I consult, write, and speak on running better technology businesses (tech firms and IT captives) and the things that make it possible: good governance behaviors (activist investing in IT), what matters most (results, not effort), how we organize (restructure from the technologically abstract to the business concrete), how we execute and manage (replacing industrial with professional), how we plan (debunking the myth of control), and how we pay the bills (capital-intensive financing and budgeting in an agile world). I am increasingly interested in robustness over optimization.

I work for ThoughtWorks, the global leader in software delivery and consulting.

Wednesday, September 26, 2007

Investing in Strategic Capability versus Buying Tactical Capacity

US based IT departments are facing turbulent times. The cost efficiencies achieved through global sourcing face a triple threat to their fundamentals:
  1. The USD has eroded in value relative to other currencies in the past 6 years1 – this means the USD doesn’t buy as much global sourcing capacity as it did 6 years ago, particularly vis-à-vis its peer consumer currencies.

  2. The increase in global IT sourcing is outpacing the rate of development of highly-qualified professionals in many markets2 – salaries are increasing as there are more jobs chasing fewer high-qualified candidates, and turnover of IT staff is rising as people pursue higher compensation.
  3. Profitability growth in the high end of the IT consumer market remains strong – As the returns of firms at high end of the IT consumer market continue to be strong – Goldman Sachs just had its 3rd best quarter in its history3 – demand will intensify for highly capable people.
This could significantly change labour market dynamics. Since the IT bubble, the business imperative has been to drive down the unit cost of IT capacity (e.g., the cost of an IT professional per hour). This has been achieved substantially through labour arbitrage – sourcing IT jobs from the lowest cost provider or geography. However, the reduced buying power of the USD, combined with increasing numbers of jobs chasing fewer people, plus an increase in demand at the high end of the labour market, means that simple labour arbitrage will have less impact on the bottom line. As IT costs change to reflect these market conditions, US-based IT organizations will face an erosion of capability.

In one sense, labour is to the IT industry as jet fuel is to the airline industry: IT is beholden to its people, just as airplanes don’t fly without fuel. For quite some time, we’ve attempted to procure labour using a commodity approach: somebody estimates they have x hours of need, which means they need y people, which will then globally sourced from the least expensive provider. The “unit cost optimisation” model of pricing IT capability defaulted into success because of the significant cost disparity in local versus offshore staff. The aforementioned market trends suggest that the spread may narrow. If it does, a number of the underlying assumptions are no longer valid, and fundamental flaws in most labour arbitrage models is exposed: specifically, that IT needs are uniform, and IT capabilities are uniform and can be defined as basic skills and technical competencies.

Unlike jet fuel, labour isn’t a commodity. Not every hour of capacity is the same. There are grades of quality of capability that defy commoditisation. This means there is a quality dimension that is present yet substantially invisible when we assess capacity. Macro-level skill groupings are meaningless because they’re not portable (e.g., one organisation’s senior developer is another’s junior). They also fail to account for labour market trends: if the population of Java coders increases in a specific market but new entrants lack aptitude and experience and their training is inferior, we have a declining capability trend that is completely absent from our sourcing model. Nor is capacity linear – two people of lower capability will not be as effective as one person of high capability, and too many low capability people create more problems than they solve. An IT organisation which stabilised around simple unit-cost optimisation will find itself at the mercy of a market which it may not fully understand, with characteristics which haven’t factored into its forecasts.

The commodity model also ignores how advanced IT systems are delivered. High-return business solutions don’t fit the “mass production” model, where coders repetitively apply code fragments following exacting rules and specifications. Instead, business and IT collaborate in a succession of decisions as they navigate emerging business need whilst constantly integrating back to the tapestry of existing IT components and business systems. This requires a high degree of skill from those executing. It also requires a high degree of meta knowledge or “situational awareness,” that is, domain knowledge and environmental familiarity necessary to deliver and perpetuate these IT assets. This includes everything from knowing which tools and technology stacks are approved for use, to how to integrate with existing systems and components, to what non-functional requirements are most important, to how solutions pass certification. Combined, this meta knowledge defines the difference between having people who can code to an alleged state of “development complete” versus having people who can deliver solutions into production.

Because the assets that drive competitiveness through operations are delivered through a high-capability IT staff, unit cost minimisation is not a viable strategy if IT is to drive alpha returns. Strategic IT is therefore an investment in capability. That is, we are investing not just in the production of assets that automate operations, we are investing in the ability to continuously adjust those IT assets with minimal disruption, such that they continue to support evolving operational efficiencies. This knowledge fundamentally rests with people. The value of this knowledge is completely invisible if we’re buying technology assets based on cost.

This brings us back to current market conditions. At the moment, tactical cost minimisation works against the USD denominated market competitor. The EUR, CHF, AUD, CAD or GBP competitor can afford to increase salaries wherever sourced without as much bottom-line impact as their USD competitors. They subsequently have an advantage in attracting new talent, and are better positioned to lure away highly capable people from US based competitors. In addition, the increased cost of IT for the US based competitor might mean more draconian measures, such as staff reductions, to meet budget expectations. To avoid the destruction of capability, a US IT organisation may look to simply shift sourcing from international to local markets. But this shift is not without its risk in durability (will the USD rise again to match historical averages?), competitive threat (other firms will follow the same strategy and drive up local market salaries), or cost of change (nothing happens in zero time, and the loss / replacement of meta knowledge comes at a cost.) Clearly, global sourcing is no longer a simple cost equation. It is complex, involving a hedge on investing in sustainable capability development relative to competitive threats and exchange rate fluctuations.

Responding to this challenge requires that the IT organisation have a mature governance capability. Why governance? Because surviving the convulsions in the cost of the “jet fuel” of the IT industry requires that we frame the complete picture of performance: that value is delivered, and that expectations (ranging from quality to security to regulatory compliance) are fully satisfied. IT doesn’t do this especially well today. It suffers no shortage of metrics, but very few are business-facing. The absence of so few business-oriented metrics gives “cost per hour” that much more prominence, and fuels the unit cost approach to IT management.

Breaking out of this requires assessing the cost of throughput of IT as a whole and of teams in particular, not of the individual. IT is only as capable as the productivity of its cross-functional execution; specifically, how effectively do IT teams steer business needs from expression to production, subject to all the oddities of that particular business environment. If the strength of currently sourced teams can be quantitatively assessed, the organisational impact of a potential change in IT sourcing can be properly framed. The lack of universal capability assessment, and the immaturity of team-based results analysis mean that an IT governance function must define these performance metrics for itself, relative to its industry, with cooperation and acceptance from its board. Without it, IT will be relegated to a tactical role, forever chasing the elusive “lowest unit cost” and perpetually disappointing its paymasters, struggling to explain the costs of execution which cannot be accounted in a unit cost model.

If an IT organisation is focused on team throughput and overall capability, it can strategically respond to this threat. Just as jet fuel supply is secured and hedged by an airline, so must labour supply be strategically managed by IT. This means managing the labour supply chain4 to continuously source high capability people, as opposed to recruiting to fill positions as they become vacant. This requires managing supply and demand by doing such things as anticipating need and critically assessing turnover, creating recruiting channels and candidate sources, identifying high-capability candidates, rotating people through assignments, understanding and meeting professional development needs, setting expectations for high-performance, providing professional challenges, offering training and skill development, critically assessing performance, managing careers and opportunities, correcting poor role fits and bad hiring decisions, and managing exits.

Doing these things builds a durable and resilient organisation – attributes that are invisible in a cost center, but critical characteristics of a strategic capability. This is, ultimately, the responsibility of an IT organisation, not an HR department. HR may provide guidelines, but this is IT’s problem to solve; it cannot abdicate responsibility for obtaining its "raw materials." Clearly, building a labour pipeline is a very challenging problem, but it's the price of admission if you're going to beat the market.

IT drives alpha returns not just through the delivery of strategic IT assets, but by investing in the capability to consistently deliver those assets. If capability moves with the labour market, an IT organisation will yield no better then beta returns to the business. Current market indicators suggest that it will be difficult for US based firms to maintain their current levels of capability, thus the business returns driven by an IT capability that moves with the market are likely to decline. Tactical buyers of IT are facing a cost disparity, and will have few cards to play that don't erode capability. Strategic investors in IT can capitalise on these trends to intensify strengths, and even disrupt competitors, through aggressive management of its labour pipeline.

1 Comparing August 2001 to August 2007 monthly averages, the USD declined 28% to the GBP, 34% to the EUR, 28% to the CHF, 37% to the AUD, 31% to the CAD, 13% to the INR, 8% to the CNY. Exchange rate data was pulled from Oanda.

2 Technology job growth and salaries are on the rise worldwide. Two recent articles highlight India
and the US. Also, I’ve referenced the following two previously, but Adrian Wooldridge makes a compelling argument for the increased competition for talent, and there’s ample data on the gap between job growth and volume of new entrants. There’s some recent articles evaluating the quality of talent but I don’t have those handy.

3 Profitability among market leaders and overall technology sector growth continues to be strong globally.

4 I am indebted to Greg Reiser for this term.