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Criteria for Allocating IT Costs

June 13, 2008
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CRITERIA FOR AN ALLOCATION SYSTEM

When planning a cost allocation system, you must first consider what criteria you would like reflected in that system. There are several different criteria, but much commonality between them. According to the U.S. Office of Management and Budget (OMB), costs must be reasonable, allocable, consistently treated, and allowable.

Others emphasize the need for a cause and effect relationship whereby the party/activity that causes a cost to arise should bear that cost. Costs should be allocated in proportion to benefits received; some even argue that costs should only be allocated to the extent that each party can bear these costs. These all relate to the basic principle of fairness.

It is also important for the allocation methodology to demonstrate consistent results from year to year- and for changes in results to be easily explainable by changes in the underlying business and cost structure, or in the methodology itself. Further, costs and the methodology should be “auditable”

And finally, the costs of implementing and maintaining the allocation system should not outweigh the benefits

HOW TO ALLOCATE COSTS

Define the Project Scope and Team

First, consider the scope of the allocation effort. Which IT service costs will be allocated, and which will be borne centrally? Which IT costs will be excluded from the allocation model (in many organizations, control-related IT services like audits and security are not allocated). To do this, you must first gain agreement on the scope of IT services under discussion; these may include any or all of the services noted above and possibly other services depending upon your organization. After clarifying this, choose the cost objective(s) to be measured: product, project, service, process, department, division, organization, or legal entity.

Involve key senior management and line-of-business stakeholders in this scope definition process. As with a systems implementation project, including stakeholder requirements up front can save much frustration and re-work later on. And as with any well-managed project, it is important to build the right project team for a cost allocation implementation. This team should include the following:

  • A representative from IT management.

  • Subject-matter experts from key IT Services areas (usually line managers) who can help determine the right cost drivers and allocation bases

  • A business process analyst.

  • A representative from the Finance/Accounting function.

  • A representative from the Tax function, particularly if allocations will happen across legal entities.

  • Representatives from key business lines and projects. These may join the project team after the initial cost analyses are complete, or may join in the very beginning of the project.

Analysis

First, what is the organization’s business model? Are products and/or services fairly homogeneous, or extremely varied? What is the average proportion of direct to indirect/overhead/below-the-line costs? Does the organization have large direct costs compared to indirect costs? Does the organization have the ability to easily collect IT service cost data?

Which processes and activities originating from which areas give rise to costs? Utilize any process flows that already exist in the organization (your internal audit, technical publications, or operational risk departments may be good places to start for this), and make sure to fill in any gaps. Identify key IT services. What is the relationship between products, services, projects, departments, and entities?

Also study available IT cost and spending breakdowns. Make sure to study not just current but historical data, actuals, and budgeted figures. Separate out direct and indirect costs in this analysis. Keep in mind that one type of cost (such as salary and benefits expense) can be either direct or indirect depending upon how easily that cost can be linked with the entity to which it will be allocated (department or project).

Direct Costs

Salary and benefits for an IT line manager’s time spent directly on a project would normally be considered a direct cost to that project; whereas time spent by them managing their department, performing staff appraisals, and so on would be an indirect cost. Other typical direct IT costs include:

  • Hardware or software licenses directly associated with the department or project.

  • Consultant charges directly associated with the department or project.

  • Systems analysis, design, programming, documentation, testing, and implementation costs attributable to the department or project.

  • IT-related supplies and materials used by the department or project.

  • IT training costs.

  • IT telephone costs.

For salary expense, make sure to consider “burdened” salary expense (i.e. inclusive of a standard mark-up for benefits (usually 30 to 40 percent in the U.S.).

Indirect Costs

Typical indirect IT costs include:

  • Rent or depreciation on IT facilities, including data centers.

  • Data center utility consumption.

  • Data center maintenance and custodial services.

  • Data center security/guard/fire and flood protection costs.

  • Hardware maintenance and repair costs.

  • Hardware rental/lease/purchase costs not directly associated with a department or project.

  • IT administrative services provided at the departmental and central level.

  • Other indirect IT salary and benefit expenses (general database administration, quality assurance, IT security, computer operations, and so on).

  • Network services, communications line charges, data channel rental.

  • Network bandwidth costs (an increasing cost as organizations make more use of bandwidth-intensive applications such as Webcasting, multimedia, and messaging services).

Evaluation of Indirect Costs

Once indirect costs are separated out and pooled, these are divided into direct costs to provide an indirect cost rate. For these costs, make sure to indicate:

  • Relationship to the function performed.

  • Measurability.

  • Controllability by the end customer.

Costs that do not meet any of these criteria will be difficult to allocate – and perhaps should not be allowable under the allocation model. Certain overhead costs may not be controllable by the business unit, but even if there is some relationship and the ability to measure these costs they can be allocated based upon a simple and accepted formula (such as department size as measured by revenues or costs, or by number of headcount).

Choose a Cost Allocation Methodology and Tool

Mandated Allocation Methodology

For contractually- or legally-mandated allocation of costs, this decision may already be made for you. The types of activities, cost drivers, cost driver rates, and indeed the allocation methodology may be set out in great detail in legal documents. Otherwise, you must determine an allocation methodology.

Best Practice Review

One way to start is to refer to best practices and practices of peer organizations. This can be done through discussions with colleagues, or with the help of your public accountant. Most large public accountancies offer specialty practices in cost allocation, as well as exposure to the practices of many organizations like yours.

Indirect Costs Proportional to Direct Costs

One of the most basic ways to approach cost allocation is to charge a department the same percentage of indirect IT costs as direct IT costs. In other words, if the sales department consumes 25 percent of direct IT costs, they should be charged 25 percent of indirect costs. Another approach is not to even charge for indirect costs, since departments have no effective control of these. However, in today’s organization (which often has a higher proportion of indirect to direct costs than ever before) this will leave a large base of costs unallocated, and is not recommended.

Usage or Rate-Based Allocations

The Principle: Most indirect costs are best allocated according to some principle of usage. This is intuitively easy to accept – after all, departments or projects that use more resources should expect to be charged more. The only exception to this is certain fixed overhead costs (for example, premiums for business continuance/disaster insurance), which can only be allocated based upon a principle of “capacity to serve,” or some measure of relative department size.

Cost Base: Start by defining a cost base. This should reflect an easily justifiable and explainable link between the cost and the cost allocation. Systems usage, total direct costs and total direct IT labor hours/costs are some of the more widely used bases for most IT services cost allocation methodologies. Costs are usually easily understood, but exactly what constitutes systems usage at your organization may vary from other organizations. This can include:

  • Number of users per enterprise IT application.

  • Number of users per network.

  • Number of transactions per enterprise IT application.

  • Licenses for special/dedicated IT applications.

  • Number of database queries.

  • Number of reports produced per key IT application.

  • Network bandwidth usage.

  • Storage usage (megabytes per day).

  • Number of pages printed.

  • Number of tapes mounted.

  • CPU usage.

  • Number of disaster recovery tests conducted per year.

  • Number of help desk/support calls.

Units of Service: In determining the cost base, you need to express these as “units of service”. (Actually, these can be expressed in terms of a number or volume per some denominator by which the number or usage volume is divided, or as a rate/percentage). The denominator could be the number of end users, based upon official headcount. It could also be some technical indicator of the number of users, like number of network connections, network ports, IP addresses, or hardware/MAC addresses. Alternatively, it could be a measure of the size of the department or project, as measured by revenues or costs (for a cost center), or of a staff function as measured by total payroll expense. Or it could be a measure of time, physical space, or similar.

To represent IT data center facilities, “racks” or rack units are often used since they represent fairly standardized measures of hardware that they can accommodate, power requirements, cooling requirements, area taken up, and so on. However, this gives no visibility into software measures. An alternative to rack units is to break up data center facility costs separately – rent, power costs, HVAC costs, hardware, cabling, cleaning, and environmental (fire/water/smoke) protection.

Rate-Based Allocations: An alternative to such “usage-based” allocations is “rate-based allocations.” These are allocation formulas based on current, historical, or estimated cost rates. Rates can be calculated based upon usage trends, or on a cost-plus basis, on negotiated service level agreements, standard costs, or even by using actual market rates for these services. A rate-based model usually classifies type of usage by time of day, class of users (e.g. “power users” versus regular users), type of data, and so on.

Note that rate-based allocations can either be based upon actual usage rates or upon “standard” rates. Standard rates, if based upon empirical evidence over time, can be a fairly good proxy for actual usage at less cost to collect and manage. However, using true usage rates gives users proactive feedback as to their usage (or even misuse) of IT services that standard rates cannot. On the other hand, standard rates are more immune from users tampering with the cost base.

Allocation Calculation: At any rate, the allocated amount is calculated as:

  • the cost pool x (usage factor / total usage)

or as:

  • the cost pool x rate.

Cross Allocations

One consideration in allocating costs is how to treat cases where departments provide services to each other. This may include IT departments like network services and server group providing support to the IT application group; it may also include other support departments like Operations receiving services from IT and then in turn providing services onwards to a front office department. The direct method of allocating costs does not factor this into the analysis at all, whereas other methods account for cross-allocations when departments provide services to each other, such as “step-down” allocation. The advantage of using such methods is that the allocations more accurately reflect the true cost structure of the organizations; however, the costs and effort involved in tracking, measuring, and managing these cross allocations may outweigh the added benefits in some organizations.

Activity-Based Costing

One popular method of allocating costs – but by no means the only one or best option for your organization – is activity-based costing. Activity-based costing distributes costs based upon the benefits received from indirect activities by assigning these activities to cost pools that can then be assigned to processes in some logical fashion. Resources and activities are applied to cost objects.

Activity-based costing is popular because it forces managers to justify the purpose of all activities within the organization. But there are other ways of performing allocations – what works best for your organization will be the best compromise of the following:

  • Contractual/regulatory/policy requirements, if any.

  • Finance/accounting/tax department input.

  • Cost of implementing the methodology.

  • Systems support for the methodology.

  • Acceptance of the methodology and allocation results by the business and management.

Other Considerations

Other questions you are likely to confront at this stage are:

  • Will you allocate budgeted as well as actual costs and volumes? In a less dynamic or homogeneous product/service environment, budgeted costs and quantities might be a cheaper alternative to collecting actual costs and quantities, without much loss of accuracy. In more complex environments, it is more common to use actuals when allocating IT service costs. Allocating budgeted costs as well as actuals can give the best control over financial planning, at the expense of additional work to track this second set of figures.

  • Will you use standard versus actual costs and quantities, or some mixture? Standard costs are an easier measure to use (they do not require detailed tracking and measurement), but may not be as accurate as actual costs.

  • Will you utilize a single cost pool (no distinction between fixed and variable costs) or a multiple cost pool (with this distinction)? The trade-off here is ease of implementation versus costs of implementation.

Common Sense Check

Make sure to subject this analysis to a “common sense check.” Do these costs relate in common sense fashion to actual business requirements for IT services? If the results do not make sense to IT or to the affected business lines/projects, then further analysis may be required. It is at this point that you should start to gain agreement and consensus as to the indirect cost rates. Do not be surprised if this is actually the beginning point of some vigorous negotiation.

Collect, Pool, and Allocate Costs

Next, you must collect and pool the IT service costs to be allocated. Then these will be run through the allocation methodology and assigned out to departments or projects. They will typically be presented in report format.

Analyze and Evaluate the Allocation Results

The allocation results are ready, and are now hitting each department’s or project’s financials. This is the part of the allocation project that will definitely get the business’ attention! Expect some grumbling and complaints – after all, the business is now being charged for services that they have been effectively receiving at no cost. You must pull the project team together and strive to separate the grumbling from valid complaints about inaccurate or unfair charges, for example. A significant volume of valid complaints means that something may need to be re-thought. Some culprits may be the following:

  • The complete set of activities, processes, and costs may not have been identified.

  • Interdependencies between activities and costs may not be taken into account.

  • Cost bases may not be computed accurately.

  • The allocation methodology may not be optimal.

As part of this analysis, compare cost-based prices with actual market prices and benchmarks. Nevertheless, do not be surprised if some of your service prices exceed “best practice” benchmarks – this may not indicate deficiencies in your allocations, but rather “opportunities” in IT service delivery.

Finally, note that the process of evaluating the allocation results will become a regular (perhaps even annual), iterative process. This is because the organization itself can change through growth, mergers and acquisitions, divestitures, and changes to the business strategy. Cost structures can change as IT requirements change and as new technologies develop. And IT processes evolve over time. All of these factors necessitate changes to cost allocation

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