ITIL Intermediate SOA - Financial Management for IT services Tutorial

7.1 Financial Management

Learning Unit 7 looks at financial management for IT services and how it contributes to SOA. It provides an overview of the objectives, scope and importance of financial management for IT services as a process for generating business value. Financial management for IT services policies, principles, concepts like funding, accounting, and charging are covered, along with the activities, methods and techniques in relationship to SOA practices. Efficient use of financial management for IT services metrics is reviewed in this unit as well as their design and implementation.

7.2 Importance of process to service lifecycle

Financial management is a complex process that all organizations use as a basis for conducting business. Finance is the common language which allows the service provider to communicate effectively with the customers and other business units. • Financial Management enables IT service provider to play a strategic role in business • Provides quantification of value of IT services, value of assets, and qualification of operational forecasting. • Enables service provider to develop capabilities of operational visibility, insight and superior decision making. • Helps business to identify, document and agree on Value of the services being received Enablement of service demand modeling and management Next, let us understand the purpose of Financial management.

7.3 Financial Management for IT Services

The purpose of financial management for IT services is to secure the appropriate level of funding to design, develop and deliver services that meet the strategy of the organization. At the same time financial management for IT services is a gatekeeper that ensures that the service provider does not commit to services that they are not able to provide. Financial management for IT services identifies the balance between the cost and quality of service and maintains the balance of supply and demand between the service provider and their customers. For example, a customer asks an internal service provider to provide a service at a certain level. If the service provider is able to quantify the initial investment and on-going costs of that service, the customer can make a decision as to whether that service will provide sufficient value to cover the costs. If the internal service provider is not able to quantify the costs, then they will be put under significant pressure to deliver the service at the highest possible level. Next slide will describe the objectives of financial management for IT services.

7.4 Financial Management for IT Services

The objectives of financial management for IT services include: Defining and maintaining a framework to identify, manage and communicate the cost of providing services. Evaluating the financial impact of new or changed strategies on the service provider. Securing funding to manage the provision of services. Facilitating good stewardship of service and customer assets to ensure the organization meets its objectives. This should be done together with service asset and configuration management and knowledge management. Understanding the relationship between expenses and income along with that ensuring, that the two are balanced according to the organization’s financial policies. Managing and reporting expenditure on service provision on behalf of the organization’s stakeholders. Executing the financial policies and practices in the provision of services. Accounting for money spent on the creation, delivery and support of services. Forecasting the financial requirements for the organization to be able to meet its service commitments to its customers, and compliance with regulatory and legislative requirements. Where appropriate, defining a framework to recover the costs of service provision from the customer. Let us understand the scope of financial management.

7.5 Scope

Financial Management for IT Services encompasses the activities that establish the expenditure expectations of the organization, the tracking of how costs are accrued and money is spent, the management of financial assets, and the association of these costs against the various service consumers within the organization. Financial management consists of three main process. • Budgeting- process of predicting and controlling the income and expenditure • Accounting – Enables the IT organisation to account fully for the way its money is spent • Charging – Process required to bill the customers for the services supplied to them Two distinct cycles associated with above • A planning cycle (Annual) • An operational cycle (monthly or quarterly) In the next slide let us understand the value to the business of financial management.

7.6 Value to the Business

Financial management provides information that is valuable in generating strategies, and in moving from the way in which assets are used currently to how they need to be used to achieve new strategic initiatives. Rigorously applied, financial management generates meaningful critical performance information used to answer important questions for an organization: Is our differentiation strategy resulting in higher profits or revenues, lower costs or greater service adoption? Which services cost us the most, and why? What are our volumes and types of consumed services, and what is the correlating budget requirement? How efficient are our service provision models in relation to alternatives? Does our strategic approach to service design result in services that can be offered at a competitive ‘market price’, substantially reduce risk or offer superior value? Where are our greatest service inefficiencies? Which functional areas represent the highest priority opportunities for us to focus on as we generate a CSI strategy? Without meaningful operational financial information, it is not possible to answer these questions correctly, and strategic decisions become little more than instinctive responses to flawed or limited observations and information, often from a single organizational unit. Such methods can often incorrectly steer strategy, service design and tactical operational decisions. Specific benefits to the business include: The ability to conduct business in a financially responsible manner and to comply with regulatory and legislative requirements and generally accepted accounting principles. This will allow the business to operate legally and avoid heavy penalties for non-compliance. Accurate planning and forecasting of the budget needed to cover the cost of service. An understanding of the cost of IT to each business unit will allow IT service providers to recover the costs through their services and (for Type III service providers) maintain profitability. Many organizations fail to account for IT costs when doing business, and find their profit margins shrinking uncontrollably when IT costs are allocated at the end of each financial period. Better matching of IT services to business outcomes results in more appropriate and controllable spending models, and more predictable profitability. The ability to make sound business decisions regarding the use of and investment in IT. In the next slide, we will discuss on enterprise financial management policies.

7.7 Enterprise financial management

Each organization applies the rules, practices and local laws of financial management according to their specific business, structure and culture. Financial management for IT services is an application of the financial management policies and practices of the organization as a whole and must therefore follow the policies and practices of the organization as a whole. The enterprise financial management policies provide a framework within which IT must work to manage all financial aspects of its services and organization. Policies that impact an IT service provider might include: What level of financial expenditure needs to be tracked (e.g. cost per desktop device, or the total cost of all desktops) Which configuration items need to be recorded as financial assets and how they should be classified How fixed assets are depreciated How taxes are managed (for example, an IT service that is sold externally is reported differently from an IT service that is only used internally) How costs are reported How revenue is accounted for (and linked to IT services) Whether the cost of services will be accounted for individually, or whether the overall cost of IT will be calculated and allocated back to the business units Requirements to comply with the legislative or other regulatory requirements. An important policy decision to be made is whether IT will be a profit or cost centre. This is a decision made by the organization’s executives, not by IT management. This is because IT, as a business unit, is subject to the same governance as any other business unit. Although IT executives may be asked to participate in making that decision, this is ultimately a matter of enterprise financial policy. Definitions of these two options are: cost centre Two definitions for the term ‘cost centre’ are commonly used in business. Although they appear close in meaning, they are different. In this context the term is used to indicate a business unit or department to which costs are assigned, but which does not charge for services provided. It is, however, expected to account for the money it spends, and may be expected to show a return on the business’s investment in it. A cost centre is able to focus awareness on costs and enable investment decisions to be better founded, without the overheads of billing. However, it is less likely to shape users’ behaviour and does not give the IT organization the full ability to choose how to financially manage itself (for example, in funding IT investment). The other definition for the term ‘cost centre’ is used in the context of accounting. Care should be taken to read the context of the term to ensure the correct meaning is inferred. Profit centre A business unit that charges for providing services. A profit centre can be created with the objective of making a profit, recovering costs or running at a loss. As a profit centre IT is able to exercise greater autonomy, even to the extent that it can be operated as a separate business entity, under the ownership and direction of the corporate entity. IT will also be able to achieve better cost control over service provision and calculate the true costs of IT by customers. Charging other business units in the same organization can be useful in demonstrating the value that the service provider delivers, and in ensuring that funding is obtained from an appropriate source (i.e. the customer that uses the services). A Type III service provider is a profit centre, since it is a business in its own right. However, the different units within the company (IT, HR, sales, marketing etc.) will be seen as either cost or profit centres, just as they would in any enterprise. Now, we will learn about Funding Model and Analysis and also will know what Funding models do and the types of funding models.

7.8 Funding Model and Analysis

Funding models help to define how and when the IT service provider will be funded. Each model uses the same financial data, adapted to the organizational culture and enterprise financial management policies. In each case the aim is to provide the organization with clarity about how IT is funded and what it achieves with that funding. The funding model chosen should always take into account and be appropriate for the current business culture and expectations. Funding models include: rolling plan funding A rolling plan is a plan for a fixed number of months, years or other cycles. At the end of the first cycle, the plan is simply extended by one more cycle. In effect this means that the plan always covers the same amount of time or number of cycles, and is continually adjusted to meet changing conditions. This type of planning is used in more volatile or dynamic environments. The advantage of this type of funding model is that it allows the service provider to adjust funding requirements as necessary and also to obtain funding more readily (since they do not always have to wait until the beginning of the next financial year to obtain funding). However, most organizations only use this type of planning and funding for specific projects, not the on-going provision of all IT services. trigger-based funding In this model a plan is initiated and funding is provided when a specific situation or event occurs. For example, the change management process would be a trigger to the planning process for all authorized changes that have financial impacts. Another trigger might be capacity planning where capacity utilization might indicate that an upgrade or migration is required. Zero-based funding Most internal service providers are funded using this model, since it is based on ensuring that IT breaks even. In this model IT is allowed to spend up to the agreed budget amount, or get special approval to spend over the amount, and at the end of the financial period (monthly, quarterly or annually) the money is recovered from the other business units through cost transfers. This equates to funding only the actual costs to deliver the IT services. Let us look into the figure describes the financial management activities.

7.9 Financial Management Activities

It should be stressed once again that this section does not cover every aspect of financial management. It is aimed at providing an overview of best practices with which IT managers will be expected to be involved. Also, note that financial management practices vary from country to country and organization to organization. It is important to adapt any guidance provided in this publication to local laws, policies and practices. The major inputs, outputs and activities of financial management for IT services are illustrated in the slide picture. Financial management is subject to legislation and requirements from other regulatory bodies. Each service management process provides financial information about how money is spent, what services are provided and what commitments are made to customers. This information is used to analyse the most appropriate funding and accounting models to ensure appropriate levels of services are provided at appropriate cost Service portfolio, contract portfolio, application and project portfolios – each of these portfolios contain financial information which is used to analyse investments in services and corresponding returns SKMS provides specific information about service assets and any related investments. This information helps to align specific assets to service so that they can be appropriately accounted for and if needed charged. In the next slide, we will understand what Accounting is and what does the Accounting assists to the service provider.

7.10 Accounting

Accounting is the process responsible for identifying the actual costs of delivering IT services, comparing these with budgeted costs and managing variance from the budget. Accounting is also responsible for tracking any income earned by services. It should be noted that income is not recorded against services where revenue was earned indirectly. For example, if IT delivers a service to a business unit that uses the service to perform a revenue producing activity, the income will be recorded against the business unit activity, not the IT service. In these cases the business unit will record the cost of the IT service and link the cost to the income it earned. Accounting enables the service provider to: Track actual costs against budget Support the development of a sound investment strategy which recognizes and evaluates the options and flexibility available from modern technology Provide cost targets for service performance and delivery Facilitate prioritization of resource usage Make decisions with full understanding of the cost implications and hence the minimum of risk Support the introduction, if required, of charging for IT services Review the financial consequences of previous strategic decisions to enable the organization to learn and improve. As accounting processes and practices mature and become more service-oriented, they provide more evidence of the contribution and performance of the IT organization. As accounting enables IT to track financial information according to services (service account) rather than as a set of expenses and investments (cost account), it dramatically changes the dynamics and visibility of service management, enabling a higher level of service strategy development and execution. Next slide will describe us what a cost model is and why do we need a cost model, what are the following policies and Practices define by cost model, what are the cost models for the IT service providers etc.

7.11 Accounting - Cost models

A cost model is a framework which allows the service provider to determine the costs of providing services and ensure that they are allocated correctly. Cost models also enable the service provider to understand the impact of proposed changes to the current service, customer and customer agreement portfolios, and proposed changes to current financial management for IT services approaches, methods and techniques. Let us understand why do we need a cost model? It is important for a service provider to know what it spends money on, but that information on its own is not enough. Knowing where money has been spent does not explain why the money was spent, which services it was used for and whether the customer received value. It also doesn’t explain how business demand will impact future spending. An important reason to understand costs is to know the cost of ownership of each service, and to understand what things make that cost of ownership rise or fall, and how to control that through the various decisions made in portfolio management, change management etc. A cost model provides a framework that identifies where money is being spent, but also links that expenditure to specific services and/or customers. If financial management for IT services is able to link specific costs to specific services and customers, then it will be able to predict how changes to those services will impact the cost of IT. Alternatively, changes to technology or increases in the price of an item can be accurately communicated to the customer of the affected services. With this type of information service provider managers and customers are able to make better decisions about their service requirements and delivery options. Another reason for using cost models is that there are different types of cost, and they all behave differently. Some costs will increase, some will decrease, while others will fluctuate. Some costs are spread over several years, while others will only ever happen once. A cost model makes it easy to identify these dynamics and make sense of them, so that the service provider can accurately forecast its expenditure, understand the relative cost and value of services and communicate effectively with customers about the terms and conditions under which services will be delivered and supported. Another major issue for many organizations is that most IT investments are shared across multiple services and/or multiple customers. The fundamental question is ‘how do we split these shared costs fairly?’. If too much is allocated to a specific service, it will become uncompetitive; if too little is allocated, it makes a loss every time it is used. This allocation needs to be well planned and implemented, and based on accurate information. The cost model provides a financial baseline that is used as input into how the service provider will identify charges or service pricing – and thus prevent unfair cost recovery models, which could result in a dispute with customers. A cost model is not just a more sophisticated financial classification framework; it allows the service provider to structure financial information into a format that supports its strategy, tactics and operations. A cost model creates a standard format that will be used to analyse and report on the services it delivers, requests for new or changed services and the customers it supports. That format will translate all the factors involved in providing services into terms that are meaningful for the business, and which will facilitate good decision making by both the service provider and the customer. Cost models enable a service provider to calculate and communicate the cost of ownership of a service. This is a fundamental tool in understanding the value of IT and ensuring that the business is able to influence its investment in IT. It is possible for a service provider to define more than one cost model, especially where groups of services or customers are distinct from one another. For example, an organization that provides services to the military at the same time as providing services to commercial customers will need different approaches to finance. The cost model defines the following policies and practices: How expenditure items will be recorded and tracked How each item will be classified in accounting terms How costs will be allocated to services and/or customers How costs will be reported. There are a number of cost models to choose from, depending on the type of organization and the financial objectives. For IT service providers the five most commonly used are • Cost by IT organisation • Cost by service • Cost by customer • Cost by location • Hybrid cost model Let us now look into the figure of a cost model, describes the cost by IT organisation.

7.12 Cost model - Cost by IT organisation

This model is typically only used in internal service providers with multiple IT organizations. In this model each IT organization accounts for its costs and reports them to the enterprise financial management function. These costs are analysed and then allocated to various business units and other functions based on one or more of a number of factors. These include number of users, number of PCs and percentage of overall utilization of IT services etc. This cost model is illustrated in the figure. In the Figure as you can see all costs are accounted for by the IT organization that spends the money. In this cost model direct costs are any costs that are incurred by a single IT organization (for example, salaries of employees in that department). Indirect costs are costs that are shared by multiple departments (for example, the costs of the network backbone). Direct and indirect costs, and methods of allocating these costs. Once the total cost of all IT organizations is added up, the total cost of IT is allocated to the business units. In the figure the number of users in each business unit is used as a way of allocating the cost of IT and the percentage of costs allocated to each business unit is indicated above the name of the business unit. In this example the following calculation was used: Percentage of IT costs allocated to business unit = Number of users in business unit / Total number of users ×100 The advantages of the ‘cost by IT organization’ model are: It is cheap, since all that is being used are the organization’s existing accounting tools and staff. It is easy to calculate and allocate costs. It is easy to track IT expenditure and measure changes in spending patterns over time. This may indicate areas of inefficiency over time. However, the disadvantages far outweigh the above. These include: The business is able to see the cost of IT, but cannot quantify the cost of the services they use. This makes it difficult to quantify the value of the services. There is no assurance that the number of users is a fair reflection of how a business unit uses IT services. In the above example, although Manufacturing and Distribution have the same number of users, Manufacturing only uses IT half as much as Distribution. This means that Manufacturing is paying double for IT, and the price of products will have to be set higher than necessary to cover that cost. This could make the products uncompetitive. The only way IT can demonstrate a direct contribution to profitability is to cut costs, which might actually reduce IT’s ability to deliver vital services. If the business is not aware of the price of services, it tends to be more unreasonable in its demand for services – in terms of both the number and the quality of services. This places IT in a very difficult position. Business users keep demanding higher levels of service (often increasing costs), while managers keep trying to reduce the cost of IT (often reducing quality). Because IT costs are not linked to services, IT managers find it very difficult to demonstrate their actual business contributions. Organizations using this type of model often cost projects separately, but there is no way of determining whether the services implemented by the project teams actually achieved the required levels of return. Service portfolio management cannot be fully effective since investments in services cannot be tracked through the lifecycle. In addition, there is no effective way of filtering services in the service pipeline, since it is almost impossible to evaluate the effect of a new service on the existing cost structures. Although this cost model is cheap and easy, and is the most widely used type of cost model, it is of little real value to IT as a service provider. It provides only the minimum information required by the enterprise accounting policies, and does not enable IT to be seen as a contributor of value. Although the business understands the cost of IT, returns on investments cannot be calculated. It is not recommended for any but the smallest and homogeneous types of organizations, which have no more than a handful of services and a small number of users. In the next slide, we will look into a figure and learn about another type of Cost model that provides cost by Service. We will also know the advantages and disadvantages of the ‘cost by service’ model.

7.13 Cost model - Cost by Service

This type of cost model is essential for Type III service providers, especially those that position themselves using variety-based positioning, since they are in the business of selling services. However, it is also one of the most valuable types of cost model for internal service providers. In this type of cost model the costs of IT are reported according to service, which makes it possible to inform customers about the cost or price of a specific service. The customer is able to use this information to determine if the service will add value to them or whether it is too expensive for the outcomes they are trying to achieve. This cost model is illustrated in the Figure. It shows an internal service provider offering services to a number of business units in an organization. Costs are accounted for according to the services offered by the service provider. Service A is shared by four business units (internal customers), while service B is dedicated to only one business unit. Direct costs are any costs that are incurred when delivering a single service (for example, a specific application that is only used to provide a single service). Indirect costs are costs that are shared across multiple services (for example, the cost of a server that is used to support more than service; and the cost of its server administrator). Direct and indirect costs, and methods of allocating these costs. Once the total cost of each service has been calculated, it is allocated to the business unit. In the figure service A is provided to four different business units and the cost is allocated to each, based on how much they used it during the accounting period. Service B is provided to a single business unit, sales, which pays the total cost of providing the service. At the end of the accounting period, the IT service provider will report the allocated costs of all services that each customer uses. Sales uses two services, covering 5% of the costs of service a (based on utilization) and 100% of the cost of service B (since they are the only customer). If charging has been implemented, the allocation will be the basis for billing in internal service providers. If not, the allocation is simply reported so that each business unit is able to add it to their other costs and calculate their overall costs. The allocation also allows the business to link the cost of each service to business outcomes and thereby calculate the value of the service. This cost model is used differently by Type III suppliers to calculate pricing. Customers are not allocated a charge based on how much the service cost, rather they are charged according to a price list – and recovery has to be more than the cost of the service to continue funding the service provider. Advantages of the ‘cost by service’ model include: Customers are able to understand the balance between the cost and quality of a service and decide what investment is appropriate for the type of business outcomes they wish to achieve. It is easier to set customer expectations about the level of service they will receive, thus resulting in greater levels of customer satisfaction. The service provider is able to ensure that it has the necessary funding to provide the agreed levels of service. Both the service provider and the customer are more easily able to quantify the value of the service and the contribution it makes to the business. Knowing the costs of IT services that are used to create and deliver services and products to external customers can help business units to price these services or products correctly – ensuring that the organization does not make an unintentional loss. The impact of changes to existing services can be more easily quantified and assessed. Disadvantages of the ‘cost by service’ model include: It is more expensive to use this cost model since it relies on specialized cost accountancy skills and tools. In addition it requires a clear understanding of configuration items and how they relate to each other and the services being delivered. The allocation of indirect costs can be quite difficult, and could require sophisticated measurement tools to ensure that costs are correctly apportioned to cost centres. Allocating costs to services may influence the utilization of the service. While this may reduce costs over time, it creates difficulties in the short term. This is because the costs do not simply disappear when a user stops using a service. Now, let us explain a hybrid model of cost by service, customer and location with a diagram.

7.14 Hybrid cost model (Service, Customer and location)

As stated in the previous sections, it is unlikely that the cost model used by any organization will consist of just one method. Most cost models employ a number of different types of cost model for various purposes and situations. The aim of this is to ensure that every stakeholder has the right information to ensure wise investment in IT, correct balance between cost and quality and, most important, whether services support the achievement of business outcomes in a cost optimized manner. Most organizations will not need a fully hybridized model, but an example is provided below. In the slide an example is given of a business that has the following needs: The business manufactures, markets, distributes and sells a range of products. Three business-critical services are used to support four business units in three locations. Each business unit must understand the costs of the services they use, so that they can find the optimal balance between cost (as low as possible) and quality (production and distribution must be able to operate at a set pace) – every outage has a cost and there is a set limit to the amount of outage that will be tolerated. The cost of each service can be applied to the business units so that their products can be manufactured, distributed, marketed and sold at a competitive price. Each location is measured on its production, sales, and profit margins, so the cost of IT for every location needs to be quantified. This example uses a hybrid model of cost by service, customer and location. Using this cost model, the organization goes through the following steps: IT costs are analysed and allocated to the three service cost centres. Since each service needs to know the cost of the services that they will be using, the cost of each service must be allocated to the four business units, using some measure that is meaningful for the type of service. Once each customer knows the cost of each service they are able to work with IT to ensure that they are able to influence the quality of the service. If they need more quality, they will be able to understand the additional cost and assess the impact of that cost on the pricing of the product. The next step is to allocate the IT costs of the four business units to the three locations. Each business unit will add the costs of all three services so that they know the total cost that has to be allocated. They then divide the total cost of all three services by the total number of users in each business unit. They could use any measure – for example, number of products produced, revenue adjusted for local currency etc. In this example, the number of employees was chosen because it was easy to calculate and will ensure a proportionate cost allocation. Finally the number of employees from each business unit in each location is counted and multiplied by the cost per employee per business unit. These are added together for the four business units in each location to provide the total cost of IT per region. In this way, costs are allocated fairly and managers at every level of the organization have meaningful information about the cost of IT. The next slide will describe the concept of cost centre and cost unit as well as the cost type and cost element of accounting system.

7.15 Accounting

Cost centres Two definitions for the term ‘cost centre’ are commonly used in business. Although they appear close in meaning, they are different. Depending on the context, the term might refer to a function or department which does not charge for services or contribute directly to the profit of an organization – for example, by selling services externally. In the context of cost models and accounting systems, however, a cost centre is anything to which a cost can be allocated – for example, a service, location, department, business unit etc. That cost centre might become the basis for a charging policy or billing method. For example, some accounting systems use the concept of cost location codes to indicate where the costs will be accounted for. The cost location code is the cost centre. Care should be taken to read the context of the term to ensure the correct meaning is inferred. This means that even a profit centre will have cost centres associated with it, since it needs to record its costs in order to understand how to calculate its margins. A cost unit is the lowest level category to which costs will be allocated. Cost units are usually things that can be easily measured and communicated in terms to which customers can relate. Cost units enable the service provider to break down the costs of a high-level cost centre into smaller categories that can be used to link the customer’s use of the service to the level of expenditure. Cost units help to increase the accuracy of forecasting and make it easier to link costs to items that customers actually use. There are at least two levels of category used to define costs, cost types and cost elements, which may be further broken down into sub-categories. Please note that the categories used in the examples are not prescribed. Each service provider should use categories that are appropriate for its situation and practices. Cost types are the highest level of category to which costs are assigned in budgeting and accounting – for example, hardware, software, people, consulting services and facilities. Cost elements are the sub-categories to which costs are assigned in budgeting and accounting. Cost elements are sub-categories of cost types. For example, the cost type ‘people’ could have cost elements of payroll, staff benefits, expenses, training, overtime etc. In general, cost elements are the same as budget line items where the purpose of the model is simple recovery of costs. Cost elements can be broken downs into several hierarchies of sub-category. However, the number of categories, and how they are organized will need to be appropriate for each organization. Some may need two levels, others three, while some may need more. Let us now understand the classification of cost as well as the allocation of costs and fixed and variable based costing.

7.16 Accounting

Cost Classification Once the cost types, elements and units have been defined it is necessary to determine how each one will be managed, analysed and reported. Another way of thinking about this is to understand how the costs will behave. For example, are they likely to change, go up, come down or fluctuate? Most cost elements behave in a predictable way if financial management for IT services is able to classify them correctly and link them to business activity. Although this is a complex area, there are six major classifications, grouped in three pairs of options (each cost element will be classified as one or the other of each of these pairs). A special type of cost classification (depreciation) is also discussed. The classifications are as follows: Capital or operational The first classification is whether the cost is capital or operational. All costs are either capital or operational: capital costs or capital expenditure (Capex) is the cost of purchasing something that will become a financial asset – for example, computer equipment and buildings. Capital costs are used to purchase fixed assets, information about which is stored in the organization’s asset register, and which are subject to the asset management process. The values of fixed assets are depreciated over multiple accounting periods. The concept of depreciation is discussed in more detail below. operational costs or operational expenditure (Opex) is the cost resulting from running the IT services, which often involves repeating payments – for example, staff costs, hardware maintenance and electricity. Operational expenses are also known as current expenditure or revenue expenditure. The second cost classification is whether the cost is direct or indirect: Direct costs refer to any cost in providing an IT service which can be allocated in full to a specific customer, service, cost centre, project etc. (for example, the cost of providing dedicated servers or personal computers). Indirect costs refer to any cost of providing an IT service which cannot be allocated in full to a specific cost centre, such as customer, service, location, project etc. (for example, the cost of providing shared servers or shared software licences). Where indirect costs are not easily allocated to a cost centre, they are sometimes known as overheads, and allocated using a separate ‘uplift’ calculation. Whether a cost is classified as direct or indirect depends on the cost model used, and which costs will be allocated to which cost centres (for example, service, customer, location, project etc.). Allocation of costs Once a cost has been defined as indirect, the next decision is how it will be allocated. This is a complex area of accountancy, and a qualified professional will need to ensure that the appropriate methods are chosen and properly used. However, accountants will need the assistance of IT professionals to provide input to these methods, and so this publication provides a very brief definition of four of the most commonly used allocation methods: activity-based costing This method analyses all the activities required to produce a product or deliver a service. The resources required to perform each activity (time and materials) are documented. The amount of each activity performed for each cost centre is measured, and the agreed costs of that activity allocated to the cost centre. This is an accurate, but expensive and complex, method. Utilization-based allocation In this method the cost of a resource used by multiple cost centres is allocated based on how much the cost centre uses the resource. For example, if five business units (cost centres) use storage, the cost of the storage is allocated using the percentage of the total space used by each business unit. Utilization-based allocation should be carefully used, as it could discourage customers from using a resource. For example, if the service desk is allocated by utilization, people will stop calling it, and the impact of incidents will increase. This emphasizes the need to apply utilization-based allocation by service usage. agreed basis for allocation In some cases there is no straightforward method for allocation, and IT and the business will agree criteria that are easy to measure, and considered fair by the business units. This could be number of users, number of PCs or something else. The most important factor here is that all parties agree that this is a fair way of allocating costs, and that the costs being allocated are visible to the business units. For example, this is often used to allocate the costs of a service desk to the business. Indirect cost rate Regardless of what method of allocation is used, there are always costs that cannot be easily allocated. The indirect cost rate method sets a consistent rate to allocate these costs The third cost classification is whether the cost is fixed or variable: fixed costs are costs that do not vary with IT service usage – for example, the cost of server hardware. variable costs are costs that depend on how much an IT service is used, how many products are produced, the number and type of users, electricity or something else that cannot be fixed in advance. It is important to note that fixed costs can change. The price of maintenance may go up halfway through the year, an employee may get a salary increase, the cost of insurance may decrease because of some risk mitigation measures that have been implemented. This does not make the costs variable. The difference between fixed and variable costs is based on a specific factor, such as usage or time, and not simply because the price goes up. Now, we will learn various methods of depreciation calculation, the chart of accounts, the aims of analysis and reporting as well as the action plans in financial management for IT services.

7.17 Accounting

Depreciation is a measure of the reduction in value of an asset over its life, and is predetermined by enterprise financial management policies or tax legislation. The reduction in value is based on wearing out, consumption or other reduction in the useful economic value. Useful economic value means that the asset is directly or indirectly contributing to the objectives of the organization. In other words, the asset is still producing a return on its investment. Please note that this is an accounting (or book) calculation and it may be possible that an asset continues to contribute in the real world even after its asset value has been reduced to zero. The depreciation methods used should be the ones most appropriate having regard to the types of assets and their use in the business. Enterprise financial management policies give guidance in this. The most common methods of assessing depreciation are described below Straight line method Where an equal amount is written off the value of the asset each year. Usually a fixed percentage of purchase cost, this results in the item having zero net book value after a pre-set number of years (although it may continue to be used). reducing balance method Where a set percentage of the capital cost is written off the net book value each year. Often this is of the form 40% in the first year, 30% in the second year and 30% in the last year. The net book value is the capital cost minus the depreciation written off to date. By usage Where depreciation is written off according to the extent of usage during a period. It is usual to estimate the total useful ‘life’ of a device and to calculate the proportion of this that has been ‘used’ during the year. For example, a laser printer may be estimated to have a useful ‘life’ of 5,000,000 pages. If the average usage is 1,000,000 pages in a year, it can be depreciated by 20% in that year. Financial management for IT services may require IT assets to be ‘written off’ before the end of their useful life, increasing the apparent cost of services but facilitating a charging system that generates revenue for the early replacement of systems. Accounting: chart of accounts The chart of accounts is a list of all the accounts that are used to record income and expenses. The chart of accounts is defined and managed by enterprise financial management. In a Type III provider, it is likely that the chart of accounts is set up according to the types of services delivered and their customers. In internal service providers, however, it is more likely that the chart of accounts has been defined according to the type of business the organization conducts. For this reason the chart of accounts is sometimes difficult for IT managers to understand, and it is therefore difficult to communicate well with the business on financial matters. For this reason, financial management for IT services needs to align the chart of accounts with its own cost models, services and expenditure. More IT organizations are creating their own charts of accounts and then aligning them with the enterprise chart of accounts. Analysis and reporting in financial management for IT services have the following aims: To build an organization-wide understanding of the service provider’s income, expenses and investments To communicate the cost of services to all stakeholders To provide a basis for controlling expenditure according to the stated strategies, objectives and business outcomes of the organization and its customers To ensure that funding of the service provider is adequate. Without analysis and reporting it is not possible to fully understand the service provider’s funding needs To ensure that the methods, risks and returns of the service provider’s financial management practices are fully understood by the officers ofthe organization, so that they can initiate any remedial action required by law or regulation To build appropriate and fair cost allocation methods that ensure that each service is properly priced so that the business can ensure that the service is competitive, and that the service provider is able to retain value for funding To help customers calculate the value of services in terms of return on their investment in each service that they use To review strategic decisions to ensure that predicted financial outcomes were actually realized. As with other components of financial management, analysis and reporting are well understood and implemented within formal accounting systems and generally accepted accounting practices. What is often missing, however, is the perspective of the internal IT service provider. Although most financial reporting has some standard reports, these may not be fully tuned to IT’s requirements, or to communicating the value of IT services. Accountants will need to understand what IT has to know in order to deliver and manage services. IT has to know what the accountants need to know in order to produce that information. There are several types of analysis and reporting, but one which is worthy of mention here is budget deviation analysis. This is because it is a common tool used by all business units, and it links the activities of the service provider to those of the customer. Although the primary use of this technique is between internal service providers and customers, it can also be used to analyse external customer activity and compare it to the forecast financial dynamics (income, expenditure etc.). The basic premise of budget deviation analysis is that any deviation from a budget represents a potential risk. The budget represents the optimal levels of expenditure to achieve a specific set of business outcomes. If there is no further input, the organization will continue to spend on the assumption that the strategy has been set and all the business units have to do is execute. In reality, budgets are hardly ever accurate. They are forecasts based on a set of assumptions and historical trends. If the actual performance differs from the forecast, the organization may need to change the way it works to adapt to the changes in the business. If actual income levels are too low, the organization’s strategy may have been ineffectual, and there is a risk that the organization makes a loss, or that IT will not be properly funded. If income levels are too high, this implies a higher demand for services, and the organization may not have adequate capacity to meet the demand. Contrary to popular belief, budgets do not exist just to authorize or limit spending. They are a valuable tool in ensuring that the level of spending is appropriate for the level of business activity. If income exceeds expectation, it is likely that spending may need to be increased. Accounting: action plans If financial analysis and reports show that the organization is on track to achieve its financial targets, little action is required but to continue executing the original plans and strategies. However, if there is significant deviation from agreed financial targets, an action plan needs to be put in place and executed. These action plans are normally short term, and are aimed at restoring the organization to its planned path within a month or quarter, or else getting the stakeholders to agree to change the original plans and targets. Reporting budget deviation on its own achieves little but awareness. A budget deviation with an associated action plan is a powerful management tool. Typical triggers that cause a service provider to initiate action plans in financial management for IT services include: Unexpected increase or decrease in costs For example, the cost of maintenance or hardware. Under-utilization of services by customers This means that the investments made were higher than necessary, which is especially problematic if the customer is being charged for the services, and the service provider now stands to make a loss. It is also a problem if related assets are being depreciated by usage. over-utilization of services by customers This means that the investment made was lower than necessary. Money will have to be found to purchase additional resources to meet the increased demand. This is problematic where an IT organization is expected to break even, and is now on track to make a significant ‘profit’. It is also a problem if related assets are being depreciated by usage, since higher levels of depreciation costs have to be recovered in that financial period. Inaccurate business planning There are occasions where a customer has overlooked some aspect of their business, or failed to communicate with IT about a project which will increase IT’s costs. Unexpected changes to the external environment These include any event that impacts the service provider’s costs, and over which they have no control. For example, a supplier goes out of business, or is acquired by another company and a new product has to be purchased. Economic downturns also put stress on the organization to anticipate a slowdown in business by cutting costs and planned projects. Unexpected changes to the internal environment Organizations are always in a state of flux. People are promoted or leave the organization, business units get reorganized, new products and services are added and old ones retired. Every one of these changes will impact the way in which the organization uses and pays for IT. Close monitoring of financial reporting will often indicate that a change has taken place and that the service provider needs to take action. Sometimes the situation will be unexpected, and will require a quick response to assess what the cause is, and then develop a plan to deal with it. In addition the action plan should include continual improvement activities to help prevent recurrence. Let us now discuss what Budgeting is along with the analysis of previous budget, assessment of plans, specification of changes to funding and spending, cost and income estimation and finally, what a budget is.

7.18 Budgeting

Budgeting is the activity of predicting and controlling the spending of money. Budgeting consists of a periodic negotiation cycle to set future budgets (usually annual) and the routine monitoring and adjusting of current budgets. Budget planning typically begins at least one quarter before the current financial year end. This is to ensure that all departments have a good understanding of how the organization will end the year, thus also providing a more accurate starting point for the next year. This also provides enough time for each business unit to gather the data required to create the budget. Budgeting begins with either the CFO or the financial controller providing budgetary guidelines, including growth expectations and cost limitations. Each department or business unit uses these to create a draft budget which is returned to the CFO or financial controller’s office. All budgets are compared, assessed in the light of the overall strategy of the organization and returned to each business unit for revisions. This negotiation might happen two or three times before the budget is finalized and the new financial year begins. Most managers are familiar with the activity of producing and approving an annual budget, and then reviewing the budget regularly to ensure that the targets are being met. What many fail to appreciate, however, is the importance of budgeting as a business tool. Budgeting: analysis of previous budget The budgeting cycle starts with two steps. The first of these is an analysis of the previous year’s budget to detect any trends of expenditure or income that were too tactical or operational to be detected during a strategy assessment. In addition, the analysis will also look for mistakes made during the previous year’s planning (for example, where costs or projected business performance were incorrectly estimated). Any errors in the planning process should also be identified – for example, the exclusion of any key stakeholders, or incorrect assumptions made because information was not available. The results of the analysis should be documented and used when defining the budget for the next year. Budgeting: assessment of plans Budgets are impacted by several initiatives and plans. Each of these plans should be assessed to determine its impact on the budget, and to ensure that the budget is updated to enable each department to execute their role in each plan. Typical plans that should be assessed within IT include: The organization’s strategy All plans that involve executing the organization’s strategy Project plans for any project planned for the next financial year Plans for changes in the customer environment (relocation, workforce reduction, new marketing campaigns etc.) Planned new services in the service pipeline Technology update or refresh plans The IT capacity and availability plans Service improvement plans Services to be retired. Budgeting: specification of changes to funding and spending Many of the changes that will impact the budget are not in formal plans. Nevertheless, they have to be specified so that any funding or expenditure required during the year is taken into account. Typical changes include: Review and revision of existing contracts Changes to service utilization forecasts Changes to financial management policies about how costs or income will be accounted for Changes in financial reporting requirements Revision of an existing charging policy. Budgeting: cost and income estimation After analysing the plans, preceding budget and any known changes it is now possible to begin compiling the budget for the next financial year. This involves going through the budget, typically a spreadsheet defined by enterprise financial management, and estimating the values for each item for each month and quarter. In most cases the costs of items in the spreadsheet are known because of the preparation work done in analysing plans, previous budgets etc. However, the cost of some budget items may not be known – for example, overtime payments, contractor payments, consumables, external network charges. These have to be estimated, usually based on the previous year’s budget, or on a forward prediction of the costs of the estimated workload. Some costs may vary from the estimates, depending on usage. An example of this is software licences that may increase (in steps) as further users are introduced. Other costs may need to be estimated to cover out-of-hours support or major equipment relocation. Budgeting: budget(s) A budget is a list of all the money an organization or business unit plans to receive, and plans to pay out, over a specified period of time. It will take into account all existing spending, and how this will change during the next financial year (for example, if the cost of maintenance is increased, or more people are employed). In addition the budget must forecast any investments in planned new services or changes to existing services. This information will be provided by strategy management for IT services and service portfolio management. The IT organization will also have plans to update, replace or invest in technology to decrease overall costs or increase performance. These will also have to be forecast in the budget. Each department head will provide a list of investments they plan to make during the next financial year and these will be recorded in the budget, and preferably linked to the services they support. In the next slide, we will explain what the Charging is, and we will also discuss in details the characteristics that charging should have, the charging policies, decide chargeable items, pricing and about billing.

7.19 Charging

Charging is the activity whereby payment is required for services delivered. For internal service providers charging is optional, and many organizations choose to treat their IT service provider as a cost centre. In this situation charging is often referred to as ‘chargeback’ since the costs of the service provider are simply re-allocated back to other business units by the central financial function using an internal charging method. Ultimately the decision about whether to charge for services is determined by the culture of the organization and the policies of enterprise financial management. While IT may influence this decision, it is not their decision to make. Unless the IT service organization has the support of the whole organization in introducing charging, it will fail. It has to be simple, fair and realistic: Simple The overheads of cost management must deliver the benefits of an improved overall cost effectiveness without the bureaucracy commonly associated with IT accounting systems. fair ‘I can obtain the services cheaper elsewhere and that’s what I’ll do.’ The system must be fair and realistic; services which are not cost effective needs to be reviewed and hard decisions taken. Each business should pay the same money for the same service. realistic ‘I’m saving money, even though it must be costing the company more.’ Anomalies in the charging system will be exploited by businesses. The charging mechanisms must be designed to achieve optimal behaviour. The image of the IT service provider is likely to change; they may be seen initially as demanding money without providing the required service, as having become bureaucratic and focused on trivial accounting. Charging: charging policies Charging policies determine how charging will work, and are defined by the office of the CFO or financial controller. The first policy decision is whether or not to charge. The second policy decision is what level of cost recovery needs to be achieved. These can be summarized as: cost recovery or break-even In this case IT will only seek to recover its costs. It will not make a profit or loss. recovery with an additional margin In this case IT will seek to recover more than its actual costs. This policy raises a number of questions, which must be answered and agreed before charging is introduced: ? What will It do with the additional funding? In some cases the money is placed in a separate account earmarked for refreshing technology or covering the costs of unanticipated projects. In other cases it is used to offset the costs of new investments that are lightly used in the first year or two. ? How will the margin be perceived? It is important to note that this is not a profit. Since the money is being transferred internally it does not increase or reduce the revenue of the organization as a whole. Viewing excess charging as a profit could actually result in undesirable behaviour – for example, cost cutting of expensive items to increase the margin, even though they are used to support vital business functions. cross-subsidization This is where a subset of services is charged with an additional margin, which is then applied to offset the cost of another subset of services. This policy is often used to fund services to business units that have run out of budget, or whose business performance is lower than expected. The danger here is that temporary subsidies have a way of becoming permanent. When that happens, one business unit might be charged too little and may not sell their products at a price that covers their true costs. Another business unit pays too much for their services, resulting in the pricing of their products or services being uncompetitive. notional charging This is not really a type of charging at all, but a type of financial reporting. Notional charging is a way of telling an internal customer how much a service would cost them if they were paying for it directly. The reason notional charging is used is to make customers aware of the true costs of the services they are using. It can also be used to compare the costs of outsourcing versus insourcing. The third policy decision is how behaviour should be managed. Whether intended or not, when people are charged for services their behaviour will change. In some cases charging is deliberately used to influence behaviour, such as ensuring more efficient use of resources (for example, charging more for using a service at peak times encourages people to use the service at off-peak hours). In other cases charging results in unforeseen (often undesired) behaviour. Whenever charging is implemented, it should include a conscious policy to monitor the impact of charging on behaviour and tune the charging system to deal with each situation. The fourth policy decision is how the organization will deal with customers who decide that they can purchase IT services from another service provider at a lower cost. The final policy decision is based on current monitoring capabilities. If it is not possible to monitor system or service usage, then it will not be possible to allocate costs or provide a reasonable explanation of the charges. Therefore the charging policies have to articulate what level of measurement will be performed, and what investments are required to enhance monitoring where required.

7.20 Charging Contd..

Charging: decide chargeable items Successful charging requires that the customer understands exactly what they are being charged for. This enables them to quantify the value of the service, and to work with IT to optimize the balance between the cost of the service and its quality. It also helps to set expectations about the level of service that will be received. Chargeable items have to be items which can be perceived and controlled by the customer (for example, PCs connected to the network or number of transactions performed). The customer can then manage their budget by controlling their demand for these items. The more closely the chargeable items relate to the organization’s business deliverables the better the interface to the customers. Only a lack of information should force charging to be directly based on resource

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