After three years of decline, technology sales started to rise again in 2003 and are even higher in 2004. These increases in corporate IT budgets are well known. Less visible is the surprising good news that over the next two years, some technology vendors could see their revenues leap to levels well above those predicted by many industry observers.

Where is this windfall coming from? Improvements in the general economy have clearly loosened up IT budgets, which are growing at 3.4 percent a year on average for Fortune 500 companies, according to conversations with their chief information officers (CIOs).¹ One source of this good fortune is the recent boom-and-bust cycle's "echo effect," which should raise capital spending on technology by as much as 12 to 13 percent this year. Such spending peaked in 2000, only to drop by more than 15 percent the following year—the first annual decline in nearly half a century (Exhibit 1). Most Fortune 500 companies use accrual-based accounting, which depreciates IT assets over three to five years, to budget for IT. This depreciation is now rolling off the books, making room for new spending during the next two or three years—until budgets are filled by this round of purchases.

The second factor behind the higher IT budgets is pent-up demand to replace an aging infrastructure. CIOs have delayed upgrades and new projects for too long; PC hardware, for instance, has now been around for nearly four years—longer than at any time since the mid-1980s. CIOs are eager to buy new PCs and servers, to improve security and reliability, and to develop custom applications that meet specific business needs.

Tech vendors shouldn't interpret this new wave of spending as a return to the fat margins of the late 1990s. Lean times taught customers to get more for their IT dollar—for example, by deploying procurement officers who wring out every cent they can from purchases. In addition, buyers now apply request-for-proposal processes and seek competitive bids. In many companies, strategists and business managers have more control over complex IT investments and demand a stronger business case for them.² Many customers not only use (or threaten to use) free open-source software to lower their costs but also send application-development work offshore.

Technology companies must understand the nature of this limited opportunity and make tactical shifts in their sales models, product offerings, and long-term acquisition plans. Hardware is in demand, and companies that make it should use the extra revenue to extend their reach into higher-margin software and service businesses or to extend their lead in hardware markets. Packaged application software, by contrast, isn't high on the shopping lists of most CIOs, who bought it in the late 1990s—and in many cases got burned. Now they are planning less ambitious installations that require fewer process changes (Exhibit 2). Software developers should acknowledge this transformed market and find ways to create and sell smaller, more modular pieces of their packaged offerings.

Since all of these purchases will come under more scrutiny than in years past, technology sales managers should restructure their organizations by shifting low-margin commodity items to lower-cost channels and by training their sales teams to build business cases that can help customers justify new IT systems. Finally, most technology companies need to improve their operational efficiency. For many years, they relied on revenue growth to save them from the need to become more efficient. The downturn drove home the lesson that they, like companies in mature industries, should tend to their own productivity. The temporary upswing must not distract high-tech players from implementing their efficiency programs; rather, it should give them a boost to invest in process change. No windfall like the present one—following a boom-and-bust cycle—has ever been seen; high-tech companies shouldn't squander it.

Purchasing priorities

What customers are buying, in many cases, is not what they bought in the past. Replacing old hardware is now the top priority. In 2001, after the technology bubble burst, capital outlays for hardware started a decline that for the first time since 1945 lasted five consecutive quarters. Capital spending for hardware jumped by 14 percent in 2003, and the momentum—driven by the need to update aging infrastructures—has continued in 2004. CIOs say that their older systems can't meet the new need for robustness and resiliency, so they are investing in disaster recovery and in security, including protection against terrorism, the pilfering of customer data, spammers, and viruses. Some companies are upgrading to more sophisticated hardware or doubling up on servers in hopes of avoiding single points of failure.

Although IT customers also want to improve their software, they are wary of big-bang packaged applications—purchases that are just now rolling off accrual budgets. This time around, CIOs are shunning expensive panaceas, especially large-scale customer-relationship-management (CRM) systems. Many tech executives lost face (or jobs) when the promised benefits didn't materialize, often because the technology demanded difficult-to-realize changes in processes and in employee behavior. Even worse than buying packaged applications, CIOs told us, was buying applications and then customizing them, for this strategy made it necessary to reinvest in customization with each subsequent upgrade. CIOs now favor narrower, more targeted, less ambitious improvements that mitigate the risk of organizational rejection (Exhibit 3). Custom software that closely adheres to a company's existing processes (and therefore requires little or no process change) is popular, and so is software developed for a specific industry.

Meanwhile, integration—a higher priority now than it was during the boom—is generating demand for enterprise-application-integration (EAI) technologies. Web services are gaining traction faster than anticipated, especially in small telecom and other companies at the forefront of IT innovation. Of the CIOs we interviewed, 8 percent said that Web services were their primary integration strategy. Despite these inroads, most companies are still at the experimental stage with this technology, which demands advanced skills and a high degree of commitment from the IT organization. Others are choosing a different path: roughly half of the CIOs we spoke with have been (or are thinking about) investing in integration broker software, often combined with Web services. Adoption is strongest among telecom and financial-services companies, whose technical complexity makes the software especially attractive.

The third-party services market could feel the pinch, however. Many companies, spurred on by lower IT salaries after the economic slowdown, hired talent and brought IT development in-house.³ These new hires often support and develop the more customized applications that today's IT budgets favor. But this move could boomerang on companies in the future: the absence of vendor support could reduce economies of scale and push up costs. Offshoring in less expensive labor markets could, of course, offset them.

Who makes decisions?

Customers have also changed the way they make IT investments, and that will pressure margins for commodity and high-end products alike. Many buyers have adopted more sophisticated management processes for evaluating new technology proposals. Increasingly, the budgets or bonuses—or both—of CIOs reflect business outcomes. Still, most companies are not as disciplined as they could be in this respect: 64 percent of the CIOs we talked to said that once IT budgets are set, at the beginning of the year, they don't have to be defended. Many CIOs reported that their companies undertook no auditing or follow-up to determine whether IT projects failed or succeeded.

Moreover, though some companies are enlisting purchasing experts to help them buy commodity IT goods and services, IT spending is still outside the normal procurement process in most of the businesses we researched. Nearly half of the CIOs we talked to said that no clear linkage exists between purchasing and IT and that the procurement department plays a role only for highly commoditized purchases.

Even so, CIOs feel they have less voice in decisions on IT spending. Several oversight models are emerging; the most common is an autonomous IT group that must get financial approval for expensive new initiatives. Strategic IT investments, such as new spending on applications, require input from the CIO's staff, but business-unit executives increasingly make these decisions. What's more, the number of CIOs reporting to CFOs doubled in 2003—a trend likely to continue as companies seek ways to get greater value from IT investments. Many CIOs support this shift because they believe that business units ought to be involved and that the finance and purchasing groups can make their budgets go much further (Exhibit 4).

The implications for vendors

Companies that sell technology gear, code, and services must deal with the new realities while the sector is being restructured.⁴ A long-overdue shakeout is beginning as industry leaders acquire or make alliances with smaller players that could help them gain scale or scope. We expect that large tech players, whose sales teams have good access to clients, will become the centers of gravity. In the past, hardware vendors often had to strike deals with software companies to gain access to their clients. Now the balance may be shifting in the other direction. In either case, smaller players will need to make alliances with the market leaders, not least because customers say that they want to deal with fewer vendors.

The view from the sectors

To take advantage of the opportunities offered by the new environment, tech players will have to understand the demands of the particular sector in which they compete: hardware, IT services, or software.

Hardware providers. The bulk of the spending increases will probably be captured by hardware companies, which should use this window to set up lucrative maintenance and service contracts that could ensure strong revenue streams in the years ahead. Demand for hardware is strong but balanced by new price pressures: as products fall under the procurement microscope, their margins will go on shrinking. Hardware companies must continue to make the case for the strategic value of their products while they shift commodity goods to lower-cost sales channels, such as telephone service centers and online catalogs.

Many hardware companies, foreseeing the commoditization of their core business, have partly repositioned themselves as software and services companies. They can expect their hardware business to improve, while some other parts of the technology sector won't be inhouse the same inflow of revenues. The value the hardware vendors capture should be used to accelerate their strategic plans for acquiring software and services companies that could support the hardware business and benefit from their expertise.

IT services firms. Opportunities abound to integrate systems and make them more reliable and resilient in the face of sabotage or intrusion. But US services providers confront at least two competitive threats that weren't as strong during the boom: the trend toward developing applications in-house and the growth of low-cost offshore alternatives. Some providers of services can stay in the game by helping companies to navigate among integration strategies such as EAI software, Web services, and broker software. Indian IT services companies should consider acquisitions that would rectify their deficiencies in the sales channel.

Software vendors. Providers of packaged applications probably won't benefit from the current spending increases, and the dollars they do capture will likely be for smaller modules rather than the large packages that underlie their business models. These companies should consider shifting some of their resources to offshore customization, which could hurt margins but help retain customers. Some may also consider acquiring industry-specific players to help themselves enter new markets and breaking up their packaged offerings into smaller, independent modules.

New approaches

Changed purchasing priorities and the consolidation of the industry also mean that companies must consider new approaches to benefit from the new opportunities.

Restructure sales. It will be essential for companies to respond to the new environment by restructuring their sales organizations. A high-tech vendor that has aligned its sales teams with the industries or with the size of its customers ought to shift to a more flexible, multichannel approach. Costly forays by highly paid sales teams aren't necessary to sell goods to procurement departments, which focus on getting the best value for commodity items, not on building long-term strategic relationships. Although few companies have effectively implemented the multichannel approach so far, some of them are starting to get better results by segmenting their audience in a more detailed way and by selecting their channel partners more carefully.

By contrast, expensive strategic purchases will demand even greater effort and detail by sales teams, which will have to help customers build a business case for their purchases. Some CIOs say that while every vendor claims to have case studies, many are irrelevant, since they fail to show a proven record of success or value creation. High-tech companies should arm themselves with a robust collection of such studies by interviewing their customers six months or a year after installing their technology. Some enterprise software companies have also created automated, interactive tools (spreadsheets or specialized software applications) that their sales teams can use to quantify the benefits of their technology. (The risk here is that accurate tools could show that a new product doesn't deliver much value.) Both tactics may require vendors to give their salespeople additional training or to hire specialists.

It won't be easy to restructure sales teams. Management will be asking them to work harder on complex sales and, at the same time, to give up control over much easier commodity sales and license renewals. It will be necessary to help salespeople become more productive. One way of doing so is to look closely at the broad range of IT goods and services that customers are purchasing and to use existing relationships to win a larger share of their IT-purchasing budgets. This information, fed back to the organization, can also make managers aware of possible acquisitions, since it may point to related products or services that could be bundled nicely with the company's core offerings.

Improve operational efficiency. The present environment also gives tech companies a good opportunity to invest in process improvements. Years ago, sales growth was enough to provide healthy profit margins. But close analysis reveals that many of the productivity gains of the 1990s resulted solely from new technologies or involved only a few star performers.⁵ More mature industries, such as manufacturing and retailing, have already learned how to improve their margins in the face of slow or flat growth. Now technology companies must follow suit as they feel the heat of low-cost competition, especially from innovative competitors such as Huawei in communications equipment and Infosys and Wipro Technologies in IT services.

Productivity leaders, in tech and elsewhere, focus on improving the core business, discovering the processes that drive productivity, and transforming them if necessary. Investments in sidelines usually deliver smaller returns—or, worse, complicate the overall business. These companies also continually hone an edge, distinguishing themselves from competitors by deciding where they will lead and where they will match. Finally—and this is sometimes difficult in the technology culture—they avoid relying on "silver bullet" cures and instead adopt the end-to-end approach of constant process innovation and redesign. Executing such changes isn't easy in a high-tech environment, where exciting breakthroughs are more welcome than iterative improvements. But top management should view the iterative approach as a strategic imperative and give employees incentives to treat higher productivity as a corporate priority.

Technology companies now have a rare opportunity. They should make the most of it. The confluence of better economic times with old purchases now rolling off the books gives customers a chance to update their old infrastructure—and should deliver fresh revenues to hardware vendors, IT services providers, and some software developers. Smart high-tech companies will use the influx to reinvent themselves for tougher times ahead.