Indirect Costs

Indirect costs are costs that benefit more than one cost object and cannot be assigned to any single one without some form of allocation. Shared infrastructure, a central service desk, enterprise security, IT management and office space are typical examples in technology. Each supports many applications, services or business units at once, so there is no obvious way to say how much of the cost belongs to each.

Indirect costs are a large and often growing share of technology spending, because consolidation and shared services move work out of individual teams and into common platforms. For IT financial management, how indirect costs are allocated determines how fair and credible the cost of each service, application or business unit looks. Poor allocation creates disputes and misleading decisions, while good allocation turns shared costs into useful information.

Definition of Indirect Costs

An indirect cost is a cost incurred for the benefit of multiple cost objects that cannot be traced to any one of them in an economically feasible way. Indirect costs are assigned to cost objects through allocation, using a basis that approximates how each object consumes the shared resource.

Indirect costs contrast with direct costs, which can be traced specifically to a single cost object. Whether a cost is indirect depends on the cost object: a shared database platform is indirect for each application that uses it, but direct for the database service itself.

Indirect Costs and Overhead

The terms indirect costs and overhead are often used interchangeably, but they are not identical. Overhead costs usually refer to the general costs of running the organization, such as administration, facilities and management, which are not tied to producing any particular output.

Indirect costs is the broader term, covering any cost that is shared across cost objects. Shared infrastructure that directly supports service delivery, such as a network or a storage platform, is indirect to each service but is not usually described as overhead.

Common Indirect Costs in Technology

Common indirect technology costs include shared data center and cloud infrastructure, networks, identity and security services, the service desk, monitoring tools, enterprise architecture and IT management.

Many of these are the platforms that make it possible to deliver individual services efficiently. Their costs are real and often substantial, but because they are shared, they only reach individual services and business units through allocation.

The indirect share of technology costs tends to rise as organizations consolidate. Replacing ten department-run servers with one shared platform reduces total cost, but turns what were direct costs of each department into indirect costs of a shared service, which then need a fair allocation method.

Importance of Indirect Costs in IT Financial Management

Indirect costs make up a large share of most technology budgets. Leaving them out understates the cost of every service, while allocating them poorly distorts comparisons and decisions.

Allocating indirect costs well is one of the central challenges of IT financial management, and one of the main reasons organizations adopt structured costing approaches.

The goal is not perfect precision, but allocations that are reasonable, consistent and understood by the people who receive them.

Full Cost of Services

The full cost of a technology service includes its direct costs plus a fair share of the indirect costs that support it. Without indirect costs, services look cheaper than they really are, and comparisons with external providers, who must cover all their costs, are misleading.

A Technology Business Management (TBM) model allocates indirect costs through layers, from cost pools to towers to solutions to business units, so each service carries its share of the shared platforms beneath it.

Fairness and Behavior

How indirect costs are allocated affects behavior. Allocations based on consumption, such as users, devices or compute hours, give business units a reason to manage their demand. Allocations based on broad measures, such as revenue, give no such signal.

Fairness also matters for trust. Business units that feel their allocations are arbitrary tend to dispute them, which can undermine the whole costing effort. Transparent, consistent and explainable allocations build confidence. Showing allocations alongside the underlying consumption data, for example through IT showback, lets business units check the figures for themselves.