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Activity Based Costing/Management

 Use ABM to develop a Business Value Framework for IT
Prepared By Dr. Mir F. Ali

It is amazing that some provincial as well as federal Chief Information Officers (CIOs) in Canada are reported to be doing reasonably well in dealing with their fiscal constraints and financial challenges as a result of using Activity Based Management (ABM) to develop and follow a business value framework whereas their counterparts in the U.S. are having difficulties in dealing with drastically reduced budgets, loss of skilled resources, and cancellation of major capital projects which were initiated in the interest of enhancing organizational capabilities as well as improving ROI.  The Information Week IT Confidence Index – a measure of IT mangers’ expectations for the economy, their businesses, and their IT budgets based on interviews with 300 IT executives – plummeted this quarter to the lowest level in its 2-1/2-year history, falling 21% from last quarter and 37% from this time last year.  The executives, polled recently, are much more negative than they have been in previous quarters about the overall US economy and the economic outlook for their industries.  It is not good-news at all.

For the last ten years most IT managers have engineered and reengineered their business processes and applied every possible improvement technique to eliminate the functional as well as the informational duplication, bottlenecks, overlaps, and redundancies with the idea of deploying compatible technologies and providing the right information to the right person at the right time.  Following these efforts they focused on maximizing relationships with their suppliers, using business intelligence tools, Client Relationship Management (CRM), etc. The idea behind these notions was to improve the performance of their resources and perhaps, most importantly, the ROI on their overall IT investments.  However the success they had was too little and too late.  It didn’t seem to be good enough for the stakeholders to keep approving funds in the environments where the bottom lines for their organizations were shrinking and they were becoming increasingly sensitive to the risk associated with their IT investments. 

[1]Clark Kelso, CIO of California noted that “the choices available to us are limited and uniformly unpleasant as California’s deficit could reach $26 billion for fiscal 2004.  Whether we cut state services and adopt revenue enhancements, virtually everybody will hate it.  Any plausible scenario will involve deep cuts in the state programs and services”.   It was reported that many states are likely to follow the example of Connecticut, which recently laid off 120 IT workers which represents 8% of its workforce, and Ohio, which has let go 92 tech people which represents 22% of its current IT Group.  Georgia, who spends about $1 billion a year on IT - 6% its total budget – faces a $900 million shortfall in its fiscal 2004 budget.  

Florida, even though it’s not facing a budget deficit, is requiring agencies to cut spending by 5% to 10% and has set up an oversight board to approve all budget requests.  Part of the board’s role is to enforce coordination and standardization among agencies.  For IT, the net result has been fewer projects.  This is consistent with a recent Information Week Research survey of 200 IT managers in which it was found that nearly a third of state government IT managers say they expect job reduction this year and only 4% of them foresee any hiring.

Carolyn Purcell, executive director for information resources in Texas is grappling with a $1.8 billion budget shortfall for its current fiscal year and is nearly $10 billion short in a two-year budget that will take it into June 2005.  In Georgia, lawmakers want to trim the budget, so the state IT group can’t get approval for costly new systems as Georgia – which spends about $1 billion a year on IT, 6% of its total budget – faces a $900 million shortfall in its fiscal 2004 budget.  Ohio faces a budget deficit of $720 million for the current fiscal year, and a $2 billion gap is expected for the coming year.  Essentially, it appears that the majority of CIOs in various states are faced with serious budget cuts.  It also means that state CIOs across the country must cut spending for new projects and survive with the outdated and costly legacy systems or convince the stakeholders that those investments have a potential for pay-off.  

Talking about the investments, recent studies by economists and others have analyzed IT’s effect on productivity.  In 2001, McKinsey concluded that “some IT investments are not delivering the intended results, and whether they ever will remains to be seen.”  This year, a multi-country International Monetary Fund (IMF) study found that during the past 15 years, IT investment contributed between 0.3 percent and 0.5 percent per year to productivity growth. 

Gartner has always made the case for smart IT investment, but not always for more IT investment. It is important to realize that technology investment is but a small part of what is really required to succeed with technology related projects.  Gartner has drawn the following basic conclusions on the subject of IT investments:  

  • IT’s beneficial effect on the economy has not been scientifically proven, but it is plausible.  There are no reports of IT being abandoned in favour of different approaches, and – in an economy that is increasingly information and knowledge based, the correlation between smart IT investment and  success is intuitive;
  • In Organization for Economic Co-operation and Development (OECD) economies, IT’s contributions are less substantial in fields where most of the payback has already been experienced (such as automation) and more significant in the areas of collaboration involving people and enterprises) and knowledge management (including product design, customer management, and partner management).  In developing countries, the effects of IT on automation are still evident;
  • Even the measurable benefits often appear not to go to enterprises, but rather to customers in the form of lower prices, higher quality of products and services, wider choice and an easier life.  This creates the impression that surviving competition without IT has become difficult; and
  • IT investments only pay off when they are accompanied by substantial organizational and human capital investments an order of magnitude higher than the IT capital expense.  Economic research on IT’s value will probably have to look at the issue with new eyes – as suggested by E. Bryniofsson and L. Hitt in “Beyond the Productivity Paradox: Computers are the Catalyst for Bigger Changes,” communications of the ACM, August 1998 – since merely looking for statistical correlation in absence of a full understanding of the detailed mechanisms of enterprise IT use can lead to illusory results.

Gartner Dataquest’s latest forecasts for the IT industry indicate that the average growth rate from 2001 to 2006 will be 6.5 percent per year for hardware, software, and services combined.  This is a tight economic climate, with a forecast global gross domestic product (GDP) growth of 1.8 percent in 2002 and 3.5 percent in 2003.  For the IT industry, with total spending of 2.5 trillion, this is not the sign of an industry in crisis.  There may be growing pains, but this is not the time to give up.  Despite the skeptics, no one is advocating that enterprises refrain from investing in IT, either at the government or the enterprise level.

Stakeholders everywhere are persistent in asking questions like “We know what we have invested in IT but we do not know what return we are having on that investment”.  They are asking, “How will we know if we are getting the value projected in the business case?”  Audrey Apfel suggested that understanding the value created from IT requires the introduction of business-relevant measurement approaches, the unravelling of the chaos around intangible assets and the development of a global economic context for IT.

Canadian CIOs are not unfamiliar with the fiscal constraints, restrictions, limitations, and challenges in general and particularly in the Canadian federal government where hundreds of millions of dollars of budget cuts were implemented in the ‘90’s in the name of Program Review and as a result thousands of civil servants were laid off.  The objective of the unpopular Program Review was to conduct a review of all federal government programs in order to bring about the best, most effective, and cost-efficient way of delivering programs and services that are appropriate for the federal government. 

Unfortunately, some of the federal departments, under intense pressure, reacted to the budget cuts in an irrational way; they encouraged as well as forced some of their employees to leave the government without considering their critical experience and expertise.  Subsequently, they realized that they had made a strategic mistake but the damage was done.

Each IT investment was scrutinized and every IT expense was questioned under this initiative.  Fortunately, there were some visionary CIOs in the government departments including Andre Morency from the Department of National Defence, who clearly understood the danger of proceeding with the budget cuts without following a systematic process to determine the feasibility of eliminating resources with minimal or no impact on critical operations. They were looking for a way to tackle the overall fiscal constraints that would enable them not only to meet the targeted level of budget cuts but also to provide them with a performance-based management model including streamlined service delivery, and increased accountability.  They realized the need for them to demonstrate the value of IT services and investments from a business perspective.

However, they also realized that every value activity performed in the interest of productivity and proficiency incurs cost such as the cost of the resources (direct and indirect labour) and technology that are used to perform the activity in order to produce a service.  Hence, it became necessary for these CIOs to understand and appreciate the cost behaviour of their activities before they invest any time and energy in the search for potential value of those activities and services.  Based on some success stories, and with the help of a [2]management consulting company, they decided to use the Activity Based Costing (ABC) discipline with the objective of costing their current business activities and processes to determine the current cost of their services.     

ABC is increasingly being adopted by organizations all over the world as a means of generating more accurate cost information than is possible through traditional costing systems.  ABC provides a cross-functional, integrated view of the organization, its activities and its business processes.  Using ABC, overhead is calculated by carefully evaluating the quantities of resources and costs consumed by individual activities for products and services on the basis of their use of specific activities. 

Managers who monitor and predict changes in the cost profile and cost structure of services can use ABC information.  ABC information can help managers: 

  • Assess impact of changes in the volume of service demand;
  • Develop and assess process changes and improvements;
  • Better manage and utilize resources;
  • Introduce new technologies; and
  • Redesign service delivery models.

As such changes are contemplated, managers can predict where either shortages or excesses of capacity will occur.  They can then either modify their decisions so that activity demand will be balanced with activity supply, or they can change the level of activities to be supplied in forthcoming periods.

It can be seen from the Diagram 1 (Please click here to see the diagram) that resources (Salaries) are assigned to all three categories of activities based on who did what and when to produce a particular service and the cost of these activities is allocated to the relevant service.  Any additional cost associated with the O&M, Capital or Other categories, is allocated to the relevant service.  Finally, any cost associated with the channel through which the service is being delivered, is also allocated to the respective service.  Virtually any cost associated with any service is calculated and allocated to the services produced by the organization, thereby providing an audit trail and balancing the budget to the dollar. 

This provides CIOs with an appreciation of the cost behavior.  They clearly understand the cost configuration and cost structure of their services and they find out what is the “real” cost of their services, what percentage of budget is spent on what service, which service is consuming maximum manpower, what is the technology cost for each service, why the cost of technology support differs from service to service or which client is consuming what percentage of their resources and why.  CIOs have capitalized on this costing intelligence to conduct various cost/value analyses, assessing the impact of IT on each service and demonstrating the value of their contribution to the overall mission of their organization. 

While CIOs were successful in using ABC to illustrate the value of IT and in convincing their stakeholders by answering their question (We know what we have invested in IT but we do not know what return we are having on that investment), they were faced with another challenge.  Realizing the fact that ABC only answers the question of what is the cost of their services, now their stakeholders were asking what should be the cost of their services? This led them to look into the possibilities of implementing an Activity Based management (ABM) discipline to answer that question. 

The focus of ABM is on activities being performed to produce a service or product:      

  • It helps to determine the best way to charge or allocate costs to various services/products;
  • It provides an opportunity to optimize and redesign these activities;
  • It clarifies and updates strategy;
  • It helps to communicate strategy throughout the organization;
  • It aligns unit and individual goals with the strategy and corresponding performance measures;
  • It links strategic objectives to long-term targets/budgets, and it identifies and aligns action steps needed to accomplish strategic goals; and
  • It answers the question, “What should be the cost of providing Service A to Client B through Channel C”.

As they already had built an ABC model, they needed to follow the following methodology starting from the phase 4 to build an ABM mode, Diagram 2 (Please click here to see the diagram):

Improvement targets were developed based on the ABC benchmarking.  The objectives of these improvements were to: 

  • Achieve functional/process effectiveness;
  • Achieve resource efficiency;
  • Achieve organization’s vision; and
  • Answer the questions raised by stakeholders.

The following activities were conducted as a part of the methodology:  

  • Conduct Effectiveness and Efficiency Analysis:  Each business process is tested to determine if the process is supporting the mandate (Effectiveness) and is it being done efficiently.  The answers to these questions help to flag each business process accordingly;
  • Conduct Seamless Services Analysis:  All business processes are reviewed to determine the possibility of delivering services/products to clients through a single window, eliminating cross-functional barriers.  This requires redesigning the way services are being provided, including a focus on client service and client satisfaction.  Opportunities and issues identified through client/stakeholder focus groups are incorporated;
  • Conduct Streamlining Analysis:  The cycle time of each service is minimized.  Staff functions are realigned from task-oriented to service-oriented.  Potential investment in staff training and new client-oriented service delivery activities is considered;
  • Conduct Choices Analysis:  Wherever possible, clients are provided with options as to how services are provided and delivered.  This may require new investments and regular reviews of clients’ needs with the potential for new opportunities for innovation on the part of staff, lower costs for service delivery, and improved choices for clients;
  • Optimize Process Flows:  Each valid business process is reviewed, evaluated, and optimized vertically and horizontally, identifying opportunities for reengineering.  It includes the identification of methods/techniques improvements, elimination of unnecessary activities, identification of outsourcing opportunities, identification of activities for merging/grouping, exploration of revenue generation opportunities, etc.;
  • Review Best Practices:  Relevant best practices from similar organizations were researched and reviewed to identify and apply lessons learned by other organizations;
  • Identify and Analyze Revenue Generation and Partnering Opportunities:  Opportunities for generating revenues from service delivery models, assets, partnerships, were identified, where applicable; and
  • Identify Technology Opportunities:  Automation opportunities to further streamline business processes and integrate business information were identified to support the redesigned business processes. 

Based on the findings, the services, processes and channels of delivery were redesigned and incorporated in the re-engineered model, indicating the information, technology and skills requirements for each redesigned process/service that was supported together with the performance measures in terms of quantity, quality, and timeliness.  Please click here to see an example of the model.

A final analysis was conducted to identify the recommended changes required to bridge the gap between the ABC Model and the ABM Model.  Models and business cases were assessed to determine the final process, information technology and legislation re-alignments requirements.  Recommendations were developed to deal with the organizational re-alignment, identifying the organizational structure and training requirements to support the proposed ABM Model.  Legislation roadblocks were analyzed and documented to include an assessment of the potential for influencing the legislation and the course of action necessary for addressing the roadblock.

The proposed changes were analyzed against the ABC Model to determine (quantify) the potential impact on the current cost structure and the potential efficiency gains.  The proposed ABM Model was analyzed against the improvement objectives in the interest of consistency.

The proposed ABM Model was analyzed to identify implementation considerations, issues and plans.  These elements were assessed in the interest of risk management and quality control to produce a high-level implementation strategy for the identified opportunities, identifying key activities, potential costs, timelines and inhibitors.

The determination and declaration of surplus resources enabled CIOs to meet and exceed their budget cuts without jeopardizing the quality of their services.  In addition to capitalizing on the potential for savings and budget cuts, they felt that the transparency of cost enabled them to change their overall attitude and they became cost conscious to every aspect of their operations.  As a matter of fact, some CIOs are using the costing capability to determine prices for their products/services where the Treasury Board of Canada allows commercialization of services.  Furthermore, they are convinced that ABM provided them with an excellent foundation and framework for considering any potential Alternate Service Delivery (ASD) or partnerships based on the cost effectiveness.  This framework also helped them to develop the Service Level Agreements.

The overall outcome of this initiative provided CIOs with enough intelligence to answer the questions their stakeholders were asking.  They were in the position to ask for the investments in the technologies as well as training to realize the potential of 30 percent reduction in the future budgets throughout the organization.  They were also in the position to document step by step the process to realize the projected benefits in order to satisfy their stakeholders.  It was a win, win situation for those CIOs.  They not only survived but they also proved to the cost conscious and cynical stakeholders that IT is capable of delivering business value to the organizations; Why organizations need to spend on IT; and IT is not just another cost centre.

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[1] Dire States by Eric Chabrow and Marianne Kolbasuk McGee published in Information Week, February 10, 2003.

[2] AIMCORP-Automated Information management Corporation

Copyright 2003 - Automated Information Management Corporation