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Why IT Should Understand ‘Costing’ Terms

When IT is expressing the value or costs associated with its services, care must be taken to ensure proper categorization and that the right terms are used. To have strong numbers that are supportable, IT really needs access to a costing or financial specialist who can assist with building quantitative models and explain what is […]

Written By

George Spafford

May 8, 2006

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When IT is expressing the value or costs associated with its services, care must be taken to ensure proper categorization and that the right terms are used.

To have strong numbers that are supportable, IT really needs access to a costing or financial specialist who can assist with building quantitative models and explain what is meant. Whether access to that person exists or not, a quick review of some business-oriented terms never hurts.

Accounting Costs
These are costs that impact an organization’s general ledger. For example, buying a product results in a chain of events wherein a purchase order is processed, a product/service is received, then an invoice arrives from the vendor; finally a check is created and mailed to the vendor. The bottom line is that the organization is out “hard” or “real” money.[1]

Examples:

Hardware and software purchases

Professional services

Maintenance

Labor

Medical benefits

Insurance

Internet Service Provider fees

Wide area network fees

The common thread in all of the above is that real money is expended or saved. Many times executives can be very fixated on these costs.

Economic Costs

Another term for economic costs are “opportunity costs.” Instead of doing X, you had to do Y. These are not hard-currency costs and it is dangerous to lump them into the cost-savings category with accounting costs because their effects will not necessarily show up on the bottom line.

To claim economic cost benefits, the savings must be identified and then what was done instead that moves the organization toward its goal.

Examples:

Reducing firefighting on incidents related to problematic changes is robbing resources from planned work (projects) and applying them to unplanned, reactive work (incidents). If you say that better change management reduced unplanned work by 20 percent, that is not an accounting cost savings, but it did free up resources to work on projects. It would be wise to identify what project progress was enabled through the action.

By training users, incidents handled by the service desk decreased 5 percent. Again, this is not an accounting cost savings unless a resource is dismissed, thus impacting labor, benefits and so on.

If IT discusses savings that involve economic cost savings, then it needs to explain such as management. I’d recommend again mixing accounting and economic cost savings together and instead wrap both types of costs with a business case explaining the benefits of the proposal.

Overhead

These are indirect costs that are absorbed by IT. For example, a portion of building rent is often allocated to IT based on some cost driver such as percent of floor space allocated. To illustrate, if IT occupies 10 percent of a building, then accounting will likely allocate 10 percent of the rent to IT. This overhead cost must then be factored into the services that IT offers in order for proper charge backs, pricing and so on.

Sunk Costs

These are costs that, once spent, cannot be changed. If something is purchased that cannot be returned or sold off, then that item should be considered a sunk cost. Sunk costs need to be factored into costing, but it also should recognized that altering them may not be possible by definition.

Cost Drivers

When determining costs, it is worthwhile to understand what drives the costs. In other words, if you do X, then you see a corresponding increase in cost Y. To illustrate, if you must buy a PC and software licenses for each new person hired, then the addition of new users is one of the cost drivers for the associated PC and software expense accounts.

Salvage Value/Salvage Costs

If you can sell an asset for more than its book value, then you are actually booking another form of income. On the other hand, if the salvage value is lower than the book value, then accounting will need to write the asset off. If you have to pay someone to take things away due to hazardous materials laws, then you may even incur expenses relating to the disposal of the asset.

Capital Assets and Depreciation Expense

Many of the assets that IT purchases have a value of 3-5 years. Accounting wants to recognize that life and spread the use of the asset over that life. Organizations often set a threshold level of $1,000 or $1,500 and only worry about capitalizing assets above that dollar level.

There are different ways to recognize the use of the asset and this is known as the “depreciation method.” There are many different forms and the straight-line three-year model is a common method. With this model the total cost of a capital asset is divided by three years and then the monthly depreciation expense is calculated by dividing the annual amount by 12. The remaining value of the asset is termed the “book value.” Hence, capital expenditures are recognized over the life of the asset.

Operating Expenses

In contrast to capital expenditures, operating expenses are recognized in the accounting period they are used. Labor, external services, rent, supplies and so on that are consumed are in this category. Assets under the capital threshold are also treated as operating expenses. Due to the very short life of desktop PCs and their relative low cost, they are often expensed.

Summary

The point of this article is that IT needs to be aware of costs and how they impact both IT and the overall organization. One of the best ways to do this is to sit down with a representative from accounting and learn both the terminology used and what issues matter most. When presenting proposals for cost savings, investments and so on IT must take these into account.

[1] Sometimes, internal funds transfers from one budget account to another is termed “funny money” because no real money changes hands. It’s all handled in the accounting systems.