Internal IT service prices – 10 problems and mitigations
The internal IT service prices may support efficiency if the organization applies it correctly. The IT department provides services for the business units. The services are defined from the user point of view, as they perceive and use them. Examples are application services, collaboration tools, office environment. As the business units set the requirements, they should be incentivized to keep the cost on the necessary level. On the other hand, IT controls the internal and external resource consumption, thus finally the spending level. Business and IT together should have a motivation system that ensures that both pursue the efficient use of the resources and budget.
The conventional approach is to set up an internal settlement. The IT department charges the internal IT service cost to the business unit. There are several models; I mention two of them here:
- Cost distribution: IT calculates the cost of the input (equipment, license, labor, and others) and distributes it to business units. The basis of this allocation may be usage, number or licenses or other pre-set proportions.
- SLA pricing: the Service Level Agreement (SLA) includes the price of the services. These rates usually cover the actual costs without a profit margin. The IT department calculates and charges the internal fee based on the unit price, and the volume whenever possible.
It looks good in principle, but the organizations face many issues during the practical implementation and usage.
1. There is no competition to assess the price level
Whenever you go to the market to look for a service or solution, you ask several offers, analyze, and find the best one. If the right vendors are invited, and the process is well managed, the market sets the price level.
However, if the business department gets the prices from the internal IT department, there is no competition, and it is difficult to assess if the services are too expensive or not. The IT department claims that they purchased the components on the market, so this is the price level. This reasoning is not entirely correct. The IT team is the integrator: they select the technology and also use internal resources. Therefore, they have an impact on cost distribution and SLA pricing. The only case when this argumentation right is when the IT purchases the whole service on the market and charges the entire fee.
Check the market price level and set as an expectation for IT based on it. Probably it is not possible to reach the benchmark price level immediately since there may be legacy technologies, sub-optimal vendor contracts, and lack of skilled staff. A step-by-step approach may work well. For example, the gap between the internal service fee and the market price should decrease with a certain percentage annually. Moreover, you can decide to outsource. It is possibly the better choice in those cases that are not mission critical.
2. There are no other customers to consume unnecessary capacity
Usually, internal IT service departments don’t have other external customers. It there is unused or unnecessary capacity, and there is no internal need, the IT cannot offer it to other companies.
As an example, the company may decide to sell a business line, and the IT support will be no longer necessary. It will free up computational capacities, that sometimes cannot be decreased. For instance, it may be part of a complex shared infrastructure with limited downscale options. Another example is the impact of headcount decrease. Fewer users require fewer licenses and computation capacity. However, the contract with the vendor might not enable to decrease the cost.
Due to the fast-changing environment, the best way is to make the capacity scalable. Use external infrastructure cloud services with flexible terms, instead of building your equipment and tools. Make sure that the license conditions enable to decrease the consumption and the fee immediately.
If you don’t want to outsource due to confidentiality, control requirement, or for other reasons, plan the capacities in due time. Forecast at least yearly, but best a few years ahead according to the integrated business and IT strategies. The IT department should understand the capacity requirements well in advance to avoid waste.
Besides, renting out of the capacity might also be an option, but only in the organization is prepared for it with technology and processes.
3. The internal fees don’t reflect fixed and variable costs
Some cost elements are entirely variable, meaning it varies with the output like a notebook, mobile phone, or user-based software licenses. Others are somewhat fixed. A typical example is the maintenance of an application when the test and deployment cost doesn’t correlate with the number of users. In reality, most service costs are a mixture of fixed and variable costs. Although the notebook itself has variable cost, fixed cost components are also necessary to use the equipment, like selection, testing, and operating the IT security solutions. As a result, the end user equipment cost is a mixture of fix and variable elements.
The unit price based internal fees, on the other hand, are variable costs for the internal users. If they increase the number of end-user equipment, the fee increases proportionally, generating profit. However, if the volume is lower than expected, the total service fee doesn’t cover the cost. As a result, it causes loss to the IT department.
Review the internal unit prices annually. Prepare a transparent calculation of the costs, presenting the fixed and variable cost elements. Make a volume forecast and calculate the unit price accordingly, distributing the fixed cost to the units. If the volume changes are beyond a specific limit during the year, the user department should carry the internal cost of the unused capacity, unless it can be allocated somewhere else.
Besides, it is also an option to apply volume-based pricing. In this case, the unit price depends on the volume, reflecting the fixed cost component to some extent. As an example, the price of the end-user access may differ in volume ranges.
4. Deadlock in internal price discussions
When the IT and the business units align the internal IT service prices, there are, and there should be conflicts. The fee is too high for the business unit (“I can buy on the market at half price,” “Please, be more efficient”) and too low for the IT (“I run legacy solutions that cannot replace” “You have a special request”). It is a good sign, as it facilitates meaningful discussions. However, the debate may turn sour, and the parties realize that they cannot find a way out.
First, the head of the IT and the business department should try to find an agreement. The best approach is full transparency and openness from both sides. For instance, this financial alignment may be one agenda item of your business-IT alignment meeting, more details here.
If it doesn’t help, go to the controlling department. They are independent of both parties, possess all information, understand well the economics, and finally set the budget requirements.
5. Internal IT service prices get obsolete due to changes
The business is highly volatile in many sectors, resulting in drastic changes in demands. New solutions require less user access; mergers, and acquisitions result in systems changes; projects deliver new applications.
The supply side is also not static, as new technologies arise very fast, and there are always new options to involve external service providers, including complete outsourcing. Besides, sometimes vendors bankrupt or contractual conditions worsen unless you follow the upgrade path.
While these changes usually don’t happen overnight, the impact on a medium run may be relevant.
Update the internal service and prices annually. The review includes the analysis of the current internal prices and the cost of providing the services. It is highly likely that there is a gap, and as a consequence, the IT may produce profit or loss. It may be against the cost center approach
The prices for the actual year should take into consideration all significant foreseen changes in demand (what the business wants) and supply (how the IT provides the service) side. To improve efficiency, apply also cost decrease expectation on the prices level.
6. Not “real money” for business users
The goal of the internal IT service prices, charges and settlement is to make the business side interested and motivated to keep the IT service costs at the necessary level. The organizations should treat the internal and external costs equally. As an example, if the internal IT costs decrease as a result of optimized demand and lower cost technical solutions, the business unit may purchase more advertising services within their budget. Vice versa, if the internal IT costs increase, there will be less budget for advertising.
If the internal IT costs don’t consume the budget of the business unit, a valuable internal IT cost reduction incentive disappears on the business side. While the transparent cost information would help cost-conscious behavior on both sides, it doesn’t require internal charging methods and processes. A few reports can serve that purpose.
Set up an internal charging and settlement system so that the price of the IT services consumes the business unit’s budget the same way as external costs do. Since the annual financial results usually have an impact on the evaluation of the department and the colleagues, implement the system carefully to avoid massive resistance. It is an excellent practice to start with the test year. During this period, the reporting and processes follow the internal settlement system. However, the business unit leaders’ financial performance evaluation doesn’t consider internal IT costs yet. The parties should have lessons learned session and fix the process wherever necessary. Afterward, during the upcoming year, they should recognize the IT costs entirely.
7. Lose-lose negative spiral
If the incentives and drivers are wrong in the internal settlement systems, the IT and the business teams may find themselves in a lose-lose negative spiral. They not only miss optimization but generate risk or loss. Internal IT service prices may become counterproductive.
As an example, let’s consider an application, where the user access has a unit price, but the vendor cost doesn’t depend on the number of users. Also, assume that there is no commitment on the number of user access in the SLA. So, whenever the business unit cancels user access, they will be charged with less internal IT fee. In this case, the business is motivated to reorganize its processes to cancel some access, after the internal price is set. The business process will not be optimal. At the same time, there is no cost saving on the organization level. Moreover, security risk might also increase if some employees share their account information.
Build a trusted relationship between the user and the IT departments. In the end, all have to pursue the organizational level goals. If they put all the information on the table, have open discussions, they can avoid the negative spiral. While it is possible to create enormous SLA text to eliminate all the traps, but it is not the right direction. It would cause significant overhead and also block productive and efficient cooperation. You can read more here how to improve the trust between the business and IT departments.
8. Financial penalty requirements
If you have a contract with an external vendor, you usually include penalty clauses. In the case of low-quality delivery or delays, you can decrease the fee. After a defined limit, you may even have the option to cancel the contract. As a result, the vendors calculate the risk margin and build it in the price.
It is tempting for the user side to build financial penalty clauses in the internal settlement in case the delivery doesn’t meet the SLA requirements. They may consider it a rational motivation, and to some extent, this logic is correct. However, it increases the complexity of the internal IT service pricing and internal settlements. As the IT department should expect some risk to materialize, they have to build it in the price. To be transparent, they discuss their assumptions and calculations with the business unit. The interest of the IT department is to create a high margin and explain later that they worked excellently compared to expectations. The debate may continue endlessly.
Avoid financial penalties in the internal settlements. It would create hostile behavior and significant waste of time and attention since both sides would spend much time to prove they are right. On the organizational level, there is no financial difference.
Use other motivation methods for IT staff to meet the SLA requirements. The best is to make SLA delivery part of the organizational and individual performance evaluations.
9. Amortization and depreciation complicate the internal price calculations
Amortization and depreciation are usually significant components of the financial statements, as they have an impact on profit and loss. There are different views if it should be part of the internal prices.
The supporting arguments include the full visibility of costs, an additional incentive to approve the investments carefully on the user side, and that may support the calculation of business line financial results.
However, others argue that it is a sunk cost, the current management has no control over it, and the central controlling department can allocate it to the financial result of the business lines without internal pricing.
Build depreciation and amortization in the internal prices only if you want to use the internal settlement to calculate financial indicators that should include the depreciation as well. As an example, the company may want to see the fully loaded cost of the products, including also the amortization and depreciation of the utilized assets. If they use the internal settlement mechanism to allocate costs to the products and the business lines, these internal charges have to include the amortization and depreciation.
10. Huge overhead due to the settlement process
The internal settlement requires resources, labor, and management attention. It starts with the definition of the services, mapping the architecture elements and resources to the services, cost calculation based on component costs, documenting the measurement methods, and negotiating the service fees. Afterward, the teams should perform regular monitoring, manual calculations depending on the level of the automatization, alignment, and dispute resolution if needed. If all services are part of the settlement, the architecture is complex, and the calculations are detailed, it is a considerable work.
Adjust the sophistication of the internal settlement to the organizational needs. Keep it as simple as possible to reach the goal.
In some cases, the internal settlement has to include the entire cost base, also the amortization and depreciation, as mentioned in the previous chapter.
In other cases, however, there is no such strict need. The purpose of the IT service charging is to establish a motivation for IT and Business that ensures the efficient use of the resources and budget. Don’t waste time and resources to define prices for the services where the cost is only a tiny chunk of the entire cost base. One significant domain is the office environment that includes end-user equipment, together with collaboration and other tools. On the application level, it is probably sufficient to apply prices for the large applications that constitute 80-90% of the total costs. It sometimes involves less than 10% of them.