IT Shared Services: Managing and Aligning Costs for Better Performance
One way to take the next step in developing an effective chargeback system is to ask where your company is on this continuum:
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• 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.
Case Study: An Example of Measured Usage Allocation
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.
Understanding the Cost of Shared Services
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.
Benefits of Understanding IT Shared Services Costing
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-ChargingOnce 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. Demand-based pricing 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 Capacity-based pricing 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.
