The economic downturn may be all but over, but the pressure to cut the cost of IT operations still weighs heavily on CIOs and IT directors.

According to analyst company Gartner, enterprise IT budgets fell 10% on average in 2009, they were flat in 2010 and will rise by just 1% in 2011. That means IT budgets will be around 9% lower next year than they were two years ago.

But unlike in 2009, when the priority was simply survival, businesses now need to grow. The job of the enterprise IT department is therefore to support more business services with hardly any extra resources. That means any new investments must be accompanied by an equivalent reduction in existing cost.

However, most organisations cut the slack from their IT departments in the wake of the credit crunch, and so there are few ‘low-hanging fruit’ left to pluck. If they are to make substantial and sustainable cost reductions, therefore, CIOs need to build a clear view of the financial structure of their IT organisation, if they have not already done so.

Beyond projects

Financial management has always been a part of an IT executive’s responsibility, but their experience is typically in project finance. Though essential, this experience may not be sufficient when it comes to balancing finances across an enterprise IT organisation, says Phill Everson, who leads the IT effectiveness team at accounting giant Deloitte.

“As IT professionals mature in their careers, they typically receive project management training, and financial management will be a part of that,” he says. “But when you reach a certain level of authority, you are suddenly managing operational spend as well as project spend. From that point, understanding the distinction between profit-and-loss and cash accounting really starts to matter.” (See: Back to basics).

He argues that the classic chart of accounts that is used to manage the profit-and-loss of IT operations may not provide the clarity required to make significant changes to the IT department’s financial structure: “If you’re thinking about redesigning the IT organisation, as opposed to simply doing the same thing for 10% less, then you need to look beyond the chart of accounts, and disaggregate the various costs into their component parts.

“CIOs can certainly account for their finances,” he adds. “But what they may not be able to do is describe the true cost of their operations.”

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An important distinction in IT financial management is between discretionary spend – things that are decided on an annual or project basis, such as new applications or services – and non-discretionary spend, things that are seen as an essential cost of doing business, such as infrastructure maintenance and support.

According to Jim Quick, principal at PricewaterhouseCooper’s IT consultancy Diamond Advisory Services, businesses tend to focus their efforts on managing discretionary spend. “Most people think you can only play with discretionary spend, and that non-discretionary spend is what it is.”

This is despite the fact that, according to Quick, nearly 70% of IT spend is seen as non-discretionary. However, he adds, a lot of that non-discretionary spend may in fact be “semi-discretionary”.

Digging deeper into non-discretionary spend can help to identify opportunities for cost reduction, he says.

“We created a framework that separates non-discretionary cost into 13 different components, ranging from corrective fixes all the way up to IT life cycle management,” he says. “That helps clients identify where they have overlaps in non-discretionary spend, or where they are doing corrective fixes but not addressing the root cause.”

He adds that identifying areas of IT expenditure that can be treated as discretionary spend gives businesses greater control of their total IT cost.

This is also a driver for cloud computing, says Bryan Cruickshank, a partner at KPMG’s IT advisory division. “One of the advantages of cloud computing is that it shifts the IT budget towards more discretionary spend,” he says. “We are seeing more and more business cases for cloud that use that as the justification.”

Zero-based budgets

Analyst company Gartner is currently touting a radical, albeit decades-old, approach to IT financial management, which it says can help free up resources for investment when budgets are flat.

Zero-based budgeting, a technique developed in the 1970s, requires departmental leaders to justify their entire budget on a yearly basis. This contrasts with the typical approach of simply raising or lowering budgets at the start of the year.

Making divisional heads accountable for every component of their expenditure will force them to cut IT systems they do not really need, argues Gartner research analyst Ken McGee. “The magic of accountability starts to makes things go away,” he explains.

“This is how you reject what seems to have been believed for many years – that no application created can be destroyed,” he says. “Businesses are going to have to recognise that in 2011 and beyond, if you want a project that costs £5 million you need to decommission an existing application that uses £5 million of assets.”

There are a couple of difficulties with zero-based budgeting, McGee admits. Firstly, it is extremely time consuming, and “there are no technologies that make it easier to do”.

Secondly, a business leader who has their heart set on a new project may not be the best judge of what existing systems can be cut. Gartner therefore advises that enterprises set up separate ‘decommissioning teams’ to identify projects suitable for the chop.

Thirdly, it is a cultural upheaval that requires strong leadership to enforce. As soon as one departmental head successfully argues that they should be exempt, the system unravels.

“Making exceptions for certain departments is like carbon monoxide – it’s odourless, it’s colourless and it’s killing our clients,” says McGee.

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A more evolutionary approach to reforming IT finance is service management. Managing IT operations as a set of discrete services, an approach that is already well established thanks to the influence of best practice framework ITIL, allows organisations to manage their IT finances according to business output, argues Michael Nieves, a senior manager at Accenture.

“The way that IT investments have been allocated and recovered in the past has been at the level of the IT assets, and in some cases down to the level of server or software licence costs,” he explains. “But service management dovetails with finance management in that it allows you to link assets to business services, in a way that is meaningful to a business unit leader.”

This allows the IT organisation to justify expenditure that will save money in the long term, says Nieves. “If you are seeking £10 million to invest in application rationalisation or data centre consolidation, it’s much more likely if you can say, ‘Based on our understanding of how you use these services, this will give you X% of non-discretionary savings to your unit’s bottom line.’”

Those companies that have already achieved service management have found it much easier to control their costs, he claims. “Businesses that have adopted service management are already doing their first lap of cost reduction while the others are still getting their shoes on.”

However, Diamond Advisory Services’ Jim Quick argues that pursuing service management to its furthest extent, in which the contribution that every single IT component makes to the business is articulated, is not necessarily the best route to IT cost control.

He says that focusing on assets at least allows the IT department to make practical decisions about where to cut cost. “It’s very easy to cost hardware components, but when you try to relate those back to business functions and value chains, there is so much guessing involved,” he says. “There are a few companies that have successfully done that, but very few.

“Some of the best practice we’ve seen is to focus on one area at a time, such as a certain business process, and use a stack mentality to identify cost cutting opportunities,” Quick argues. “You start at the bottom and ask how much you can cut from your infrastructure costs, and then you think about the people who support the infrastructure, and work up through the stack. I don’t disagree with the service management approach, but it’s a utopian state.”

Charging back

Once IT departments have adopted service management, the idea often occurs to them to start charging business units for IT services on the basis of usage. “Once you are allocating and recovering investment based on service management, the next natural consequence is a discussion on chargeback, because it becomes much easier to do,” says Accenture’s Nieves.

In principle, charging business units for IT resources according to usage is a fair way to allocate cost and a transparent tool for keeping track of demand. However, there are a number of management challenges to be overcome.

Firstly, says Diamond’s Quick, a business unit’s usage of IT systems may fluctuate wildly from year to year, and presenting them with a bill they weren’t expecting can cause disputes. “It’s a tough proposition for the business units,” he says. “I’ve seen a client get to the point where they could produce bills for their business units, but they’ve since stopped doing it.”

Secondly, there are ways that business units can exploit the chargeback system. “How do you prevent a business unit from staying out of an SAP implementation to preserve their budget, but using the application when it is up and running?” asks Accenture’s Nieves.

That question is at the cutting edge of IT management theory, he says. The answer lies in what he describes as financial governance for IT, allocating decision rights within the organisation.

As this demonstrates, the more radical approaches to managing IT finance require cultural upheaval and therefore strong leadership.

Furthermore, says Jim Quick, any measure to improve financial transparency will remain simply an academic exercise if the cost cutting opportunities it identifies do not receive executive buy-in.

When most organisations run into financial trouble, they try to mandate cost cutting initiatives from the top down, Quick explains: “I would argue that if you have clarity from the bottom up, in a sophisticated yet achievable way, you can make those decisions a lot easier,” he says. “But a lot of the time, companies just don’t have the patience for it.”