom up” approach to tech budgeting. This may lead to the company being well above or below the “industry average” for their space, but it ensures the leadership knows exactly why they’re at the level they’ve chosen.

  • A company may be spending more than their competitors if they’re investing highly in disruptive capabilities. e.g. Netflix spent significantly more on its technology than did Blockbuster.
  • A company may be spending more than their competitors if they’re positioning to expand to other markets or revenue streams. i.e. if their denominator is about to grow significantly these investments make sense.
  • A company may be spending less than their competitors if they’re able to fit their business into standard off-the-shelf software solutions and can avoid significant custom development costs their competitors are forced to bear. This is an advantage many new market entrants often have who are making software selection decisions in 2021 for a new business process which is still flexible, rather than having designed processes and org-charts decades ago based on the capabilities of enterprise software at the time. Most large companies which were around in the late 1990’s made major investments to move to new enterprise platforms ahead of Y2K, and those choices are still echoing for many of these companies all the way to today.

IT Budgeting is Part Art, Part Science, Part Tedium – But it’s also an Opportunity

Hopefully the commentary and suggestions above make it clear that the budget cycle presents a unique opportunity to IT leaders to gain leadership attention, support, and funding to move their organizations in innovative directions. One size does not fit all, which makes this process (and innovation overall) a significant challenge; but what is challenging is also an opportunity, because it means many of a company’s competitors will fail to grasp the opportunity.

We hope that the concepts and framework above help you to grasp it, and succeed in this most exciting time of innovation and transformation.

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