Robert Kugel's Analyst Perspectives

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. Regards, Robert Kugel – SVP Research

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