Mark McDonald

Cost is part of the appeal of cloud computing as organizations lease services based on scale pricing rather than owning and operating IT assets on their own.  While the efficiencies of large scale IT operations are undeniable, current IT financial management practices pervert that savings and actually make it cheaper to a business unit to build, own and operate IT solutions.

How is this possible?

Well it all depends on your point of view and how you look at IT finance.

The IT financial management regime in place in many companies work something like this:

• Capital investment in IT is determined at the enterprise level where they allocate enterprise funds for IT.  A business unit may have to prioritize its own capital before it is allocated, but it does not have the option to skip investment in order to inflate earnings
• Capital expenditures are recouped by depreciation charges to the business unit.  So it comes out of the business unit budget not as expense but as depreciation.
• The same business unit leaders are measured and receive bonuses based on their EBITDA performance.  EBITDA stands for earnings before interest, taxes, depreciation and amortization.

Under such a regime, traditional IT projects are essentially free to the business unit leader.  Free in the sense that CAPEX is allocated at the enterprise level and therefore are not spending real money, from the BU perspective of course.  Free in the sense that depreciation charges for that CAPEX do not count against their performance bonus because they are below the EBITDA line.

Compare that to a cloud based services model.  True there is no capital expenditure.  But there is also no depreciation.  That means that the cost of cloud services comes out of the business units sales and operating expense which is ABOVE the EBITDA line.  In this context cloud services cost real money to the BU because it has an impact on their performance and performance bonus.

There are some ways to get over this hurdle.  The company could expense their entire IT investment and operating budget to remove this distortion.  This is called going from accrual to a more cash based accounting approach.  Many companies already do this now.  However, expensing IT, particularly large transformation initiates can distort earnings as the company invests current dollars ahead of future expected benefits.

Another approach is to move IT onto a cost accounting style of financial management.  Activity based costing and other techniques raise the transparency of IT costs, their Allocations and the like This is a tact being taken at a number of companies where that have business based CIOs who are frustrated by IT’s in ability to understand their cost structure, cost drivers or manage from a cost basis.

These approaches recognize that current CAPEX/OPEX/Accrual based approaches to managing IT finances are running out of steam.  They worked well when IT’s primary job was to build out the company’s technology base.  Now that that base is laid and new service based models are available, its time to upgrade IT financial management to reflect actual costs and not those distorted by accounting.

Otherwise we can easily make decisions based on perfectly inaccurate financial information — such as the cloud point made in this post.

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Category: budgets CFO CIO Cloud Personal Observation Strategic planning Strategy Technology     Tags: 2011 Planning, Personal Observation, Strategy and Planning, Technology, Technology Leadership

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