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C
ost management is becoming linked to Information Technology (IT) more closely. The globalization and proliferation of the computer and Internet-related systems have changed the paradigm for how business is
conducted. CIOs, CFOs, and managers in IT are aware that costs need to be controlled for companies to remain competitive and improve performance in a changing world. Managing costs is an operational necessity in for- ward strategic planning in the IT environment.
Cost Management
Using ABC for
IT Activities and
Services
Fall
VOL.6 NO.
Fall
THE IT DIVISION OF A SUCCESSFUL INTERNATIONAL COMPANY DEVELOPED AN
ACTIVITY-BASED COSTING MODEL TO MEASURE AND ASSIGN THE COSTS
OF THE INITIAL IT SERVICES THE DIVISION PROVIDES, ENABLING BETTER, MORE ACCURATE
PRODUCTIVITY MEASUREMENT AND EFFICIENCY.
B Y B R U C E R. N E U M A N N , P H. D. ; J A M E S H. G E R L A C H , P H. D. ;
E D W I N M O L D A U E R ; M I C H A E L F I N C H ; A N D C H R I S T I N E O L S O N
EXECUTIVE SUMMARY: With the proliferation of computer-related services, the explosion in data communication, and ongoing trends toward globalization, managers in high-tech industries are considering new ways to manage and control costs. The fact that most Information Technology (IT) services have varied degrees of intangibility makes it a chal- lenge to measure the costs of the services delivered. Activity-based costing (ABC), the alternative to the traditional cost accounting systems, has been applied to manu- facturing and service industries. Successful implementations in the healthcare, insurance, and transport industries have been reported over the last few years, but few publications relate ABC to IT. This article reports on a cost management project using ABC modeling focused on an IT division of a publicly held software development firm. The needs of the company to establish accurate recharge rates and define appropriate activities pertinent to business culture were the main driving forces behind the project. The modeling process required the definition of resources, activities, cost objects, and drivers that correspond closely to the organizational functions within the IT division. The resulting model provides a managerial tool to measure productivity and efficien- cy and is currently being used for IT cost chargebacks and process improvements. Such activities have not been reported in professional publications or activity dictionaries.
John Shank suggests that cost management in a con- temporary firm must not be internally focused nor should it use single cost drivers.^1 Instead, cost manage- ment should: ◆ Be externally focused, ◆ Add value, ◆ Use multiple cost drivers, ◆ Reflect unique cost drivers for each value-added activity, ◆ Base cost management activities on cost drivers or linkages with suppliers and customers, and ◆ Identify cost drivers at the individual activity level and pose strategic questions (outsourcing, forward/ backward integration, establish new linkages with suppliers and customers). The project we describe in this article reflects all of these dimensions of strategic cost management, ranging from benchmarking to establishing better communica- tion and knowledge about recharge rates with an IT division’s internal customers. We also explain how cost management was used to accomplish a variety of objec- tives relating to IT users in a major software firm, how the problems encountered by this company may help others, and how cost management processes can be uti- lized effectively for IT services. Other firms have had similar problems, but a literature survey finds that no similar solutions have been reported yet. Data centers and client-server architecture develop- ers have started using more meaningful accounting terms. Instead of using “CPU seconds” and “I/Os,” new terms such as “cost per transaction” are becoming more common. But despite the new focus, IT has a long way to go in using accounting systems to meet the business needs of the organization at a level of detail that will satisfy every customer. Chargebacks for spe- cialized IT services, such as CPUs, data storage, and communications, are not derived, for the most part, from strict cost accounting calculations.^2 Companies using chargeback systems often overestimate the value and accuracy of their cost accounting systems. Tradi- tional cost systems have been known to distort costs and often provide inaccurate information while assign- ing costs to unrelated accounts. Activity-based costing (ABC) is regarded as an improvement upon this situation because it assigns the
cost of resources to a group of activities and then to par- ticular services (cost objects). In this article, we will describe how an ABC model was developed for an IT- based business entity. Company XYZ (name withheld on request) is the IT division of a successful global soft- ware development firm. The ABC model traces and maps the consumption of IT costs for a wide range of internal services provided within the organization. The resulting model provides a managerial tool to measure productivity and efficiency and is currently being used for IT cost chargebacks and process improvements. We provide information on the design choices for each model component and data to evaluate the utility of the model: the cost percentages channeled through the model, a range of recharge rates, and a comparison of these results with historical allocations. The major challenge in developing this model was dealing with limited information availability because technology changes quickly in the IT environment, and, as a result, few prior cost management studies have been conducted. Furthermore, the majority of services provided by the IT division have a high level of intan- gibility that makes it more difficult to pinpoint the processes and activities that consume costs in real time.
ABC M O D E L R E Q U I R E M E N T S The ultimate design of an ABC model must take into account the trade-offs among accuracy, flexibility, and cost.^3 Company XYZ provided very specific instructions that the final ABC model should not be too complex or too detailed. The company indicated a strong willing- ness to accept less accuracy in favor of a more manage- able model. Simplicity and user acceptance were the foremost modeling requirements. ABC is similar to many of the techniques concerned with the improvement of operating performance, such as process mapping and redesign, performance mea- surement, and cost analysis, but the link between activ- ity analysis and information systems (IS) is rarely made. Those setting an IS strategy can systematically analyze the information required to run the division but not necessarily be aware of quantifiable cost drivers. The ability of a comprehensive ABC approach to provide insight into the inadequacy of a company’s information system is well known to cost accountants.
calculate their recharge rates. The most revealing report was a survey of 75 top information executives done by CIO magazine, where just over half (40) chose a rigorous cost accounting approach to charging back their customers.^7 The remainder chose a “rough justice” approach. As Thomas D. Oleson stated in the CIO article, “traditional cost accounting requires strict rules and controls around each expense category. The alternative, rough justice, uses estimating and ratio development, an accounting practice that divides the total number of dollars spent by the total number of service usage.” Oleson also believes that “presenting internal customers with fair billing for far less money and with less anguish will win hands down as a more useful and less expensive methodology.”^8 It is difficult for an IT department to develop recharge rates that are accurate and perceived as fair by business unit managers. While it is easy to use the number of personal computers in the company as the recharge basis, there are “other cost components that need to be factored in as well: desktop software licens- es, help desk services, electronic mailboxes, and Inter- net access. Whether they are billed as separate line items or folded into a per-node fee, these resources must also be calculated into the overall average charge- back scheme.”^9 In 1982, Hewlett-Packard reevaluated its production and support processes to improve product costing and inventory valuation. HP used recharge bases such as number and type of parts needed to build and the amount of time required for product testing.^10 Another example is a bank that used ABC methods to calculate recharge rates for telephone inquiries. The bank deter- mined that it cost $0.766 per minute to assist customers with mortgage information. Although the call center received calls that varied in length, the bank could then determine their costs associated with providing mort- gage information.^11 The primary design choices for usage-based billing are the inclusion of charges, the selection of the base, and the portion of the charge that is variable. The first choice is whether to include all IT costs or only some. For example, Bose Corporation allocates all IT costs except training, research, and development.^12 In con-
trast, Liebermann mentions ITT (Fluid Technology), which states, “No IT expenses should be immune from departmental chargeback. As a service organization, our chargeback allocation covers 100% of our budget, including R&D and administration.”^13 ITT uses a per- employee chargeback rate that depends on where the employee is located. In 1997, employees in North America cost $467 while European and Asia/Pacific employees were $562 and $1,300, respectively. “It’s better to charge by the employee than per network node. Charging per node creates an incentive not to put a computer on the network…. We want to structure our program to encourage usage.”^14 Technology makes it possible to bill users at a very detailed level, such as cost per sign-on and server usage. Gathering this data to calculate the costs requires extensive network monitoring. ITT is against using network-monitoring tools to determine recharge rates. They believe the expense outweighs the benefit and that it is easier for managers to plan if they are given a flat rate.^15 Using recharge rates under ABC enhances the process further when paired with an external bench- marking program that offers a comparison to other simi- lar organizations. The added insight from an external benchmark lets managers compare their operations to the best and worst practices of others and to integrate the most appropriate practices into their own program.^16 This comparison should aid the business unit manager in forming an objective opinion regarding the fairness of the charge. Table 1 lists possible recharge rates as iden- tified in our literature survey. With these suggestions in mind, Company XYZ wanted to develop recharge rates so that they would be meaningful to both the IT department and the rest of the company. They favored the usual view that “A typi- cal business manager is unlikely to spend time worrying over ways he or she can reduce CPU cycles or disc stor- age costs; they are more likely to be worried about the business.”^17 It was critical to avoid creating recharge rates that might inhibit managers from implementing new technologies that could increase productivity.
Possible Cost Drivers in an IT Environment The hardest part of the ABC implementation in an IT
environment is identifying which processes to use as drivers. The drivers should be representative of activi- ties performed. Table 2 suggests possible drivers for systems, net- works, and applications. To summarize, there is very little knowledge about the effective application of ABC to the costing of IT activities based on published findings. There are some general findings in the literature survey suggesting that ABC should be moved closer to the user in order to better understand the business, but they do not provide the detailed guidance a cost accountant needs to deter- mine model requirements, recharge bases, and cost dri- vers. In the following sections, we outline the ABC design choices for the IT services of Company XYZ and report on the results of those choices.
T H E I N F O R M AT I O N T E C H N O L O G Y U N I T Company XYZ develops, markets, and provides imple-
mentation, training, and support services for its enter- prise resource planning (ERP) software. Its software applications give customers the ability to obtain inte- grated functionality for manufacturing, finance, distrib- ution/logistics, human resources, and customer service management operations within a multisite and multi- national organization. The company previously used various methodologies to allocate IT costs throughout the organization. Costs that were directly identifiable with the user of the ser- vice or product were charged directly to that user’s divi- sion. Examples of this type of cost include special software requests (over and above the standard software package that is provided to every employee), long dis- tance telephone charges, and cellular and paging charges. In addition, certain equipment is dedicated to specific functions/divisions within Company XYZ. These costs were charged directly to the development division through the financial accounting system. Typi-
Table 1: Potential Recharge Rates to Be Used in an IT Environment
SERVICE COST OBJECTS ALTERNATIVE RECHARGE RATES Internet Amount of network traffic Number of employees Size of message Intranet Number of messages Number of employees Size of message Messaging Number of messages Size of mailbox Server Platforms Number of log-ins to server Number of PCs Training Number of classes Number of employees Number of students PC Services Number of PCs Number of licenses Type of hardware/software LAN/WAN Services Number of employees Phone Number of telephone ports
Table 2: Possible Activity Drivers for Systems, Networks, and Applications
APPLICATIONS SYSTEMS NETWORKS
Number of instances for code revision, Number of tapes to be installed, mounted, Troubleshooting requests maintenance, updates or replaced
Time spent on each instance Number of technical support requests Time spent per incident
Number of maintenance incidents Number of network upgrades Number of PCs replaced, upgraded, or added Number of software additions, upgrades, or replacements
- Source: Michael Seadle, “A Better Mousetrap for Computing Costs,” Enterprise Systems Journal , October 1995.
telephone systems, voice messaging, cellular phones, and pagers.
Management Information Systems This last group provides to the company the internal business applications, such as the development of cus- tomized Internet and intranet applications and the acquisition and integration of third-party solutions.
D E V E L O P I N G A N D D E S I G N I N G T H E M O D E L The activity-based costing model used in this project is based on the cost assignment approach, which assigns resources to activities and then to cost objects.
The Cost-Assignment Model The cost-assignment model comprises three entities and two processes. The intention of the model is to show how the resource/cost entity reflects costs con- sumed by activities. The cost driver process assigns resources to each activity. The activity entity shows where work is performed. The activity-driver process assigns activity costs to the final cost objects. Figure 1 shows the cost-assignment model.
Resource/Costs Entity The starting point of the model was to narrow the gen- eral ledger costs down to six main categories: labor, Internet/data, equipment, phone, software, and other. For example, labor costs in the IT unit were about 33% of total IT costs, which are split between the divi- sions as shown in Table 4. Equipment is another major IT cost (40% of total IT costs), and Table 5 describes equipment costs for each division. The breakdown of
costs between labor (33%) and equipment (40%) illus- trates the importance of charging back labor as well as equipment.
Activity Entity The most difficult part of ABC modeling is to define activities at an appropriate level of detail to satisfy the primary objective of providing accurate, usable, and meaningful recharge rates. In order to determine appro- priate activities, each director of the five IT divisions and their reporting managers were interviewed exten- sively. We looked for activities that would be general enough to cover all areas of the IT organization and sought to identify only seven activities as an optimal number. Follow-up meetings were held as open forums where questions were raised and answered, suggestions were given, and concerns were addressed. A short-list of activities that were acceptable and applicable to the
Figure 1: The Cost-Assignment Model
P R O C E S S E S
Table 4: Percentage of Labor Costs by IT Division
DIVISION LABOR COSTS* Computing 14.6% Networking 10.6% Voice 2.4% Worldwide Service Delivery 48.8% Management Information Systems 23.6%
*Labor consists of all costs associated with salaries, travel and entertainment, and contract professional services. The company had never allocated the labor cost out to the internal users, so it was important to provide a way in which the total indirect cost could be assigned with or without labor.
R E S O U R C E S A C T I V I T I E S C O S T O B J E C T S
entire IT organization evolved from these forums: Requirements Analysis; Planning and Design; Project Management and Performance; Operations Support; Technical Support; Keeping Current; and Supervision, Administration, and Other. While the activities are somewhat general in nature, and therefore subject to some overlapping, the man- agers involved in the project accepted the following descriptions: ◆ Requirements Analysis— Developing requirements from user groups/individuals, assessing alternative courses of action and needed resources, and determin- ing the optimal course of action for the company. This category includes the pre-project engagement or life cycle. ◆ Planning and Design— This activity relates to tasks that are recurring in nature, such as capacity planning, performance tuning, lease/equipment replacement, and identifying/researching equipment to utilize. ◆ Project Management and Performance— Project management is the leadership/responsibility of a series of related tasks directed toward a major output, usually nonrecurring in nature. A project usually crosses organi- zational boundaries and has a timeline and budget asso- ciated with it. Performance of a project includes how well team members carry out the project. ◆ Operations Support— Directly supporting a piece of equipment, software, and/or environment. This cate- gory encompasses all tasks performed on an ongoing basis (i.e., normal operating activities). Examples include working on the help desk (first-level trou- bleshooting), maintaining training centers, daily back- up procedures, and software development. ◆ Technical Support— Providing assistance to a user in an effort to correct or repair a problem (“putting out fires”). This category includes second- or third-level troubleshooting. ◆ Keeping Current— Informal and formal training, including attendance at seminars, conferences, and trade shows. This category includes scanning the envi- ronment, competitors, etc. ◆ Supervision, Administration, and Other— Includes supervisory or administrative tasks such as preparing time sheets, tracking Service Level Agreements, and preparing personnel evaluations that are not directly
related to an activity defined above. Table 6 summarizes the costs associated with activi- ties in the IT division.
Cost Objects Entity Cost objects are the final entities in any ABC model. Ultimately, they are the IT-specific products or services provided by the IT unit and charged back to the rest of the organization. Note that these cost objects are ser- vices that users can meaningfully identify and describe. They are not technical components of networks or soft- ware programs. They differ markedly from typical IS/IT cost objects that are often expressed as CPUs, bandwidth, nodes, etc. The cost objects defined for Company XYZ were: Internet, intranet, messaging, AT and Managed labs, server platforms, training, PC ser- vices, LAN/WAN services, phone, and marketing sup- port. Table 7 summarizes costs consumed by the IT division for these services.
Table 5: Percentage of Equipment Costs by IT Division
DIVISION EQUIPMENT COSTS* Computing 50.0% Networking 12.0% Voice 0.7% Worldwide Service Delivery 35.0% Management Information Systems 2.3% *Equipment is all the equipment (and depreciation) for which the IT division is responsible. Company XYZ continued transferring equipment costs directly from the resource entity to the cost-object entity.
Table 6: Costs Associated with Activities in the IT Unit
ACTIVITY ACTIVITY COSTS Requirements Analysis 8.5% Planning and Design 16.0% Project Management 13.0% Operations Support 21.0% Technical Support 15.0% Keeping Current 7.9% Supervision, Administration, and Other 18.6% Total 100.0%
become the primary mechanism to analyze IT costs. They are also used to determine returns (ROI) on IT investments. The primary objectives of chargebacks are: ◆ To allow management to decide whether IT services will be free or billed to internal clients, ◆ To account for who uses IT and then allocate the costs to those users, ◆ To efficiently manage increasing IT costs, ◆ To influence and motivate improved performance of management through increased efficiency, and ◆ To combine financial and computer performance evaluation (CPE) information. Based on these objectives, the analysis of chargeback systems leads to a more refined profitability analysis for an IT department. Assigning costs equally to clients requires rational solutions to the problem of cost alloca- tion and transfer pricing. The less frequently IT costs are changed, the more stable the IT system appears to clients. The quality of a chargeback system based on forecasted data, however, is dependent on the accuracy of the forecast. In addition, frequency of management review of the IT charges will affect the accuracy of the chargeback system. In an unstable and high-growth environment, like many IT departments, overly ambitious projections of cost or volume critically undermine the credibility of IT recharge rates. One international study by Michael D. Shields, Chee W. Chow, Yutaka Kato, and Yu Nakagawa found that Japanese firms change standards more frequently than U.S. firms. The study also found that Japanese firms “focus on the performance for some future length of time,” whereas U.S. firms “tend to ‘emphasize the past’ in setting standards.”^20 Frequency of changes in charge- back rates is also pertinent to the frequency of budget- ing. Japanese firms often adopt six-month budgeting cycles, while 12-month cycles are more typically used in the U.S. Quarterly or six-month budget cycles, with appropriate adjustments of recharge rates, can be more accurate and more relevant, particularly in dynamic industries. Another major outcome is the impact on business- unit performance. Performance evaluations are based, in part, on the business unit’s profit (or segment mar- gin) performance; IT charges are used to calculate
divisional profit performance. Hence, business-unit managers are very concerned that the recharge rates are accurate and fair. Using ABC methodologies in this project resulted in new recharge rates. These rates are perceived to be more accurate than the rates produced by the former process because they capture more costs (including labor and technology used to support labor), are based on drivers that reflect actual support-staff effort for each of the supporting activities, and provide a more detailed description of services. For example, compared to the original method of determining recharge rates, Compa- ny XYZ found that the ABC rates reflect a 15% improvement for networking services and a 24% improvement for PC services. Further comparisons are not meaningful because of differences in how services are defined.
C O N T I N U O U S D E V E L O P M E N T Company XYZ is “cash rich.” More than one manager revealed that budgets were not necessarily followed simply because “they didn’t need to be.” While IT managers have a competitive and instinctive desire to limit expenditures in favor of “revenues,” they are not
Table 9: Recharge Rates for Services and Cost Objects
SERVICES & COST OBJECTS RECHARGE RATES Internet $ 230 Intranet $ 219 Messaging $ 136 AT and Managed Labs* Negotiated Server Platforms $450 – $ 650 Training $ 514 PC Services $2,289 hardware, $ 774 software LAN/WAN Services $ 850 Phone $ 238 Marketing Support** 100%
*The Recharge Base for AT and Managed Labs is shown as “Negotiated” because its costs will be charged directly to each business unit using the facilities. **All costs for Marketing Support are assigned to marketing business units.
operating as profit centers. Their goal is to charge out their services and come as close as possible to breaking even. It is also widely understood that the current cost allocation process is flawed, so failure to break even is often not even discussed. Aggressive or intrusive cost limiting measures may easily be dismissed as unneces- sary in this type of environment. History tells us that complacency is a prescription for failure. Commitment is imperative in any new management concept. Top-down commitment must be present to preserve the infrastructure and data-gathering processes required for ABC. This issue is linked to compensation and management controls. Tying compensation to implementation or to successful improvements as a result of implementation can increase commitment to the new system. Similarly, if there is commitment from the top, there will also be controls in place to increase the rate of continuous improvement as well as the prob- ability that the company will achieve its goals. These controls may be quality control, organizational or bud- getary controls, or controls such as job rotation (to enhance employee training or breadth of perspective). The ABC model that was developed in Company XYZ is the first step in what will probably become an evolutionary process. The new ABC recharge rates are more accurate and easier to understand—especially because they include labor costs and are based on readi- ly identifiable and understandable activities. Costs that were often “mysterious,” questionable, or unknown are now revealed (i.e., relevance found). The ABC model requires ongoing refinements while it is used for cost- assignment or decision-making purposes. These refine- ments, which will need to be carefully weighed in a cost/benefit context to fit the company needs, include: ◆ Reviewing the methodology used to aggregate his- torical costs including the accounts (object codes) that were grouped together and the specific business units that were combined. ◆ Assessing the cost drivers used and the need for increased accuracy and specificity for the time esti- mates employed in the ABC model. ◆ Ensuring that the activities are defined properly, encompass all of the work that is performed, and represent the appropriate level of detail. ◆ Selecting an appropriate number of activity drivers—
for example, seven activity drivers, which traditional cost accountants may view as too aggregated. ◆ Identifying alternative activity drivers and develop- ing measurements for the activity drivers selected. This is perhaps the most important refinement needed, and it will also be the hardest to accomplish. ◆ Ensuring that the services are properly identified and defined. ◆ Assessing the alternative recharge bases available for each service and identifying which bases would pro- vide the most equitable allocation of costs. In general, there are several conclusions about ABC that need to be considered before engaging in such a project:
1. Fixed-rate systems lead to higher use and more variability. 2. Management and users perceive a variable cost allocation structure to be fairer than a fixed structure. 3. A more accurate model is more defensible. 4. Accurate chargeback systems will enhance manage- ment performance. 5. The chargeback system will be a helpful instrument for budgeting and IT strategic planning. The refinements detailed above require a collabora- tive managerial effort to critically review and develop an understanding of the assumptions and methodolo- gies inherent in this model. Managers were able to offer specific suggestions for improvement for each related portion of the ABC model. An iterative, recursive process is essential to building an accurate and usable ABC model in an environment where there are few precedents and protocols to follow. ABC modeling provided a foundation for evaluating value-added and nonvalue-added activities, and it helped managers assess which activities could be reduced or eliminated. The costs of IT services could be more accurately and meaningfully charged to the clients/users. ABC cost data resulted in more accurate cost estimates for IT project requests submitted by customers/clients. Some consolidation of operating units was achieved through restructuring. While restructuring could have occurred without ABC, it was more obvious using the ABC results regarding which units could best be combined.
