Cost Allocation Methods – A Basic Guide

4 minute read


Many companies are looking to employ IT Financial Management (ITFM) or Technology Business Management (TBM) processes for chargeback or showback on their technology costs.

It’s easy to understand why. IT is expensive and often amounts to significant costs for most organizations. Chargeback and showback enable IT to better communicate the value of the services they deliver. They also ensure business units understand their contribution to the total amount spent on IT so they can make smarter usage decisions.

But just how much is spent on IT?

According to a November 2017 report from Deloitte, IT spending as a percent of revenue ranged from 1.51 percent for construction firms up to 7.16 percent for banking and securities firms. The overall average across all industries clocked in at around 3.3 percent.

What does this percentage mean?

Well, even if your company is small, you could be spending millions on IT expenditures. Because of this, understanding IT service consumption and the distribution of these costs across the enterprise is the mainstay of many IT chargeback models.

Finding the specifics in the ways these costs are distributed is the essence of Cost Allocation.

What are Cost Allocation Methods?

Think of Cost Allocation Methods as the IT equivalent of “Generally Accepted Accounting Principles” or “GAAP.” GAAP are a common set of accounting rules, standards, and procedures that must be followed by public companies. The purpose of GAAP standards is to ensure the consistency of financial statements, and to provide for meaningful comparison between reporting periods.

Cost Allocation Methods similarly provide a standard by which IT costs are reported and distributed. The methods provide consistency so business managers can understand what they are being charged for and how those charges are being calculated. Using cost allocation methods, they can make better decisions about their IT spend.

The following are the different methods of cost allocation.

The Methods:

High-Level Allocation (HLA)

High-Level Allocation uses business metrics to distribute costs such as the number of employees or total sales. HLA is easier to implement than other methods, and the metric is easily understood by the business manager.

Low-Level Allocation (LLA)

Low-level allocation is similar to HLA in terms of ease of use and deployment. LLA is often more IT group specific and may use metrics such as number of network ports, workstations, or network IDs.

Measured Resource Usage (MRU)

Measure Resource Usage is looked at as a best of both worlds approach because it is easily understood across business units and manages to be highly equitable. MRU is easiest to think of as a “pay what you consume” model.

Tiered Flat Rate (TFR)

This allocation method varies costs depending on quantity of usage or quality of service. This can be more challenging to implement as two important elements are required: 1) detailed knowledge of costs per services; 2) the ability to calculate usage if the tiers are set by quantity.

Negotiated Flat Rate (NFR)

NFR is an individual pricing agreement between a service provider and the consumer. This is commonly used in outsourcing agreements or internal IT departments that dedicate resources to a particular business unit.

Direct Cost (DC)

Direct Cost is an allocation method that attributes all costs to a specific consumer. In order to use this method, all the costs must be directly and fully traceable to a specific service.

Market-Based Pricing (MBP)

Market-Based Pricing helps IT make meaningful comparisons with external providers, and also enables them to manage their own P&L. Market-based pricing, however, is harder to implement as the IT department needs deep understanding of direct and overhead costs, rates of competitors and a complete understanding of the needs of the business.

How to deploy Cost Allocation?

One of the best ways to get running on cost allocation is finding the appropriate ITFM solution to effectually deploy your chargeback system and allocation method of choice.

For a vendor agnostic look at the best practices in choosing an ITFM vendor, why not check out our White Paper “Selecting an ITFM Vendor.” This guide is an unbiased look at all the steps to choose an ITFM vendor and their timeframes.

This white paper is designed to help you understand what you need to know about yourself and your organization, and how to engage vendors to help ensure that you end up with the best fitting solution for your organization.

Be sure to check out “Selecting an ITFM Vendor” today!

Reliable products. Real results.

Every day, thousands of companies rely on Upland to get their jobs done simply and effectively. See how brands are putting Upland to work.

View Success Stories