Metrics Portal Blog

IT financials are an enigma to the business, a source of consternation to the CFO, and almost always a target for spending cuts when belts need to be tightened.  On the road to better Fiscal Responsibility, you need to know your financials even better than the Finance folks do.  Fluency in this area is a prerequisite to all other IT metrics that will follow.

What is it about the IT budget that warrants different treatment from the rest of the business?  There are salaries, benefits, contractors, T&E, capital purchases, depreciation, rent, service fees, utilities, administrative costs, etc., which are reported monthly using standard policies as defined by Corporate Finance.  From a financial point-of-view, IT really isn’t that different from other departments. 

Difficulty with the IT budget comes not from any inherent complexity in its financial structure, but from the complexity of its operation.  IT is a confederation of separate but interrelated functions, each with its own processes, skill sets, deliverables, and cost structures:

• Strategy and Architecture:  long-term planning, system architecture design
• Business Process Redesign:  scope definition, project prioritization, business requirements, workflows
• Application Development:  new development, on-going enhancements, data management
• Application Support:  upgrades, defect fixes, release management, change control, user support
• Data Center Operations:  mainframes, servers, storage, facilities management, DR, security
• Telecommunications:  network, telephone, mobile, field office support
• Desktop Services:  file servers, device inventories, license management, break/fix, help desk
• Document Management:  printing, off-site storage, mailing
• Administration:  finance, HR, PMO, planning, compliance, measurement

Mashing these distinct operations together into a single budget structure forces each function to “dummy down” its information to the least common denominator.  Just because corporate policy requires a roll-up for all of IT doesn’t mean each function can’t still use the details of their operations to give the business a more transparent view of the budget.

Three Views of IT Financials

For each IT function, budgets should be analyzed and presented along the following dimensions (see IT Financial Reporting framework):

• Functional view:  Based on classic administrative categories, such as salary and benefits, consulting services, hardware, software, telecom, utilities, real estate, etc.  This is the view shared by all departments regardless of function, to be rolled up into the overall Corporate financial statement.
• Service view:  For IT more than others, each set of services needs different data to track its activities.  Mapping financials to a service- or project-based view gives managers more specific information with which to oversee their operation, while maintaining the integrity of a functional view within each service category.
• SBU view:  Depending on the company, individual business units may need to have their IT charges rolled up into a separate set of financials.  This is the dreaded “chargeback” view of IT, where much angst and many hours of analysis are expended by business and IT alike to address concerns of those who feel they are being unfairly charged.

With these three views, you can expose IT spending in a manner that is meaningful to different constituencies, allowing them to better understand where their money is being spent, and how they can rejigger priorities to get more value.

Shared Costs and Transfer Pricing

To map the financial data between different views requires certain assumptions about how to distribute costs for each service among the SBUs:

• Direct costs:  Expenses that can be directly attributed to a service, project, or business unit.  Usually administered via a time tracking, asset management or other activity tracking system.
• Indirect costs:  Expenses like Real Estate, data network, utilities, security, etc., that are used by everyone, and for which everyone has an obligation to support.
• Shared costs:  Expenses like Infrastructure, Human Resources, Finance, and other enterprise-level activities that multiple groups may consume in varying quantities.

Chargeback for the direct costs are easily understood and rarely contested.  The difficulties come from trying to get each group to absorb its share of the non-direct costs.  Here, simple transfer pricing for each service can be computed by dividing total expected costs for that service over a given time period by the total expected units to be consumed.  For example, if the budget for Desktop Support were $1 million, and there were to be an average of 1,100 devices supported, then the transfer price for each device would be $909.09, possibly rounded up to $950 to account for unplanned unit growth or other expenses ($45K extra).

The benefits of using this type of model are (1) administrative simplicity, and (2) user incentive to control consumption, thanks to the direct correlation between usage and chargeback.  However, its weaknesses can be glaring when costs charged to an SBU vary widely from what is actually being spent.  This happens when unit consumption grows faster or slower than plan, resulting in an over- or under-recovery of expenses.

Graph – (Over)/Under-Recovery of Chargeback

For the model to work correctly, actual units consumed must equal the number used for planning chargeback rates.  In reality, this rarely happens because the actual expenses will have both fixed and variable components, resulting in a growth slope that is not as steep as that of the fully variable model.  Then, when actual units come in higher than plan, actual costs will be lower than what is recovered from the SBUs (over-recovery), and vice versa when the actual units lag the plan (under-recovery).

Problems pop up when IT groups try to variablize more of their budgets than they should, especially the indirect and shared costs.  Although a fully variable chargeback model is easier to implement, it is also particularly risky, because the increase in administrative costs (as groups add resources to analyze the fairness of their charges) will trump other benefits.

Arguments over how this over- or under-recovery gets allocated can lead to some very dysfunctional behaviors between the business and IT.  Often, the company will end up throwing away real dollars analyzing how the internal (non-real) dollars are being allocated, and producing special reports to placate those that are unhappy with the chargeback model.  Companies can address this issue in several ways:

• Add an “(Over)/Under-Recovery” line item to each SBU’s budget to net out any chargeback error
• Pay a “dividend” to those SBUs that are over-recovered, and collect an “assessment” from those SBUs that are under-recovered
• Periodically adjust rates to account for higher or lower than expected costs vs. plan
• Separate shared costs into fixed and variable components within each category; variable costs get transfer priced, fixed costs get allocated at some pre-arranged percentages

At the end of the day, only the real expenses of the functional budget get paid, so obviously an over-recovery won’t cost the company any extra money.  Unfortunately, this logic will not be well-received by business unit executives who have their own P&L targets to hit, because a significant over-recovery can result in some SBUs being unfairly burdened with more IT expense than they are actually consuming.  Over- and  under-recovery at the Corporate level will always net to zero, but the performance of individual SBUs (and their bonuses) could vary according to the accuracy of the chargeback model.

Reporting Your Financials

Reporting on the financials is easy.  You only need four standard graphs, which can then be varied by team, service, project, SBU, and other variables to make the data granular enough for managers to understand and act upon.  (See Financials page of the Metrics Portal library.)

• Budget vs. Actual: A simple line graph that compares budget vs. actual spending each month.  The starting point for all discussions about financials.
• Variance: Plots each month’s variance (difference between budget and actual) and the cumulative variance, which gives a running total of budget overruns (negative variance) or funds yet to be spent (positive variance).
• Spending Ratios: For like comparisons across divisional budgets that vary in size, you’ll want to track spending ratios like Processing % of Total Budget, Strategic % of Development Spending, Consultant % of FTE Spending, etc.
• Rates and Units: Managers can improve the financials by (a) reducing unit costs, (b) controlling consumption, or (c) both.  These graphs decompose spending into rates and units for tracking progress on each dimension.

Better reporting of financials is one of the fundamental improvements—and one of the easiest to achieve—that IT managers can make when trying to improve their operation.  Proactively digging into the financials and presenting the business with multiple views of spending data will go a long way towards demystifying the IT “black box”.  It won’t necessarily change their view that they aren’t getting enough value from what they’re spending, but it will help create a collaborative environment where business and IT folks can work together to find real value and real savings based on hard data.