Mark McDonald

A member of the Gartner Blog Network

Mark P. McDonald
GVP EXP
8 years at Gartner
24 years IT industry

Mark McDonald, Ph.D., is a former group vice president and head of research in Gartner Executive Programs. He is the co-author of The Social Organization with Anthony Bradley. Read Full Bio

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IT spend as a percent of revenue – a dubious metric at best.

by Mark P. McDonald  |  April 6, 2010  |  9 Comments

Ask about IT metrics and you get a range of answers from “all of them are wrong” to “some more wrong than others” and “they are about all we have.”  I want to single out one metric in particular – IT spend as a percent of revenue aka sales.

I have no issue with the metric itself.  Its clear, easy to calculate and it has an intuitive simplicity that says that there should have some meaning to it.  Unfortunately, being easy to calculate does not mean that the metric has any value in making management decisions.

IT spend to revenue is of less use (useless) to management because its one sided – on the downside.  Here is what I mean.

CIOs with an IT spend to revenue ratio about the industry average quickly find themselves forces to cut/restructure the IT budget to bring it into line with the industry average.  IT is a luxury in this case and IT budgets are fat because the IT budget is above the industry average.  We can debate the merits of such a management shortcut in another post.

CIOs with an IT spend to revenue ration below the industry average however, do not find themselves getting greater budget increases to bring them into line with the industry.  No these CIOs are rewarded by keeping the undersized budgets while executives see firms more invested in IT as being the ones at a disadvantage or uninformed.

See the one sided nature of the metric.

A good metric provides information that informs a decision that could go either way.  In this case, it is all one way – in favor of being at or below the industry average.

This metric is pernicious for another reason, namely that when sales go up, the IT budget is not allowed to expand at the same rate as sales.  Here the CFO states that IT is a source of leverage and it should not rise as fast as sales.  If there is not upside to the metric then the downside bias shows itself again.

Finally metric is increasingly irrelevant in terms of managing IT or managing sales for several reasons.

  • First, IT transaction volumes have largely divorced themselves from revenue levels since the widespread use of customer and supplier Internet portals in 2003.  I talked about this in an early post about a capacity gap.    But the point is clear, there is little to say that IT resource demand increases at the same or greater rates because of sales growth.
  • Finally, there is little causality at best, between sales levels and IT.  Sure when IT systems fail it’s tough to book revenue, but there is no general relationship between changes in IT spend and changes in sales levels.  IT spend is not like marketing or sales spend in this regard.

So what are we to do?

We need to recognize that the metric has no meaning because the numerator does not influence the denominator.  You might as well measure the weight of the Board of Directors and compare it to changes in sales – they have the same ‘connective’ logic between them.

Replace IT budget / revenue with a metric that has meaning – like IT headcount to Free Cash Flow.  That is a metric one CIO is using and it makes more sense because it can be managed.

Measure IT headcount because more than 70% of most IT budgets are already contractually committed – effectively removing them for short-term management changes.  IT headcount is the result of factors the CIO can control, like the level of automation, the skill of their people, the structure of their operations and the nature of their IT investment budget.

Free cash flow is a better numerator, as it is more indicative of a company’s health.  Management can influence free cash slow and manage it to some extent in either a strong or weak economies.  Case in point; look at organizations building cash in the recession.  Free cash flow is also something that IT can influence as IT systems integrate process and information flows which improves end-to-end process and cash performance.

I know it is harder to measure, free cash flow and IT headcount, but it should produce a clearer signal and inform better management decisions and actions.

One final note, remember that the value of IT exists through time, so any measure of IT should be shown across time – usually via a control chart to separate the true performance signal from day to day operational noise.

First kill all the metrics, starting with IT budget as a percent of revenue or sales.

9 Comments »

Category: 12 things business should know about IT CFO CIO Strategy     Tags: , ,

9 responses so far ↓

  • 1 Evan Quinn   April 6, 2010 at 8:11 am

    Sounds like a good opportunity for Gartner to build a tool for CIOs and senior IT types, and offer some consulting. Unfortunately nobody is going to kill all the metrics, CFOs undoubtedly want to know what the right spend is for IT, so if Gartner could take these thoughts and package them, might be helpful. I imagine Gartner already has raw data from EXP surveys.

    The tool would need to prompt for a variety of information that describes each company’s business model. A few key variables might include employee mix (% knowledge workers), level of mobility, ratio of IT that contributes directly to revenue (e.g. a DDA system at a bank has direct contribution to revenue, the HRMS arguably much less so), some kind of industry/peer standards, age of infrastructure, etc.

  • 2 Lorie English   November 29, 2010 at 3:58 pm

    What is the best source of IT as a percent of spend by industry?

  • 3 Mark McDonald   November 29, 2010 at 4:47 pm

    Lorie

    Thanks for your post and I have a post coming up to offer an alternative. The main point of the post above is to point out that comparing IT as a percent of revenue for an industry is a rather meaningless metric as its always taken by business executives to be a sign that either we are spending too much or that others are spending too much.

    Rather than talk about IT spend, which is driven by so many other factors, I would suggest that you compare your companies operational metrics against its peers in the industry. For example, the amount of capital to sales, the working capital required for sales, etc. (The post will detail this) as comparisons will show difference in the way the company operates and therefore the potential value of investing more or less in IT.

    For example, lets say that your company needs $50 million in working capital to generate $100 million in sales, but your competitor needs only $25 million to generate the same sales. They are more efficient than you are and perhaps part of that efficiency comes from their investment and application of IT.

    The reason for using such a measure to compare is to tie any change in IT funding levels to observable business outcomes that can be expected form increased IT investment. Otherwise you are asking the business to spend more on IT just because others are spending more.

    As I mentioned at the start I am working out the details for a post in the next few days, but I thought I would share some thoughts here.

    Thanks for your comments and welcome your and other thoughts.

    Mark

  • 4 IT Metric With Meaning – IT Headcount to Free Cash Flow « IT Benchmark Blog   March 18, 2011 at 4:39 pm

    [...] See full article: http://blogs.gartner.com/mark_mcdonald/2010/04/06/it-spend-as-a-percent-of-revenue-%E2%80%93-a-dubio… [...]

  • 5 How much should you spend on IT?   November 7, 2011 at 7:04 pm

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  • 6 When Frugality Fails   January 20, 2012 at 11:49 am

    [...] conditions and micro-executive vision about the role of technology.  So long as you were measuring IT spend as a percent of revenue, you could claim success as it appeared that IT frugality worked – we were getting more for less, [...]

  • 7 How Much Should You Spend on IT? « Dream. Develop. Direct.   January 22, 2013 at 3:14 am

    [...] P. McDonald contributed a contrasting perspective in an article for Gartner titled “IT spend as a percent of revenue – a dubious metric at best”. In it he conjectures that “we need to recognize that the metric has no meaning because the [...]

  • 8 What are the feedback systems that drive a Technology Game?   February 20, 2013 at 7:09 am

    [...] Feedback has been a challenge in the old IT game.  Cost, quality of service, risk have dominated past IT feedback systems – with cost being the prominent guide for measuring IT’s impact, CIO success and IT performance.  This feedback system is embodied in the most common of all metrics IT budget as a percent of revenue, a dubious metric at best. [...]

  • 9 Paul K   August 5, 2013 at 9:48 pm

    I think I have to argue against the main point of this article at least in the healthcare industry. IT spending as a % of revenue is lower in healthcare than in other industries even though a pretty good argument could be made that it is one of the most information-intensive industries. But spending really does have to go up as “sales” go up because that means there are more patients and more doctors and a lot more to keep track of. Faster hardware and more disk space are required as well as more sophisticated software to meet government and other demands. Because HIT tends to keep costs down as much as possible, transaction levels are still closely tied to hardware capacity.