IT Financials Glossary

Costs

Posted in Costs by mgentle on August 26, 2010

Costs: Costs can be categorized in different ways.

The most fundamental cost categories are fixed costs and variable costs:

  • Fixed costs: these are costs not directly influenced by business activity or usage – eg, rent or annual software maintenance. Fixed costs are generally easy to plan and to manage, but they are risky in that they represent long-term commitments and therefore need to be entered into with caution.
  • Variable costs: these are costs that vary with business activity, or usage, such as telecoms charges or disk storage. Because variable costs are usually driven by decisions or events outside of IT control – eg, changes in BU usage policies, or a peak in customer service activity following a product launch – they are more difficult to plan and manage.

Fixed and variable costs are useful from an overall perspective in terms of pricing and negotiations, but they don’t help in understanding who or what is driving the totals. It is therefore useful to be able to assign these costs directly or indirectly to a customer or an activity, so as to help justify IT expenditure, facilitate pricing or explore opportunities for cheaper alternatives:

  • Direct costs: these are the portions of the fixed or variable costs that can be directly attributed to a cost centre, activity or customer. Examples include dedicated hardware, software or application support costs.
  • Indirect costs: these are the portions of the fixed or variable costs that cannot be directly attributed to a cost centre or an activity – eg, shared infrastructure and network services. Such costs have to be apportioned or allocated based on criteria like number of users or BU revenue.

All costs, fixed or variable, direct or indirect, are ultimately classified as either capital costs or operational costs:

  • Capital costs: more commonly known as capex (short for capital expenditure), this represents the substantial assets of the company, like plant, property, equipment – and IT systems. Capital costs figure in the balance sheet the year in which the asset is acquired, and are depreciated as expenses in the P&L during its useful life. Capex in essence pushes out expenditure incurred today to subsequent years, thus making the current year look “better” (which is why most CIOs like it…). It is therefore closely monitored by the CFO, lenders and financial markets – eg, via the capex-to-sales ratio – though clearly not closely enough to prevent a major telco of creative accounting fame from incorrectly capitalizing $3.8b of expenses to make its 2001 and 2002 numbers look better (what has the WorldCom to…?).
  • Operational costs: more commonly known as opex (short for operational expenditure), this represents day-to-day running expenses whose effects can be measured within a short timeframe. Unlike an asset, an operational expense has no intrinsic value. It’s just that – a one-time expense. When companies go through a round of cost-cutting as explained at the start of Chapter 1, it’s usually the opex that’s being cut. This is what the CIO monitors closely each month in the IT financial reporting.

There are clear rules for what can be capitalized and what must remain an operating expense. This is explained in detail in Chapter 2 (Budgeting rules for capex vs opex).

The sum of capex and opex is called cash out, which is the “real money” that the company has to pay for goods and services, regardless of how it will be accounted for later.

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4 Responses

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  1. Fixed costs said, on April 5, 2011 at 15:36

    […] costs: see Costs. Filed Under: Costs […]

  2. Indirect costs said, on April 5, 2011 at 15:36

    […] costs: see Costs. Filed Under: Costs […]

  3. ABC (Activity-Based Costing) said, on April 5, 2011 at 20:04

    […] (Activity-Based Costing): a method for assigning costs to products and services based on the activities required to produce them. Knowing how much […]

  4. Variable costs said, on June 13, 2011 at 01:08

    […] costs: see Costs Filed Under: Costs […]


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