Turning a Profit on IT

A metric evaluating the performance of IT is more than just a metric when it becomes a habit of mind for managers who ask such questions as, "How will this technology investment increase shareholder value?" Rare is the CIO who asks this question, unless that CIO happens to use economic value added (EVA), a financial performance measure.

A trademarked term of global consulting firm Stern Stewart & Co., EVA's provenance arises from economic thinking more than 100 years old, arguing that accounting profits - earnings - provide an incomplete and sometimes misleading picture of a company's financial performance. The argument extends far beyond the alleged fraud and misrepresentation of Enron and WorldCom; honest companies with clean books will report earnings increases. But sometimes the full financial story isn't as sunny.

EVA is used to argue that capital deployed for any project or corporate strategy - including IT - isn't free and that its cost must be discounted in the cost/benefit analysis of the particular investment. The economic argument is that unless a company earns a return beyond its cost of capital, it's destroying wealth for shareholders, not creating it.

A company can be reporting solid earnings, yet the returns on capital deployed to generate those earnings are in a free fall. More dollars must be spent to generate lower returns on the investment. Earnings, the offspring of accounting, fail to reflect the wealth-generating or -destroying capacity of the company, which EVA, the monster child of economics, takes into consideration. The precise calculation can be found at www.sternstewart.com under "About EVA."

Consider the implications to IT investment assessment. A simple example: A $100,000 investment will produce quantifiable benefits of $20,000. ROI is 20%. However, this total overstates benefits because the capital costs aren't included. Suppose the company's cost of capital is 12%. A $12,000 (12% times the investment cost - in this case, $100,000) charge must be subtracted from the $20,000 "profit." The EVA here is $8,000. This calculation works for any kind of IT investment.

Using the same example, suppose the quantifiable benefits are $10,000, for a 10% ROI. The cost of capital is 12%. Here, the EVA is negative $2,000: $10,000 minus $12,000. This project destroys wealth.

Under EVA, IT, the single largest asset base for some service firms, is held just as accountable for the generation or the destruction of wealth as any other capital investment, such as buildings, machines or research and development. (Under EVA, R&D is capitalized, not expensed. The reasoning is that R&D has the potential to generate future wealth beyond a company's cost of capital.) Does a negative EVA mean that the company should take a pass on the project? Technically, yes.

But as is the case with everything in IT, the real answer is more nuanced. Companies will sometimes invest in technology despite a negative EVA because the investment is necessary, and because many benefits are very difficult to quantify upfront. A domestic company transformed into a global player by virtue of acquisition needs an industrial-strength human resources system to replace an existing one that is less scalable and has far fewer administrative features - despite a negative EVA.

Then why use it? Evidence has shown that EVA, when mapped to the proper employee compensation scheme, is a powerful motivational tool, a reminder to managers for the need to place focused, shrewd bets anytime company money is spent in service of operational or strategic goals.

Unfortunately, it is unlikely that the EVA approach will work if implemented in the IT organization autonomously. EVA is designed to change the way managers think about the allocation of labor and capital to reach profitability goals across the entire organization. A company that doesn't acknowledge EVA's importance because it doesn't use it - and there are many - will hardly be impressed by the IT manager who uses it during investment assessment.

This isn't to suggest that a CIO who has the ear of the boardroom can't suggest taking the time and effort to embed EVA companywide. It might be one of the most valuable investment suggestions he can make.

John Berry is an IT management consultant and analyst in Bend, Ore. He's currently writing a book about the mea-surement of intangible assets. Contact him at vision@according2jb.com.

Copyright © 2002 IDG Communications, Inc.

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