What is a Cost Model and why is it needed?

Most research papers do not explicitly call out the need for or importance of a cost model, when in reality it is an enabler of many ITFM disciplines.

Much of the discussion with IT Financial Management (“ITFM”) refers to the different disciplines and outcomes or views of ITFM, but most research papers do not explicitly call out the need for or importance of a cost model, when in reality it is an enabler of many of the ITFM disciplines (such as Spend Management, Strategic Investment, Service Costing, Benchmarks, Cost Optimization and Business Value).

What is a cost model?

 Gartner defines the purpose of a cost model as follows: "To define the data structure required to aggregate and allocate sources of spend and consumption data into a common data construct" (from “Build a Focused ITFM Cost Model and Use a Simple Allocation Approach to Deliver Rapid Value” by Robert Naegle & Chris Ganly, 2020).

In simple terms, a cost model achieves the following:

  • It combines the General Ledger spend, services and consumption data/service relationships, and creates data that enables views, transparency and insights of that spend.
  • It comprises the allocation logic from source to consumer, while enriching data through the process.
  • It provides the internal rules of who can allocate to whom, and the rules that govern how costs flow.
  • It defines the services (things to measure or price up), and then allocates spend into those services and out from those services to the consumers.

What are the Benefits of a Cost Model?

A cost model is an enabler of many benefits, as follows:

  • It enables multiple views of spend.
  • Doing so, it creates the transparency needed to manage your spend effectively.
  • It creates a repeatable data structure, which with the aid of automation can be maintained (e.g., introduction of new services) and regularly refreshed (monthly, quarterly, annually).
  • When well designed and built for scale, it allows for expansion and inclusion of new views as stakeholders’ requirements evolve (e.g., “Could I please see the total cost of our most expensive application?”).
  • It forms a detailed baseline for future Budgets and Forecasts.
  • It allows comparison between scenarios.
  • It forms the basis of showback and chargeback.

A cost model can be housed in many tools, such as Excel (which is a common birthplace for cost models) or the General Ledger (we cover this in this post). However, as data increases, allocation keys change, the model requires regular updating, new products and services are introduced, and stakeholders demand more insight and what-if scenarios, a tool like Excel is simply not agile enough or scalable to meet the needs.

This is when an ITFM tool like MagicOrange comes into play to automate your cost model and provide the flexibility you need to expand and evolve your cost model rapidly and at scale, while providing comprehensive self-service analytics.

Written By : Blake Davidson

Blake heads up Customer Success at MagicOrange and has experience in ITFM and Shared Services Finance. He has completed numerous ITFM implementations across many sectors including Financial Services, Retail, Manufacturing, Mining and Government