from new software solutions. The previous year’s revenue totaled $1.29 billion. Its real variable costs (RVCs) were $210 million ( 16.3% of revenue). The resulting throughput (all revenues minus RVC) was $1.08 billion. The company’s fixed costs totaled $910 million, hence its earnings before interest, tax, depreciation, and amortization, or EBITDA, the previous year was $170 million (see Table 2).

Now suppose the company can consistently achieve annual revenues of $1.29 billion. If we use a conservative EBITDA multiplier of 10, the company’s market value is $1.70 billion.

Suppose the IT division succeeds in implementing the kind of improvement practices described here, thereby increasing the amount of software solutions delivery by 20%. Suppose, too, that the value-creation potential of these additional 20% software solutions is on average only 25% compared to average projects in the current realization portfolio. Since only 30% of the revenue originates from the introduction of new software solutions, the additional revenue for the following year would be $1.29 billion multiplied by 30% multiplied by 20% multiplied by 25% = $19 million. RVC will probably increase proportionally to $213 million, or still approximately 16% of revenues.

If the IT division achieves this increase in productivity of software solutions with the same resources, and does it without adding human resources or assets to the company, then fixed costs are unchanged. Our own calculation shows the corporate EBITDA would grow to $186 million, a 9.4% increase over the previous year (see Table 3). Using the same EBITDA multiplier of 10, the market value of the company reaches $1.86 billion without adding significant resources or other investment. Our experience shows that implementing the strategic-gating mechanism adds even more value to the company overall.

These improvement steps require
a change in an organization’s over-
all culture, thus the leadership of the
CEO, CIO, and top management team.
The strategic-gating mechanism and
IT division’s internal improvement
activities are synergic and must be im-
plemented concurrently. If the busi-
ness divisions have doubts regarding
the IT division’s commitment to in-
troduce required improvements, they
would be reluctant to participate in
the strategic-gating selection mecha-
nism or submit project requests in the
form of complete kits. Likewise, if IT
management does not define requests
according to the complete-kit concept
free of over-requirements, it will have
little motivation to improve its own
processes. The culture of splitting
large software solutions into “stages”
or “releases” can be introduced at a
second stage, once the other improve-
ment steps are in place.

Conclusion

This approach to reducing the software value gap complements conventional approaches outlined here through a high degree of synergy. Its ability to add value has proved to be achievable without further investment. Improvement is possible in several months. Success along these lines is easier to accomplish when the initiative for the improvement project comes from the CEO or the board of directors and the CEO becomes the “owner” of the project. Reducing the software value gap for enhanced value creation complements other value-creation activities when other sectors of the organization (such as marketing, sales, R&D, engineering, project management, and operations) pursue them.

 

References

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Shimeon Pass ( [e-mail]) is a senior consultant and implementation facilitator at Focused Management Ltd., Tel Aviv, Israel.

Boaz Ronen ( [e-mail]) is the Professor Simon I. Domberger Chair for Innovative Value Creation and a professor of technology management and value creation in Recanati Business School, Tel Aviv University, Israel, and a senior consultant at Focused Management Ltd., Tel Aviv, Israel.

Copyright held by Author/Owner(s). Publication rights licensed to ACM. $15.00

Table 2. Profit-and-loss summary.

Last year ($ millions)

Revenue 1290

Real variable costs 210 [ 16.3%] Throughput 1080

Fixed costs 910 [ 70.5%] Earnings before interest, tax, depreciation, and amortization

170 [ 13.2%]

Table 3. Value creation, as seen in the profit-and-loss summary.

Last year (million $)

Next year (million $)

Revenues 1290 1309

Real Variable Costs 210 [ 16.3%] 213 [ 16.3%] Throughput 1080 1096 Fixedcosts 910 [ 70.5%] 910 [ 69.5%] EBITDA 170 [ 13.2%] 186 [ 14.2%] ∆(EBI TDA) [~∆Value] + 9.4%