Kurt Marko of Processor.com has written some excellent articles on the field of IT Financial Management  (see my previous blog Quantifying the Cost of IT).  His article this week, To Chargeback or Not?, provides a very nice overview of the key arguments pro and con to implementing chargeback.

His summary of the problem statement (below) is dead on.  90% of the customers we work with have either no official chargeback or allocation system, or have a crude system based on rough estimates or non-consumption based methods.

“Past crude allocation mechanisms provided no real insight into IT costs and led to the perception that the cost of IT always seemed to exceed its value,” says Craig Symons, vice president and principal analyst at Forrester Research, in a recent report. These factors have led business executives to demand greater IT cost transparency. Financial experts agree that IT chargeback, or the practice of selling IT services using consumption-based rates, is the most effective means of clearly exposing IT’s costs.”

This is spot on…right up to the last 3 words.  While chargeback probably is the most effective way to expose IT costs, that’s not the end game.  Cost Transparency gives business managers the knowledge and power to decide how to apply their precious budget with respect to IT.  The end target, therefore, is to create a system and a business process around managing the demand for IT services to ensure resources are applied to the most strategic services and to align IT and Business in their pursuit of corporate goals.  Chargeback of discrete IT services and a demand management process shifts some of the accountability of cost management back to the business manager.

Chargeback also provides accountability for IT consumption, says Steve Sorota, so users are incented to request only what they need and not what they’d like. “Without chargeback, there’s no reason to be efficient,” he adds. A lack of financial feedback leads to overusage and waste and, Symons says, makes it impossible for business units to manage IT spending.

IT chargebacks also can improve alignment of scarce IT resources with enterprise needs. According to Symons, usage-based billing provides visibility of most important services, which can ensure IT operational budgets and new investments are spent on the right activities.

This is not an “also” this is the fundamental business reason to adopt a chargeback policy.  Economists have long argued that the best way to allocate scarce resources is through a market where the forces of supply and demand can take effect.  While we are far from a free market with lots of competition, a chargeback system at least creates the market and fosters the discussion on supply and demand where today there really is none.

The initial change to a chargeback process is likely to be painful for all parties involved, but it will also create a more painless way to get IT projects funded.  Too often today, when business leaders want to kick off a new project they come to IT and say “you must support this,” not well educated on the full costs to do so.  The CIO then says, “I can’t. I have no budget and am being asked to reduce by 10%.” 

With a good IT Financial Management system in place that provides visibility into the true and total cost of IT Services, the funding of new strategic projects comes from the business units themselves.  If they need a new application or more IT resources to meet their business objectives, IT can quickly analyze what it will take to support that initiative and wrap that cost into the overall business proposal for the business owner to drive.  In this way, IT and the business are aligned and can avoid the “I can’t support this” argument.

Stepping into the tactical for a moment, Kurt brings up the key success factor where most chargeback systems fail.

An indirect benefit of chargeback funding is that it addresses the perceived unfairness of IT allocation systems that apportion IT costs using a rough formula based on business unit revenue or headcount. According to Symons, “The problem with these allocation methods is that they don’t necessarily correlate with actual IT use, which leaves ‘light’ IT business units subsidizing ‘heavy’ IT business units.”

Allocation policies need to be “Accurate, Fair and Understandable.”  Accuracy implies that costs are accurately calculated and all costs are recovered. In short, that the equations are functionally accurate. This implies nothing about the allocation scheme.  That’s “fairness.”  Fairness means that the distribution strategy used to allocate IT costs to the business units are fair according to their usage.  For instance, a distribution strategy based on headcount might work well in the case of desktop services, where each additional head will drive cost for additional desktop services (laptops and end-user applications.)  But headcount is a poor distribution strategy for engineering services such as CAD/CAE applications or collaboration services, which are never used by finance, marketing and sales.  More into the grey area are financial trading systems.  While the wealth management group may make trades once or twice a day, they by no means match the volume of those at the trading desk.  In this case, setting a distribution strategy based on the number of transactions may be most fair.

This is where most allocation policies fail today.  Strategies that are too broad brush, not representative of the consumption of those services  or otherwise “unfair” will meet resistance by the business units that are being unduly charged.    

 Understandable means that the budget holder must be able to understand the allocation policy.  Don’t make it so complex that it becomes itself a black hole, or no one will buy into the chargeback policy.  Simple and fair policies are best.  The best practices that we have seen base distribution strategies on business metrics (# of transactions, headcount, cellular minutes used, etc.), not on technology metrics (CPU cycles, memory, # of VMs).  The technology metrics mean nothing to the business consumer, and will only draw resistance. This is akin to the price of a car being based on how many factory machines were used to build the car, not how fast it can go, MPG or brand.

But sometimes “simple” to the business user means “sophisticated” to implement. Balancing Accuracy, Fairness against Understandability is sometimes at odds.  Often the answer is in activity based costing (ABC), which requires a sophisticated allocation system, but enables the distribution strategy to be both Fair and business oriented (Understandable.)