When CEOs sought cost savings in the past, typically they looked to the direct costs in the business. Individual moves to reduce direct costs might cause limited pain at the business unit level, but the organization could, and did, adapt. However, after several years of cost reduction in many sectors, business units that carry the majority of direct costs are likely to have little left to cut without impairing their ability to carry out their main activities.
The next logical step is consolidation of commonly relied-upon services across the entire organization. Many organizations have effectively reduced the costs of providing support services to their businesses simply by concentrating them in corporate shared services departments. Theoretically, by shifting the workload out of the individual business units and into a consolidated center responsible for servicing the functional needs of the organization, cost reductions could be achieved and service levels maintained, if not improved. This move resulted in a step change in the costs of support services such as IT, HR, and facilities, and was considered to be a best practice.
But this practice has presented many CIOs with a growing dilemma. The boards and executives of many organizations grapple with authorizing continuing investment from shared services functions such as IT without insight as to how such spending relates to the demands of the business units or how it will impact long-term profitability. Regardless of whether shared services are provided in-house or by a third party, organizations need far better insight into these costs and particularly the costs of the IT function, which for many is simply a black hole. CIOs must understand these numbers in support of future IT investment, corporate cost and profitability initiatives, and their own continued career success.
The true strength offered to corporations by business performance management is the underlying collaborative and synergistic efforts of the operational and financial sides of an organization working towards set key performance indicators (KPIs) and performance standards. IT shared services organizations and the business units that they support have a unique opportunity to deliver direct cost savings to the corporation, enhance profitability, and help the CEO, CIO, and each other meet and exceed their own business objectives.
For example, exhibit 1 shows a typical cost center for a telecommunications provider. More than half the costs carried by the center's P&L are allocations from shared services departments or other corporate overhead. Should this enterprise be seeking a modest 5 percent reduction in costs, this manager has only two options: Remove 10 percent from his own direct costs, most of which are to do with people, or lobby the executive to critically examine the costs of the shared services functions.
Despite the gains to be had by building shared services departments and by locating them where the required skills can be obtained at the lowest cost, many organizations still have a limited understanding of the relationships among shared service centers and business units. One reason is that shared service departments tend to plan their resources and budget separately from business units. As the financial year progresses, the capacity of shared services departments and the demands of operational business units can become grossly misaligned.
Frequent realignment of the resources and capacity of shared services functions with the needs of the business units is needed. For this to happen, organizations need to progress towards more frequent reforecasting so that business units are routinely updating the key nonfinancial data that drives their shared services demands. The shared services functions can then use this information to realign their own resource requirements for the coming periods, taking their actual costs through an activity-based costing (ABC) methodology to calculate monthly cross charges that are passed back to the business units.
Exhibit 2 can be used to represent where an organization's shared services functions might lie in terms of their costing and planning. The vertical axis represents the reliability and robustness of shared services costing while the horizontal axis represents the degree to which the planning and budgeting of the business units and the shared services are integrated.
As such, the top left quadrant represents any organization that has already adopted an ABC methodology for costing IT shared services and is highly accountable to the business units. But having implemented a reliable and robust costing methodology, its challenge now is to receive more frequent forecasts of demand from the internal business users. Once IT resources are more closely aligned with the needs and demands of the business units, the company would move to the top right quadrant.
To fully understand the costs of the IT function so they can be allocated to the business units in line with the way in which they consume IT resources, any costing methodology needs to recognize that not all departments use IT resources in the same way. For instance, some business units may need secure payment processing over the Web in addition to more general firewall and anti-viral security on the desktop network. Likewise, it should allow for business units to use the same service at varying degrees.
Additionally, it must reflect reciprocal costs. Just as HR provides services to IT, IT provides services to HR. To calculate the true cost of providing a service, these reciprocal costs should be passed between these departments reiteratively until they become insig-nificant, while still providing an audit trail.
Finally, the costing method must capture and incorporate other costs from other departments that should be allocated to the provision of IT services. These may include such things as property costs from the Facilities cost center and recruitment and payroll costs from the HR cost center.
While some line item costs that appear in the G/L of an IT department are easy to understand and can be allocated directly to a business unit, many line item costs will need to be reallocated to new cost pools, where they can be combined with other costs from the departments that provide support to IT, such as HR and Facilities. Some of these cost pools may then be allocated directly to services, but the majority will be allocated to the activities that IT staff perform to better understand how they relate to the services the IT function provides.
Typically, the cost of hardware and software needs to be amortized over their lifetime to avoid spikes in calculated costs at the time of the investment. Many IT departments deploy time-capture systems to record the amount of time staff such as programmers spend on individual projects.
Two of the more typical methods of chargeback are apportionment and allocation. Apportionment is the process of assigning a share of the total IT costs based on a designated target such as business unit revenue or headcount. Allocation involves assigning a deserved share of IT costs based on the actual consumption of the services in question.
Correct methodology for use should be decided by the head of the IT department in conjunction with the finance and accounting organizations. The methodology employed may vary based on quantitative measurement requirements and the ability of the organization to effectively and accurately compute the necessary billing agent.
When examining a chargeback policy, it is critical to ask if it is fair and based on reality. Too often business units get hit with charges that they perceive to be another way of IT covering its cost. Cooperation in deriving the chargeback methodology must be reviewed with the business units prior to its implementation. Also, the chargeback method must be comprehensive, help control costs for the IT department, and help IT predict its costs.
One way to take the next step in developing an effective chargeback system is to ask where your company is on this continuum:
• High-level apportionment of total IT costs: All of the IT costs charged to a business unit are based on a designated target such as revenue or headcount. While this does not reflect actual consumption, it does cover all costs. This methodology can have a debilitating effect on the P&L of the business units and potentially a serious impact on overall corporate profitability by penalizing a very profitable business unit with unwarranted expense that it did not incur.
• Lower-level apportionment of specific IT costs: Total costs of specific items are apportioned and charged back to the business unit. This method does not reflect actual business unit usage. While a step in the right direction, this methodology ignores the true cost associated with usage by simply apportioning back against an arbitrary guidepost.
• Direct cost allocation: Specific ownership can be identified, such as projects or applications and where over 50 percent of IT costs are for shared services. This approach is an improvement as it does take into account resource utilization by specific areas. It is an improved reflection of costs as it incorporates a resource use. However, resource requirements tend to vary over time for projects, and this method does a limited amount to help in predicting future recurring cost requirements.
• Measured usage allocation: All parties find value in this gauged usage of products and services. Business units have a much better feel for why they incurred specific costs and have an idea as to how they might control them better in the future. IT shops provide a level of transparency for the charges billed to business units and quantifiable information on usage, patterns, and predictability for the future.
A large multinational conglomerate with a diverse product offering that includes food retailing, cookware, travel services, banking, insurance, and funeral services made the move to a shared services model. A large insurer with more than 4.5 million customers and more than $36 billion in funds under its management, it found that the insurance market had become more competitive following a period of successive mergers and new entrants. The company's chief accountant recognized the need to develop a better understanding of how individual products were incurring costs from the IT organization. To provide reliable costing information in a complex multi-product and multi-channel business, it became evident that traditional costing techniques would not be sufficient. The company employed activity-based costing (ABC) and used ABC data to accurately assign IT costs to the departments and products that consume IT activities.
The IT department itself carries no residual cost as all costs are continually allocated out of IT into other departments. IT provides seven principal services under the following headings: new systems, desktop support, mid-range system support, mainframe system support, communication services, laptop services, and data preparation. IT personnel enter their activities in these areas on timesheets and mark them against the 1,000 codes in their database. Each of the codes represents an activity against one of the services listed, categorized by product or product group.
One of Canada's oldest mutual life insurance companies implemented centralized shared services in the early 1990s. The company formed a corporate services division with five main areas: information systems, finance, corporate affairs, strategic planning, and shared business services (including HR, administrative services, and legal).
At the time, corporate services employed more than 800 people and had a cost base of more than $100 million, which was one-third of the company's total non-sales-related expenses. Initially, the business units viewed corporate services as an overhead function that added little value, so they placed tremendous pressure on corporate services to cut expenses quickly. The business units also requested cost information to support their pricing decisions. Many of the business units believed that the cost system used by corporate services was inaccurate and that in some cases actually motivated the wrong behavior.
In response to these concerns, corporate services employed a costing model so that it might:
• Identify costs that could be eliminated or reduced.
• Provide a mechanism to accurately charge costs to business units based on their consumption of the shared services on a monthly basis.
• Provide accurate cost information to support pricing decisions and profitability analysis.
• Communicate the service levels provided and the costs of outside service providers for evaluating outsourcing decisions.
• Provide a better tool for facilitating budgeting by internal services providers.
Corporate services soon evolved from being perceived as an overhead department that added little value to being viewed as a business partner that was critical to the success of the business units and the organization as a whole. Corporate services now can identify and bill consumers of the products and services it provides based on actual consumption.
After adopting a methodology for costing IT services, your organization will have a detailed understanding of the services provided by IT, the activities involved in providing them, and how they consume resources and costs. Detailed invoices can be produced showing the business units' use of the service, the unit price. and the total cross charge. Should more detail be required, the costs can be traced back to their origin.
By fully understanding what activities are consuming resources and costs and which add value, the business unit and the IT function are better able to enter into a dialogue and understand how they can work together to reduce costs. This may involve no more than taking simple steps to adjust service levels such as response times or batching transaction processing to reduce setup costs. Removing non-value-adding activities can help to reduce costs and provide an immediate return on any investment.
Options for Cross-Charging
Once the total cost of a service is calculated, there are various options for calculating a unit rate for cross-charging the business units for their use of the service.
If the organization wishes to fully allocate the total cost of the IT function across the business units, the unit rate charge is typically based on the total cost of the service during the period divided by the actual demand for the service during the period. This leaves the IT function with no residual costs. This can be represented by the equation below where TC(x)t is the total cost of service (x) during period t, TD(x) t is the total demand for the service during period t and UPdem(x)t is the unit price of the service based on demand for the service during the period.
TC(x)t / TD(x)t = UPdem(x)t
However, other options are possible. The rate could be based on the total cost of the service during the period, divided by the amount of the service available during the period; that is, based on the capacity of the IT function rather than the demand of the business units.
Here, if the service is over-resourced, and IT is able to provide more than the business units consume, IT will be left with residual costs, and this may drive IT to reduce capacity during the next period. The formula now becomes:
TC(x)t / TCap(x)t = UPcap(x)t
However, some shared services units are operating as profit centers, and in these instances, calculate a rate based on either of the methodologies above, to which a fixed or percentage mark-up may be added before being charged out to the business units.
Ultimately the choice of pricing methodology can lead to an under- or over-recovery of IT costs. Unless rules are set for how any under- or over-recovery of IT costs will be balanced out in future periods, this gives rise to resentment from the business units that they are "over-charged." Organizations also should explore whether it is prudent to have under- or over-recovered amounts in their year-end accounts and may wish to involve their auditors in this discussion.
Richard Barrett is vice president of global marketing for ALG Software. He first became involved with ABC while working for DHL Worldwide in the late '80s, and his interest in the topic has continued ever since.