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Accounting for cloud computing

Cloud adoption changes how IT spends money. The cloud pay-as-you-go model converses capital expenses into operational expenses. And fixed costs are converted to variable costs. That is not an easy accounting exercise.

When operating your own data centre, equipment is paid upfront and monthly costs, like data centre fees, software licenses and depreciations are well understood. Infrequent reporting is acceptable since day-to-day costs of the data centre do not vary. In the cloud, costs are directly linked to consumption. Predicting costs is tricky. The bill is not easy to understand. The purchasing power transfers partly from the procurement team to engineers.

Engineers talk gibberish about accounts, subscriptions, tags and labels. Poor CFO. The financial team babbles about general ledger, depreciations, CAPEX, OPEX and variabilize costs. Poor engineers.

Expense or profit centre?

In traditional IT accounting, the IT department is treated as an expense centre. All costs for IT assets are cumulated in IT. The latter is assigned a budget based on a percentage of the total revenue, headcount, or another rule of thumb.

IT costs are typically reported using general ledger accounts and cost centers. Accounts reflect the type of costs, like hardware, software licenses, salaries, consultants, utilities, depreciations and amortizations. Cost centers typically reflect an organizational unit, like cybersecurity or IT network and systems. Nowhere in this kind of reporting are the costs linked to the value IT services create for the business and company as a whole. This kind of setup triggers questions like: do we pay too little, too much or just the right amount for IT? Which is not really the right question to ask.

On the other side of the spectrum, the IT department is treated like any other business unit: a profit centre. This model makes sense when IT generates its own revenue stream, for example through professional IT services, or by commercializing in-house written software. More and more companies – also those that are not historically a technology company – have this ambition.

In a profit centre model, the IT department will position itself to the other business units more like a commercial partner. IT will markup all costs to deliver IT services and bills accordingly to the other business units. This can create friction between the IT department and other business units. For example, try to explain why in-house delivered IT services are more expensive than what is offered on the market. Since the IT department is responsible for its own profit and loss (P&L), funding large transformation programs like cloud adoption might become very difficult.

The cost centre model makes it hard to understand the value IT creates. This is not a model fit for a modern enterprise where digitalization is high on the agenda. The profit centre model is only viable if the core business is technology. But surely there is some middle ground to find.

Become a value centre

The consumption-based model of the cloud makes implementation of a chargeback accounting model more straightforward. In a chargeback model the consumption by a specific business unit of IT services are treated as operational expenses in that business unit. When operating your own data centre this is harder to do, because someone still needs to carry large capital expenses and depreciation. When implementing a chargeback model, the cumulative costs IT must carry go down. In doing this the IT costs can – at least partly – be linked to the value IT creates for the business. Financial decisions will shift from being based on the merely cost of IT, to including the business value a specific IT service creates for a specific business line. The IT department is no longer treated and looked up to as an expense centre, but a value centre.

Due to the consumption-based model of the cloud, the business units gain control over the costs of the IT services. Consume more, pay more. Consume less, pay less.

Note that chargeback is not fit for every company. As an alternative for chargeback, consider showback. Showback is just reporting the cost of IT services to business units, without changing the financial accounting scheme. With showback all IT costs stay cumulated in IT. Creating this transparency can be enough to drive the shift from a cost-to a value centre.

There is a lot of debate about when to use charge- or showback. Often showback is considered less mature as chargeback. Showback can be implemented as an intermediate step to a chargeback model. Indeed, chargeback can have some negative side effects, especially in less mature organizations with an inefficient IT department. However even in the most mature environments showback can be the better option. The decision is often rooted in the way P&L is handled.

A new love affair

This exercise is not easy. Adopting cloud will have an impact on accounting. The accounting scheme will impact how the cloud is set up. For example, how resources are organised in hierarchies and via tagging. A status quo is not possible. The CFO and members of the finance team need to come together with engineers. This will cause the biggest culture shock since Pocahontas first made eye contact with captain Smith. But didn’t that end up in a beautiful love affair?

Further reading