CFO

Need COGS Insights and Cloud Cost Controls? Chargebacks Can Deliver

By Lorna Garey, Executive Editor, Brainyard
March 23, 2020
Man holding a wallet

In short:

  • If you haven’t considered a chargeback model, it could be just the tool you need to determine if spending is in line with expectations
  • Showbacks — doing the accounting without the actual charges — are a good first step to help executives understand where resources are being consumed
  • Chargebacks also generate data on cloud use and stave off sticker shock, but a poorly crafted internal program can foster resentment and finger-pointing

CFOs faced with murky cost of goods sold data, tighter cash flows and higher demands for services might consider an underused budget tool: chargebacks.

With a chargeback, the cost of centrally procured cloud services, or of internal teams like finance, IT, legal, marketing or HR, is measured, and each business unit, department or work group is billed a portion of the cost based on its use of that service. Showback is when finance tracks use, but payment is from a central budget.

Cloud services are well-suited to chargebacks since they’re metered by design. For internal functions, companies that use a shared-services model, where certain internal departments operate like service providers, are more likely to succeed versus firms with HR, marketing or IT embedded in each division.

If you tried and abandoned chargebacks or showbacks a decade or more ago and are now more apt to use cloud services, the practice may be worth another look. We’ve all heard stories of huge, and completely unexpected, bills. This is a way to introduce predictability.

Chargebacks can also shine a spotlight on inefficient processes and duplicative spending and may reveal that a product or service you thought was highly profitable actually costs much more to produce or sell than expected.

The chargeback concept is likely not new to your CIO, because IT is often the first internal team whose services business units pay for directly. But use is certainly not limited to technology. And, as a bonus, charging back demands a singular focus on customer satisfaction on the part of internal service teams, as we’ll discuss.

The Uptime Institute provides a rundown of some core principles for chargebacks:

  • Buy-in from executive leadership and finance is crucial. Not just for putting the practice in place, but for making sure business units don’t hesitate to buy the resources needed to support growth.
  • When a chargeback reflects work by an internal team or contractor, there are political ramifications. Suddenly, every line of business that consumes marketing services, for example, is keenly interested in whether a new hire will make their costs rise.
  • Accurately itemizing can be a challenge when it comes to compound services comprising multiple departments or cloud providers.

Chargeback Models

The goal is to both improve service levels and add cost transparency. We spoke with experts to learn how chargebacks can get you there, plus deliver deep insights on cost of goods sold and enable cloud cost optimization.

Design to Cost Yields COGS Insights

“You can bet the head of the Cadillac division of GM knows exactly what manufacturing costs are per vehicle, broken down by model and option, and if costs are up X percent compared to a year ago,” says technology analyst and former head of cloud strategy for Capital One Bernard Golden. “You’d better believe they pay attention.”

Likewise, your business leaders know what an additional billable hour or scoop of ice cream costs to produce. But often, cloud-based and internally delivered services are opaque when it comes to how they affect those costs.

Take marketing. By 2022, CMOs will spend more than $122 billion on marketing technology, according to a recent Forrester survey. The latest Gartner CMO Survey shows marketing budgets overall hovering around 10.5% of company revenue, and expenditures are growing at about 9% annually, says the 2020 CMO Survey. While that’s likely to slow if we enter a prolonged recession, it’s still far faster than revenue growth. Charging back may help identify how much marketing spend is warranted.

More than 10 years ago, Golden made a compelling case for pricing consumed resources on a granular basis using chargebacks, which enable companies to “move from accurate cost assignment (essentially a budget assignment exercise) to a product design cost element.”

In a design to cost model, popular with manufacturers, business stakeholders need granular data on the total cost to produce a product or service. The goal is to formally integrate cost management with decision-making at the design stage. It’s an idea applicable to any business that needs a handle on KPIs, including total cost of goods sold, so it can price a product to yield desired margin.

We asked Golden if companies have taken his advice. The answer: It depends.

Cloud-native and startup firms are much more likely to have a handle on costs, he says, as are those that have embraced the concept that every company is now a tech company. In fact, chargebacks make the most sense for industries, like media, finance or insurance, where a very significant part of the cost of production is tech services. Many times, these firms have specialized groups supporting product development, and those costs must be accounted for to know if a proposed product or update is viable.

But for the majority of firms, it’s just not happening.

“There's been virtually no real direct tracking of costs,” said Golden. “There might be an understanding that we spent $500,000 last month, maybe cost distribution of how much is for marketing or sales, but it's pretty rare that it gets assigned down to an application level.”

Bernard Golden

It’s even less likely that data is used to affect behavior, even though in our Brainyard Winter 2020 Outlook Survey, producing better reporting on KPIs was a top priority for CFOs.

“Finance departments want to do it, but they’ve got to dig in and figure out how,” said Golden. “It's often not just the fact that they have to do work to track it all down, they then have to go convince business organizations to take that information and do something with it.”

For companies not even showing back, this is a major change that likely won't be easy from an accounting or cultural standpoint. Some business units don’t particularly want cost transparency. Others prefer not to use central services but rather contract locally. But if you’re concerned about spending on IT, marketing or other services raising the cost of goods sold and cutting into margins, chargebacks are an effective way to add transparency.

When it comes to using chargebacks for design to cost, CFOs should be aware that they almost always make small products look unprofitable — but unless you can shrink the charged back organization or cloud contract linearly, closing those small products will in turn make bigger products look less lucrative because you’re spreading costs across fewer profit centers.

It’s hard to get right, and that’s one reason big companies often prefer to acquire rather than build. Another approach is to structure internal startups as skunkworks projects and subsidize until they’re mature enough to be analyzed and cost-encumbered.

However, the alternative — letting each division contract for what it needs — means you’ll never get any economies of scale. CFOs have the acumen and long view to understand where to allow some variation versus insisting that units purchase a standardized offering.

“There’s no doubt that it’s more work,” says Golden. But he expects most companies to demand transparency in cloud and other services costs eventually.

“It’ll maybe more be forced on companies rather than embraced,” he says. “At some point, you’ll say, ‘Gosh, our peer company’s profitability is greater than ours. Why is that?’”

Well, in many cases, it’s because someone bit the bullet and enforced accountability, through chargebacks or otherwise.

Cloud Overruns as a Service

When business units aren’t incentivized to contain costs and new services can be launched with a credit card and a few clicks, the results are predictable: 85% of companies overspend their cloud budgets by as much as 50%, according to finance professionals responding to a new survey from 451 Research and Cloudability.

Most, 68%, of those finance respondents find out about that overspend only after it’s too late to do anything about it.

To encourage accountability, about half of those whose companies spend more than $1 million per month on cloud services use chargebacks (38%) or showbacks (10%). That number declines in tandem with spend — but we’d argue that the time to put a chargeback model in place is when a company is small enough to get its arms around the task of allocating costs.

“A growing cloud bill could be a good thing,” says Jo Peterson, VP of cloud and security services for consultancy Clarify360 and a Brainyard expert adviser. “It may mean that your business is growing and the extra costs you’re seeing support revenue growth. But even if that’s so, cloud cost optimization is a needed part of the conversation.”

Cloud consumption, in some organizations, is a strategic, well-thought-out endeavor. But not in all, and again, in a rush to launch new products or implement new services, there’s a danger of cloud costs spiraling out of control.

“There are sometimes no set budgets,” says Peterson. “We then see arbitrary ones, then defined cost saving goals, then activity-based costing. But this progression follows a timeline of years, not months.”

Jo Peterson

Fortunately, chargebacks for cloud services tend to be more straightforward than for internal teams because use-based pricing is built in. But that doesn’t mean they’re widely used.

“Chargebacks for cloud can be a controversial topic,” says Peterson. “Business units appreciate predictability, and chargeback models in a pre-cloud environment were based on concrete financials. Fixed-cost items like equipment and packaged software could be apportioned by percentage, and a non-variable monthly charge could be calculated. That’s much more difficult now.”

In other words: When faced with a bill for actual usage, some product owners will get a bad case of sticker shock. We say, the time for that wake-up is during planning, not when the bill is presented.

Success is considerably more likely if you have a central cloud purchasing or governance group that will ensure savings tools, like management platforms, are in use; take advantage of discounts, like reserved instances, that require advance planning; make strategic use of software licenses; and use resource tagging to get visibility into and properly allocate cloud spend.

Resource tags are labels that can show who used what services down to an extremely detailed level.

Unless your cloud use is modest, Peterson says it’s worth investing in a cloud management platform, like those from Apptio, CloudAware, CloudHealth or Densify. Even at a base level these systems provide cost optimization with chargeback/showback functionality. Most offer security and resource monitoring and compliance mapping as options.

If you decide to flip the switch to a chargeback system, Peterson says, it needs to be fair, clearly defined and offer transparency in all aspects. Generate reports that show how you are divvying up savings, such as for volume discounts and pre-payment for contracted services. And be aware that there’s going to be overhead.

“Some multi-tenant environments, for example, create spend that is not taggable,” says Peterson. “Will those costs be paid from a central account or apportioned?”

Caution: Lack of Expertise Ahead?

One core driver for chargebacks is to encourage departments to spend more carefully. But Owen Rogers, research vice president and leader of the Digital Economics Unit for 451 Research, part of S&P Global Market Intelligence, says to watch for some common risks.

“Are non-technical employees really in a position to assess what is good value for money?” said Rogers. “Do they have the tools, the experience or access to a specialist who knows the options?”

Just because someone is a really great marketer, for example, doesn’t mean she knows which product or service is best for the business. Nor does it mean she can accurately predict costs or the likelihood of a product’s suitability for a shared services model. Lacking expert advice, money could be wasted.

Owen Rogers

In terms of line of business leaders, he warns that some essential services won’t be seen as adding value to the department. Security is a prime example.

“My advice is: Enterprises can’t just implement chargebacks and expect users to make the best decisions,” said Rogers.

Departments need guidance to choose the best tools for their requirements, and companies must set governance controls. Moreover, there must be non-optional purchases, such as a core security, end user productivity and communications bundle.

There are other fundamentals to chargeback success.

  • For a fixed-cost internal asset, such as a cloud purchasing team or any central service function, from an accounting perspective, begin with a cost-allocation showback. Say Department A consumed 15% of a resource that you spend $1 million on; that’s $150,000. Even if that’s covered from a central budget, it’s well worth providing visibility.
  • Build sufficient capacity, and show why. Business leaders may not understand why IT overprovisions certain cloud services for unforeseen scenarios, like all employees suddenly working from home, or why an internal team needs to add headcount. On its face, that spend may seem wasteful. Be prepared for the conversation to escalate to finance.
  • Ensure that service providers aren’t baking in costs for items that some or most lines of business don’t need. We’ve seen cases where companies built Cadillac marketing bundles when most divisions would much prefer Chevys. Creating a core product that delivers 90% of what 75% of departments need and offering a service catalog to fill in gaps is better than charging everyone for niche requirements.
  • As much as possible, remove disincentives to use services. One frequently cited concern with chargebacks, related to Rogers’ caution on a lack of expertise, is that business units won’t add licenses, call a managed service provider or engage with legal until something’s on fire. People who pay by the hour versus those with fixed-price service contracts are reluctant to ask for help: “Don’t call them! It costs us $150 to say hello!” Consider establishing service contracts that specify base service levels and discourage business units from engaging in penny-wise, pound-foolish behavior.
  • Focus on internal customer satisfaction. If the rate payer doesn’t have any way to provide feedback, you can expect things to go bad. All service departments must do regular surveys to gather data on how well they’re meeting the customer’s needs and whether stakeholders continue to perceive a good return on their investments. For cloud resources, IT or your purchasing team should track satisfaction. Templates are available online.
  • Report, report, report. Near-real-time insights are needed to provide visibility into spending variances over the month and quarter, as well as to close allocation gaps. Golden says that at best-in-class companies, managers get weekly reports on all factors that affect cost of goods sold, and by extension, margin and profitability.
  • But ... also think strategically. We threw out marketing as a function that’s getting expensive. If business units balk at the cost, the CMO is going to come back with 20 good reasons why martech investments are imperative to stay competitive. But of course, funding is finite, and a dollar spent on something like predictive lead scoring is a dollar not available for product development. Do you spend on both and cut margins or reduce the cost of goods in other ways? This goes back to executive leadership and the expertise Rogers mentioned.
  • Be flexible and fair. A real or perceived lack of equity and choice are the crux of many problems, so unsurprisingly the word “fairness” is used frequently by chargeback experts. Of course, fair is always in the eye of the beholder. If you tell a department head to lay off recruiting with Indeed for $100 a month because you’re allocating $10,000 of an HR professional, are you reflecting that in his budget? No one likes unfunded mandates.

At the very least, Peterson recommends opening a discussion on how the business can optimize spending. Companies that she’s moved down the showback path begin by comparing actual spend against forecast on a monthly basis.

“Again, reporting comes in handy,” she says. “It will provide insight into cost drivers and anomalies. Attention can then be focused on variances. The IT or cloud purchasing team can work with business units to implement changes before the next monthly review cycle.”

And, before an eye-popping bill lands on the CFO’s desk.

Lorna Garey is executive editor of Brainyard. She was formerly editor in chief of Channel Partners and Channel Futures and content director, digital, of InformationWeek. Got thoughts on this story or want to contribute to Brainyard? Drop Lorna a line.

  

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