Published: April 25, 2008

To better understand the individual actions in the financial management process flow, it is helpful to look at the facets that contribute to financial activity in an organization. These areas share a need for information that is collected and evaluated through the financial management function.

Figure 6. Processes and areas relating to financial management

Financial management is applied to many areas of the organization to ensure that appropriate value expectations are established and that expected value is actually realized in these areas. Consideration is given to costs and benefits, using risks and returns as a way to describe value. Each area requires its own perspective about financial data.

Executive Management Review

During this review process, upper management defines the needs and goals of the organization that, in turn, drive the requirements that IT turns into systems and, ultimately, services. Additionally, these individuals are responsible for approving investment models that might include ROI, cost, chargeback, and revenue, among others. Finally, they establish levels of risk tolerance and determine the desired balance of risk across the IT portfolio.

Risk Tolerance

Risk management may use a variety of methods to identify and characterize risk, but risk tolerance must be determined through an organization’s governance function. Financial managers can contribute to this discussion by using the concept of hurdle rates to set expected risk and ROI ratios.

The term hurdle rate originated in the financial services sector, but it can be applied to determine the expected returns from investments at different levels of risk. The closest thing to a zero-risk investment is placing money into government bonds from very stable countries. The bonds may yield a low, but reliable, rate of return (for example, 3 percent) that can be used to benchmark any zero-risk investment. Any zero-risk investment that exceeds this rate of return is said to exceed the hurdle rate and therefore passes the financial return acceptability test.

Any proposed IT investment likely has a non-zero risk; thus, it will have a hurdle rate that is higher than the benchmark 3 percent. Low risk might be 8 percent, medium risk 14 percent, high risk 23 percent, and maximum risk potentially more than 38 percent.

Needless to say, executive management must approve of these risk bands and their associated hurdle rates in order to drive desired IT investments at acceptable levels of risk. By providing a consistent method with which to classify risk, hurdle rates help ensure that expected returns from IT can be compared to other business investments.

Business Case Analysis

During a business case analysis, management evaluates new ideas that support a changing business environment—this involves determining the feasibility of proposed projects from the standpoints of cost, benefits, and risk. This is also the point where management establishes discretionary and non-discretionary requirements.

Non-Discretionary Projects

Non-discretionary projects require little discussion; they are upgrades and improvements to infrastructure as well as work done to meet regulatory and compliance requirements. For a variety of reasons, there is no choice but to invest in these initiatives. However, getting non-discretionary items funded requires documentation of:

• The problem (brief summary).
• The solution (capabilities that will be enabled).
• The benefit (brief statement of how the problem will be eliminated or mitigated).

Discretionary Projects

Discretionary projects involve deeper analysis than non-discretionary projects, and decisions about these projects often require the consideration of trade-offs. They are undertaken for a variety of reasons: they represent efforts to change and expand the business or to execute against new strategic directions. Funding a discretionary project requires documentation of:

• The situation (the specific organization capability that is not being met).
• The target (a measure or measures that substantiate the situation).
• The proposed solution (how the target measure will be improved).
• The impact on the target if nothing is changed.

Figure 7. Discretionary project: Documenting expectations for value realization

Portfolio

An organization’s portfolio consists of existing services, as well as those that have been approved for development. It represents risks and expectations for returns across the portfolio—the “all up” view. For more information on portfolio management, see the  Business/IT Alignment SMF.

Budget

A budget is a plan that estimates the financial resources that may be spent on creating and delivering services in the IT portfolio. It forecasts future fiscal needs based on business requirements and planned projects; it also reflects the impact of regulatory and standards requirements.

Accounting

Accounting is the system of record for expenditures and charges, including:

• Depreciation and software licensing and maintenance fees for purchased software.
• Salaries and benefits for IT management and staff and outsourcing and consulting costs.
• Chargebacks for services, SLA adjustments, and other ongoing costs.

Value Realization

Value has multiple dimensions that vary from organization to organization. The value realization process quantifies the value of IT investments so that decision makers can prioritize according to expected value and, later, have the means to determine whether expected value was, in fact, realized.

Investment decisions should reflect three basic considerations:

• Invest only when value can be tied to organizational strategies.
• Invest only when the sponsor is willing to be held accountable.
• Invest only if value can be determined.

Investments yield value that can be separated into categories. Figure 8 shows some common ways to categorize value, along with examples of how a specific initiative should affect value in a number of different respects.

Figure 8. Possible value categories

Monitor Value Realization

Continual monitoring of asset value is crucial to competent financial management. Items subject to monitoring include costs to plan, build, and deploy, as well as management resources and operations costs.

The monitoring process takes into account hard benefits (for example, a reduction in the number of servers needed) and soft benefits (for example, a marked improvement in customer relations). It serves to validate the organization’s investments by comparing initial expectations with actual results. Underperforming investments may be changed or dropped, and resources can be allocated for better returns and improved value.