A finance department breaks down costs in multiple ways, dependent on the business model and what is being measured. For example, consider the different approaches to company valuations: mature companies, or those in mature industries, are generally valued on profitability metrics such as earnings per share, gross margin and EBITDA (earnings before interest, taxes, depreciation and amortization). In contrast, young companies, especially those in high growth markets, are primarily measured on growth, market share, the value of their intellectual property, and other metrics to indicate emerging market dominance. Today the IT Finance Manager, CIO or IT director is also expected to present costings in many ways. But how do you do this?
Financial IT metrics can help a company to make better decisions and communicate with stakeholders in a language they will understand. Yet, different models and goals exert different pressures on the IT department and there isno one-size-fits all approach in the business of IT. At one end of the spectrum, the role of IT is that of a utility provider, where IT is bound to tight operational budgets to support existing business services as efficiently as possible. This is where cost-reduction is king. On the other end, IT serves as a strategic partner with business leaders in delivering new lines of revenue or penetrating new markets.
An IT department needs to deliver value based not only on the varied demands of your business units, but also in terms which are familiar to your business leaders. Financial metrics combined with data on IT service consumption and quality can be invaluable but only if they are used within the context of your business—for example there is little point delivering reports on information that your company does not measure. To this end choosing the right metrics based on your business’s role is invaluable.
• Delivering services that match or beat the cost and quality of those offered on the open market
• Investing in projects to enable long-term competitiveness and business growth.
In general, IT plays one of three distinct roles in business:
• Efficiency – Delivering efficient IT services, such as desktops, networks, telecommunications, storage, and servers. CIOs in this role focus on cost reduction and quality metrics such as infrastructure availability and failure rates.
• Service Delivery – The business role is composed of basic IT services combined with service classes, value-added products and services, defined service owners and structured service-level agreements. Here, the business consumers value the quality of services and are more willing to negotiate service levels in order to strike the right balance between quality and cost.
• Business Transformation – When the CIO is seen as a peer to business leaders, she is expected to facilitate long-term competitiveness and revenue growth. IT organizations in this role often struggle to allocate enough of their budget to growth and transformation initiatives.
The Essentials – Financial metrics for IT
Unit costs are simply the direct costs on a per-unit basis for key (and generally commoditised) components of your services. Common examples of this include mobile devices, laptops, telephony, storage, networking and data.
The fixed to variable cost ratio helps you understand your cost structure relative to your strategy. With nearly two-thirds of most IT budgets being fixed cost, you may be seeking a more variable cost structure that favours agility and flexibility (i.e., lower fixed-to-variable cost ratio). By maintaining a high proportion of your costs as variable, you can more easily scale up or down based on demand.
To determine direct vs. indirect costs, you must answer one question: to what are your costs (primarily) allocated? In organisations that have not completed the transformation to a service delivery model, the objects of allocation are generally business units or cost centres. For example, IT organizations in this model may allocate the cost of a server to the business unit (cost centre) to which it is dedicated. In organisations that are aligned to service delivery, the objects of allocation are generally their services. Resources that are dedicated to a business unit or a service would be described as a direct cost.
Opex, or operating expense, is an expenditure that immediately flows through your income statement. Capex, or capital expense, is an expenditure that gets capitalized, or booked as an asset, and flows through your income statement as depreciation over a period of time (generally equal to the useful life of the asset). Capex not only includes hardware and software, but also the costs to deploy them and certain application development costs. The accounting rules governing the capitalization of costs are complex and vary from company to company, but every CIO and IT executive should understand how the rules apply to them.
Budget vs. Forecast
While budgeting is generally an annual exercise, forecasting should be done on at least a monthly basis allowing you to estimate how much you expect to spend in a given period or for the remainder of a project. Forecasted amounts are generally added to actual expenses in order to determine any expected variance from your budget.
Knowing your expected variances is vital for effective IT management. By identifying variances early, you can take prescriptive action. At a minimum, you must inform stakeholders who are directly impacted by variances, such as the business units that will be charged for them. There are few things as detrimental to the CIO-business relationship than large, unexpected budget variances, or bills.
Using IT financial metrics not only demonstrates value to the business in a language business leaders understand, also enables both IT leaders and the business consumers of IT to make informed decisions to improve business value. Respecting the relationship of metrics to the business role of IT is crucial. Employing the right metrics will help ensure better alignment.