The chief operating officer and chief financial officer of a Fortune-1000 company faced a challenge: Revenues were growing, but profits weren\u2019t. They had to get a handle on costs, especially corporate overhead (G&A). \n\nOne really visible part of corporate overhead was IT. The IT budget was growing even faster than was total overhead, and it was a big number. The COO and CFO weren\u2019t clear on the benefits they were getting from their investments in IT, so they decided to put a stop to its budget expansion. However, they didn\u2019t want to target IT\u2019s vendor costs. These were less controllable because they were negotiated deals (like infrastructure licenses and the offshore applications development relationship), and they already had their \u201cstrategic sourcing\u201d procurement staff helping with vendor negotiations. Plus, they didn\u2019t want to discourage outsourcing, which they believed saved them money.Thus, they issued the following edict: No growth in IT headcount (employees).\n\nWhy Caps BackfireThe CIO and her leadership team respected the cap, and only hired staff to fill existing open positions. But IT costs didn\u2019t come down. Why? Clients in the various business units understood the return on IT investments far better than the COO and CFO, whom they privately considered out of touch in the ivory tower of corporate headquarters. These business leaders knew they needed to buy more IT to stay competitive and grow. When the corporate IT budget wasn\u2019t sufficient, the business units transferred incremental money to IT to get what they needed. IT used this money to hire contractors to get the job done. Of course, the contractors were more expensive than employees. So the net result of the cap was an increase in IT costs, not a decrease! When the CFO saw what was occurring, he was very upset. But he couldn\u2019t tell the CIO to refuse client projects they were willing to pay for\u2014at least not directly. To do so would be counter to the corporate-wide customer-focus program. So he modified the edict: No growth in IT headcount, including contractors. And then he added another edict, just to be sure: No growth in the IT budget (total spending). The business units still needed more IT. But no edict can magically make IT more productive (the old \u201cdo more with less\u201d delusion). When the corporate IT department couldn\u2019t satisfy the business units\u2019 demands, clients did the obvious. They hired their own IT staff (many of whom were hidden under other titles), and they went directly to outsourcing vendors. In other words, the cap didn\u2019t reduce IT spending. All it did was cap the \u201cmarket share\u201d of the corporate IT department. Decentralization inevitably drove costs up as economies of scale were lost, and as little pockets of generalists attempted to do work formerly done by teams of specialists. And a lot of little outsourcing deals drove costs up too. Furthermore, corporate synergies were lost, the pace of innovation slowed, and quality suffered. Again, the net effect of the cap was to increase, not decrease, IT costs. The lesson here is straightforward: You can\u2019t control spending by controlling supply. The only effective way to contain costs is by limiting clients\u2019 spending power. \n\nBureaucratic Governance ProcessesHow can executives constrain the amount that business units spend on IT? Some people advocate a \u201cgovernance\u201d process that imposes bureaucratic hurdles in an IT project-approval process\u2014ROI thresholds, committee and CIO approvals, and piles of paperwork. Their theory is that the committee or the CIO is smarter about investing than clients, and they\u2019ll stop business leaders who try to buy something that\u2019s a poor investment. In their cynical moments, advocates of bureaucracy might admit that simply making it difficult to do business with the corporate IT department will reduce demand, since people won\u2019t make the effort to run the gauntlet for any but the really important projects. While these hurdles may, in fact, dampen demand, they certainly don\u2019t engender optimal resource governance. Some people make up ROIs. Others may not bother with projects that are really good investments. People break up their requirements into small \u201cenhancements\u201d to circumvent the committee. No doubt you know all the games people play. Furthermore, bureaucratic hurdles chase business to the competition (decentralization and outsourcing), where clients are treated as customers (not like children in a candy store who need to be controlled) and where it\u2019s easy to get what they need. Like caps, bureaucratic project-approval hurdles drive costs up. \n\nMarket EconomicsThe alternative to bureaucracy is market economics. In a market economy, your spending isn\u2019t limited by the size of the store. It\u2019s limited by your checkbook. Similarly, within corporations, cost containment is best achieved by limiting the size of the business units\u2019 checkbooks, not by limiting the size of an internal service provider like IT. In other words, the corporation must constrain demand, not supply. Then, the business units can be free to spend whatever they have on whatever they see fit. They\u2019ll naturally use their limited funds to buy what\u2019s most important to them and skip the rest, without time-consuming hurdles. Resources will automatically flow to the best investments. I call this a < a href= http:\/\/www.ndma.com\/resources\/ndm2260.htm target=_new>market-based internal economy.There are three things required to make this marketplace work: business units that care about their bottom lines, a limit to their checkbooks, and the information they need to make good investment decisions. As to the first requirement, most business unit leaders already care about their bottom line. If this concern doesn\u2019t ripple down through their ranks, then they have a management problem\u2014one that will affect spending on everything, not just IT. There\u2019s nothing IT can do about this. So presuming that clients want to spend their resources wisely, the two remaining challenges are to limit their checkbooks for IT, and then to provide the information they need to make good spending decisions. \n\nLimiting the CheckbookIf IT charges for its products and services, then spending on IT is limited by clients\u2019 budgets. With chargebacks, IT costs can be contained only by managing business units\u2019 budgets (e.g., by setting appropriate profit targets).However, if IT gets a budget directly (or through allocations) rather than through chargebacks, then IT sees the limits of this spending power but clients do not. Even if they understand the limits of the IT budget, they might not care; they may feel that IT is tasked with meeting its budget, and this is not their problem. The solution is to treat the portion of the IT budget intended to benefit clients (the bulk of it) as a \u201cprepaid\u201d account\u2014money put on deposit with IT at the beginning of the year, but owned by clients rather than by IT. Then, clients can be given the power to write checks within the limits of this checkbook. Decisions may be made by a single committee, or the checkbook may be divided among the business units. In either case, clients must live within their means, and there\u2019s no need to cap IT headcount or spending.Thus, even without chargebacks, a market effect can be created. And since clients cannot buy more than their checkbook permits, IT costs are fully controlled with no need for caps on headcount or expenses. \n\nInformation for Decision-MakingFor clients to make decisions on which checks to write, and for IT to decrement the checkbook when work is delivered, IT must calculate the fully burdened cost of all its products and services. Using concepts of activity-based costing, it must forecast its budget in terms of the cost of deliverables (not just expense codes by manager). This is the only way to know what its budget does and doesn\u2019t include. In addition, it must calculate rates (prices) consistent with its budget, and use these rates to decrement the checkbook as work is completed. The fully burdened cost includes direct costs plus a fair share of all indirect (so-called fixed) costs. This is a critical concept. If the indirect costs are paid by IT or put in a pool and allocated to the business units, and the checkbook given to the purser covers only direct costs, the market will not work properly. It misleads clients into thinking things are less expensive than their true cost to shareholders, so they tend to buy more than is economic. Furthermore, the indirect costs do not expand or contract as the IT business grows or shrinks. Indeed, they become a target for arbitrary cuts. Soon, IT will find it cannot deliver on its commitments for lack of needed internal support services. \n\nBottom LineMarkets work. And caps don\u2019t. It\u2019s that simple. The only practical way to manage IT spending is to create a marketplace where clients\u2019 demand is constrained by the limits to their checkbooks. Implementing a market without chargebacks takes a bit of thought, but the mechanics and the process are well understood. What it really takes is a commitment to control costs systemically, rather than through ineffective caps and budget cuts. We all believe in market economics outside the office. Let\u2019s apply the same dynamics within corporations to govern resources effectively with minimal bureaucracy. \n\n Dean Meyer helps IT leadership teams design high-performance organizations. Author of six books, numerous monographs, columns and articles, he brings innovative systematic approaches to what others consider the \u201csoft\u201d side of leadership. Contact him at email@example.com or visit his website for information that can help you implement these ideas, or with suggestions for other buzzwords to analyze in future columns.