IT Spending As A Percentage of Revenue: A Common But Misleading Ratio

IT Spending As A Percentage of Revenue: A Common But Misleading Ratio
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Measuring IT

Data Center (Image Credit: Wikimedia Commons)

In accounting and financial analysis, ratios are a common method to evaluate and compare companies. For example, liquidity and solvency ratios like working capital and inventory turnover can help you determine if a company is likely to honor its debts. Given the longstanding practice of measuring financial activity in this way, it is understandable that one popular way of measuring IT departments is the ratio of spending as a percentage of revenue. This ratio is focused on describing IT spending as a cost to the business. The implication of this measure - there is nowhere to go but down - has led some to describe this as “the metrics trap.” Rather than finding ways to add value, improve productivity and serve customers, IT leaders focus on ways to reduce costs in order to improve this ratio.

The IT Spending Ratio: What Does The Research Say?

Determining what this ratio should be for your company requires knowledge of your industry, the nature of your company’s IT division and an understanding of the ratio itself. In news articles and coverage, IT spending is commonly used as a barometer to describe the state of corporate IT departments. To make use of this measure and benchmark your company’s IT spending, you will need to consider a variety of surveys and sources to create a reasonable benchmark. Carefully read the examples presented in this article to understand this ratio better.

You may think that this IT ratio is easy to understand and measure, but there are competing ways to define it. For example, a survey conducted by Computer Economics found that “IT operational budgets fell to 1.6% of revenue in 2011 from 1.8% in 2010.”

From a management perspective, increased capital spending can be a warning sign or simply indicate that the company is investing a great deal to build new systems (e.g. in the 2000s, Google invested a great deal in building data centers, servers and other infrastructure that form the backbone of the company’s services).

In comparison, consider the findings by Gartner, an IT consulting firm, in 2011. The average ratio for companies was 3.5% but for technology intensive industries such as financial services and software services, the ratio can range as high as 6%. Gartner has also found variations in this ratio depending on geography. In EMEA (Europe, Middle East and Africa), IT spending as a percentage of revenue is 4.4%. In North America, the figure drops to 3.5% and in Asia, the ratio is the lowest in the world at 2.9%. In Gartner’s view, these regional variations can be explained in several ways. The lower ratio in Asia may be partially due to lower labor costs. However, long term economic growth in China, inflation and increased real wages may erode the price difference between Asia and other regions in the future.

The Way Forward: Alternative Measures and Ratios To Measure the Value of Corporate IT

Since IT spending measures IT organizations in terms of expense, there has long been interest in finding other measures and metrics that emphasize the value of IT. Depending on the organization and the opportunity, there are different measures one can use. For example, IT managers and executives can describe their contribution in terms of reliability and customer access. By making systems available 99.9% of the time, it is possible for more customers to interact with a company’s website. In the case of online retailers, this is crucial - if were to go down, the company would lose millions. While this measure successfully communicates the value of IT, it can be misunderstood as a low value “keeping the lights on” metric. Given this limitation, it is best to use availability and reliability metrics in association with other measures.

PriceWaterhouseCoopers, the global accounting firm, has argued that much IT spending is focused on upkeep. Its research has found that IT contributed a great deal to productivity growth in the 1990s but the link between IT spending and productivity gains have weakened after 2000. Several solutions to this challenge have been proposed including simplifying the complexity of IT systems and emphasizing IT’s contribution to productivity increases. This research suggests that IT professionals find ways to demonstrate how IT contributes to new projects, new revenue and so forth. Ultimately, alternative measures of IT require a focus on value creation rather than the traditional “necessary evil” or “problem avoidance” measures which have afflicted IT divisions in the past.