Chargeback as success factor in sourcing
A common complaint in the outsourcing world is that the service provider is paid more money than was stipulated in the business case. After all, this original plan promised in writing that all will become less expensive, but the bills keep pouring in.
Cost management requires transparent insight into the financial situation: the actual costs and the source of these costs. Chargeback links these two issues and provides all parties involved with clarity on the financial consequences of their actions. In fact, effective chargeback is an important pillar for adequate steering of the cost component within the sourcing of IT.
Why do the bills not reflect the forecasts?
Many mangers attribute this to the service provider’s out-of-scope steering. Activities that fall outside the agreements come with a hefty price tag. It soon emerges that most of the activities fall outside the contract rather than within it. And the more of these activities you as the client sign up for, the more profit the service provider makes. This is true to a certain extent: service providers are commercial entities and are always in search of extra turnover.
But the actions of not only the service provider, but also the outsourcing organisation play a role. We often assume that savings ensue from the low price that was agreed with the service provider. However, not only the price, but also cost drivers such as volume, complexity and quality determine the overall IT expenditure.
And there are limits to how much you can tighten the screw and steer towards price reductions. The only alternative for outsourcers to keep control of the costs is to improve the management of the entire chain from demand to supply. Chargeback supports this process.
Insight into the effects of cost drivers
A typical example of an IT cost driver is utilisation, i.e. the extent to which hardware makes optimal use of capacity. Excessively low utilisation often results in excessively high costs. The link to costs is simple to make.
There are also cost drivers for which this is not as simple. For example, the quality of the change process is an important cost driver for the helpdesk: the number of phone calls will increase if something goes wrong with the implementation of a new software version that everyone uses. Many indirect cost drivers are linked to the IT organisation’s level of professionalism and the conduct of the organisation as a whole.
Without chargeback, the inefficiencies and the effects of cost drivers often remain unaddressed. Rising costs, for example, are seldom if ever linked to professionalism and conduct, and are simply dismissed as an effect of increased volumes. IT does give account of cost totals, but not in relation to its own level of professionalism. And the business takes no responsibility for choices that lead, for instance, to a highly varied IT landscape, complex integration programmes and the relevant high costs.
Chargeback helps to translate assumptions about total IT costs into insight on how that total amount was achieved. This ensures that the endless discussions on the undesirable result (excessive costs) are transformed into discussions on the causes and targeted changes.
Who pays for it?
If IT is organised in a decentralised fashion, then the breakdown of costs is clear. Everyone pays his own part and if a business unit feels that the costs are too high, there is scope for taking measures. The past decade saw the centralisation of many IT facilities such as data centres, networks and core systems. So who pays what?
Various payment models are in use, each with its particular pros and cons.
- The costs are kept centralised and the ‘users’ receive no bill. The advantage of this model is low administration costs, but the drawback is that clients gain no insight into the financial consequences of conduct and choices.
- The costs are recovered from the business units. In theory, this allows a business unit to measure the use of IT against the costs. This rarely happens in practice, however.
- Chargeback based on allocations. Business units receive an allocated share in the overall costs instead of an itemised account. The most popular method is apportionment: based on the number of employees.
Chargeback of costs to the responsible party is an effective steering tool. It is clear to everyone where the costs are allocated and what the relevant responsibilities are. A condition for this is that everyone is treated fairly and that the ‘accounting rules’ are clear from the start. A proper discussion is needed beforehand on the various types of IT costs (not everything can be lumped together) and the relevant cost drivers (not all causers of costs are equally influencable by individual components).
Don’t punish, steer
Chargeback is an effective steering tool, but should not turn into a form of punishment. This could become the case if the IT facilities exceed the business unit, for example during the implementation of a company-wide ERP platform. This results in costs which the decentralised components did not ask for. The business should be able to meet its targets for the coming quarter without fear of being punished for centrally made decisions. It is important that the internal rules for chargeback take this into account. Money used for change processes should not be treated as a regular expense.
Management can also decide to halt chargeback temporarily. A good example of this is what Jan Hommen did during his time as CFO at Philips. He wanted to get rid of the dozens of decentralised e-mail systems in favour of a single platform. To persuade the business units to take the first migration step, he decided to reward the early adopters. They were exempt from chargeback for up to 18 months if they made the switch promptly.
It is also worth looking into if and how chargeback can have a positive effect in the case of other strategic objectives, such as application rationalisation. A chargeback on the basis of ‘the polluter pays’ increases the pressure. However, tightening the chargeback screws as a means of enforcing change is futile: the business needs prospects for realising structurally lower IT costs in the long term.
More flexible incentives are the best means of ensuring that the business becomes truly committed. The IT organisation can help by proposing various scenarios and migration routes, with the alleviation of the changeover pain as an important component. If a business unit has good reasons for keeping things as they are, then the consequence, at any rate, is clear: the specific costs are charged directly.
Chargeback and outsourcing
Chargeback is a vital part of the outsourcing preparations. The service provider’s terms of reference improve, because more is known about how the current costs came about and are structured. Discussions around costs focus on not only the price and volumes, but also the indirect cost drivers, behavioural change and the desired level of professionalism from within the own organisation. The discussions help gain insight into whether cost savings are realistic and how they are realised in cooperation with the service provider.
Chargeback is an important regulation tool towards the service provider for the duration of the contract. The increasing importance of IT for the business ensures a rising demand for services at this level. A commercial service provider will not easily say ‘no’ if he can provide the service, which means the outsourcer himself must keep a close eye on what exactly he is asking for.
Outsourcing might initially seem to do little towards facilitating the process of chargeback: the service provider’s bill must correspond with the internal rules. In our experience, the bills sent out by service providers are rarely renowned for their clarity in general. If a process of chargeback is already in place, it won’t do much good if the input consists of general bills that cannot be itemised. An often neglected fact is that service providers must provide not only the service itself, but also the input for internal, financial steering processes.
The next step in chargeback
Two developments run parallel with the effective realisation of chargeback:
- the use of on-demand services, and
- payment on the basis of business impact.
Innovations in IT service make it possible to charge for the use of applications and infrastructures. These service models have three main advantages:
- the avoidance of capital investments;
- fees are based on actual use;
- in the case of infrastructure, various models can be used side by side (which used to require significant investment in the past).
Because these services are largely automated, the chargeback process is relatively simple.
Organisations are also oriented towards the use of payment models where the achievement of business impact takes centre stage. This leads to a closed, transparent cycle: an objective is followed by a demand made to the service provider, with the relevant costs charged back after the provision of the agreed impact.
Chargeback is not an aim in itself, but instead supports the IT governance of the entire enterprise. Chargeback should ensue from decisions taken by the business – decentralised and centralised together. For example to outsource part of the IT activities. And the success of outsourcing depends on good steering tools to intervene when needed. Chargeback provides a solid financial basis for this set of instruments.
Case: From ‘spending money like water’ to steering and insight
At one of the large, listed companies in the Netherlands, a benchmark showed that EUR 100 million was being spent annually on external consultants. No further details could be found for this amount. Analyses showed that ninety percent of the expenses related to software projects that were carried out at the request of the business. The CIO found himself confronted with a warped image of the IT organisation – spending money like water – and a situation where clients in the business were failing to pay for the software they were using. The CIO took a number of steps in the field of chargeback to restore the situation:
1) Refining the ledger
The financial administration department was not splitting the costs according to each stage of the IT life cycle. Decisions were usually based on the purchase price and issues of the day. Today, all budgets have amounts split into components such as construction, maintenance and costs related to the dismantling of the supplied systems. The upshot is that the company is no longer fixated on the costs of today, but is able to anticipate the costs five years from now by when the infrastructure would for example be outdated. This helps ensure that timely updates are included in the considerations.
2) Reflection on and standardisation of the range of services
The business found it difficult to comprehend why IT had to cost so much money. They cast envious glances at external providers who explained in clear language what they can offer and at what price. The CIO understood that the fragmentation and chargeback of internal costs wherever possible would not lead to the desired transparency. For that reason, the IT activities were translated into services that are recognisable to the business and would make it easier to compare with what the rest of the market has to offer. An example of this is a functional workplace that consists of the pooling of all the relevant expenses. The services have also been standardised for everyone, so that the IT organisation is better able to explain that an additional service also comes at an additional price.
3) From cost centre to internal service provider
The supply of internal IT services takes place against the backdrop of market-level prices. The business now has a clear overview of how a request leads to ultimate costs. The IT organisation now cooperates with the business in looking at where and how costs can be reduced. There is no truck system, and the business is free to cooperate with any external party of its choosing, as long as the provider conforms to the security requirements as well as the legal requirements for listed companies.