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IT Cost Allocation applying the correct costs to right areas

June 11, 2008

How to Develop a Cost Allocation Program for IT Services

IT resources are one of the most significant support costs in modern organizations, and must be correctly allocated to entities like departments, business units, and projects. Use this guide to help you fully understand the concept of IT services cost allocation, where it is best applied, and issues involved in rolling out an actual allocation system.

INTRODUCTION

Most of the focus on managing organizational resources tends to be on those resources that support the organization’s mission or revenues. However, resources are also used in a supporting role, facilitating processes that contribute to these goals. IT resources have become one of the most significant support costs in modern organizations, along with human resources costs and facilities costs. What we will see is that it is important that such IT costs are correctly allocated to entities like departments, business units, projects or contracts, or even to various products and services. This is to enable better control of these costs, improved inventory management, better decision-making, enhanced measurement and management of profit and loss at various levels, and, in certain cases, compliance with contracts that require strict cost tracking.

This report will define the concept of IT services cost allocation and present some common reasons why costs should be allocated. A decision to embark upon a program of IT services cost allocation may itself involve additional costs and effort, and must be made with a full understanding of the benefits of this effort. The primary focus of this report will be on those things you should consider when rolling out an allocation system for IT services costs, and what issues normally arise when doing so. It excludes technical discussion of the relative merits of various allocation methodologies, which involves advanced management accounting knowledge and should be made in conjunction with accountancy and taxation professionals. However, concepts that will be useful when dealing with these professionals will be discussed. Finally, we will describe common challenges in doing so and present some tips for meeting these challenges.

The scope of this report is restricted to IT as an internal service department, meaning that the primary or even exclusive rationale of IT is to provide services to other departments, rather than to supply a product or service externally for profit. This includes instances where IT is part of a shared service center concept. Where the “business is IT” (a software company, a telecommunications carrier, and so on) costs will be treated differently

WHAT IS IT SERVICES COST ALLOCATION?

Cost allocation is the assignment or re-assignment of costs from one organizational “activity” to another. In the context of IT services cost allocation, an activity is an event that causes consumption of IT resources. An activity can be associated with:

  • A department, or group of departments.

  • An individual.

  • A division, cost center, or profit center.

  • A legal entity.

  • A product or service.

  • A project.

  • A contract.

In the context of this report, the entity from which costs will be allocated will normally be the IT Services department(s), and to which costs will be allocated the various business departments or projects. IT Services can include the following functions, and possibly others:

  • IT management and administration.

  • Help desk/call center.

  • Network design and maintenance

  • Telephony.

  • E-mail support.

  • Server and host management.

  • Database administration.

  • Data center hosting.

  • Hardware maintenance.

  • Software development and maintenance.

  • Software testing and quality assurance.

  • Software configuration management and deployment.

  • IT security.

  • Business continuity/disaster recovery.

  • Technical documentation.

These functions may or may not be distinct, and may or may not be situated within one organizational unit, legal entity, or even geography. They may involve both internal staff costs as well as external consultancy costs.

IT Services costs may also be in the form of a wider-ranging project, which can have a budget and cost structure distinct from departmental breakdowns implied above. For example, an application rationalization initiative may have its own funding and budget, with implications for applications software costs, database costs, and server costs. Many organizations had “Year 2000” projects whose cost structures were separate from IT department costs, but needed to be allocated anyway.

We will define some other terms that are helpful in understanding cost allocation.

Definitions

  • A cost is the value of money, time and resources associated with an activity (defined below) or a purchased good or service.

  • An activity is an organizational process that adds value and consumes resources.

  • A cost driver is an activity that causes costs to be incurred.

  • A cost pool is a grouping of overhead costs related to a specific activity.

  • A cost driver rate is calculated as the cost pool for the activity divided by the cost driver volume

  • A key distinction always made when discussing costs is between direct and indirect costs. Direct costs are easily identified with a single activity, whereas indirect costs cannot be identified with a single activity. Materials and direct labor costs are often considered direct costs, whereas overhead charges like data center rent, license costs, and management labor costs are indirect.

  • A cost base represents the accumulated direct costs used to distribute indirect costs.

  • Overhead costs are administrative charges like taxes, rent or insurance that cannot be attributed to any specific activity, but are necessary for the organization to operate.

  • A cost allocation plan is a description of the procedures, methods, and tools that will be used in identifying, measuring, and allocating costs.

  • An allocation itself is the division and distribution of pooled costs

WHY ALLOCATE COSTS?

A “Do-Nothing” Approach

Why allocate costs at all – aren’t such costs nothing more than “funny money”? After all, someone pays “real” IT costs like hardware costs, software license fees, and programmer salaries no matter what – the choice of which organizational department or project pays is ultimately revenue-neutral.

Indeed, a “do nothing” strategy of purely centralized and non-allocated IT service costs is one option that is obviously cheaper and easier than implementing cost allocation. Of course, doing nothing hinders effective benchmarking of IT costs versus service quality and will not bring the benefits of allocation described below. However, such a strategy of not allocating IT service costs can sometimes be successful in the following instances:

  • Smaller organizations or smaller IT service organizations, where IT service costs and service levels are sufficiently visible to management for them to easily evaluate.

  • As a short-term option to study IT costs prior to implementing an allocation methodology.

  • As a question of timing, where cost allocation occurs only AFTER implementing strategic initiatives in IT that greatly affect the cost structure of IT – such as application rationalization, database rationalization, data center consolidation – or after a merger, acquisition, divestiture, or strategic shift is complete.

Flat Charges

Some organizations opt for an “absorption costing” or flat charge approach to distributing IT service costs, rather than allocations. This involves a standard flat charge for IT services for each department. This usually involves the following:

  • Cost centers are established.

  • Direct charges are made to the cost centers.

  • Overhead and other indirect charges are distributed to the cost center on a flat charge basis.

This approach is easy, relatively inexpensive to implement, and may be appropriate in cases where there is a simple product or service range and/or a small organizational structure. However, in other cases it can be problematic because:

  • Large or highly profitable departments will pay the same for IT services as small departments. Assuming that larger departments use more IT services than smaller ones (usually the case), then this is inherently unfair, favoring the former and penalizing the latter.

  • Flat charges can provide disincentives to use essential services. If a department is under severe cost pressure, they may choose not to pay for IT services like anti-virus software, IT security programs, disaster recovery provisions, testing, and quality assurance.

Benefits of Cost Allocation

We will see that it can be imprudent and self-defeating for IT to support a do-nothing approach, or flat charging of IT expenditure. This is why:

  1. Speaking the Language of Business: When IT begins to allocate costs using a reasoned allocation methodology, it begins to speak the language of business. Even the least technically literate department will be familiar with concepts of services and their costs – truly a lowest common denominator in any organization.

  2. Better Accountability and Service Quality: Allocating IT costs can promote accountability in IT for these costs, and can improve service quality vis-a-vis these costs. This is because these costs become more visible to the departments or projects that bear them – often raising questions about whether sufficient value for the money is being received. This can spark healthy debates about IT that would not have otherwise occurred were IT to remain a pure unallocated cost center function. If these discussions lead to better decision-making, improved IT performance, and lower IT costs, then the result can be more satisfied business users and other stakeholders.

  3. Basis for Information Decisions about Outsourcing: If costs are competitive and service levels satisfactory, this can help avoid or to provoke more informed decisions about outsourcing IT services. One thing that many business executives find compelling about outsourcing is that the service provider will (usually) provide a clear menu of services and prices; such information is usually not available from an internal IT department run as a pure cost center. Cost allocation can change that, making services and their costs more visible to the business.

  4. IT as a Business Partner: In fact, cost allocation combined with implementation of IT performance metrics and tracking can transform IT from a technical function to a business partner. A more business-focused IT can lead to more motivated IT staff, who see themselves more as business partners to their revenue-producing counterparts and less as necessary costs.

  5. Incentives to Reduce Costs and Improve Service: Allocating IT costs rather than retaining these centrally gives business lines a greater incentive to reduce these costs or push for greater services for these costs. Effectively, cost allocation is a management tool that can help shape behavior. Costs should be spread in a way that motivates departments to know which support services are necessary and to use support services wisely. Many organizations, for example, have experienced problems with some users or departments downloading multimedia (audio, video) over the organization’s Internet connection. A cost allocation program would assign these costs to the department using these services – which might make them think about more cost-effective ways of retrieving this information. But if these costs were retained centrally, that department would have no incentive (short of corporate “good citizenship”) to change its behavior.

  6. Contract Compliance: In some organizations, there is more than a simple business justification for allocating IT costs. Some “cost-plus” contracts and/or regulation, often found in defense contracting, public utilities, and other government agencies, require allocation to occur following strict formulas

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