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What does it cost to run an IT department? That’s an easy question to answer, but for most companies, why it costs that amount is not. IT departments often complain that most of their budget is devoted to funding daily operations and basic maintenance (“keeping the lights on”), but often, one big overlooked problem is the chargeback process that most companies use to assign IT department operating costs.
From a cost allocation perspective, IT spending falls into three basic categories. One includes general IT costs such as expenditures for organization-wide infrastructure (networks and hardware, for example), the salary and bonus of a company’s CEO and items that are either too small in value or too difficult to allocate with any kind of accuracy. These items are (and should be) allocated to business units based on some formula that approximates their utilization of these core costs.
A second category includes the costs incurred directly by a budgetary unit (division, department or business unit) that can be assigned to it unambiguously, such as software used only by a single unit or licensed on a named user basis.
It’s the third category that poses the problem: the costs of supporting the business operations of each of the units. Typically, organizations have a poor understanding of IT department cost drivers because they have not created systems that track IT department activities and connect them to the “things” consumed by each of the business units. Consequently, they assign these costs in the form of a general tax that is beyond the control of operating managers. Since the managers have no understanding of how their actions drive IT costs, they cannot optimize their consumption of IT services. Their only incentive is to limit or reduce IT spending overall.
Depending on the nature of the business, how the corporation is structured (centralized versus decentralized) and what executives considers essential, this third category of costs typically represents 20 to 50 percent of IT operating expense.
Using a general expense allocation formula for costs that ought to be directly assessable creates a dysfunctional spiral. The lack of transparency in IT cost drivers almost inevitably winds up increasing IT department focus on maintenance and decreasing focus on innovative or productive uses. With no incentive to dig into how they affect IT costs, business managers keep demanding items of marginal value. Managers with budget authority argue for keeping IT spending as low as possible so that they can show greater profitability or have more resources that they control directly. If IT charges are viewed as a general tax, it discourages innovation because the impact of an increased expense allocation is clear but benefits are not. Yet, since this part of IT is a common cookie jar, managers have little incentive to refrain from asking for services or not using them as wisely as possible.
If IT organizations want to broaden their activities well beyond keeping the lights on, they must track and manage their expenses more intelligently, in ways that enable them to accurately allocate costs to business users. Companies need an approach that enables them to accurately determine what’s driving their IT department costs, but several complications stand in the way of doing this. One is the inability of a company’s systems to track the connection between specific costs and cost drivers. This may be because the IT organization has not created the means to track costs or because it has not identified specific cost drivers. As a consequence, these IT costs wind up in a general pool charged back to business units using some agreed-upon formula. While the formula may not appear arbitrary, it is a barrier to achieving greater value from IT spending because it effectively eliminates any “vote” that a business manager has on an element of IT spending for which he has responsibility. If the allocation is based, for example, on occupied space, the manager would have to shrink his footprint to reduce IT costs – a difficult proposition because space may be under a long-term lease. Even if it were determined by a headcount formula, such a process holds managers ransom. In order to lower their IT costs, they would have to let people go. Or, it may just be a negotiated percentage of revenues – in effect an excise tax.
In order to increase IT spending transparency, companies need to use activity-based costing as well as IT asset/portfolio management processes and software, which help track the sources driving IT department costs. Activity-based costing is way of accurately assigning costs (especially indirect costs) to products and services produced by a business unit. It first identifies specific activities performed by an organization, then assigns the cost of the resources consumed in the creation and delivery of those activities. For example, the creation and maintenance of a custom application used by several business units consumes IT personnel time and processing cycles among other costs, and these costs would be assigned to specific business units. IT departments can accurately keep track of the cost of these activities using project portfolio management. PPM is an approach to scheduling and tracking the activities of services organizations such as consulting firms or IT departments in a way that connects the costs of specific resources (people, subcontracted services and the like) and the projects performed. A project in this sense might be a formal, multi-period task involving a large working group, or it might be an individual work order performed by a single individual on demand.
If IT departments want to do more than keep the lights on, they need to do a more accurate and transparent job of allocating IT costs. To address this strategic issue, IT executives must recognize the connection between shortcomings in their chargeback systems and the reluctance by many line-of-business executives to spend more on IT. Addressing the issue requires an ongoing process in both IT and finance departments for accurately identifying the cost drivers and having the software and systems in place to measure them. CIOs must work in partnership with finance organizations to ensure that IT dollars are spent most effectively.
Robert Kugel – SVP Research
One of the major issues IT executives face is how to charge their departmental costs back to each part of the business according to their usage. It’s a touchy issue that can be the source of end-user disenchantment with the performance and contribution of the IT organization. Ultimately, charge-back friction can hobble IT’s ability to make necessary investments in new capabilities and become the primary cause of misallocated IT spending. The two risks are related: Unless an IT department can calculate the real costs of the services it provides to specific parts of the business and charge for them accordingly, it is almost impossible for line-of-business department managers to assign priorities to the “keep the lights on” part of the budget, so even low-priority maintenance or upgrade efforts can crowd out all but the most pressing needs. The issue of allocating IT department costs spills over to Finance, which typically handles the allocations in budgeting and profit calculations. As a first step toward establishing an effective means of funding the IT function, I believe the finance department must establish better methods of allocating IT costs. Eventually the proper allocation of IT costs also becomes an issue for senior corporate executives as well because it has a direct impact on how effectively a company uses information technology.
To illustrate how using inept IT cost allocation methods can lead to bad results, let’s start with a very simple example. A company decides to lump together all IT costs and charge each department a prorated share based on some proxy; for example, headcount or floor space occupied or some combination of proxies. Any such proxy system inevitably will favor one department over another. Human nature being what it is, the inability to draw a straight line between the charge and the benefits delivered will leave everyone thinking they are paying more than their fair share. Moreover, in most companies, because business managers are not charged directly for their consumption of IT services, they have no idea how that impacts IT department costs. In the absence of price signals, unintended overconsumption and misaligned priorities are almost inevitable, and thus IT spending does not support the business as effectively as it should.
Our benchmark research illustrates the fundamental problem that companies have in allocating IT costs. Either they do not have the processes in place to ensure that they connect the right information to the appropriate action (for example, they do not charge costs accurately enough to end users so the users can’t make more rational decisions about what they are willing to spend), or they are not collecting the right information about the costs. Many suffer from some combination of the two. Having greater visibility into what a company actually is spending and on whose behalf and a better process for deciding what to spend money on are likely to increase the value the IT budget buys.
Our research also assessed the effectiveness of companies’ IT spending on a five-point scale from very ineffective (1) to very effective (5). The research finds that participants who said they have accurate systems for identifying and allocating IT costs have higher spending effectiveness scores (averaging 4.0) than those who said theirs were generally accurate (3.6), generally inaccurate (3.0) or very inaccurate (2.6).Tracking actual costs and charging them to specific users who incur them is the best way to be sure funds are spent well. Having visibility into the true costs of those IT resources and a process for controlling them promotes better use of the resources.
The research also finds that for IT departments there is a virtuous cycle in accurately measuring and charging IT costs. Companies that are more effective in using their IT budgets are also likely to have had greater IT budget increases in the preceding years than those that were less effective. In other words, a more accurate costing system gives a company more bang for its IT buck, which results in more bucks for IT. IT departments that give managers better visibility and control over IT costs charged back to them – and can demonstrate to their business clients that they are getting a positive return on their investment – are likely to be rewarded with higher budgets than those that do not or cannot.
Having the right data, the right analytical tools and the right allocation methods are all prerequisites to having an accurate IT charge-back system. As part of their overall responsibility to manage their portfolio of IT assets, CIOs must have the ability to track who and what is driving which IT costs. CFOs should play a larger role in the budgeting and expense allocation processes by ensuring that IT costs and cost drivers are more visible to the organization rather than relying on broad-brush allocations. Done correctly, I think this will improve the alignment of IT spending with the company’s needs. For their part, CEOs must understand the importance of achieving better alignment of IT spending and the strategic requirements of the company. They must ensure there is a formal process for periodically reviewing that alignment and capabilities to measure accurately spending on and use of information technology.
Robert Kugel – SVP Research