Shared Service Costs using Activity Based Costing (ABC)

First of all, I wish you and your family a very happy and prosperous new year.

A shared service is an operational philosophy that involves centralizing administrative functions that were once performed in separate divisions or locations. Services that can be shared among the various business units of a company include finance, purchasing, HR and information technology. Shared Services is a service model designed to gain efficiencies in routine processing by leveraging common practices and enabling technology. In the earlier days the costs were not significant, but because of the IT services it has gone up. In some of the financial services companies or telecom companies the cost of IT function contributes more than 25% of the costs.

The primary objective of forming the share service departments is to leverage the economies of scale to improve the cost as well as the productivity of the departments. Some of the other drivers for moving to shared service model are a) Process standardization b) Process improvements c) headcount reduction d) Improve service levels e) Increase control f) in case of mergers it is used to capture the synergies. All these objectives look logical as well as moving towards the improved performance. But still the recipients of the services do not seem to be happy with the costs. This is generally because there is not transparency in the calculation of the cost of the services. There is also no relationship seen between the volume demand from the business units and the cost of the services.

The typical method of allocating these costs to the business units is headcount, capital employed, revenue, area occupied, # of users, # of workstations etc. These statistical keys may not always relate to the volume of the services received by the business unit. The planning of the shared services is also not in line with the business volume planning of the units. With this situation the utilization of the shared services is not in line with the business units’ volume requirements.

The chargeback system for the shared services should be

a) Equitable – It should be fair to all the recipients. There should not be any kind of cross-subsidization among the business units. This may generally happen when the basis of distribution of cost is ‘Revenue’ or ‘Headcount’. The business units should pay for the capacity of the resources they use. The underutilization of the shared service department should be charged to the business units. This overcapacity can result as there is no relation between the requirement for the business units and the resource planning by the shared service departments.

b) Repeatable and Accurate – The cost of the service should be the same irrespective of the time. It should cost the same across the year for the same volume requirements. Assuming the same input it should consume the same level of resources every time.

c) Understandable – Both the service provided and the business units should understand the methodology of charging the costs.

d) Predictable – The business units must be able to predict the costs of the services. They can plan for the higher volumes if required. In turn the service provider can plan the resources as per the requirement of the business units.

Activity Based Costing (ABC) can be the answer to reduce the conflicts between the service provider and the business units and also fulfill the requirements for the good cost allocation method. In ABC the model for shared service cost calculation can consider various shared service departments like IT, HR, Procurement, Facilities management and define their services (as activities) and business units as the Cost Objects. Sometimes the services provided can be defined as the ‘Services’ in the Cost Object and Business units as the ‘Customers’. In that case the activities are the various steps for completing the services. Some of the consultants create a separate model for the shared service cost calculation only. The final model starts with the resource costs as per the cost center accounting plus costs from the shared service model.

Let us consider the various services that can be defined for the departments.

a) Accounts payable – Vendor payment, employee reimbursements

b) Accounts receivable – Billing, accounting for receipts, ageing reports

c) HR – Recruitment, training, grievance management, performance measurement, payroll

d) IT – Application management, infrastructure management, help desk – applications, help desk – hardware

e) Corporate services – Travel management, facilities management, internal functions management

In the first step the demand for various services is collected from the various business units. Based on this demand and the various activities required and the time taken by various activities the total resource requirement is calculated. In this way the resources of the shared service departments can match with the business plan of the business units and they can plan for the resources for themselves. This in turn saves the business units being charged for the unutilized capacity of the shared service departments.

Once this demand is converted into the resource requirement and the same is planned for, the second step is calculating the cost of those services. For the all the costs for the shared service department is accumulated as a cost center. Care should be taken that these shared service department as providing services to the other are also receiving services. For example as IT department is providing services to HR, it is also services from HR department. This ‘reciprocal’ assignment of cost should be modeled properly. Once all those costs are collected, they flow through the ABC model and calculate the unit costs for each of the service. Then based upon the volume of services availed by the business units the cost is allocated to them. In this way even if there is any excessive capacity in the shared service department, it is not transferred as cost to the business units.

In this way the business units can see the unit cost of the shared services and they can either question the shared service departments for the same or if allowed they can avail the services from the third party. Sometimes the ‘Employee self service’ program is also taken by the business units. In this program the employees perform the services for themselves. This reduces the cost of the organization and the satisfaction levels can be matched. The performance of the shared service departments can be improved by creating the ‘Service level agreements (SLAs)’ and/or defining the performance indicators for the services. At least three types of performance indicators can be defined.

1) Productivity type – Cost per service

2) Cycle time type – Time taken to perform the service

3) Quality type - % of times the service is provided with required quality

Activity Based Costing (ABC) models for shared service departments help the organization to achieve their goals for the initiative as well as provides transparency in allocating costs and utilization of resources of the shared service departments. The planning of the shared service departments can happen in line with that of the business units.