Activity-Based Costing for IT

by Ken Rau

April 2005

Before you can get on top of IT spending, you need a platform to stand on

Overview

Activity-based costing has shown itself to be a very powerful tool for product line profitability analysis. As a result of the success of activity-based costing in this area, many companies are successfully extending its use to other areas of their value chains, including sales and marketing, manufacturing and customer services. Results have been used to identify and eliminate unprofitable products, customers, channel partners, and territories. Perhaps more importantly, findings from activity-based costing often spur changes to business and product development strategies and tactics.

As a result of the success of activity-based costing in the product area, many companies have or are successfully extending its use to other areas of their value chains, including sales and marketing, manufacturing and customer services.

Yet little has been done to date to extend the use of activity-based costing to the information technology (IT) function of the enterprise. This extension would seem to make good sense from both a practical and potential return basis. IT often accounts for as much as 10% of corporate expenditures; therefore, improved efficiencies in IT identified by the application of activity-based costing could add significantly to the corporate bottom line and shareholder value. Given the process documentation requirements of activity-based costing, the implementation of the technique in IT also promises improved performance, control and governance. Finally, as an enabler of company strategy, competitive advantage and market transformation, improved effectiveness of IT from application of this technique can contribute significantly to the overall success of the enterprise.

IT is also a logical extension of activity-based costing. Since IT’s emergence and recognition as a key function, IT management has continually flirted with the principles of activity-based costing, first as the basis for allocating, or charging back the costs of the function to other parts of the business, whether for the cost of developing new systems, processing transactions or providing telecommunication services or devices. More recently, in attempting to report technology’s “total cost of ownership,” IT has provided activity-based costing information to management and users in all but name.

Insights Obtained

Many insights are discovered by organizations that adopt activity-based costing in IT. These include the ability to:

• Produce clear, concise, compelling comparisons to world class organizations’ spending on IT, and, as a result, identify anomalies and suggest corrective actions to be taken to improve the IT’s performance in the organization;
• Understand the financial impact of strategic decisions on IT spending,;
• Model future IT spending and generate alternative funding scenarios;
• Identify systems in the application portfolio that are nearing the end of their useful life and should be replaced;
• More meaningfully allocate the cost of projects and system production to the organization; and
• Enhance communication of IT costs to senior management and the IT customer base in an understandable and familiar form.

It has frequently been observed that the IT function in an organization is like “a business within the business,” possessing an R&D process (systems development), a production process (systems operation), a maintenance process, and a customer service process (the help desk). Much like other management practices, methods and tools that originated elsewhere in the business but have been usefully employed in IT (budgeting, performance measurement, strategic planning, outsourcing), activity-based costing is a technique ready to be applied in IT to good effect.

Activity-Based Costing in Action

A simple example of an activity-based costing model for IT illustrates the power of this approach. Figure 1 compares a hypothetical organization’s activity-based IT spending to an industry benchmark.

This comparison reveals significant anomalies that may reflect unique circumstances, but that more likely are highlighting important problems within its IT function that require serious and urgent attention.

• Company X is spending much less on new systems development than the industry benchmark. It needs to understand why, and to be sure that it is not creating a serious competitive disadvantage by under-investing in needed technology.
• Company X’s ratio of maintenance to operations expense is over three times what it should be. This is a very strong indication that its business operations are being supported by a collection of obsolete applications that have become very difficult and expensive to maintain. This interpretation would be reinforced if we discovered that its current under-investment in new systems development reflects a longstanding practice.

It is possible that Company X’s spending pattern is consistent with its business strategy, but it is more likely revealing business risks that should be reviewed and addressed by its leadership team.

Figure 1
IT Activity-Based Costing Model Illustration

Summary

Activity-Based Costing for IT represents a new way of thinking about and organizing the collection, analysis and presentation of data about IT spending. For IT, activity-based costing is not a radical departure from conventional techniques for reporting on IT spending. It need not supplant well-established approaches, nor, is it a concept that is overly complex to grasp. Rather, it collects and organizes several techniques that have been intuitively evolving for many years in IT financial reporting under a single mantle. It provides a commonly accepted, well established principals and a body of knowledge for communicating the approach to peers and senior management. It offers several novel analytic techniques and benchmarks for identifying and dealing with inefficiencies and risk, and for projecting future spending.