Behavioral economists have long discovered that the human beings are predictably irrational. Can their findings help us better understand, and manage, the system behavior of enterprise IT?
Financial Services IT Goes Digital
By Hakan Altintepe, CIO
“Bruce heads a billion-dollar business unit. His team is developing a multi-year digital product strategy, but he is unable to get time from IT to validate business assumptions, identify technology imperatives and commit to roadmaps…Barbara is the executive lead of a global digital transformation program. All along, her program status has been green; however, she just found out that a major customer deliverable will delay for weeks, and a new funding request needs to be submitted to the board…Michael, the global head of architecture, developed a solid plan to generate significant savings by modernizing one of the business application clusters, but he cannot proceed since all project funding is consumed by mandatory initiatives…Jennifer, a business product manager, couldn’t fund several critical features in the upcoming product release, while her colleagues have unused funding.”
None of these scenarios sound rational, but they happen all the time regardless of leaders, organizations, cultures and geographies. In fact, they describe a series of predictably irrational behaviors of the enterprise IT organizations.
Richard H. Thaler, one of the leading scholars of behavioral economics, won the 2017 Nobel Memorial Prize in Economic Science for his pioneering work in establishing that people are predictably irrational — that they consistently behave in ways that defy economic theory. People will offer to buy a coffee mug for $3 and refuse to sell it for $6; they will continue to go to gym when they are injured just because they paid for the monthly fee; they will use the savings from lower gas prices to buy premium gasoline during a financial crisis.
Binyamin Appelbaum of the New York Times writes: “Mainstream economics was built on the simplifying assumption that people behave rationally. Economists understood that this was not literally true, but they argued that it was close enough. Professor Thaler has played a central role in pushing economists away from that assumption. He did not simply argue that humans are irrational, which has always been obvious but is not particularly helpful. Rather, he showed that people depart from rationality in consistent ways, so their behavior can still be anticipated and modeled.”
If so, is it possible to make sense of the seemingly irrational, but inherently consistent patterns of behaviors of an IT organization, and devise management strategies to maximize the desired outcomes? I believe that the answer is a resounding ‘yes’.
In his most recent book, “Misbehaving,” Professor Thaler articulates a ‘stunning’ graph, depicting the value function embedded in human behavior. The graph focuses on changes in wealth with respect to the status quo, rather than the absolute levels of wealth, because changes are how humans experience life. Humans also feel a diminishing sensitivity to gains and losses, whereas the loss function is considerably steeper than the gain function. Furthermore, people are risk-averse for gains, but risk-seeking for losses. This asymmetry in the value function leads to the endowment effect, a term coined by Thaler to describe the observation that a good often appears to be more highly valued when it is part of an individual’s endowment, compared to when it is not.
In Figure 1, I recreated Professor Thaler’s graph for enterprise IT. Today, most enterprises treat technology spending as a cost of doing business. In this context, enterprise IT is expected to deliver efficient and reliable solutions as specified by the customer. The expectations of IT are limited to meeting the budget and schedule targets and avoiding unfavorable major events, like breaches and outages. Therefore, most IT organizations are unfairly criticized as non-innovative, reactive, and risk-averse; they are just doing what is expected of them.
When technology spending is treated as a cost of doing business, most constrained resources – such as budgets and people – are allocated not based on opportunities but based on affordability, which is a function of the historic spending patterns of the enterprise and the current spending trends in the industry, i.e., benchmarks. (Note: recently, the zero-based-budgeting approach has gained popularity as it aims to emphasize opportunities and needs over affordability in budget allocation decisions. However, because assumptions about unit-cost, demand volume, and productivity remain deeply rooted in the history, progress has been often limited to the form rather than the substance.) The affordability criterion provides a simple way of ensuring cost control, but it also creates an enormous amount of endowment effect among business and IT managers – that is the only way to ensure a steady supply of funding and key resources in the future is to own as much of them as possible today.
Let us go back to the scenarios we introduced at the beginning of this article. Bruce cannot get IT participation, because there is little to gain but a lot to lose for IT by committing to any roadmap without understanding where funding will come from. Furthermore, most IT organizations are not funded to provide strategic advisory, as those resources are often considered an ‘overhead’, and let go first during a cost-reduction cycle.
Barbara’s organization uses traditional program and project management metrics, which focus on meeting the budget and schedule targets by looking back and determining how much work has been completed. This type of reporting carries little insights about how much work is remaining in the digital age due to the proliferation of iterative and agile methodologies. Because the remaining work is harder – but certainly possible – to predict, and risky to communicate, managers tend to stick to what they know best and what is considered safe. Besides, by the sheer fact of voluminous data and myriad progress reports, managers gain a sense of overconfidence about their ability to forecast future progress.
The reason why Michael couldn’t find funding for his plan is that his enterprise is not equipped to properly govern the return on technology spending, because it is considered a cost of doing business, not a source of alpha. Sure, IT organizations put a small amount of discretionary budget for initiatives, like Michael has proposed, but they have neither the mandate or the means to portfolio manage a meaningful portion of the overall technology budget.
Jennifer’s challenge is a textbook example of the endowment effect at enterprise IT. Simply put, IT budgets and people are not fungible, they are owned, and hence cannot be forfeited to someone else, even if that would improve the overall business outcome of the IT organization.
What is the solution?
Intuitively, most CIOs are aware of the unfavorable shape of the enterprise IT value curve and they constantly take actions to improve it. On the side of the gains, workforce transformation programs promote new cultural traits such as proactivity, risk awareness and sense of accountability, enabled by an enhanced performance management and leadership recognition framework. Leading IT organizations invest in product organizations with persistent teams, as the traditional project teams tend to be temporary; they also transition the basis of their performance management philosophy from benchmarking to continuous improvement. Very few organization, mostly born-in-digital enterprises, have reduced the divide between the business an IT through aligned portfolio objectives, and successfully elevated the gain function of enterprise IT.
On the side of the losses, there are quite a few management practices available, which promote resource sharing (e.g., competency centers, resource pools), control sharing (e.g., product/ service management, cross-functional/organizational governance bodies), and to some extend funding fungibility (e.g. IT investment pools). Sharing technology investment risks between the business and IT seems to be the next plausible option to further level the loss function of enterprise IT.
Any improvements in the value function can surely help reduce the irrational behaviors of enterprise IT, but there is even a bigger gain to look for: by reducing the asymmetry of the value function, we can hope for a true portfolio management across all technology investments within the enterprise. When gains and losses are similarly weighted, managers will be more encouraged to pool their initiatives to diversify risks and share gains. This is the nirvana of maximizing the business value of technology investments.
What does it take to improve the value function?
An important characteristic of the value function of enterprise IT is that it is top-down driven. Whether to treat technology spending as a cost of doing business or a source of alpha is entirely decided at the top of the house, i.e., the board and the C-suite, and their guidance permeates throughout every corner of the enterprise. Just to illustrate the significance of this point, I asked several senior IT leaders at financial services companies if they would be rather enticed by a solution that improves the business outcome of technology spending by 100% while increasing the spending by 10%, or reduces spending by 10% with no apparent change in the business outcome. Essentially, I gave them a choice between one less unit of loss and nine units of net gain. They chose one less unit of loss. Their rationale was that the board was solely focused on containing and reducing IT costs, a textbook definition of technology spending as a cost of doing business.
I believe that a real progress in maximizing the business outcome of technology spending requires a visible shift in executive thinking that technology spending is a source of alpha, like any other corporate investments.
What does this mean for CIOs and their teams?
In my previous article, “Is technology spending a cost of doing business or a source of alpha?” I discussed how CIOs and their teams can become a transformational force in the way corporate and business leaders think about technology spending in a digital world. In summary, leaders of enterprise IT need to answer two fundamental questions for the senior members of corporate governance:
How can technology help us truly differentiate our business?
How can we measure the business outcomes of our technology investments?
At the same time, IT organizations need to decisively invest in innovative technology management practices to overcome the shortcomings of their current operating model. By better understanding, and then influencing, the systems behavior of enterprise IT, IT organizations will not only improve their business relevancy and meet the elevated expectation of their stakeholder, but also create exciting and sustainable career growth opportunities for their members.