FINANCIAL OPTIONS | The Budgeting Process

Zero-based Budgeting

Typically, the IT budget is based on the past year's spending, which factors in the growth (or decline) of the business. The main justification is based on differences in spending when compared to the prior year's budget. Start building the budget from the ground up and justify all costs. Companies call this zero-based budgeting because you must justify every item. This process is intense and time consuming, but it forces IT to know the costs. It is helpful to do zero-based budgeting once every three to five years, when there is new IT leadership, or when there are major business strategy changes.
Zero-based budgeting

"With zero-based budgeting, it's important to look at every cost. We plan the capital outlay and calculate when those expenses will be removed from the budget. We have a three-year plan for fixed costs. That way we can anticipate those costs in overall planning."
—Peter Bellavance
Tastefully Simple

Start the process months prior to the company budgeting cycle to provide enough time for a complete analysis. Engage the assistance of the IT management group, communicate the objectives, and assign individuals to update inventory documentation, research contracts, and costs. It is helpful to engage an external consultant at this time for an objective review of the entire IT environment and to establish a complete IT strategy prior to the zero-based budgeting exercise. An alternative method is to target two or three areas for zero-based budgeting each year.

Leasing versus Buying

IT makes use of three financing tactics when acquiring capital items: purchase, capital leases, and operating leases. Each option has its place. Capital leases are reflected in your financial statements just like loan financing, that is, total value is captured on the balance sheet as an asset, a portion of which is expensed as depreciation each period over the useful life including interest expense. Operating leases are truly a rental transaction and so reflect each payment as an expense on the income statement, which is also known as off balance sheet financing. Accounting rules determine which type of lease you have. Generally, it is a capital lease unless:
  1. No ownership is transferred to the lessee during the term
  2. there is no nominal price (i.e., bargain) whereby the lessee buys the asset at the end of the term
  3. The asset is leased for less than 75 percent of its useful life
  4. The present value of the cumulative lease payments is less than 90 percent of the asset value
In all cases, you are responsible for the maintenance and upkeep of the equipment. At the end of the lease, you can send the equipment back to the leasing company, extend the lease, or buy the equipment from the leasing company. It is important to understand your lease agreements and know when they are due since you need to take action typically several months before the lease expires.
Leasing equipment

"Leasing all PCs, servers, and IT equipment allows us to guarantee stability and uniformity across the organization. It provides a three-year revolving cycle and isn't dependent on traditional, annual capital funding mechanisms. It helps us keep an accurate and centralized inventory. A standardized set of machines reduces staff and parts inventory requirements."
—Samuel J. Levy
University of St. Thomas

Leasing is really a financial decision for a company, and normally the CFO or finance department is heavily involved in the decision. If the company has limited cash availability, leasing is attractive with smaller predictable payments. Off balance sheet financing is sometimes required where your company's debt covenants place limits on capital expenditures or other secured financing.
Leasing also allows for regular upgrades of equipment because it takes care of the old equipment. However, leasing gets complex as you need to manage the lease and keep good inventory records. For example, if some PCs are leased and some are owned, you must keep track of which ones must be returned to the leasing company at the end of the lease cycle. There are also complications if you upgrade the equipment before the end of the lease; specifically, the equipment needs to be coterminous with the original lease. Leases are also complicated if the vendor or lessor goes bankrupt. Negotiating an IT lease is intricate, and experienced advisors or lawyers are useful. Pay particular attention to the detailed terms and conditions.

Charging Back IT Costs

Although chargebacks are a practical way to discourage frivolous IT spending and resource requests, many organizations do not use chargebacks for several reasons. First, it can lead to bad decisions for the enterprise as a whole by optimizing parts while lowering overall standards. Second, it can be costly and, unless processes are automated, the effort to manage and track detailed chargeback costs are high. Third, it can have a chilling effect on usage. For example, users may stop calling when they need help, which results in more problems down the line.
That said, a number of corporations do use chargebacks effectively. The positive aspect of chargebacks are that it communicates to business units that IT is not a free resource, which makes business units reconsider their requests. Chargebacks help a business make decisions regarding cost vs. value trade-offs. It also manages IT demand and makes prioritization and governance easier. As one CIO claimed, "We have no IT backlog. If the business wants it, they pay for it and it gets done."
Consumption based chargeback

"Create a consumption based chargeback system that is driven by the business. Establish a services catalog with defined services and invoice the business for consumption. This will provide the business with the levers it needs to control spend."
—Mike Degeneffe

Charging back IT costs

"We use chargebacks to allocate costs to the business. It provides true line of sight between usage and costs. Chargebacks force the business to manage IT resources and changes behavior. It is one of the reasons IT spending is down."
—Mike Thyken
Merrill Corporation

There are tools and web services available to help facilitate IT chargebacks. You can develop a rate card or service catalog for various services. For example, the cost of a desktop would include the purchase price, maintenance, and help desk support. Payment for service and rate visibility can help executives consider the business value and objectively evaluate each additional tool or service.
You can get some of the same benefits of chargebacks by simply providing transparency to the costs, then presenting them in terms that relate to the areas of the business. There are also different degrees of chargeback costs: charging back every cost, using broad allocations based on business indicators to chargeback costs in total, or charging back portions of costs, such as infrastructure costs by user count. Consider chargebacks for services that are difficult to control centrally. For example, use phone bills to chargeback long distance phone calls to the individual work unit actually incurring the cost.
Chargeback transparency

"We use chargebacks to provide total transparency to the business. The business unit works with the IT relationship manager to determine how much they want to spend in IT throughout the year. Costs are allocated based on usage. It is the best way to manage shared services in a very decentralized company."
—Beth Nordin
CHS Inc.

Chargebacks with reductions

"If you didn't have chargebacks before cutting costs, do not implement it as part of cost reductions. It will be viewed as displacing the responsibility for reductions. The use of chargebacks depends on the culture—the social and economic contract in the organization."
—Samuel J. Levy
University of St. Thomas

Managing the Budget | The Budgeting Process

The budget identifies the money you will need to spend. Finance uses the budget to manage cash flow, which is why it is critical that you meet your budget projections. Expense and budget management is an on-going activity regardless of financial conditions or the time of year. On a regular basis, make sure you (or someone in IT) carefully reviews monthly spending reports that compare the budget to actual spending. It is usually not enough to assume that accounting or finance is executing this function. If significant overages (5 to 10 percent) occur, communicate it immediately. Trying to hide or delay communication of major overruns costs you credibility and is career limiting. If you have the opportunity to reforecast in the middle of the year, be sure you re-analyze in total and consider the timing of expenses. If you have unplanned expenditures, make projections to identify the variation in the budget.
In addition to watching budget-to-actual spending, it is critical to thoroughly review and check invoices against contract terms and conditions. It is amazing how much cost savings you are able to realize by being diligent and watching invoices. Be sure to report project-related financials as a function of the project reporting process.
If company results are less than forecasted, you may need to stop or postpone projects. If that is the case, complete a full analysis depending on where each project is in the life cycle. Postponing projects midstream often costs 10 to 30 percent more than original estimates due to the momentum and knowledge lost in stopping the effort.
Frequently, the business improves and the outlook is favorable as the business enters the fourth quarter. Know what expenditures would be useful and provide business value if you are given the go-ahead to overspend the budget.

Operating Costs versus Capital Costs | The Budgeting Process

When budgeting, you must consider if an expense is a capital or operating expense item. Capital items represent an asset (similar to furniture or equipment) whose total value you report on the balance sheet and then depreciate (i.e. expense) incrementally over the useful life of the asset. A capital expenditure is typically for something that has a useful life of several years and the cost exceeds a threshold, like a server. An expense item is something whose value is absorbed by the business within a single fiscal period and cost is below the threshold (e.g., paper used for printing or a printer cable.) The finance department assigns to IT capital equipment an estimated life (typically between three to seven years) and depreciates the asset over that time frame once the asset has been put into use. For example, a $50,000 capital asset with a useful life of five years would have a $10,000 depreciation expense each year. The purpose is to align the expense of the asset with its useful life. Some capital items also may be eligible for research and development or investment tax credits.
Write-off unused assets

"We reviewed the numbers, starting with the largest areas, such as depreciation. We reviewed every asset and looked at what we could write-off, eliminate, or consolidate. We wrote off $4M of asset value, or $1M in annual savings. This is an example of something that typically doesn't get reviewed in good times."
—Greg Hayhurst
Tennant Company

Capital items are usually budgeted separately from operating expenses with typically more flexibility and variability than the operating budget, which depends on the company's financial position. Moving items to the capital budget provides relief in the annual operating budget. Similarly, moving items to the expense column allows for purchases in a capital-constrained environment.
It is important to understand what items are capital and what items are expenses. Generally Accepted Accounting Principles (GAAP) dictates whether an item is capital or an expense. Within this framework, each company adopts its own specific categorization policies. For example, one company treated project management costs within a capital project as an expense, except if it was bundled within a fixed-fee consulting bid. For purchased off-the-shelf software, the company treated systems development time and systems integration costs as capital assets. Often, companies offset any planning, operational, and implementation costs for internally developed custom software, but it varies by company policy.
Typically, after implementation, as you depreciate hardware over the equipment's useful life, the depreciation expense impacts the IT budget. Similarly, amortized software costs appear on the IT operational budget. The finance department usually calculates these costs for the annual IT operational budget. Further, it is important to understand how you should treat assets because you need to account for the cost when you no longer treat assets as capital items. Likewise, if an IT capital asset is prematurely retired, or you fail to put it into production, then the company must immediately write-off (or write down) the remaining value of that asset. Depending on the size of the company, you often need to explain financial write-offs in board meetings and financial statements, which is one of the reasons failed projects are so financially disruptive.