by Joel Friedman
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Determining the actual cost of technology is a “must do” for any IT organization that hopes to succeed. Companies that use outdated, generalized costing models do not have a full understanding of the performance of their IT Organization. They also do not have enough accurate data regarding IT cost to make proper decisions regarding their investment in technology.. Wise investment can only occur through identifying and thoroughly understanding the true drivers of IT Cost. Not understanding the true IT Cost Drivers leads to misallocated costs and potential mis-alignment of IT and the business segments that IT supports.
Activity-based costing (ABC) is a tool that can be used to help Leaders “see the light” and accurately understand where their costs are. ABC is a relatively basic concept that breaks work down into units of activity, and assigns the unit cost of each activity to the consumer of the activity. Much like your electric company charges you for the amount of electricity that you use for the month.
ABC Modeling directs the costs of an organization back to the function that requires that cost to be incurred. For IT Organizations the original objective for ABC models was to assign the costs of technology directly back to the business units that consume the technology. However, ABC is not just a financial model, it is a measurement model. There are more benefits other than a charge back system that can be realized through implementing an ABC model in an IT Organization. Activity Based Costing in IT organizations can also be used for measuring IT Performance, trends, and opportunities for improvement.
Where to Begin?
Identifying each activity that drives cost within the IT organization, and what the cost components of each activity are (i.e. staff, service level, hardware, software, etc) is one of the first steps in developing an ABC model.
Let’s use the Help Desk as a basic example of identifying cost drivers. The primary activity of the Help Desk is handling inbound contacts. The volume of inbound contacts is the primary COST DRIVER of the Help Desk. The cost components of the Help Desk are people, voice/data infrastructure, software, facilities, etc. As the volume of inbound contacts increases the more people, infrastructure, software and facilities increases as well. In an ABC Model, each inbound contact would represent a cost driving unit of activity.
To determine the cost of each unit of activity, we need to take the sum of the cost components for the Help Desk and then divide by the total volume of cost driving units of activity.
For example:
Help Desk Cost Driver: Inbound Contact
Help Desk Cost Components: People, Facilities, Infrastructure, Misc.
Assuming that the sum of the cost components is $500,000, and the total volume of inbound contacts is 20,000. The Help Desk’s cost per for a unit of activity (cost per contact) can be calculated as:
$500,000/20,000 = $25/inbound contact
The unit cost of each activity should become a key metric in your organization. This metric can be used for charging back the consumers of the activity, serve as the basis for justifying budgets/expenses, and it is the benchmark for trending the performance of the operation.
Using ABC Metrics for Improving Performance
Once you understand the activities that drive cost in an organization, you can begin to identify opportunities to improve through properly managing the cost drivers within the organization.
Referring back to the Help Desk example, you have identified the cost driver (# of inbound contacts) and you have identified all of the cost components of the Help Desk. You now have a Key Metric/Performance Indicator of $25 cost per inbound contact. As the Help Desk Manager, you should now focus on identifying opportunities to improve this metric by finding lower cost alternatives to the cost components of the Help Desk. As improvements to areas of cost components are implemented, the effect on this key metric is realized.
For example, let’s say that the manager implements a new triage program that allows the Help Desk Analyst to handle more inbound contacts. This program eliminates the need for 2 FTE’s @ $50,000/year. This lowers the cost components of the Help Desk by $100,000.
Original Cost per Contact: $25 $500,000/20,000
New Cost per Contact: $20 $400,000/20,000
Assuming that the total volume of inbound contacts remains consistent, the Help Desk Manager can now demonstrate the improvement in the Key Metric and he can identify the specific actions taken to realize this improvement. Through managing the drivers of activities that generate cost, managers can effectively demonstrate true value and performance achieved in the organizations that they manage.
As IT Organizations use ABC to improve operations through managing the drivers of the activities that cause costs to be incurred, they gain a clearer insight as to how they can improve operations and “tell the IT Story.”
Using ABC Models to Evaluate New Investment
Leaders can also use ABC to more accurately evaluate the technology cost ramifications of pending business decisions. As the IT Organization becomes more cost transparent through ABC modeling, business leaders can more accurately model the business cases for new products, programs, offerings, etc.
Activity Based Costing Models allow leaders to have a clearer understanding of the true cost of each activity. This leads to a greater understanding of which products and services are truly profitable and which services/products need to either be “re-priced” to be made profitable or eliminated due to the inability to make profitable.
Understanding Fixed Costs
When using ABC to create performance metrics, be aware that you have to understand and factor in the fixed costs associated with the organization. Basically, a fixed cost is considered any cost incurred whether or not a unit of activity takes place.
In the Help Desk example, the fixed cost would be the basic infrastructure and the human resources necessary to cover the hours of operation. These costs are incurred whether an inbound contact (the cost driver) occurs or not. Therefore these costs are fixed.
It is important to understand the fixed cost components of organizations when attempting to demonstrate scalability and financial modeling scenarios. Leaders need to understand that the fixed cost component does not decrease as the units of activity (occurrences of the cost driver) decrease.
Therefore, in the Help Desk example, as a result of the fixed cost component, a 30% reduction in the cost driver (Inbound Help Desk Contacts) does not necessarily translate to 30% reduction in Help Desk costs.
Using ABC to Allocate IT Costs
In traditional cost accounting, cost is a function of the number the units produced. ABC accounting not only focuses on the cost of the activities to produce each unit of output but who consumes the output as well.
An ABC system looks at activities from 2 different perspectives. From a Cost Perspective, ABC provides information regarding the cost of the resources and activities necessary to produce a unit of output. From a Procedural Perspective, ABC provides vital non-financial information regarding the operational process of how the costs are incurred, why they are incurred, and provides the basis for improving cost position through implementing process improvement.
Along with the creation of metrics that serve as Key Performance Indicators, ABC can effectively allow IT Organizations to allocate costs directly to the areas that consume the services that create the cost. Thus creating a much more equitable method for business segments to be charged for their portion of the IT Spend.
Convincing the Organization to Change
The successful implementation of an ABC system cannot occur unless it gains the support of Senior Leadership. Leaders need to understand and agree to the fixed cost components, variable cost components and the cost drivers that were selected to serve as the basis for the ABC System.
Leaders must see the value that can be gained through understanding what drives cost, who consumes the service/product that creates the cost, and what actions can be taken to lower the cost. Once the leaders understand the value of this type of cost transparency, they should be an advocate of the process and will not be a barrier to success.
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