THE VALUE OF SHARED SERVICES
Almost every C-Suite executive will agree that shared services, done well, are a critical factor in moving the business forward. The problem is that implemented poorly they can potentially overload good processes and profitable service lines with villainous overhead allocations.
IT chargebacks are important because, used well, they can assist the business with the following:
- help IT prioritise service delivery to the most profitable business units,
- help the business understand which IT services are value-adding to the market verticals, and
- reduce the overall vulnerability of IT-enabled business capability.
OVERHEAD ALLOCATIONS CAN RUIN GOOD PROCESSES
However, many shared service implementations are poorly received by the business units because they add little or no value and are charged at higher than the market rate. As Kaplan pointed out in his seminal work “Relevance Lost: the rise and fall of management accounting” the result of poor overhead cost allocation is that perfectly profitable processes and services, burdened by excessive and misallocated overhead costs seem to be unprofitable. Kaplan goes further and points out that all overhead which cannot be directly incorporated into the cost-of-goods-sold should be absorbed by the business and not charged back to the market verticals and service lines. This is the fairest method but most businesses avoid this method because high SG&A costs has a negative impact on financial ratios and therefore investor attractiveness.
In a recent article (shown below) McKinsey & Co pointed out a variety of methods which their client firms use to calculate IT chargebacks. Even though they differentiated between new and mature models it is worth noting that very few companies charged their business units for what they used (Activity-Based Costing). Rather, they used some form of bespoke methodology. This is usually (i) a flat rate, (ii) a budget rate with penalties (for behaviour change), or (iii) a market rate (usually with additional penalties for IT R&D costs).
ALIGNMENT & ACCOUNTABILITY
Chargebacks are essential. They are a critical means for companies to take charge of their IT costs. Otherwise, a ballooning IT overhead can destroy perfectly good processes and service lines. However, chargebacks can obscure accountability. If they are not calculated transparently, clearly and on the basis of value then there will be no accountability of IT to the business and whose capabilities they enable. Without accountability there can also never be alignment between IT and the business.
CHARGEBACK AS AN INDICATOR OF MANAGEMENT-VALUE-ADDED
Traditional methods of IT cost modelling, on which standard chargebacks are calculated, only account for the hard costs of ICT, namely infrastructure and applications. It should be noted that chargebacks should only be applied for Management Information Systems (eg, knowledge bases, team collaboration sites such as MS Sharepoint, CRM systems, and company portals etc). All other systems are either embedded (eg, robotics etc) or operational, (ie mission critical to a business unit’s operations). MIS are largely used by overhead personnel whereas operational systems and the finance for embedded systems should be accounted for in the cost-of-good-sold. The real question therefore, is: what is the value of the management support to my business? The question underlies the myth that Use = Value, which it does not. Good capability applied well = Value.
THE COST OF CAPABILITY
The cost model, therefore, needs to determine the cost of capability. Metrics based on per unit costs are inappropriate because the equipment amortises so rapidly that the cost largely represents a penalty rate. Metrics based on per user costs are unfair because each user is at a different level of ability. In previous blogs we have outlined how low team capabilities such as distributed locations, poor requirements, unaligned processes etc all have a negative and direct financial correlation on project values. We have also written about how projects should realise benefits along a value ladder, delivering demonstrable financial and capability benefits – rung by rung – to business units.
It is reasonable to say, therefore, that managers should not have to pay the full chargeback rate for software which is misaligned to the business unit and implemented badly.
It is unfair for under-performing business units to be charged market rates for inappropriate software which the IT department mis-sold them. If that business unit where a company in its own right they be offered customisation and consulting support. In large firms the business often scrimps on these costs to save money. Given the usual overruns in software implementations business units are traditionally left with uncustomised, vanilla software which does not meet their needs. The training budget is misallocated to pay for cost overruns and little money is ever left for proper process change.
In order to create a fair and accurate chargeback model which accounts for the Cost of Capability, use the following criteria:
- Incorporate the COSYSMO cost coefficients into software and service costings so that low capability business units pay less.
- Only charge for professional services which the business doesn’t own. Charging for professional/consulting serrvices which are really just work substitution merely encourages greater vertical integration. This is duplication and duplication in information work creates friction and exponential cost overruns.
- Watch out for category proliferation, especially where the cost of labour for some unique sub-categories is high. Don’t let the overall cost model get skewed by running a few highly specialised services. Remove all IT delivery personnel from the verticals. Where there are ‘remoteness’ considerations then have people embedded but allocate their costs as overhead.
- Do not allow project cost misallocation. Ensure that cost codes are limited.
In order that businesses do not fall into the “Build and they will Come” trap a clear and precise chargeback model should be created for all IT costings. Businesses should start by charging simple unit costs such as per user. Everything else will initially be an overhead but firms may then move to a more complex chargeback model later.
It is important that low capability business units do not pay full price for their software and services. As Kaplan is at pains to point out, where businesses do this they are at risk of making perfectly good processes and service lines seem unprofitable. The only way to properly broker for external services is to account for the cost of capability.