Costing Framework for IT Services Firms

Description
overview of the costing practices in IT services firms in India. It also gives classification of the major costs in a typical IT services firm and the unit cost calculation methods. Project costing is then presented with examples from real-life projects to illustrate the costing practices prevalent in the industry.

Costing Framework for IT services Firms
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Executive Summary
This report attempts to present an overview of the costing practices in IT services firms in India. We begin with an introduction of the organizational structure of a typical IT services firm, a classification of the major costs in a typical IT services firm and the unit cost calculation methods. Project costing is then presented with examples from real-life projects to illustrate the costing practices prevalent in the industry. The application of advanced concepts such as Activity Based Costing, Time-driven Activity Based Costing and Target costing in IT services firms is also explored followed by a close look at the influence of nature of engagements and project lifecycles on costing. The report ends with a speculatory note on the future of costing in IT services firms.

Organizational Structure of a typical IT services firm
A typical IT services firm has a structure that is quite similar to the popular line-staff models that we see in most organizations, as depicted below.

EXECUTIVE Line Functions V E R T I C A L 2 V E R T I C A L 3

MANAGEMENT Staff Functions Human Resources Sales, Marketing Finance Planning and Performance

V E R T I C A L 1

Infrastructur e and support

The verticals or business units are generally services offered with a focus on a particular industry, such as Banking and Financial Services or Healthcare. Each vertical is split up into accounts that identify with customers and projects that identify with specific set of services / projects for a customer. The staff functions are generally independent of the line function (usually referred to as the delivery function) and they work towards augmenting and supporting the delivery function

Share of the pie – costs in a typical IT services firm
The typical costs in an IT services firm can be split up as show below into 3 types
The C ost Pie

Others 25% S alary 50% SG& A 25% S alary S G& A Others

The salaries form the major part of the costs and vary from project to project based on the number of people deployed.

Computing Unit Cost
For decision making purposes, a unit cost is arrived at for each person in the delivery function. Variable Costs (Salaries) The single cost driver in the IT services industry is person-hour. The estimate and rate of billing are also mostly expressed in/driven by this unit. The following attributes influence the nature of the cost driver to the greatest deal. a. Employee Designation b. Employee Location Selling, General and Administrative expenses (SG & A) The SG & A expenses are distributed evenly across the number of people in the delivery function to arrive at the contribution to unit cost. Overheads Costs (Others) In most IT services firms, the procurement or the purchase division is a subsidiary function of the infrastructure management group. These costs are distributed across people uniformly to arrive at the unit cost. This is quite justified, as whatever is purchased is mostly distributed across multiple projects and ultimately adds to infrastructure of the firm. For example, a license is procured for a period of 1 year, maybe for 1 project, but in the course of 1 year, this license might get used for multiple projects. The same could be the case with a computer that is purchased. Just like an inventory is maintained in a manufacturing context, an IT services firm maintains a steady ‘bench’ of re-assignable human capital. The typical size of bench varies from 12-20% of the organization. The cost that goes into maintaining the bench (mainly salaries again) is also an overhead cost that gets factored into the unit cost uniformly. The bench and the infrastructure are the major components of the overheads. So to summarize the Unit Cost for an IT firm would be as follows: Unit Cost = Unit Variable cost + Unit Fixed Cost , where Unit Variable Cost ? Designation, Location and, Unit Fixed Cost is a fixed contribution from SG & A and Other overheads (Bench and Infrastructure) Currently, the usage of finer techniques of costing, in terms of Activity based costing and Time Driven Activity based costing is not wide-spread. How and when these techniques will be used is dealt with in the last section in this report.

Project Costing
Now that we have arrived at the Unit cost, computation of project cost is straightforward and simple. Project cost = effort * unit cost There is one slight catch here. In the IT services industry, employees are paid salaries monthly and are expected to work only 8 hours (or 8.5 or 9 hours) a day. There is no concept of over-time. However, most employees work for 10-12 hours daily. An employee may be spending more time per day due her lower levels of competency or experience. In such cases, the effort expended may not give a true indication of the actual cost incurred, as overtime is not paid for. So sometimes, managers use the following computation to arrive at project cost. Project cost = no: of days * 8 * unit cost The range of unit costs available for an organization depends on the size of an organization. Small & Medium firms use designation bands that have an average unit cost for 2-3 designations, while larger firms have costs for each designation and even employee rating (as there is a significant variation in the salaries of employees in the same designation with different employee ratings; employee ratings are a summary of previous appraisal grades). FTE approach Another quite popular and simple technique used to track costs denominates all the employees in a project as FTEs (Full Time Equivalent). This is popular in managing costs at offshore for a project (low variance in unit costs across designations). Assume, cost of 1 FTE = $12; the manager will have in the project people ranging from 0.25 FTE (usually 1st 2 months for freshers) to 1.25 FTE, which is the same as people with unit costs of $3 to $15. The allowable sum of FTE for a manager would be based on the estimate and the loading plan. This can be used to track the utilization, which is quite similar to tracking costs. Utilization = Current FTE / Allowable FTE Revenue ? Invoices Profitability Costs ? Utilization Top line is tracked (Revenue is recognized) based on the invoices raised and closed, while the bottom line (Costs) is tracked by utilization. Time period An employee sticks around in a project for a specific period. The optimal minimum period to be used for tracking utilization is very important while using the FTE approach. The movement across projects has become so dynamic that firms using the FTE approach nowadays use a week or a month as the optimal minimum period. The above 2 approaches (Unit Cost and FTE) are illustrated with two examples provided in Appendix I.

Target Costing in IT projects
The target costing technique is widely prevalent in the IT services industry as a good percentage of projects are fixed bid in nature (30-40%). As explained earlier the major driver for cost is the person hour. All efforts to reduce the person hours for a project can be considered as a means of using the target costing technique. The various means of reducing the costs are: • • •



Automation Deploying junior staff (to reduce unit cost of deployment, lower FTE) Training, leading to improved productivity Reuse of components, leading to savings in effort

An example is given below to illustrate how target costing is used in an IT project that is fixed bid in the nature of engagement. Example Scenario The estimated number of hours for a project = 30,000 person hours Blended rate = $35 The fixed Bid price = $35*30,000 = $1,050,000 Unit cost = $20 Predicted cost = $20*30,000 = $600,000 Expected profitability = 43% Target profitability = 55% Target costing measures Reduction in effort due to code reuse = 200 person hours Reduction in effort due to automation = 1000 person hours Reduction in effort due to improved productivity after training = 3000 person hours Reduction in effort due to junior staff being employed (<1 FTE) = 2000 person hours Total Reduction = 6200 person hours Effort incurred on automation = 300 person hours Effort incurred on training = 600 person hours Additional effort incurred on training junior staff = 600 person hours Total effort in reduction = 1500 person hours Grand total reduction = 4700 person hours (6200 – 1500) Results Total reduction in cost, due to target costing measures = 4700*$20 = $94,000 Profitability achieved = 52% An increase in profitability of 12% has been achieved here by target costing measures! (This example is reproduced in Appendix I in Excel format)

Note on types of Engagement and Project Life-cycles
There are 2 types of engagements used widely in the IT services industry. • Time and Material (T&M) • Fixed Bid (FB) A solution delivered through an engagement can be any of the following types, • Maintenance (SLA based) • Development • Re-engineering • Testing To deliver a solution various lifecycles can be employed such as, • Waterfall model • Incremental prototyping model • Agile methodologies The current framework for costing followed in the industry does not have different methodologies for any combination listed above! For example, the costing methodology for a FB development solution delivered on the waterfall model is the same as that of a T&M testing solution.

Future of costing in IT services
Costing as a management technique in the IT services industry is in its nascent stages today. This is manly due to the high margins and the focus on the top line, as the industry is in a growth phase. Once it matures, then the focus has to shift to the bottom line to maintain profitability. It is in this scenario that elements of costing such as, Activity Based Costing (multiple cost drivers) and Time-driven Activity based costing would gain more prominence. In fact, the current trends indicate that this is not too far away. There is a general pressure on the bottom line for all the IT firms in business today with the margins coming down due to the increase in salaries and competitive prices in the market. Today, many companies have started providing unit costs based on the vertical / SBU. This means that a person with the same designation and in the same location would have a different unit cost, when he works for the financial services vertical and a different one in the healthcare vertical. This indicates a varied contribution from the overhead costs to the unit cost based on business unit / vertical. The other practices that are emerging are varied contribution from overheads to the unit cost based on, • Centers of Excellence (CoE) concept (Technology as a cost driver) • Offshore Development Centre(ODC) concept (Customer as a cost driver) An illustrative example of how unit cost computation would change in future is attached in Appendix I. These trends, in fact, herald the arrival of Activity Based Costing in the IT industry!

Appendix I

C:\Documents and Settings\pgdm206-50\Desktop\Appendix I.xls



doc_127011827.doc
 

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