With somewhere between 48% and 62% of total IT expense flowing outside firms to vendors, the IT supply chain and associated contracts determine an organization's technology economics.
The terms of the contracts themselves, specifying duration, termination conditions, fees, costs, volumes, service levels and such, play a major role in shaping the foundation of a company's “fixed versus variable” cost structure.
The built-in assumptions underlying these contracts - such as that volumes will grow and unit costs will decline at the rate of current technology advances - were likely sound at the time the deals were done, but are likely not valid in the long-term. And the very nature of many past contracts, with long terms and termination penalties, renders them an impediment for companies that need to transform their technology economies to adapt to the new normal of the financial services sector. As such, organizations trying to move forward are more likely to spend time trying to break old contracts as the vendors attempt to hold on to them rather than being able to work rapidly towards their new operating models.
To avoid a future that repeats the past, organizations need to establish core tenets for how they approach contracts and manage the IT supply chain. And at the same time, vendors -- on the sell side -- must rethink the constructs that underlie their contract terms, and get with the program of what the buy-side needs. They need to have new offers ready for new times. Otherwise they will be bound in contention with their long-term customers and leave the proverbial door open to switching and creating opportunities for competitors who have been better able to adapt to the current economic reality.
Follow the Money to Size the External Flows
"Follow the Money" is an interesting phrase. It played a major role in the nation's politics in the Watergate era and was cited in the 1975 book, "Crime in Britain": "Always follow the money. Inevitably it will lead to an oak paneled door and behind it will be Mr. Big. It is a tip that has paid off in many cases".
In Technology Economics, this guidance is proving to really pay off -- especially in the area of assessing the potential to reshape an organization's technology economics by transforming the operational model of its IT supply chain and contracting foundations.
A typical "Follow the Money" stack for IT expense in a typical big bank
It is definitely not a surprise that labor costs are around 45% of IT expense.
But if you apply ‘Follow the Money” from a slightly different vantage point, you can follow the money inside and outside the firm.
In most large firms, 48% or more of IT expense flows out into the IT supply chain. In other words, it leaves the firm.
Looking at these figures another way, a bank with a $5 billion IT budget may have $2.5 billion annually flowing through its vendor contracts. If that same bank has 2 billion shares of stock outstanding, its IT external costs are worth about $1.25 per share -- that is an astounding number relative to the earnings per share of many institutions.
Follow the Contracts
As money leaves the firm, the dynamics of these expenses are controlled by contracts -- some long term, some short term, some with onerous termination clauses, some with minimum volume requirements. In addition, the longer the term of the contract, the more likely that the contract terms themselves did not foresee the current state and needs of IT in the financial services sector.
The majority of contracts, whether for hardware, software, labor, market data, data center space or telecommunications services are based on assumptions and economic models that no longer stand the test of time. And perhaps even more constraining is the fact that compensation for the vendor sales and account teams is tied to these outdated models that are the foundations of the contracts.
As the needs for the future change, front line sales teams just don't want to let go of the past. Therefore just as companies need to move forward and transform IT with new operational models, new models of consumption and the introduction of new technologies, they are constrained by current contracts and supply chain practices. But worse, as companies have a need to decouple from past deals to move forward, they are faced with contentious debates and negotiations with their vendors and suppliers. Massive energy and time is spent unraveling the past while opportunity for rapid movement to a new future is lost.
Similarly the principles used by IT organizations for the management of their IT supply chains are likely inappropriate for current business and IT needs of economic agility, leverage, and the rate of technology change and innovation. The "art of the deal" is no longer about low unit cost and increasing volumes over time -- it is about agility, speed, service quality, and leveraging supplier capability and experience.
Transforming Supply Chain Economics
Two things are apparent in the technology economics of the IT supply chain. First, the foundation of future deals must capture lessons learned from the constraints of the past. It is essential that organizations first create a "deal portfolio" that clearly shows all commitments, timings, volumetric assumptions, termination penalties, and so on -- covering at least 80% of contract commitments.
Next, the organization needs to identify the constraining factors in these deals and where current internal trends (again along the lines of volumes, cost structure, funding, etc.) are counter to the current deal portfolio.
And finally, the organization needs to put together an end state model of where it needs to be and then identify required deal intervention points.
Define Your New Contract Principles
To avoid the pitfalls of past deals, some new guiding principles are needed. The purpose of these principles is to provide a foundation for needed agility: Deals cannot contain lock-ins created by termination fees, volume growth rates, or dependencies with other contracts.
To more effectively and efficiently manage the IT supply chain, a new model is likely needed.
Lessons learned from outside the financial services sector in retailing and manufacturing, clearly tell the story of the strategic value of effective supply chain management. Companies such as Wal-Mart have learned to leverage supplier know-how and talent to increase the efficiency of their own business by leveraging a model in which suppliers and vendors manage others who offer complementary services, while fostering fierce competition that provides continuous value to them as well.
These companies have found success using category management - a systematic, disciplined approach to managing a product category as a strategic business unit. In the IT supply chain, like in retail, categories are easily defined and might include contract labor, storage, processing and end-user devices. Yet category management has not been adopted by the IT community.
Wal-Mart and other retailers have also successfully used the concept of category "Captains," where one particular supplier into a category is nominated by the retailer as a category captain, who is expected to have the closest and most regular contact with the retailer as well as investing time, effort, and often funds in the strategic development of the category within the retailer.
In return, the supplier will gain a more influential voice with the retailer. The category captain is often the supplier with the largest turnover in the category. In order to do the job effectively, the supplier may be granted access to a greater wealth of data-sharing, e.g. more access to an internal sales database.
The category Captain is a highly desirable position for any vendor. That desirability itself is a key lever for the IT organization. Clever retailers make it clear that captainship is a highly contended honor -- other vendors will vie for that position by showing they can do more. The "more" is more analysis of your supply chain, more analysis of options, more optimization of that category -- and all at the Captain's expense.
Vendors Need to be Proactive
Those on the sell-side play a significant role in this transformation too. New offers to clients and contract structures offering agility should be put on the table sooner than later. New models that accept rapid technology change and market uncertainty need to be crafted. New sources of value creation (like offering to be a category Captain) need to be communicated and implemented.
A New Technology Marketplace
IT organizations today are stressed to find ways to optimize costs and increase value in the face of uncertain market trends and complex regulatory pressures. Most current efforts to meet these challenges have focused on labor arbitrage, downsizing, outsourcing, and contract renegotiation.
There is an apparent opportunity to transform the economics of IT by going beyond this standard practice. The path, in part, is to “Follow the Money” (the money that goes outside) and adopt supply chain principles and new vendor management models to optimize expense outflows and their value. And while this may seem onerous to suppliers, who are already facing enough market pressures, the opportunity to make new offers to create new forms of value to customers may transform the supply-side in the technology marketplace itself.
The transformation of IT supply chain management, vendor management, and the nature of deals being offered by vendors and suppliers points the way to a new technology marketplace. Those that reach the frontiers of this new model first stand to prosper and attain competitive advantage. At that frontier we may see yet another transformation itself -- the start of “futures” markets in the form of IT “commodity” exchanges for processing, storage, labor, and more. It is not question of "if" this will occur; it is a matter of "when."
Dr. Howard A. Rubin is a Professor Emeritus of Computer Science at Hunter College of the City University of New York, a MIT CISR Research Affiliate, a Gartner Senior Advisor, and a former Nolan Norton Research Fellow. He is the founder and CEO of Rubin Worldwide.
Dr. Howard A. Rubin is a Professor Emeritus of Computer Science at Hunter College of the City University of New York, a MIT CISR Research Affiliate, a Gartner Senior Advisor, and a former Nolan Norton Research Fellow. He is the founder and CEO of Rubin Worldwide. Dr. Rubin is ... View Full Bio