Six Cost Allocation Methods Every CIO should Know

With today’s economic pressures, and a business philosophy of “doing more with less,” IT managers find themselves needing to communicate the value of IT and reduce costs while maintaining or increasing service levels.

As a result, they need more visibility into the full costs of IT services to understand the cost burden that specific business units place on IT. There are many methods for determining this “cost allocation” — the trick is finding the best approach to provide the most accurate data.
Allocations are high-level formulas that distribute IT costs into pools. Trying to make them accurate is truly one of the most stressful challenges CIOs face. Nonetheless, the CIO succeeds by clearly defining and applying allocations strategies that assign IT costs to business units.

From a governance point of view, however, the CIO is begging for a fight by trying to hold business unit leaders accountable for their bottom lines and then imposing a tax (i.e., the allocated IT cost) they can’t control.
Allocation strategies fall into six main categories:

1. Even Spread – Dividing IT costs evenly among business units is the easiest way to perform cost allocation. With this approach, IT costs are simply split into equal parts. The Even Spread method makes good sense for a company that is in the early days of scrutinizing IT spending and wants to quickly establish a starting point.
2. Manually Assigned Percentage – This method provides more accurate cost assignment than the Even Spread method. With this allocation method, someone in the company who can provide an educated guess of how costs should flow will assign percentages to various categories. This method recognizes that some services generally consume a greater share of IT resources than others. In many instances, the cost data in this method already exist in a spreadsheet-based financial model.
3. Manually Weighted – With this allocation method, percentages are no longer important. Instead of adding up expense columns to total 100 percent, the financial method owner would plug in whole numbers, representing consumption or activity. The manual weightings have an advantage over percentages, because they are rooted in solid numbers. With this method, each asset (i.e., a server) is assigned its weighted share of the total expense, and linked to the total cost of the particular application being supported (i.e. CRM).
4. Direct Spend Weighting of Shared Expenses – This allocation method typically weighs shared expenses as a portion of overall spend. For example, an entire company may share a help desk or an email database, but dividing those expenses evenly across departments may neither be fair or accurate. To determine how much each department should pay, this cost-based method leverages other IT spending. Suppose a company has $10 million of shared IT expenses and $100 million of IT spending attributed to individual departments. The HR department spends $50 million on IT expenses, or half of the company’s IT spending. Therefore, we can then assign half of the $10 million of shared IT expenses, or $5 million, to this department. Grand total for HR: $50M + $5M = $55M. This method is advantageous, because it requires no new data. The weighting of attributed dollars is the data.
5. Activity Based Costing (ABC) – This method is even more accurate and tracks IT activity that actually happened — as captured in a system of record — and then uses those numbers to distribute shared costs. For example, helpdesk costs get allocated according to per-ticket costs that were driven by the helpdesk users. In IT, ABC is most popular where the usage data. When you use the term “data,” think “unstructured information” in a readily consumable format, so helpdesks and asset management systems are good sources of activity data. With the ABC method, each business division can be assured that costs are being fairly allocated, not estimated. When a business unit can see they are being charged based on actual usage, they’re less likely to object to the charge and more likely to be aware of how they’re consuming IT services.
6. Multi-dimensional – This strategy is a mix of methods described above that produces a new weighting. The multi-dimensional method consists of using two or more dimensions of data at once to produce a single weighting for use in cost allocation. Picture a model with a cost pool of network charges, and above that, a pool of application charges. The goal is to allocate from network costs to the various applications. A multi-dimensional approach might say, “For each web application, multiply (a) the number of logins times (b) the number of critical network-related tickets.” So, each web application gets a weighting that splits up a subset of network charges across the web applications.

Picture a model with a cost pool of network charges, and above that, a pool of application charges. The goal is to allocate from network costs to the various applications. A multi-dimensional approach might say, “For each web application, multiply (a) the number of logins times (b) the number of critical network-related tickets.” So, each web application gets a weighting that splits up a subset of network charges across the web applications.

Cost allocations are a core component of any IT financial model that aims to express cost in a manner that makes sense to business consumers. It is common to find several methods in play at once, with strategies evolving over time and becoming more sophisticated when better data become available. When you use the term “data,” think “unstructured information.”

No matter which of the methods you have implemented, you can quickly implement an accurate multi-dimensional allocation method by relying on KEDARit Solutions KITS: Services Utilization Manager (SUM™) and Cost Optimization Service (COp-S™) provide you with the strategy, guidance, automated tools and training that you need.

These KITS accelerate your implementation and analysis of services as defined in the ITIL® Framework Guidance. The SUM™ and COp-S™ KITS provide the automated tools to create a comprehensive Service Catalog in four weeks and multi-dimensional allocation strategy in eight weeks.