Sunday, November 5, 2017

The Cost Center Trap

In the 1960’s, IT was largely an in-house back-office function focused on process automation and cost reduction. Today, IT plays a significant strategic and revenue role in most companies, and is deeply integrated with business functions. By 2010, over 50% of firms’ capital spending was going to IT, up from 10-15% in the 1960’s.[1] But one thing hasn't changed since the 1960’s: IT has always been considered a cost center. You are probably thinking "Why does this matter?" Trust me, cost center accounting can be a big trap.

Back in the mid 1980’s Just-in-Time (JIT) was gaining traction in manufacturing companies. JIT always drove inventories down sharply, giving companies a much faster response time when demand changed. However, accounting systems count inventory as an asset, so and any significant reduction in inventory had a negative impact on the balance sheet. Balance sheet metrics made their way into senior management metrics, so successful JIT efforts tended to make senior managers look bad. Often senior management metrics made their way down into the metrics of manufacturing organizations, and when they did, efforts to reduce inventory were half-hearted at best. A generation of accountants had to retire before serious inventory reduction was widely accepted as a good thing.[2] 

Returning to the present, being a cost center means that IT performance is judged – from an accounting perspective – solely on cost management. Frequently these accounting metrics make their way into the performance metrics of senior managers, while contributions to business performance tend to be deemphasized or absent. As the metrics of senior managers make their way down through the organization, a culture of cost control develops, with scant attention paid to improving overall business performance. Help in delivering business results is appreciated, of course, but rarely is it rewarded, and rarer still is the cost center that voluntarily accepts responsibility for business results.

Now let’s add an Agile transformation to this cost center culture. Let’s assume that the transformation is supposed to bring benefits such as faster time to market, more relevant products, better customer experiences. And let’s assume that the cost center metrics do not change, or if they do change, process metrics such as number of agile teams and speed of deployment are added. I’ll wager that very few of those agile teams are likely to focus on improving overall business performance. The incentives send a clear message: business performance is not the responsibility of a cost center.

Being in a cost center can be demoralizing. You aren’t on the A team that brings in revenue, you’re on the B team that consumes resources. No matter how well the business performs, you’ll never get credit. Your budget is unlikely to increase when times are good, but when times are tight, it will be the first to be cut. Should you have a good idea, it had better not cost anything, because you can’t spend money to make money. If you think that a bigger monitor would make you more efficient, good luck making your case. Yet if your colleagues in trading suggest larger monitors will help them generate more revenue, the big screens will show up in a flash.[3]

Let’s face it, unless there are mitigating circumstances, IT departments that started out as cost centers are going to remain cost centers even when the company attempts a digital transformation. What kind of mitigating circumstances might help IT escape the cost center trap?
  1. There is serious competition from startups.
    Startups develop their software in profit centers; they haven’t learned about cost centers yet. And in a competitive battle, a profit center will beat a cost center every time.
  2. IT is recognized as a strategic business driver.
    You would think that a digital transformation would be undertaken only after a company has come to realize the strategic value of digital technology, but this is not the case. IT has been treated as if it were an outside contractor for so long that it is difficult for company leaders to think of IT as a strategic business driver, integral to the company's success going forward.
  3. A serious IT failure has had a huge impact on business results.
    When it becomes clear exactly how dependent a profit center is on a so-called cost center, people in the profit center are often motivated to share their pain with IT. Smart IT departments will use this opportunity to share the gain also.
Many people in the Agile movement preach that teams should have responsibility for the outcomes they produce and the impact of those outcomes. But responsibility starts at the top and is passed down to teams. When IT is managed as a cost center with cost objectives passed down through the hierarchy, it is almost impossible for team members from IT to assume responsibility for the business outcomes of their work. When IT metrics focus on cost control, digital transformations tend to stall.

Every ‘full stack team’ working on a digital problem should have ‘full stack responsibility’ for results, and that responsibility should percolate up to the highest managers of every person on the team.  Business results, not cost, should receive the focused attention of every member of the team, and every incentive that matters should be aimed at reinforcing this focus.

The Capitalization Dilemma

Let’s return to the surprising assertion that in 2010, over 50% of firms’ capital spending was going to IT.[1] One has to wonder what was being capitalized. Yes, there were plenty of big data centers that were no doubt capitalized, since the movement to the cloud was just beginning. But in addition to that, a whole lot of spending on software development was also being capitalized. And herein lies the seeds of another undue influence of accounting policies over IT practices.

Software development projects are normally capitalized until they are “done” – that is they reach "final operating capability" and are turned over to production and maintenance.[1] But when an organization adopts continuous delivery practices, the concept of final operating capability – not to mention maintenance – disappears. This creates a big dilemma because it's no longer clear when, or even if, software development should be capitalized. Moving expenditures from capitalized to expensed not only changes whose budget the money comes from, it can have tax consequences as well. And what happens when all that capitalized software (which, by the way, is an asset) vanishes? Just as in the days when JIT was young, continuous delivery has introduced a paradigm shift that messes up the balance sheet.

But the balance sheet problem is not the only issue; depreciation of capitalized software can wreck havoc as well. In manufacturing, the depreciation of a piece of process equipment is charged against the unit cost of products made on that equipment. The more products that are made on the equipment, the less cost each product has to bear. So there is strong incentive to keep machines running, flooding the plant with inventory that is not currently needed. In a similar manner, the depreciation of software makes it almost impossible to ignore its sunk cost, which often drives sub-optimal usage, maintenance and replacement decisions.

Capitalization of development creates a hidden bias toward large projects over incremental delivery, making it difficult to look favorably upon agile practices. Hopefully we don't have to wait for another generation of accountants to retire before delivering software rapidly, in small increments, is considered a good thing.

To summarize, the cost center trap and the capitalization dilemma both create a chain reaction:
  1. Accounting drives metrics.
  2. Metrics drive culture.
  3. Culture eats process for lunch.
The best way to avoid this is to break the chain at the top – in step 1. Stop letting accounting drive metrics. Alternatively, if accounting metrics persist at the senior management level, then break the chain at step 2 – do not pass accounting metrics down the reporting chain; do not let them drive culture. When teams focus on improving the performance of the overall business, accounting metrics should move in the right direction on their own; if they don't then clearly something is wrong with the accounting metrics.

Beware of Proxies

This year Jeff Bezos's annual letter to Amazon shareholders[4] listed four essentials that help big companies preserve the vitality of a startup: customer obsession, a skeptical view of proxies, the eager adoption of external trends, and high-velocity decision making. These seem pretty clear, except maybe the second one: a skeptical view of proxies. Just what are proxies? Bezos explains:
“A common example is process as proxy. Good process serves you so you can serve customers. But if you’re not watchful, the process can become the thing. This can happen very easily in large organizations. The process becomes the proxy for the result you want. You stop looking at outcomes and just make sure you’re doing the process right. Gulp.”
“Another example: market research and customer surveys can become proxies for customers – something that’s especially dangerous when you’re inventing and designing products.”
Here are some common proxies we find in software development:
Accounting metrics are proxies, and not very good ones at that, because they encourage local sub-optimization. 
Project metrics – cost, schedule, and scope – are proxies. Worse, these proxies are rarely validated against actual outcomes.  
“The Business” is a proxy for customers. Generally speaking, so is the product owner.
Proxies should be resisted, Bezos argues, if you want a vibrant startup culture in your company. But without proxies, how do you manage the dynamic and increasingly important IT organization? You make a habit of measuring what really matters - skip the proxies and focus on outcomes and impact.

In his excellent book, “a Seat at the Table,”[5]  Mark Schwartz proposes that IT governance and oversight should begin with strategic business objectives and produce investment themes that accomplish these objectives. IT leaders fund teams to produce desirable outcomes that will have impact on the strategic objectives. Note that these outcomes are not proxies, they are real, measurable progress toward the strategic objective. Regular reviews of teams’ progress -- quantified by these measurable outcomes -- provides leaders with insight, flexibility and an appropriate level of control. At the same time, detailed decisions are made by the people closest to customers after careful investigation, experimentation and learning.

Schwartz concludes: "this approach can focus IT planning, reduce risk, eliminate waste, and provide a supportive environment for teams engaged in creating value."[5] What's not to like?


[1] From “What is Digital Intelligence” by Sunil Mithas and F. Warren McFarlan, IEEE Computing Edge, November 2017. Pg.9.

[2] The 1962 book “The Structure of Scientific Revolutions” by Thomas Kuhn discussed how significant paradigm shifts in science do not take hold until a generation of scientists brought up with the old paradigm finally retire.

[3] Thanks to Nick Larsen. Does Your Employer See Software Development as a Cost Center or a Profit Center?

[4] Jeff Bezos - Letter to Shareholders - April 12, 2017

[5] "A Seat at the Table" by Mark Schwartz