Cut the Appropriate Costs | IT PROCESSES

A company's IT spending is comprised of:

• Nondiscretionary spending. This is the operational cost of keeping the lights on. These costs result from past decisions on hardware and software that support business functions implemented over the past decade or more. They include maintenance costs for hardware or software, or the labor costs to keep existing systems functional.
• Discretionary spending. Typically, this includes projects and improvements to the existing environment. These are projects requested by the business to add business value, to reduce business costs, or to support the business strategy. They are also efforts that improve efficiencies and reduce future operational costs.
• Hidden costs. These are not typically in the IT budget but in the business unit's budget. If a business unit is not able to get its needs satisfied by IT, the problem may be solved by obtaining software and having individuals within the department support the software. A common example is an engineering department that is running ProE or some CAD/CAM application that requires higher-powered PCs and dedicated servers supported by the engineering department.

Unfortunately, even the cost of just maintaining often increases. As an infrastructure ages, keeping it running takes more resources and money. Compliance with new regulations and keeping up with increasing security demands also increases costs.

Over time, reduce nondiscretionary operational costs so you are able to spend more time on discretionary project spending that adds value to the business. Many organizations spend approximately 70 to 80 percent of their budget (including resources) on operational nondiscretionary costs while upper-tier organizations that have implemented best practices strive to have a lower-maintenance environment in which they can devote 40 to 50 percent on projects. It is important to identify and track all nondiscretionary spending. Conduct an evaluation of all these costs to determine where you are able to realize potential cost efficiencies. Tracking this over time will help determine if cost savings initiatives are effective.

IT has more pressure than ever to deliver business value while reducing costs. As shown in Figure 1, IT spending on nondiscretionary maintenance costs and discretionary new projects are both facing pressure, creating the IT cost squeeze. Discretionary spending on each new project must deliver increased business value. IT is faced with an increasing backlog of projects to reduce business costs, improve end-user productivity, provide a competitive advantage, enable new technology, and help the business meet competitive pressures. Maintenance, operational costs, and nondiscretionary spending face cost pressure as well since IT must meet increasing requirements relative to regulations, security, performance, availability, reliability, and an increasing speed of technology obsolescence.

 

Figure 1: IT cost squeeze

As nondiscretionary spending is not usually optional, many companies when faced with budget constraints cut discretionary spending as it is easier and quicker. However, the discretionary spending is moving the organization forward and creating value. In addition, companies need to make wise choices on discretionary spending because it becomes nondiscretionary spending in the future.

Hidden IT costs can be a significant amount of money and a substantial percent of spending, but these often go unnoticed, unmanaged, and even unmeasured. Oftentimes, as IT cuts discretionary spending, hidden costs increase as the users find solutions to their own problems. The company must strive to make decisions to reduce nondiscretionary spending and hidden IT costs over time as shown in Figure 2 and Figure 3.

 

Figure 2: Unmanaged IT costs

 

Figure 2: Managed IT costs

Look at Total Cost of Ownership | IT PROCESSES

When looking to make IT investments, make sure proposals include recommended budget increases to cover all the costs—initial as well as ongoing—and projected budget decreases associated with the promised cost reductions. Often, companies focus on the initial costs to purchase and implement a solution rather than the total cost of ownership. Have the CFO make these budget adjustments automatically upon completion of each project. 

Suggestions on how to collaborate effectively with finance and the CFO. Similarly, when comparing to the base case of doing nothing, make sure you include all the costs, such as the opportunity cost of lost savings due to inefficiencies. It is a challenge to determine the base case correctly because the future without doing the project (i.e., the base case) is often different from the current situation (i.e., your existing budget). Ensure that the base case reflects the full effect of not doing the project in question, including new costs. Examples of total cost categories to review are:

• External implementation costs:
  • Software
  • Database
  • Server
  • Network
  • Software modification
  • Consulting for implementation
  • Interfaces, conversions, customization
  • Training and change management
  • Project management
  • Travel and expenses
  • Sales tax
  • Investment tax credits (to defray the investment costs)
• Internal implementation costs:
  • IT setup and operations labor
  • Business analysis and configuration labor
  • Subject matter expert labor
  • IT interfaces, conversions, customization labor
  • Training and change management labor
  • Project management labor
  • Travel and expenses for internal labor
• On-going costs:
  • Application maintenance
  • Database maintenance
  • Operating system maintenance
  • Server maintenance
  • Network maintenance
  • Sales tax (varies by state)
  • IT operations and support
  • Depreciation
  • Business labor
  • Interest expense (if investment was financed)
  • Software license expansion for growth
  • Software upgrade

Backward-Looking Cost-Based Pricing of Access

The traditional approach to computing interconnection charges consists in applying the methodology of cost-of-service regulation to the operator's wholesale offerings. There are a variety of possible cost allocations.

A popular cost-of-service methodology is that of additive or usage-proportional markups. Suppose that several services utilize a common element. After the allocation of costs that are attributable to a particular service to the corresponding services, there remains a residual corresponding to the "fixed cost" or "common cost." This unallocated residual is then spread across services, and the additive markup on each price is the same for each service. In other words, a usage-proportional markup is tantamount to a fixed (price-independent) excise tax, whose magnitude is computed so as to cover the unallocated cost.

It is interesting to note that usage-proportional markups satisfy the ECPR. ECPR requires the access price to be equal to the operator's opportunity cost on the competitive segment. The operator's price on the competitive segment is equal to total marginal cost, that is, the marginal cost of access plus the marginal cost of the segment itself, plus the markup. The access charge, which is equal to the marginal cost of access plus the markup, is thus equal to the difference between the price and the marginal cost on the competitive segment, that is, the opportunity cost.

Another popular approach to allocating the fixed cost is that of uniform or price-proportional markups. The markup over the marginal cost of a service is proportional to this marginal cost. The uniform markup is thus akin to a proportional (VAT type) tax. Unlike additive markups, uniform markups do not satisfy ECPR. Because the total marginal cost of the competitive segment exceeds the marginal cost of the access facilities used by this segment, the price of the competitive segment is inflated more than that of the access segment, and so the access charge is set below the operator's opportunity cost. The burden of cost recovery then falls disproportionately on the competitive segments.

The benefit of fully distributed cost pricing is that it commits the regulator to allow the operator to recoup its investments and to break even. Thus, to a large extent, it solves the problem of regulatory takings. In particular, an operator who incurs a large fixed cost to install fiber optics in the local loop or to endow switches with new functions need not be concerned that this investment will later be expropriated by the regulator's setting low access charges, for example.

Despite this advantage, in the context of retail pricing, fully distributed cost pricing has been as frequently decried by economists as it has been used in practice. It has well-known flaws. First, it is determined through a cumbersome process. For example, a rebalancing of access charges must be cost justified, a requirement which is likely to imply a delay of several months in the rebalancing. Second, fully distributed cost pricing is cost based and therefore does not encourage cost minimization. Third, it yields an improper price structure and is a vastly suboptimal way of financing the access deficit. Because it is cost-based, it "subsidizes" inelastic-demand segments to the detriment of elastic-demand ones. In the presence of competition, fully distributed cost pricing tends to create an inefficient amount of entry. For example, under uniform markups, an inefficient entrant producing the same service as the operator in the competitive segment finds it profitable to enter as long as its cost handicap relative to the operator is smaller than the markup on the operator's marginal cost on the competitive segment. Furthermore, under all fully distributed cost methods, the markup on access invites inefficient bypass.

To alleviate the cost of the first and third drawbacks (delays in price revisions, inefficient entry in the competitive and bottleneck segments), the prices set by fully distributed cost methods have sometimes been interpreted as ceilings or caps, providing, in particular, flexibility to respond to competitive threats such as those by competitive access providers. By letting operators respond to competition, this downward flexibility has perhaps brought actual prices closer to Ramsey levels, but fully distributed cost methods still have only limited appeal.

Develop a Cost Management Vision

Why develop a cost management vision? Controlling costs within the telecommunications network is hard work. Some projects are easy with a high payoff; others require constant review. Without a clear vision of the outcome, good intentions may falter. Similar to affirmations in self-help books, a cost management vision might read as follows:

The architecture of the network (data, voice, hardware, leased lines, etc.) will, by its structure, minimize costs.

Monitoring systems will alert management of financial exceptions.

Configurations and clusters of technology will be flexible and scalable to reflect declining unit costs resulting from technology improvements.

Network investments will match the business culture — no long-term investments for an organization that demands a very quick payback from all its other capital expenditures.

Financial commitments for telecom services are flexible and can accommodate acquisitions, divestitures, major application changes, and rapid growth.

Telecom should be perceived as an asset — not just a commodity.

All alternatives that best support the core business, including outsourcing, will be periodically reviewed for applicability.

After the telecom cost management vision is developed and tailored to the culture of the organization (risk tolerance, scope and level of desired savings), the next step is to consider how to start.

How Do Organizations "Make It Happen"?

Telecom cost management is both a project and a process. A project is needed to gather information and make the right decisions. The process ensures that any gains will be maintained. When considering how to start the process, management should start with the following questions:

Does staff exist within the organization to perform the analysis required to manage costs? For large organizations, a telecom cost management project may require months of work by skilled analysts.

Does the firm have the appetite to consider telecommunications changes (either technical or procedural)?

Is there a bias for or against outsourcing? One note of caution: even if the business culture is strongly pro-outsourcing, it is important to have at least a high-level, in-house understanding of the telecom environment to ensure that agreements with the vendor of choice are equitable for both parties. Another approach is to use the services of a third-party outsource consultant.

Do the individuals assigned to perform the initial analysis have the right background for the project? Do they know telecom billing, tariffs, telecom taxation, and industry trends (business and technical)?

What outside resources are contemplated — consultants, telecom auditing firms, outsourcing firms, or others?

When considering how to move forward with the project, risks should be explicitly considered. For example:

What would be the effect of changing carriers? Telecom managers generally dread carrier changes, even if they are dissatisfied with the carrier. Changing circuits and other infrastructure often causes some disruption that users notice.

Are users willing to accept technical changes if they cannot directly see the benefits? For example, consider the change from remote dial-up (using a remote access server) to using a VPN (virtual private network) for connecting to the network. Until all the ISPs across the country get their account numbers correctly loaded, remote users might occasionally fail to get on the network. In the long run, it is certainly the most economical practice for large numbers of remote workers, but there is some short-term pain in the transition.

Are negotiators for contract changes experienced in telecommunications? Strong negotiators can push telecom vendors for rates so low that the result is not a win-win situation. The telco may be tempted to devote attention to other customers. Also, negotiating for the right prices and services is critical. Why negotiate a 5-cent-per-minute rate to the United Kingdom when the firm makes only a small number of calls there each month?

Looking for the Quick Fix
Organizations have many agendas and priorities. Sometimes, telecom decisions are not made for the long run because there are more pressing issues. Like the Russians in World War II who, in desperation, sometimes sent unpainted tanks to the front in winter, business managers have to survive the present and not worry about the rust of the future. Accordingly, there may be times when a quick fix is necessary. Save some money now and go after the deeper savings later.

Following are some considerations and approaches for telecom short-term relief:

Use contingency-based auditing firms. Relying on splitting the proceeds of finding errors and overbillings, contingency firms become speedy and efficient. Their goal is to send in highly trained, "drill-down" staff; find the gold nuggets; and move on. The downside to this approach is that changes in processes that would prevent the errors from occurring in the first place are sometimes not addressed. In addition, this style of telecom auditing emphasizes reviews of bills, agreements, etc., rather than technology alternatives. The question "Was there an erroneous bill for a T1 after office X closed?" might be asked. The question "Should frame over DSL be used in place of a T1?" will likely not be asked.

Renegotiate the contract for immediate relief. Many carriers, anxious to lock in a customer for several years, will lower unit costs in return for longer contracts.

Throw telecom "over the fence" to an outsource firm. In fairness, this may be a perfectly acceptable long-term solution as well. However, if the deal is done quickly and without adequate knowledge on the part of both parties, it might not be optimal for the long term. But certainly if telecom is "out of control" and expense management has not been a priority, outsourcing can likely assuage the financial worries of management (at least for telecom).

It is important to recognize that the above comments are generalizations. For example, Houston-based Teligistics performs both contingency work and some process work, such as long-term "pre-audits" of bills. In other words, for a monthly fee, Teligistics will take the client's bill from the carrier, run it through an automated error detection system, and then send it to the client for payment (or the bill may be paid on behalf of the client). A sample variance report provided to the client is shown in Exhibit 1.


Exhibit 1: Automated Variance Analysis: Billed Rates versus Contracted Rates

Special Needs and Groups within the Organization
Like Orwell's pigs, some groups are clearly more equal than others in terms of their telecom needs. When developing a comprehensive vision of telecommunications — how costs are to be minimized while maintaining service levels — all special groups need to be considered. The classic example is the call center. With hundreds or even thousands of agents, call centers (also called contact centers) are massive bandwidth and service users. Uptime is essential and in some cases, such as Dell Computer Corporation, telecommunications provides the sole "face" of the company to the end customer. If the phone lines and Internet cables are down, how can computers be ordered?

Tailoring of requirements helps in negotiations and architectural design. If electricity traders make 50 percent of their profits in just 5 percent of the available trading day, the phone lines really need to be up 99.999 percent of the time. Hence, additional circuits, rerouting features, and other contingency services need to be included in any negotiations with the local or long-distance carrier. If the contract negotiator fails to appreciate specialty group requirements, long-term telecom costs could be inadvertently increased.

Some other considerations that affect the cost management vision include:

Is telecom decision making centralized or decentralized? The preference for centralized-decentralized operations swings along its arc every decade or so. However, for telecommunications cost management, centralization has always been best. Carriers reward volumes and a balkanized approach to telecom always means higher cost. "Boudreau" in Beau Bridge, Louisiana, may get a good Frame Relay price from his brother-in-law; it may, in fact, be better than the corporate office in Houston was able negotiate with the carrier of choice. But considering the sum of all telecom costs, the corporate agreement is most likely less expensive.

Is change constant? If so, long-term contracts are even more risky.

Do the voice and data people talk with each other? IT, data communications, and voice communications should be integrated. Otherwise, sub-optimization will result.

Incidental Revenue
The best way to reduce telecom costs is to find ways to make them go below zero — in other words, collect revenue from telecom-related functions. For example, one Midwestern department store chain operates a 900 number service that charges firms that call to verify prior employee work history. Telephone services for students have long been a revenue source for universities. Businesses have become increasingly clever in using telecommunications for profit, or at least offloading some of the costs to customers.