IT Financials Glossary

Capital costs

Posted in Costs by mgentle on August 26, 2010

Capital costs: see Costs.

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Cashflow

Posted in Financial statements by mgentle on August 26, 2010

Cashflow: the difference between income and expenses. Even if revenue and profits are up, what ultimately counts in the short term is a positive cashflow – ie, money in the bank – to pay employee salaries and vendor invoices. Hence the adage “Turnover is vanity, profit is sanity, cashflow is king”.

Cash out

Posted in Costs by mgentle on August 26, 2010

Cash out: the sum of capex and opex.

Commitments

Posted in Purchasing by mgentle on August 26, 2010

Commitments : the amount owed to a vendor once a product or a service has been delivered but the invoice has not yet been paid.

Note that a commitment is not the same as an accrual. Commitments are recorded in the management accounting system, whereas accruals are recorded in the financial accounting system – and are therefore officially “on the books”.

Some companies extend the scope of commitments to include the total cost of a PO, minus the notice period for cancellation. So if a PO for six months of services can be cancelled with a notice period of one month, then commitments would be the sum of all uninvoiced work plus one month of invoicing. Needless to say, only the uninvoiced work actually done can be accrued.

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.

Depreciation

Posted in Accounting by mgentle on August 26, 2010

Depreciation: the reduction in value of an asset over its useful life (usually several years) through usage or obsolescence.

There are several methods of depreciation, the simplest of which is the linear or straight-line method, which divides the cost equally across the lifetime of the asset. So a $90k server with a useful life of 3 years will have an annual depreciation of $30k.

The financial impact on IT costs of mixing up capex and opex should hopefully be clear. If the server is correctly capitalized, the IT department will incur no costs this year against the IT budget; instead it will be charged $30k per year for 3 years starting next year. If, however, the PO incorrectly assigns the purchase to an opex account, then the $90k would figure as a current-year cost and hit the IT budget.

Or, to use a less obvious example, if a development team inadvertently enters $90k worth of time entry against functional design (opex) instead of technical design (capex), then instead of being depreciated as part of a software asset from next year on, the $90k would figure as a current-year cost.

Very important: depreciation is not a cost in terms of money out of the bank! The cost is what the company paid to acquire the asset (in cash or through borrowing). Depreciation is an accounting exercise that allocates a portion of the asset’s cost to the current financial year. The term expense in “depreciation expense” does not refer to a cost, but to operating expense, or opex. (Confused? Don’t worry, so was I not too long ago!).

FURTHER READING: for an accounting view of fixed assets and depreciation check out the following article by Michael Sack Elmaleh.

Direct costs

Posted in Costs by mgentle on August 26, 2010

Direct costs: see Costs.

EBITDA

Posted in Financial statements by mgentle on August 26, 2010

EBITDA: Earnings Before Interest, Taxes, Depreciation and Amortization. This represents the first part of the P&L (Profit & Loss) or Income Statement.

In plain English, EBITDA is operating profit, which is sales minus operating costs – ie, the day-to-day running costs like sales, marketing and administration. But plain English doesn’t help the non-specialist to understand what the remaining costs are, and that’s where EBITDA comes in:

Sales (top line)

– operating costs

EBITDA (operating profit)

Depreciation

Amortization

EBIT (operating income)

– Interest

EBT (earnings before taxes)

– Taxes

Net Income (bottom line)

So, you might ask, why bother with EBITDA? Why not just go straight to the net income at the bottom line? The main reason is to be able to compare the performance of companies in different sectors: because some industries are more capital-intensive than others, subtracting depreciation expenses would distort comparisons. EBITDA is therefore only useful for companies with large amounts of fixed assets, which generate large depreciation charges (like telcos or manufacturing companies).

Finally, because EBITDA was often misunderstood by investors before the dot-bomb crash in 2001 as representing cashflow – a misconception that companies didn’t exactly go out of their way to correct – EBITDA also became known as Earnings Before I Trick Dumb Auditors!

Equity

Posted in Accounting by mgentle on August 26, 2010

Equity: the difference between assets and liabilities. Equity can be owner’s equity or shareholder’s equity. Also known as net worth.

FURTHER READING: for an accounting view of equity, assets and liabilities, check out the following article by Michael Sack Elmaleh.

Expenses

Posted in Costs by mgentle on August 26, 2010

Expenses: Operating expenses or opex. Sometimes used as a verb, as in “expensed”.