IT managers, end user managers, project managers, procurement people, sales people, IT or business consultants all have to make or influence decisions about IT. However, IT is only of value if it contributes to the ultimate purpose of the organisation using it, and that contribution is usually measured in financial terms.
Michael Blackstaff will be presenting the IRM UK seminar Finance for IT Decision-makers in London, 9-10 March.
There are some financial matters that often cause particular difficulty to IT decision makers. They are summarised in the following paragraphs.
Justification - the financial (or ‘cost/benefit’) case
We live in difficult times. Some organisations are able to invest their way out of recession; others unfortunately are having to cut back, at least temporarily, by disinvesting, cancelling or delaying IT (or other) projects. Fortunately the same financial justification and evaluation methods are applicable to all these activities.
It is easy to get IT financial cases magnificently wrong. The information that they contain has often been contributed by people from different disciplines. These may include people from IT, purchasing, legal, personnel, and other ‘user’ departments who may not have been financially trained.
They may also include financial people who may not necessarily be specialists in the particular financial and accounting challenges posed by IT. People running small businesses may have the superhuman task of having to wear all the above ‘hats’ themselves.
There are different rules for ‘cash flow’ and ‘profit and loss’ cases respectively. For example, cash flow cases include the cost of fixed assets and any sale proceeds, but exclude depreciation and loss on sale because these are not cash items; the converse applies to profit and loss cases.
It is also important to know how to identify attributable costs and benefits and to handle ‘opportunity costs’, ‘sunk costs’, attributable changes to working capital, cross-charges (allocations), inflation, leasing, interest and other ‘financial’ outgoings or income.
‘Return on investment (ROI)’ has an everyday meaning, but also a specific one. ‘ROI’ is the only investment evaluation method that is applicable to ‘profit and loss’ financial cases. All the other commonly-used methods apply only to cash flow cases.
These include: net present value (NPV), internal rate of return (IRR), payback, discounted payback and a variation of what is sometimes called ‘shareholder value added (SVA)’. All these methods, if used inappropriately or applied to the wrong kind of financial case, will give meaningless results.
Long-term (‘fixed’) assets should be ‘depreciated’ over their expected useful lives. Overestimation of useful life can inhibit the replacement of IT assets by new ones having higher levels of function that may be of considerable benefit to the organisation. This is because of a possibly substantial ‘loss on disposal’ (the difference between book value and market value) when the asset is scrapped or traded in. Also, the depreciation of upgradable assets has its own particular challenges.
Leasing can be a useful way of financing IT, but it has pitfalls for the unwary.
For example, leases which are too long or that have inappropriate terms and conditions may have broadly similar financial effects to those of the overestimation of useful life (mentioned above). These may include unexpectedly expensive charges for renewal periods or upgrades, and possibly substantial lease termination charges.
No law requires organisations to budget. However, some budget procedures can, if rigidly applied, also inhibit the replacing of old IT assets with new.
For example, the practice in some organisations of not crediting the proceeds of asset disposal to the IT (or user) budget is sometimes a hangover from the days when most business assets had long lives and negligible residual values.
It is questionable whether it is appropriate for IT assets, typically of short life and substantial residual value, and whose price/performance continues to improve dramatically year after year.
An IT (or other) contract is regarded as ‘long-term’ if the time taken to complete it falls into at least two accounting periods.
Obviously the precise outcome of a long-term contract will only be known on its completion. However, to await completion before taking into account any revenue (and resulting profit or loss) during the intervening years, during which costs will be incurred, would distort the accounts of those years.
There are specific rules designed to ensure that the accounts in any year show, as accurately as possible, the revenue and costs attributable to long-term contracts, and the resulting profit or loss.
There are some specific rules for the guidance of those who either build or interpret financial cases for outsourcing (or its converse - ‘insourcing’), reflecting the characteristics specific to this kind of decision.
Finance fundamentals and accounting jargon
The fundamental principles of finance and accounting are not particularly difficult, but many people are intimidated by the jargon. The emergence of International Accounting Standards will ultimately (perhaps) make easier the communication of financial information between countries, although we are currently in a period of transition pending their full implementation.