2007/03/19

The Triple Whammy - the true cost of I.T. Waste

Background


There's a report around at the moment that says spending on I.T. is 3-4 times more effective than anything else. [Link to come]

In the first couple of decades of commercial computing, all the "low hanging fruit" - the best returns - for I.T. were exploited. That's when 'the books', financial information and large internal databases (assets, employees, stockholders, vendors, customers, ...) were computerised.

1991 - the first IT recession - marked the end of this era. For the first time, IT staff were laid off in an economic downturn. Previously other staff could be displaced by automating their jobs with I.T.

The 2000 I.T. recession - which we are only just starting to recover from - was industry backlash (and rightfully so) to "Y2K" and the "Dotcom Bust"). The general I.T. justification before then was: "We need this, trust us". After 2000, business needed to be convinced...

The Triple Whammy



The Triple Whammy of wasted I.T. dollars in the Private Sector:
  • Straight off the 'Bottom Line'. Direct reduction of Profit.
  • Opportunity Loss. The IRR (Internal Rate of Return) for most businesses on direct production investments is 30%+. This is cumulative and compounds the direct profit loss.
  • Cost of funds wasted. If the wasted money wasn't funded internally, this is a real cost. Otherwise total company debt may have been paid down.
  • Forgone Future Benefits. Every IT project is backed by a Business Case. None of which should be approved without a projected 10-20% return.


For Government and Not-for-Profit:
  • the 'Bottom Line' is collected Taxes or Debt repayment.
  • There are no direct Opportunity Losses - only mainly intangible benefits for provision of other services.
  • Cost of money is not a issue with governments not running deficeits.
  • Cumulative Forgone Future Benefits are very real - Government efficiency is driven by reducing costs. These foregone benefits do not compound, only accumulate.

What's the scale of this?



Australian GDP passed $1,000Bn/year around 2005, and total Market Capitalisation of the ASX has passed $1,000Bn as well.
The ASX only accounts for public (local) companies, not the whole private sector. There is evidence that larger companies both spend a high proportion of their turnover on I.T. and get leverage it more than smaller organisations. Their force multipler (military jargon) due to I.T. is higher - presumably linked to their economies of scale.

Combined Government taxation is around 45% of GDP. Most of which goes back into direct 'benefits' and payments - such as pensions, education, healthcare and roads. Around 17% of the workforce are in 'public sector' according to the ABS. (Education and Healthcare seem to account for around 75% of 'public sector' employment). The total 'public sector' labour cost is at least $60Bn/year - with no estimates available for the administration and policy component costs of the 'public sector'.

Private Sector



For the private sector, the average "Price to Earning Ratio" (P/E ratio) is around 20-25 times. Therefore, the whole profit generated from the ASX is around $40-50Bn/year. So probably over $1.5Bn is spent on canceled I.T. projects - and maybe 2-3 times that avoidably wasted on I.T. each year. I'll use an estimate of $2-4Bn/year for total private sector I.T. waste, assuming 50% of GDP is from private industry and gross profits are around $50Bn/year.

10% Gross Profit on turnover ($50Bn from $500Bn) seems a reasonable aggregate across all industries. Retail sales are around 2.5%, Mining is lower (?) and Services are much higher.

The economic impact of an 4-8% reduction in private sector Gross Profit is large:
  • 4-8% off shareholder returns
  • 4-8% decrease in company taxes paid - or a 2-4% reduction in Government revenue
  • 10-20% opportunity cost of through reduced investment, and
  • compounding lost profit at the IRR, say 30%pa for each year.


Private Sector - Effect of cumulative, compounding loss of lost profits


The following table calculates, over10 years, the cumulative and compounding effect of lost profits. If $1,000 is wasted on failed I.T. projects every year, then financial position of the company if the waste had been avoided is easy to calculate:
the amount lost + (amount lost)*IRR.

The amount lost in the second year is:
(first year cumulative total)*(1+IRR) + (current year loss)*(1+IRR)

And so on... The opportunity cost of the lost money, what the company could have achieved if it had been able to invest the wasted money in it's main lines of business, compounds every year.

After 10 years, at a constant waste of $1,000/year, a total of $10,000 has been wasted.
But the effect on the bottom line of the business during those 10 years is $195,000!
Very soon that gets to be "real money".
















Year Start










TOT
110003001690219728563713482762758157106041378654,405
2
100030016902197285637134827627581571060441,619
3

1000300169021972856371348276275815731,015
4


100030016902197285637134827627522,858
5



10003001690219728563713482716,583
6




1000300169021972856371311,756
7





10003001690219728568,043
8






1000300169021975,187
9







100030016902990
10








10003001,300
Total
10,000








195,757



Public Sector


For the public sector, it is difficult to introduce any compounding amounts. There is no real Opportunity Loss and no Internal Rate of Return from investing activities...

For $1,000/year wasted and projected savings of 20% forgone:
In the first year, the loss is $1,000 - and the same again for each year = $10,000
Savings per year for the first year loss is: 10*($1,000 * 20%) = $2,000
For the next year is: 9*($1,000 * 20%) = $1,800
etc until the last year: 1*($1,000 * 20%) = $200
Total: 10*($2,000+$200)/2 = $11,000

Total losses are capital + forgone savings = $21,000
Assuming no "cost of capital".


The Totals


Inflation Effects are ignored through this calculation.
This makes the assumption that real wages, the main input cost of I.T. projects, does not vary greatly over time.

Forgone Private Sector Profits


at loss of $2Bn/year and a 30% IRR, over 10 years = $110Bn in year 10,
and $400Bn total.

The under-performing profit is twice the total profit of the public companies.
Remember this is just for eliminating avoidable waste.

As a pension (superannuation) fund investor, I'd certainly like to double my returns!


Forgone Public Sector Savings and Expenditure


at waste of $1.5Bn/year and a 20% savings = $30Bn total.

This is roughly half the total wages bill - and each year the previous forgone savings just keep mounting. In 20 years, it will be 4 times as much.


Apparently these figures are too small to be of interest to Government, Institutional Investors and Corporate Regulators and watch-dogs.

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