How IT spending is changing

From the McKinsey Quarterly
Special to CNET News.com
August 8, 2004 6:00 AM PDT

After three years of decline, technology sales started to rise again in 2003 and are even higher this year.

These increases in corporate IT budgets are well known. Less visible is the surprising good news that over the next two years, some technology vendors could see their revenue leap to levels well above those predicted by many industry observers.

Where is this windfall coming from? Improvements in the general economy have clearly loosened up IT budgets, which are growing at 3.4 percent a year on average for Fortune 500 companies, according to conversations with their chief information officers.

One source of this good fortune is the recent boom-and-bust cycle's "echo effect," which should raise capital spending on technology by as much as 12 percent to 13 percent this year. Such spending peaked in 2000, only to drop by more than 15 percent the following year--the first annual decline in nearly half a century. Most Fortune 500 companies use accrual-based accounting, which depreciates IT assets over three to five years, to budget for IT. This depreciation is now rolling off the books, making room for new spending during the next two or three years--until budgets are filled by this round of purchases.

The second factor behind the higher IT budgets is pent-up demand to replace an aging infrastructure. CIOs have delayed upgrades and new projects for too long; PC hardware, for instance, has now been around for nearly four years--longer than at any time since the mid-1980s. CIOs are eager to buy new PCs and servers, to improve security and reliability, and to develop custom applications that meet specific business needs.

Most technology companies need to improve their operational efficiency.

Tech vendors shouldn't interpret this new wave of spending as a return to the fat margins of the late 1990s. Lean times taught customers to get more for their IT dollar--for example, by deploying procurement officers who wring out every cent they can from purchases. In addition, buyers now apply request-for-proposal processes and seek competitive bids. In many companies, strategists and business managers have more control over complex IT investments and demand a stronger business case for them. Many customers not only use (or threaten to use) free open-source software to lower their costs but also to send application-development work offshore.

Technology companies must understand the nature of this limited opportunity and make tactical shifts in their sales models, products and long-term acquisition plans. Hardware is in demand, and companies that make it should use the extra revenue to extend their reach into higher-margin software and service businesses or to extend their lead in hardware markets. Packaged application software, by contrast, isn't high on the shopping lists of most CIOs, who bought it in the late 1990s and, in many cases, got burned.

Acknowledging transformation
Now companies are planning less-ambitious installations that require fewer process changes. Software developers should acknowledge this transformed market and find ways to create and sell smaller, more modular pieces of their packaged offerings.

Since all of these purchases will come under more scrutiny than in years past, technology sales managers should restructure their organizations by shifting low-margin commodity items to lower-cost channels and by training their sales teams to build business cases that can help customers justify new IT systems. Finally, most technology companies need to improve their operational efficiency.

For many years, they relied on revenue growth to save them from the need to become more efficient. The downturn drove home the lesson that they, like companies in mature industries, should tend to their own productivity. The temporary upswing must not distract high-tech players from implementing their efficiency programs; rather, it should give them a boost to invest in process change. No windfall like the present one--following a boom-and-bust cycle--has ever been seen; high-tech companies shouldn't squander it.

Packaged application software isn't high on the shopping lists of most CIOs.

What customers are buying, in many cases, is not what they bought in the past. Replacing old hardware is now the top priority. In 2001, after the technology bubble burst, capital outlays for hardware started a decline that, for the first time since 1945, lasted five consecutive quarters. Capital spending for hardware jumped by 14 percent in 2003, and the momentum--driven by the need to update aging infrastructures--has continued in 2004.

CIOs say that their older systems can't meet the new need for robustness and resiliency, so they are investing in disaster recovery and in security, including protection against terrorism, spammers, viruses and the pilfering of customer data. Some companies are upgrading to more-sophisticated hardware or doubling up on servers in hopes of avoiding single points of failure.

Less-ambitious improvements
Although IT customers also want to improve their software, they are wary of big-bang packaged applications--purchases that are just now rolling off accrual budgets. This time around, CIOs are shunning expensive panaceas, especially large-scale customer relationship management (CRM) systems. Many tech executives lost face (or jobs) when the promised benefits didn't materialize, often because the technology demanded difficult-to-realize changes in processes and in employee behavior. Even worse than buying packaged applications, CIOs told us, was buying applications and then customizing them, for this strategy made it necessary to reinvest in customization with each subsequent upgrade.

CIOs now favor narrower, more-targeted, less-ambitious improvements that mitigate the risk of organizational rejection. Custom software that closely adheres to a company's existing processes (and therefore requires little or no process change) is popular, and so is software developed for a specific industry.

Meanwhile, integration--a higher priority now than it was during the boom--is generating demand for enterprise application integration (EAI) technologies. Web services are gaining traction faster than anticipated, especially in small telecom and other companies at the forefront of IT innovation. Of the CIOs we interviewed, 8 percent said that Web services were their primary integration strategy.

Web services are gaining traction faster than anticipated.

Despite these inroads, most companies are still at the experimental stage with this technology, which demands advanced skills and a high degree of commitment from the IT organization. Others are choosing a different path: Roughly half of the CIOs we spoke with have been (or are thinking about) investing in integration broker software, often combined with Web services. Adoption is strongest among telecommunications and financial-services companies, whose technical complexity makes the software especially attractive.

The third-party services market could feel the pinch, however. Many companies, spurred by lower IT salaries after the economic slowdown, hired talent and brought IT development in-house. These new hires often support and develop the more-customized applications that today's IT budgets favor. But this move could boomerang on companies in the future: The absence of vendor support could reduce economies of scale and push up costs. Offshoring in less-expensive labor markets could, of course, offset them.

More sophisticated
Customers have also changed the way they make IT investments, and that will pressure margins for commodity and high-end products alike. Many buyers have adopted more-sophisticated management processes for evaluating new technology proposals. Increasingly, the budgets or bonuses--or both--of CIOs reflect business outcomes. Still, most companies are not as disciplined as they could be in this respect: Sixty-four percent of the CIOs we talked to said that once IT budgets are set at the beginning of the year, they don't have to be defended. Many CIOs reported that their companies undertook no auditing or follow-up to determine whether IT projects failed or succeeded.

Moreover, although some companies are enlisting purchasing experts to help them buy commodity IT goods and services, IT spending is still outside the normal procurement process in most of the businesses we researched. Nearly half of the CIOs we talked to said that no clear links exist between purchasing and IT and that the procurement department plays a role only for highly commoditized purchases.

Even so, CIOs feel they have less of a say in decisions on IT spending. Several oversight models are emerging; the most common is an autonomous IT group that must get financial approval for expensive new initiatives. Strategic IT investments, such as new spending on applications, require input from the CIO's staff, but business unit executives increasingly make these decisions. What's more, the number of CIOs reporting to CFOs doubled in 2003--a trend likely to continue as companies seek ways to get greater value from IT investments. Many CIOs support this shift because they believe that business units ought to be involved and that the finance and purchasing groups can make their budgets go much further.

Companies that sell technology gear, code and services must deal with the new realities while the sector is being restructured. A long-overdue shakeout is beginning as industry leaders acquire and make alliances with smaller players that could help them gain scale or scope.

We expect that large tech players, whose sales teams have good access to clients, will become the centers of gravity. In the past, hardware vendors often had to strike deals with software companies to gain access to their clients. Now the balance may be shifting in the other direction. In either case, smaller players will need to make alliances with the market leaders, not least because customers say that they want to deal with fewer vendors.

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