ABC Costing Model for IT

Introduction

Economic performance management has become a key challenge for IT Departments which must be able to present the full costs of IT services they provide. An Activity Based Costing approach is a way to meet this challenge. In this article we will present this approach, address its implementation and illustrate it with a practical example.

This entire article presents the ABC approach in an Information Technology (IT) context. However, this approach is applicable to any sector of activity and any organization (Industry, Energy, Banking/Insurance, ...).

This article can also be viewed in two short videos. Links are posted at the end of the article.

1. What is the ABC method ?

ABC stands for Activity Based Costing. It’s a cost modelling method structured in 4 levels:

• Resources
• Activities
• Services
• Clients

What are these 4 levels?

• Resources are all expenses of the IT department. This level represents an accounting view of the costs such as staff costs, depreciation, contracts, etc;
• Activities are all operational and infrastructure tasks within the IT department such as support, corrective maintenance, servers or storage;
• Services are all IT products or services provided by the department. It will contain workplace services such as desktops or laptops, as well as applications managed by the IT department such as CRM, ERP or business applications. Services can also be Business Projects managed by the IT department;
• Finally, Clients are all consumers of IT services. They can be of different natures depending on the organisation of the company.

The method is to successively allocate 100% of the costs to the 4 levels considering that resources are mobilized by activities, activities produce services and services are consumed by the clients. 

This logic creates a causal link between the 4 levels because clients consume services, services consume activities, and activities consume resources. This principle of consumption makes it possible to respond to the fundamental problem of IT costs management:

• the 'Resources' view corresponds to the budget management: we identify and control expenses;
• the 'Services' view provides the key for good rapport between the IT department and its clients.

Nevertheless, direct cost allocation from resources to services may pose a problem. In fact, most IT resources can not be assigned directly to a service. For example, when we buy a storage bay it’s often impossible to allocate the expense to a specific IT service.

The introduction of an intermediate level 'Activities' solves this problem : we know how to allocate resources to activities, and services consumption of activities is measured by technical inductors. This involves IT operating managers in the costing process.

The 'Activities' vision allows a measurement of operational performance and opens the door to benchmarking.

An ABC costing model is a techno-economic approach which enables IT operating managers to work in conjunction with controlling. It’s is a cost management tool for IT professionals.

With this model the controlling team ensures budget management, measures gaps and identifies productivity levers. Clients understand the costs of IT services that are consumed. IT operating managers drive the performance of their activities and the CIO is no longer just a cost center but a value-added service provider.

2. How do you implement the ABC method ?

The method can be executed in 8 steps. To do so, we need an ABC costing tool where the full costing model will be set up. Here we will see the main steps and what they consist of.

It is worth recalling that the implementation of an ABC costing model for IT is a team effort between the Financial Department (Controlling) and the IT Department (IT operating managers).

1. The first step consists of identifying all IT department’s clients. As we have already mentioned, these are all consumers of IT services.
2. In step 2 we build the catalog of IT services provided by the department. This step is essential as it structures the products and services that the IT department offers. It will involve the main players in the IT department, such as application managers, projects managers and production managers.
3. In step 3, we define the set of IT activities, ie identify all the human and infrastructure activities carried out in the department. In an IT context, the CIGREF framework of activities can serve as a reference.
4. In step 4, we analyse and structure all the technical and financial sources. It essentially consists of importing data from a time tracking tool and structuring the accounting data.
5. In step 5 it’s then possible to allocate expenses to the activities and calculate their total cost. This task essentially consists in associating the team's time spent (thus payroll) and other accounting entries (external purchases, allocations to depreciation, ...) with the activities of the model.
6. In step 6 it's then necessary to collect the activity inductors, that is to say the technical vector of consumption of the activities by the services (e.g: number of Gb of storage consumed by each IT application). At this stage, the interaction of financial and operational teams become crucial. These exchanges bring techno-economic value to the costing model. The allocation of costs will be done using the technical elements (inductors) provided by operating teams such as production managers, support team managers, etc.
7. The full costs of IT services can be calculated at step 7 after all inductors are collected. For example : the total cost of a laptop or the total cost of a business application. With the total cost of services, it is now possible to establish a good rapport with clients in order to regulate demand. Clients are aware of IT costs associated with service quality requirements or project requests.
8. Finally at step 8, it is possible to invoice or inform clients, based on their actual consumption of services. To do so we will see later that the use of work units will be essential.

All the results of the model can be used in a specific Business Intelligence report. The model data can also feed benchmarking studies.

3. Practical example

To illustrate the approach, let’s take a simplified example of an IT department setting up a costing model based on an ABC approach.

This IT department has identified its clients. Here it will be 2 subsidiaries they wish to invoice.

It has built its services catalog composed of 3 services:

• Email for mailboxes;
• CRM for client management;
• ERP for the accounting;

The example here is very simple since an IT department can offer several tens or even hundreds of services.

This IT department then defined its set of activities: support, corrective maintenance, storage and software. Once again our example is very simple, since an IT department can manage up to fifty activities.

In step 4, an analysis of all IT expenditures allows us to structure costs into 3 categories, staff costs, purchases and depreciation. These expenses are respectively $400k, $300k and $300k, for a total of $1,000k.

Resources are then allocated to the consuming activities using the time-tracking tool, the identification of supplier invoices in the accounts and the analysis of depreciation in the asset management tool. For example here the payroll ($400k) is allocated to human activities according to the past time of the teams (3/4 for Support and 1/4 for Corrective Maintenance).

In step 5, 100% of resources, that is $1,000k, was allocated to Activities.

Step 6 is to identify and value the activities inductors. In our example operating and finance teams defined the following inductors :

• number of tickets for the Support activity;
• direct allocation to services for the Corrective Maintenance and Software activities;
• number of Gb for the Storage activity.

After the collection of activities inductors, it is now possible to calculate the total costs of services. The services will receive Support costs depending on their ticket consumption, Corrective Maintenance costs based on time spent by maintenance teams, Storage costs based on their Gb consumption and Software costs based on the corresponding license acquisitions.

In the example below the Email, CRM and ERP services consume respectively 10, 40 and 50 thousand Gb. These services will therefore share the storage costs proportionately to their storage consumption, that is to say $20k, $80k and $100k.

When the total costs of activities have been allocated, the full cost of services is obtained. For example the full cost of the ERP is $440k , this amount corresponds to the total costs of activities that the ERP has consumed. 

The last step is the charge-back (or show-back) to clients. Clients will be billed and informed based on their actual consumption of services.

For this purpose, a work unit is defined for each service. In our example the Email service is consumed depending on the number of email boxes available in each subsidiary ; the CRM according to the number of users of the application and ERP depending on the number of invoices.

When the entire model is valued, there is a causal link between the costs of the different levels.

Here the total cost of the CRM, $460k , is composed of all the costs of activities necessary for its production:

• $180k in Support;
• $100k in Corrective Maintenance;
• $80k in Storage;
• $100k in Software.

By deduction it is also possible to calculate that CRM consumes $230k in staff, $50k in purchases and $180k in depreciation.

It is possible to calculate the unit cost of CRM depending on the volume of consumption. In our example this service costs $2,000 per user.

4. Calculation and analysis

In order to perform the calculation, an ABC calculation tool will need to be powered by time tracking data, accounting amounts, technical inductors and services volumes. With this data the engine successively calculates resources, activities, services, and clients.

This results in a 4-dimensional matrix that can be used for model analysis. After this calculation the results can be analyzed in Valoptia.ABC or in a DataVisualization tool such as Power BI, Tableau Software or Qlik Sense.

In this Power BI report example, we find the 4 dimensions of ABC, services, activities, resources and clients.

The analysis of services costs allows us to understand their composition in detail, by activity Software, Support, Corrective Maintenance and Storage but also by resources, Purchases Depreciation and Staff costs.

The ABC costing model will also provide an understanding of how each of the model’s activities are consumed. For example, CRM is the main consumer of support. It will also be possible to identify in which activities the different types of resources are allocated.

Conclusion

As we have seen, Activity Based Costing is a complete costing calculation method based on services production process. Costs are no longer a matter for financial teams alone, but are based on a permanent exchange between them and the operational teams.

You can find ABC costing models at www.valoptia.com and www.cost-house.com

Discover this article in video on the links below:

First part

Second part

Written by Jorge Vicente

Economic Performance Consultant at Cost House