When–and How–to Implement Chargebacks

A number of readers have asked me to write about chargebacks—that is, charging client business units for the products and services that they buy from the IT organization.

I could write a book on this topic. In fact, I did write a book about chargebacks in the context of the broader issues of resource governance.

In researching the book, I found that people often ask the wrong questions. Success is not determined by things like data collection mechanisms, accounting systems, or cost allocation methods. (Yes, this space will be ablaze with protests from consultants and vendors who do these necessary mechanics. But hear my point….)

The single most important question—the key to successful implementation—is this: Why do you want to implement chargebacks?

In this column, I’ll just focus on this number-one critical success factor: your purpose for chargebacks, and how that affects implementation.

Cost Allocation

A narrow view says that the purpose of chargebacks is to distribute IT costs to the business units. This perspective is touted as a way to hold business units accountable for their total cost structure, so as to more accurately view their contribution to corporate profits.

From this cost-accounting perspective, a chargeback system is working well if it distributes costs fairly—that is, when charges are roughly associated with utilization and key cost drivers. Having this purpose in mind leads to a number of serious mistakes. Here are just three common problems:

Problem 1: In pursuit of accuracy, implementers focus on technical cost drivers and come up with chargeable items that bewilder clients. As a result, clients feel stupid and resent having to pay for things they don’t understand. And for lack of understanding of the complex formulas that went into determining the rates, clients become suspicious that they’re being overcharged.

Problem 2: In search of simplicity, implementers bundle a large number of discrete deliverables into a single charge. Clients can’t turn down the whole bundle; it includes things that are necessary to “keep the lights on.” So clients rightfully feel that they’re being held hostage and have to pay for things they don’t want.

Both problems 1 and 2 create a situation where clients don’t feel that they can control the charges that hit their bottom lines. These kinds of chargebacks are like allocations—otherwise known as “taxation without representation,” and we fought a war over that! In fact they’re worse than allocations in that they imply that clients can control IT costs when in fact they cannot.

Problem 3: To assure that “fixed” costs are recovered, some implementers have allocated indirect costs by formula, and left only direct costs within chargeback rates. As clients buy more and more of the deeply discounted chargeback items (perhaps more than is economic since they appear so cheap), the so-called “fixed” infrastructure and support staff cannot expand in proportion and become a bottleneck.

Meanwhile, the allocation of indirect expenses creates its own controversies. Clients naturally want to control their costs, so they feel they have a right to micromanage IT and have a say in its internal infrastructure investments, overhead and staffing decisions.

(OK, bloggers, how about some heads nodding and “been there, done that” confessions! These mistakes are far from uncommon.)

Mitigate Demand

Another view of the purpose of chargebacks is to mitigate demand. If clients’ requests have a price attached, they’ll think twice about demanding things from IT. This is closer to the truth. When there’s money at stake, only the really important requirements will be approved.

But just scaring business away can’t be the real purpose. If that’s what you want to do, it would be a lot easier just to set up a bunch of bureaucratic hurdles, like forms and committees, that make your organization difficult to do business with.

The Real Purpose

As in all my writings, the comprehensive answer is found in the business-within-a-business paradigm. An IT is a business that sells products and services to clients throughout the corporation—its market.

In this context, chargebacks are simply prices for its products and services. They drive internal market economics, in which customers make purchase decisions and providers like IT match supply to funded demand. This simple observation leads to a number of critical implementation guidelines:

Units: The selection of units (items on the price list) is critical. Customers must know what they’re buying, and have a choice in whether to buy it or how much of it to buy. (OK, sometimes their boss forces them to buy basic commodities from IT; but the principle remains.)

First and foremost, units must describe things customers buy—deliverables that they own or consume, not cost drivers or technical factors of production. Furthermore, units must be understandable to clients, controllable by clients and measurable (at least to some degree).

Bundling: In addition to describing the right things, units must be at the right level of granularity.

Despite the attractiveness of simplicity, items on the price list must not be high-level bundles that include many separate purchase decisions. Forcing clients to buy the whole bundle (when they may only wish to buy a subset of it) builds resentment and the feeling that IT costs are too high.

On the other hand, units must never be below the level of a purchase decision, implying that customers can choose how a product or service is produced. Customers decide the what, not the how.

Costs: Prices send a signal to the marketplace that help customers decide which investment opportunities are economically sound, i.e., decide what they will and won’t buy from IT.

To drive the right decisions, chargeback rates must represent the true cost to shareholders of each purchase decision, and must be comparable to competition (e.g., outsourcing). They must include not only direct costs, but a fair share of indirect (fixed) costs, just as outsourcing vendors’ rates do.

However, rates must not include unrelated costs which competitors don’t include, such as a share of the cost of corporate-good activities (like architectural standards, policy facilitation, and PC consumer-report style research). These deliverables must be funded directly (either via a core budget, or perhaps allocated to business units).

An effective costing tool and method based on activity-based budgeting makes these calculations straightforward.

Transparency: The calculations behind the rates must be understandable for customers to have confidence that they are equitable and frugal. Thus, the method must be well structured and clearly documented. And all cost calculations must be available for audit.

Checkbooks: Prices have no effect if customers don’t know how much money they have to spend and when it’s run out. If daddy pays the bill, the proverbial kid in the candy store doesn’t care about prices.

The IT organization may have to help clients establish clear resource-governance processes, including determining who manages their IT budget and how their staff go about getting projects and services approved.

By the way, an organization can achieve many of the benefits of chargebacks without actually transferring money to clients. It can treat its core budget as a pre-paid account, and putting it in a “checkbook” that clients manage. There are various ways to create a market effect where clients manage their finite spending power, without actually turning over the budget to them with the risk that they’ll take their money elsewhere (to outsourcing, decentralization or something other than IT).

Invoicing: The IT organization must issue understandable invoices based on the rates and actual delivery of products and services. This may involve technologies that measure infrastructure utilization as well as greater discipline in time-accounting.

Contracting: Fundamental to client control over their spending power, the IT organization must never do any chargeable work without a customer’s agreeing to buy it. This involves not only an explicit approval process, but also the concept of internal contracts for products and services.

The Context

The key point is this: Chargebacks are not an end in themselves. From the perspective of a business within a business, they’re just one step on the path to an internal market economy that gives clients meaningful control of their IT purchase decisions and creates a marketplace that optimally aligns resources.

Without that context, and without the other mechanisms that make an internal marketplace work, chargebacks can become a controversial, bureaucratic nuisance with little benefit.

So back to basics…. Let’s not implement chargebacks. Instead, let’s run an effective business within a business that delivers great value at competitive prices. And let’s implement resource governance processes driven by market economics rather than cost accounting.

Dean Meyer helps IT leadership teams design high-performance organizations. Author of six books, numerous monographs, columns and articles, he brings innovative systematic approaches to what others consider the “soft” side of leadership. Contact him at dean@ndma.com or visit his website for information that can help you implement these ideas, or with suggestions for other buzzwords to analyze in future columns.