To ABC or not to ABC?

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To ABC or not to ABC?

“A cost allocation research for tariff setting at the Philips Global Service Unit IT Services”

By

Walter-Willem van den Berg June 2004

University of Groningen, The Netherlands Faculty of Management and Organization

Public Version

Figures are Fictive

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To ABC or not to ABC?

“A cost allocation research for tariff setting at the Philips Global Service Unit IT Services”

Author:

Walter-Willem van den Berg Student International Business Faculty of Management and Organization

University of Groningen Supervisor Philips:

David Resnekov

Finance Director, GSU IT Services and GSU Finance Shared Services Royal Philips Electronics N.V.

Supervisors University of Groningen:

Drs. M.P. van der Steen Department Financial Management Faculty of Management and Organization

Drs. A. Smeenge

Department Financial Management Faculty of Management and Organization

Date:

14 June 2004

‘The author is responsible for the content of the master’s thesis, the copyright of the master’s thesis rests with the author’

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Management Summary

This research paper reports about the results of a graduation assignment at the General Service Unit IT Services (GSU) of Royal Philips Electronics N.V. (Philips). The GSU, one of the standing organizations of the Corporate IT department (C/IT), provides a range of IT services that support the operation and exploitation of the non-business specific technical and information infrastructure. These services are available worldwide to all Philips organizations. A limited number of Philips Global Network (PGN) access and Deploying Intranet Applications and Messaging On Notes and Domino (DIAMOND) services, support Philips trading relationships with third parties and, in this sense, are shared outside the company. The GSU recoups the costs of providing these services from the business on a non-profit basis. The majority of services have tariffs set by the GSU, but a few are funded at corporate level. The GSU is responsible for controlling the costs of these global and regional services provided to its customers, i.e. the Philips Product Divisions (PDs).

The DIAMOND service is one of the services the GSU is providing. The Management Team noted that there are cross-subsidies in place which result in a lack of transparency and costs being recovered through the Diamond Basic Mail service that are related to other business applications. In order to improve the transparency within the DIAMOND service, the Management Team decided to research this problem. The Management Team of the GSU required a full transparent cost reporting system, minimal cross-subsidies and the most suitable driver for billing purposes. The objective for this assignment is to give the GSU a theoretically based judgment and recommendations to improve the transparency of the charges to customers and to get better insight into cross-subsidies. The main question of this research paper is formulated as:

‘Which financial cost allocating method should be used in a services oriented organization, such as the GSU, according to proper theories for optimal control and management?’

In order to research a problem two types of data may be used, primary data and secondary data. Both types of data have been used for this research. First of all, the Intranet of Philips, an online databank of Philips with a lot of shared knowledge (secondary data). Secondly, different Philips personnel of the C/IT are interviewed to collect data that could not be found on the Philips Intranet and the Internet (primary data). Thirdly, specific books and articles are used, discussing financial management accounting and research subjects, in which proper scientific theories could be found (secondary data).

A selected number of cost allocation methods are described and analyzed to answer the main question.

• Traditional costing system

• Target costing

• Kaizen costing

• Life cycle costing

• Production center method

• Activity Based Costing

Theoretical insights about these methods provided a basis in selecting and judge one of them. Finally ABC has been chosen. ABC has been chosen, as it is the most complete and accurate cost system useful in most businesses. Besides ABC also proved to fit all the characteristics and criteria of the GSU, large company, hierarchic, centralized, shared service center, diverse services, complex services, tight budget control, cross-subsidies, cost-driver driven and transparency.

ABC is a cost price system allocating cost prices by analyzing which activities are necessary to deliver a certain product/service. Inventorying the activities and applying the costs of these activities, the costs are spread. Allocation is done with the help of cost drivers, which relate the costs among the cost objects. In this case the cost objects are the services delivered by the DIAMOND service. The core of an ABC model lies on the word “activity”. Activities are the focus of the costing process. Costs are traced from activities to product(s)/service(s) based on the product(s)/service(s) demand for these activities during the production process. At the same time, costs are also the result of resource usage to perform activities.

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A selected number of authors and their theories have been taken into account. Taking all the authors into account was not possible within the limits of this research. The designed model is based on the CAM-I ABC model (1988) and Kaplan and Cooper (1998).

Figure: Designed ABC model

The ABC model has been put in practice after design by implementation of the DIAMOND service.

The first step, specify resources of an organization, has been done by using the accounts of the general company ledger and the annual operating plan (AOP) 2004. The AOP is a plan in which all the managers of the services delivered by the GSU give their view on how much their service will spend during the next year. The second step, inventory of activities, has been done by interviewing the members of the DIAMOND team in order to know which activities have to be performed delivering the DIAMOND service. The third step in the model has been done by relating the specified resources of the GSU with the created list of activities. Last step, relating the activities to the cost objects, has been done by calculating the costs of the activities and spread them among the cost objects using activity drivers.

As many activities to deliver the DIAMOND service are outsourced, a problem raised during the second step, inventory of activities. Some activity processes were unable to provide any proper insight because of outsourcing. Therefore, outsourced activities have been grouped into four groups and were to be considered an activity.

To prove the value of the designed model for the GSU, a sensitivity analysis has been done. A sensitivity analysis has been done based on two scenarios, better management of personnel and better management and structure of the infrastructure, achieving efficiency. The costs personnel and infrastructure have been decreased by 30% and 20% respectively. Both scenarios have proven changes in the activity processes have little impact on the ABC cost price of most services delivered by the DIAMOND service using the cost allocation method ABC at the GSU. Cause of this is the fact that most activity processes are being outsourced, resulting in the fact that these processes cannot be controlled by the GSU. Hence, it has proven ABC is not applicable for the GSU due to many outsourced activity processes.

Using ABC or not, a new point of discussion can be added in the choice which cost allocation method to use. Although ABC will remain the most complete and accurate cost system in order to get transparency, minimal cross-subsidies and to find the most suitable driver(s). However, it will not be able to control the costs, if most activities are outsourced as proven by the research.

Activities Activities

Performance drivers Performance

drivers Resource

cost assignment

Resource cost assignment

Cost drivers Cost drivers

Activity cost assignment

Process View (ABM) Activities are the focal point of both views

Resource Resource

Cost objects Cost objects

Resource drivers Resource

drivers

Activity drivers Activity drivers

Cost View (ABC)

Activities Activities

Performance drivers Performance

drivers Resource

cost assignment

Resource cost assignment

Cost drivers Cost drivers

Activity cost assignment

Process View (ABM) Activities are the focal point of both views

Resource Resource

Cost objects Cost objects

Resource drivers Resource

drivers

Activity drivers Activity drivers

Cost View (ABC)

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Therefore, before choosing ABC, a new point of discussion has to be added:

If yes, first of all, an organization has to analyze how many activities are outsourced. Secondly, the organization has to analyze if the outsourced activities are value added or non-value added.

If no, an organization will not have any problem implementing ABC based on this new point of discussion. Of course, it has to be mentioned that other criteria may reject the choice of ABC.

The overall conclusion is not to use the designed ABC model in the next financial year (long-term), but just during the current financial year (short-term). In the short term the GSU can report the customers with the set tariffs calculated with the help of ABC. The cost prices of the services are comprehensive and accurate. In the long term the model will not be useful, as it is not able to control outsourced activities and get better insight into these outsourced activities.

Does the organization outsource business processes to deliver a certain product/service?

YES… NO…

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Preface

This thesis is the result of my research on cost allocation, especially Activity Based Costing, over the last seven months. This final graduation project marks the end of my study in Business Administration, majoring in International Business, at the University of Groningen. After this period of studying, I look back on a successful process during which I received a lot of support from various people.

First of all, I want to sincerely express my gratitude to David Resnekov for giving me the opportunity to do my graduation assignment at Philips and for all his time and effort he spent in supporting me.

Despite David’s very busy schedule, he always found time to support me. His practical and theoretical insights into finance and knowledge were very helpful and constructive throughout writing my thesis.

Working with David was very pleasant.

Secondly, I want to especially thank my supervisors of the University of Groningen, Martijn van der Steen and Albert Smeenge. Martijn van der Steen’s theoretical insights and knowledge about the subject were very useful and constructive. He advised, guided and supported me throughout writing my thesis. Besides, he made me view problems from a different perspective and was helpful all the time. The support of Albert Smeenge primarily concerned the overall structure of this thesis in which he also advised, guided and supported me writing my thesis. Working with both of them also was very pleasant.

Last but not least, I would like to thank the persons who are not mentioned so far. With many internal and external discussions, they also supported me in achieving my goals.

This thesis is a combination of theoretical knowledge obtained during my studies, and the practical research, conducted at Royal Philips Electronics N.V. The possibility of conducting my research within a business allowed me to conduct my research in a stimulating environment and to obtain insights into several issues and the dynamics of a multinational company.

Walter-Willem van den Berg Eindhoven, June 2004

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Chapter 1 Introduction

This graduation assignment is an obligatory part of the study Business Administration, majoring in International Business, at the University of Groningen. The graduation assignment started in November 2003 at the General Service Unit IT Services (GSU) of Royal Philips Electronics N.V.

(Philips).

The GSU is responsible for controlling the costs of the Global and Regional Services provided to its customers i.e. the Philips Product Divisions (PDs). For the Global Services, which are all managed in Eindhoven, the customers are represented by the PD CIOs of each of the major PDs. Regional Services are agreed between the Regional CIOs and the customers in the region that they service. The financial management of the GSU is aimed at controlling costs and providing flexibility to Philips if parts of the company are divested. At the same time, there is an expectation that costs for mature services decrease and that service levels are maintained or improved. Within one of the services the GSU is providing, the DIAMOND service, it was noted that there were cross-subsidies in place which result in a lack of transparency and costs being recovered through the Diamond basic mail service that are related to other business applications. In order to improve the transparency within this service the Management Team decided to research this problem statement. Therefore the GSU provided a graduation assignment, developing a transparent cost reporting system to be used setting up tariffs for the customers of the GSU.

In order to know the set-up of the thesis, you will find a short overview of each chapter below. In chapter 2 the research set-up of the graduation assignment will be provided. Chapter 3 will describe the GSU and the services it is delivering. Chapter 4 will describe the main cost allocation methods known in the literature in order to choose a method solving the problem situation. In chapter 5 a cost allocation model will be designed based on the chosen cost allocation method, which has been done in chapter 4. In chapter 6 a pilot study will be done on the DIAMOND service with the help of the designed cost allocation model. In chapter 7 a sensitivity analysis will be done using scenarios. Chapter 8 will give the scientific value of the performed research. Chapter 9, at the end, will provide the conclusion, recommendations to the Management Team, based on findings during the research, and an evaluation on the performed research.

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Chapter 2 Research Set-Up

This chapter will provide a research set-up for my graduation assignment about cost allocation within a business of Philips. Philips is number one in Europe and one of the World’s largest electronics companies with sales of €29.037 billion in 2003. It is a global leader in color television sets, lighting, electric shavers, color picture tubes for televisions and monitors, and one-chip TV products. Philips has 164.438 employees who are active in more than 60 countries and sales & services in 150 countries.

Philips is organized in five relatively autonomous product divisions (PDs), namely Lighting, Consumer Electronics, Domestic Appliances and Personal Care, Semiconductors, and Medical Systems. Each PD has its own ‘staff departments’ like Strategy, Finance, Human Resources and Logistics. The business activities are organized through the PDs, businesses, regions and Country Organizations.

Figure: Organization chart Philips (Intranet Philips, October 2003)

EMEA:

• Europe

• Middle East

• Africa AMEC:

• North America, including Mexico border zone

• Canada LatAm:

• Latin America

• Central America, including Mexico APAC:

• Asia-Pacific

• Australasia

Regions

Poduct divisions:

• Consumer Electronics

• Domestic Appliances

• Lighting

• Medical Systems

• Semiconductors Other businesses:

• Centre For Industrial Technology

• Design

• Digital Systems

• Enabling Technologies Group

• Intellectual Property & Standards

• Research

• RF Solutions

• Philips High Tech Plastics

Businesses Functions

Board of Management Supervisory Board

• Corporate Functions

• Branding

• Communications

• Control

• Export Controls

• Fiscal

• Group Data Management

• HRM

• Internal Audit

• Investor Relations

• IT

• Legal

• Mergers &

Acquisitions

• Pensions

• Purchasing

• Quality

• Real Estate

• Security

• Strategic Alliances

• Strategy

• Sustainability

• Treasury

• Venturing

• Corporate Center

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This thesis is for the GSU of the Corporate IT (C/IT) department of Philips. The GSU is part of C/IT, which is one of the Philips corporate staff departments. The GSU consist of several groups as shown in the following chart.

Figure: Organization Chart (Intranet Philips, December 2003)

As already mentioned in the introduction, the research seeks to provide an answer on how the Management Team of the GSU can achieve a more transparent cost reporting system.

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Scope

In this chapter, the scope of the graduation assignment is discussed. The scope is the cost allocation of IT services within the GSU. IT is defined as “IT for business applications and generic IT for desktop users”. Excluded are all activities related to software engineering, embedded software, robotics etc.

Philips spends about 4% of its revenues annually on IT. Of this total IT spend, about 61% is spent on business specific IT including new projects, managed operations of existing Enterprise Resource Planning (ERP), Product Data Management (PDM), Customer Relationship Management (CRM) and Environmental Information Services (EIS) systems, depreciation and staffing. The other 39% is spent on generic IT infrastructure, including service provision for more than 100,000 users worldwide. A shared services unit, the GSU provides a substantial part of this service.

The distribution of IT costs at Philips is as follows:

Figure: C/IT distribution costs of IT (Intranet Philips, November 2003)

The GSU provides a range of IT services that support the operation and exploitation of the non- business specific technical and information infrastructure. These services are available worldwide to all Philips organizations. A limited number of Philips Global Network (PGN) access and DIAMOND services, support Philips trading relationships with third parties and, in this sense, are shared outside the company. GSU recoups the cost of providing these services from the business on a non-profit basis. The majority of services have tariffs set by GSU, but a few are funded at corporate level.

The mission of the GSU is:

“GSU delivers a portfolio of IT services of agreed levels of quality¹ at (below) market prices to Philips businesses, as an internal business with a zero IFO target”.

The portfolio of GSU is decided by the Philips IT Policy Board and the architecture is designed by C/IT / Office of the CIO.

GSU operates on behalf of the internal Philips organizations, based on an optimal customer alignment.

1 Disclaimer: Quality can be below expectation due to influence of third parties.

Business Applications

Operations 41%

New development 20%

Network Application and E-mail 4%

Wide Area Network 4%

Local Infrastructure

Desktop 11%

Local Area Network 6%

Telecommunication 8%

Other 6%

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Problem Statement

Based on the scope, the problem statement for the thesis needs to be defined. The problem statement will be divided into an objective, the main question and appropriate sub-questions (De Leeuw, 1996).

The objective of this graduation assignment will be formulated as:

‘To give the GSU theoretically based judgment and recommendations to improve the transparency of the charges to customers and to get better insight into cross-subsidies’

For optimal controlling and management, the GSU Management Team requires the following:

• A transparent² cost reporting system

• Minimal cross-subsidies³

• The most suitable cost driver⁴ for billing their services

First of all, it is known that there are cross-subsidies in place, which result in a lack of transparency, and costs being recovered through the DIAMOND Basic Mail service that are related to other business applications. Secondly, the costs of the global services have to be separated in fixed and variable costs to provide the Management Team with better quality information upon which to set future tariffs for the portfolio of services.

To see how these shortcomings can be eliminated the main question of the graduation assignment will be formulated as:

‘Which financial cost allocating method should be used in a services oriented organization, such as the GSU, according to proper theories for optimal control and management?’

In order to answer the main question, it is important to break it down into sub-questions:

1. How is IT managed within Philips?

2. Which cost allocation methodology best meets the GSU Management Team’s requirements (i.e.

full transparent cost reporting system, minimal cross-subsidies, most suitable driver for billing services)?

3. Is the selected cost allocation methodology appropriate for the GSU Global Service “DIAMOND”?

4. Has the initial analysis for the DIAMOND service confirmed the choice of methodology?

5. Should the chosen cost allocation method be implanted as tool for the Finance control, according to proper theories?

2 Transparent: A system of reporting data that provides clear, readily understandable and meaningful information upon which management can make business decisions. There should be no hidden cross-subsidies.

3 Cross-subsidy: Using the extra profit on a product/service for the development or promoting of another product/service.

4 Cost driver: Any factor that causes a change in the level of activity.

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Conceptual Model

In the conceptual model, you can see how the different sub-questions are related to each other.

Secondly, it gives a “quick picture” about the problem the GSU is dealing with. The model scope is based on top management level, which means it is on the highest hierarchical level within Philips.

Philips is allocating its costs with a particular cost accounting method. This method has to be compared with Activity Based Costing in particular and with other scientific theories.

Figure: Conceptual Model

In the following scheme you will see how the different sub-questions are discussed in the chapters of this graduation assignment.

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Methodology

This section will discuss the methodology used by this research.

A) Data Collection Method

There are two types of data (Saunders, et al 2000):

1. Primary Data:

Data gathered and assembled specifically for the research project at hand

Distinction between qualitative and quantitative research methods

2. Secondary Data:

• Data that have been previously collected for some project other than the one at hand

• Can be internal or external to the organization

Both types of data are used for the graduation assignment and are found in several ways. First of all, the Philips Intranet, an online databank of Philips, with a lot of shared knowledge (secondary data).

Secondly, different Philips personnel of the C/IT have been interviewed to collect data that cannot be found on the Philips Intranet and the Internet (primary data). Thirdly, specific books and articles are used, discussing financial management accounting and research subjects, in which proper scientific theories could be found (secondary data). If necessary, more resources have been used/chosen where there was insufficient data.

B) Constraints

The following constraints have been determined by Philips and the University of Groningen to do this graduation assignment:

• The graduation assignment has to be finished at the end of May 2004

• The graduation assignment should focus on the following deliverables:

o Practical application of the ABC-methodology for the DIAMOND service

o Demonstrate management and cost accounting knowledge in the analysis of the fixed and variable costs of the GSU

o Recommendations as to how the GSU could achieve greater transparency in relation to the reporting of fixed and variable costs for the global GSU services

• The paper has to meet the requirements of the course “International Business” of the master study “Business Administration”

• The content of the paper, which will be made public, has to be in consultation with Philips requirements

Conclusion

This chapter has provided a research set-up containing; the scope, objective, main question, sub- questions, conceptual model and methodology. These items are described, in detail, and will be the guideline for the performed research. The next chapter will provide insight information about the C/IT department and services delivered by the GSU in order to get more common with the organization and the delivered services.

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Chapter 3 Philips Corporate Information Technology & Services

This chapter, offers background information about the C/IT department. First of all, IT within Philips will be discussed. Secondly, the C/IT organization will be discussed. Thirdly the main boards and committees will be discussed which support the alignment of Philips IT at top-level. The last part of this chapter will discuss the C/IT standing organizations, the GSU and the Office of the CIO. GSU will be covered in more detail, as this is the organization for which this graduation assignment has been performed.

Information Technology in Philips

The following paragraph will discuss how IT is being managed within the Philips organization. It is important to describe the term “IT” according to Philips more explicitly to better understand the term, in context with the research. This description will be based on the Philips corporate directives for IT (2002).

IT within Philips comprises the application of technology to commercial, financial and industrial business processes. This includes IT for:

• Business information systems

• Supporting tools and applications

• Office automation and personal computing

• Communications and processing

• Technical infrastructure

Described IT within Philips could be business or non-business specific IT. This differentiation originates from the mid nineties. Since this time Philips is using generic and business specific IT activities instead of infrastructure activities as also the term “IT”. Non business-specific IT of Philips consist of:

• Technical infrastructure, including the Philips Global Network (=PGN), the communication and collaboration environment and the desktop environment

• Information infrastructure, including the management of corporate data

• E-business applications common across two or more PD’s

• Strategic control, including cost and quality control and IT-Management Development

Business-specific infrastructure and services are specifically designed to support the needs of a particular business. Their design and implementation is the responsibility of the PD’s or other business units.

Non-business specific infrastructure and services are standardized across Philips. The standardization facilitates multinational, cross-organizational working and adoption of new technologies and products.

It eliminates duplication of effort and helps to contain costs.

Corporate IT

The C/IT department is one of the corporate staff departments of Philips. The function of Philips C/IT is to add value to the business by establishing policy guidelines for effective application of information technology and ensure the provision of the technical and information infrastructure needed to support Philips company's business strategy. C/IT is responsible for provision of the non business-specific infrastructure, infrastructure services and solutions shared by two or more of Philips PD’s. They are responsible for ensuring that these services are available across Philips geographic and organizational boundaries. Furthermore, they design and procure, in consultation with Philips PDs, the products and services that constitute the common infrastructure in their organization.

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Functions included by the C/IT department are:

• Development of a C/IT vision to support the Concern business plan and the policies necessary for its successful implementation

• Setting of corporate standards to ensure inter-connectivity and inter-operability of information and communications and monitoring adherence

• Provision and procurement of an effective and efficient C/IT infrastructure

• Definition and management of investment projects to extend and enhance the shared IT infrastructure

• Delivering value to the management of businesses through:

o Review and assessment of critical IT investments

o Enforcement of corporate message and data standards essential for sharing information o Enforcement of security and contingency standards to minimize risk managing the MD

process for all key IT positions

The mission of Philips C/IT is, to provide the information and technical infrastructure solutions needed to support business requirements across organizational and geographic boundaries. This includes leveraging both internal and supplier relations at corporate level to control investment.

The vision is to ensure state-of-the-art IT infrastructure and services, globally available, at lower than market cost, with functional leadership for IT focused around four IT domains.

C/IT develops its strategy in order to satisfy requirements at business and enterprise level for non- business specific IT infrastructure and solutions that can be widely shared across the company.

Infrastructure enhancements and solutions are developed by the C/IT programs. Where a solution is mandatory or widely used across the enterprise, it is developed as a service. C/IT procures these services from third party suppliers on behalf of the company. C/IT is responsible for managing the operation of these services.

IT Boards and Committees

As already mentioned IT at top-level within Philips is supported by several boards and committees.

This paragraph will describe the main IT boards and committees at Philips. Main boards and committees are:

• The IT steering committee

• The IT policy board

• The CIO meeting

• The domain boards

• The global and regional customers meeting

• The IT architecture board

The IT steering committee is chaired by a vice chairman of the Board of Management. Together with the CEO’s of the product divisions, Philips’ CIO and a representative from Research, they are responsible for the alignment of the long-term enterprise IT strategy with the long-term strategy of the business. The IT steering committee meets three times a year and they confirm decisions that are put forward by the IT policy board.

The IT policy board is responsible for approving Philips’ IT strategy and makes decisions on IT projects with high financial impact. The members of the policy board consist of the CIO’s of the product divisions, the Philips CIO, representatives of Research and the Corporate Center and are also led by a vice chairman of the Board of Management. They meet 4 times per year. The IT policy board will also meet 2 or 3 times per year to specifically discuss IT services. They will determine the service portfolio and the service tariffs, and monitor service delivery in terms of costs, quality and customer satisfaction.

The CIO meeting is the one constituted by the Philips CIO, the CIO’s of the PD’s and the Research CIO together. This meeting is chaired by the Philips CIO and meets 8 times per year. The CIO meeting is responsible for the development and deployment of Philips’ IT policy regarding strategy,

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organization and management development, the technology direction, the enterprise architecture, innovation programs and service portfolio. They also monitor the service delivery of the General Service Unit, assess quality and risks in organizations and monitor IT costs. The figure below shows the above described boards and meetings.

Figure: IT boards and committees (Intranet Philips, February 2004)

The IT domain boards prepare strategy, policies, directives and standards to the CIO meeting/IT policy board and will deploy them after agreement. Their objective is to ensure consistent development of Philips’ IT strategy through effective steering of programs within their area of responsibility. They represent all business interests in order to maximize alignment with business priorities. They are composed of representatives from the PD’s, the C/IT innovation programs and IT services, and are chaired by an IT domain manager. The figure below depicts a structure for discussions for the domain boards within the C/IT department and other boards and committees. The figure below shows the describes the IT domain board.

The global and regional customers meeting is the one constituted by the meetings of the IT policy board.

Figure: Governance structure including domain boards (Intranet Philips, February 2004)

The IT architecture board, finally, encourages integration of the divers architectures underlying both different IT domains and the IT environments of the businesses.

IT steering

IT policy board

CIO meeting

IT domain boards

Domains PD’s

IT STEERING COMMITTEE Chair: Vice Chairman BoM Members: PD-CEO’s, Research, Philips CIO

Three Meetings/Year

IT POLICY BOARD Chair: Vice Chairman BoM

Members: PD -CIO’s, Research, Corp. Centre, Philips CIO

Four Meetings/Year

CIO MEETING Chair: Philips CIO Members: PD-CIO’s, Research-CIO

Eight Meetings/Year

Define & Deploy:

-Strategy -Organization/MD -Technology Direction -Enterprise Architecture

-Innovation Programs -Service Portfolio Monitor Service Delivery

Assess Quality/Risks Monitor IT Costs Make decisions on operational level

Make decisions on subjects with strategic and/or high financial

impact.

Business Ownership / Alignment Make/confirm decisions put

forward by the IT Policy Board IT STEERING COMMITTEE

Chair: Vice Chairman BoM Members: PD-CEO’s, Research, Philips CIO

Three Meetings/Year

IT POLICY BOARD Chair: Vice Chairman BoM

Members: PD -CIO’s, Research, Corp. Centre, Philips CIO

Four Meetings/Year

CIO MEETING Chair: Philips CIO Members: PD-CIO’s, Research-CIO

Eight Meetings/Year

Define & Deploy:

-Strategy -Organization/MD -Technology Direction -Enterprise Architecture

-Innovation Programs -Service Portfolio Monitor Service Delivery

Assess Quality/Risks Monitor IT Costs Make decisions on operational level

Make decisions on subjects with strategic and/or high financial

impact.

Business Ownership/

Alignment Make/confirm decisions put

forward by the IT Policy Board

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C/IT Standing Organizations

As already mentioned C/IT is divided into two standing organizations, the GSU and Office of the CIO.

The GSU manages all aspects of infrastructure service management. This is intended to ensure a reliable, quality service to all countries and organizations. The Office of the CIO manages services such as competence centers and license administration.

Figure: Organization scheme Philips C/IT (Intranet Philips, November 2003) The GSU

The GSU, one of the standing organizations of C/IT, within Philips delivers a portfolio of IT services of agreed level of quality at (below) market prices to Philips businesses. The GSU is responsible for

‘service management’, which includes contract management, service level management, and demand management. They are also responsible for management of ‘service improvement projects’. The portfolio of the GSU will be decided by the IT Policy Board and designed by the Office of the CIO.

The GSU does not perform any R&D activities themselves. Neither do they initiate service projects.

The GSU works on a demand and supply basis. Besides this they operate full on behalf of the internal Philips organization, based on an optimal customer alignment. The service portfolio supports the needs of Philips’ businesses for technical and information infrastructures and standard applications. The portfolio for the long term includes generic IT infrastructure services, common core application services and application services for business applications on request of the businesses. The vision of the GSU is to be a professional customer-centric internal IT services management & delivery organization.

GSU is a shared IT Service organization with a target of zero income from operations (IFO). All their costs, approximately 20% of the total IT costs, are covered by their service tariffs. The service tariffs are based on uniform tariff structures.

GSU are produced and managed all over the world. The GSU makes a distinction between six IT regions. The six regions are Asia, Benelux, Latin America, Middle & East Europe, North America and West & South Europe. Each region consists of several clusters and countries. At each geographical

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level, there are managers who are responsible for one of the infrastructure service areas or another application service area. Although service delivery is coordinated centrally it depends on the characteristics of the service how it is executed. Global, regional or local level. A quick view on the strategic direction of the GSU and a description of the Office of the CIO will be given after a description, which services the GSU delivers.

Figure: GSU governance model (Intranet Philips, February 2004) The GSU Deliverables

As already been known C/IT provides a range of IT services, done by GSU that support the operation and exploitation of the non-business specific technical and information infrastructure. Main services are:

• Common Application Services

• Common Office Desktop Environment

• Deploying Intranet Applications and Messaging On Notes and Domino

• Philips Global Network

• Information Technology Security

All these services are available worldwide and to all Philips organizations. As the main objective for the graduation assignment is DIAMOND this service will be discussed in more detail than the other services.

The Common Application Services (CAS) is delivering specific application maintenance and support services to corporate functions. Currently CAS is containing 4 departments. CAS - Control is servicing Corporate Control, CAS - Treasury is servicing Corporate Treasury and CAS - PGP is doing the same for Philips Global Purchasing. CAS - ADS is a common Application Development and Support offering solution for all Philips departments with a focus on the Philips Corporate Center.

The Common Office Desktop Environment (CODE) program provides Philips-wide standardization of desktop hardware and software. The standard, managed desktop environment supports end-to-end, compatible communications across the enterprise. It promotes synergy in application management across the company. It has delivered increased productivity through elimination of version incompatibility and simplification of support.

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Deploying Intranet Applications and Messaging On Notes and Domino (DIAMOND) is Philips standard, company-wide electronic messaging environment that supports a number of e-Mail, Collaboration and Application services. DIAMOND provides a managed backbone infrastructure at enterprise level to enable first of all the standardized, internal and external electronic mail for all Philips employees. Secondly it is hosting applications.

The Philips Global Network (PGN) is the company’s common infrastructure for data, voice, video and multimedia communications. It supports the needs of over 110,000 people in approximately 650 sites spread across 70 countries. It brings further benefits through its ability to share resources within Philips and the Internet community. This increases flexibility in establishing connections between Philips sites and business partners.

The Information Technology security (IT Security) program provides the necessary facilities to ensure that the risk to all aspects of Philips’ IT environment is acceptable. Those facilities include policies, organizations, security tools and services. The program ensures that policies and tools are effectively deployed throughout Philips.

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Strategic direction Vision

GSU aims to be a professional Customer Centric internal IT Service Management & Delivery organization, which contributes to structural reductions of IT costs together with maximizing value for our customers.

Mission

GSU delivers a portfolio of services of agreed levels of quality at (below) market prices to Philips businesses, as an internal business with a zero IFO target.

Values

• Delight Customers

• Deliver on Commitments

• Develop People

• Depend on each others Strategy

• The portfolio of GSU is decided by the Philips IT Policy Board and created by the Philips CIO Office

• GSU operates on behalf of the internal Philips organization, based on an optimal customer alignment

• GSU is a single global organization with centralized management of all aspects of the

• Service portfolio to achieve maximum efficiencies

• Service management is executed at global, regional and local levels to provide the highest level of customer support

Figure: One Page Strategy of the GSU (Intranet Philips, January 2004)

Business enablers Leadership

• Establish IT Services as one global organization

• Develop Customer alignment as key differentiator

• Implement values

Policy & Strategy

• Cost reduction through leverage, consolidation and standardization

• Flexibility in sourcing to enable flexibility in service delivery

• Professional operational service delivery together with maximum customer alignment

People

• Recruit, develop and retain a professional team with an open and pro-active mindset and a forward looking attitude

• Stimulate and enable job-rotation and skill development

• Reward in line with values &

performance

Partnerships & Resources

• C/IT: Maximum alignment &

cooperation between Programs &

Services

• Customers: Involve customers in service development

• Suppliers: Continuously manage supply base to optimize costs and quality of services

• Leverage of internal resources

Processes

• Implement the IT Infrastructure library foundation for all service management processes

• Measure process maturity using the IT Process Service Tool

• Have excellent processes in place with appropriate People Performance Indicators

• Measure Customer Satisfaction with periodic Customer Surveys

Results Financials

• Complete cost coverage

• Benchmarked price performance of services

• Improve price performance of services

Customers

• Improve Customer Satisfaction

• Increase number of signed off Service Level Agreements (SLA’s)

• Meet Key Performance Indicators agreed upon in SLA’s

Processes

Improve maturity of:

• Service Planning

• Service Development

• Service Deployment

• Service Delivery

• Customer Management

Competence

• Completeness of portfolio with competency descriptions

• Fill out IT Management positions with adequate staff

• Identify talent

• Succession plan for key positions

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Office of the CIO

Office of the CIO, the other standing organization of C/IT, will not be discussed in detail as the Office of the CIO does not fit in the scope of the graduation assignment. The Office of the CIO is responsible for optimizing the value of Philips’ investments through providing an environment that fully supports the needs of the PD’s at a minimal cost. The Office of the CIO consists of four facilitating departments and four functional IT domain boards.

The facilitating departments are:

1. IT purchasing 2. IT-control 3. IT-HRM 4. IT-governance

The functional IT domain boards:

1. Enterprise Computing Infrastructure 2. Enterprise IT Architecture

3. Enterprise Applications

4. Enterprise Communication & Collaboration

The objective of the IT Domain Boards is to ensure development and deployment of Philips’ IT vision and strategy. This is done by effective steering of programs within the area of responsibility of the domain boards. The domains provide functional responsibility for IT at corporate level as well as technology innovation in order to realize an 'IT enabled' Philips. They help to define the portfolio of program groups for the Office of the CIO and are responsible for their strategic direction setting.

DIAMOND

As already mentioned, The DIAMOND service will be discussed in more detail as it is the main objective of this graduation assignment.

Philips has a standard, company-wide electronic messaging environment that supports a number of e- Mail, Collaboration and Application services. These services are collectively known under the name DIAMOND (Deploying Intranet, Applications and Messaging On Notes Domino). DIAMOND provides a managed backbone infrastructure at enterprise level to enable:

• Standardized, internal and external electronic mail for all Philips employees

• Hosting of applications

The DIAMOND team is organized in 3 responsibility areas for the DIAMOND Mail & Infrastructure and Application Services. Those areas are:

• Service Development

• Service Delivery

• Customer Relations Management

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Service Development is responsible for the creation and evaluation of new services or service functionality in the DIAMOND service. New developments can be program driven or based on Enhancement Requests (ER) asked for by DIAMOND service customers. An accepted ER is input for a business case. When accepted new developments are started, mostly in projects. Projects are carried out and implemented in a new service.

Service Delivery is responsible for the delivery of the DIAMOND services according to the Service Level Agreement (SLA). The activities are based on ITIL process:

• Incident management and problem prevention

• Problem Management

• Change Management

• Release Management

• Asset and Configuration Management Tactical management focuses on:

• Service Level Management

• Availability Management

• Capacity Management

• Financial Management

• Benchmark and Improve Service

Customer Relations Management is responsible for the relations with the customers. The activities are:

• Build customer relations

• Market knowledge regarding customer needs based on the business plans

• Feedback of the customers needs and requests for improvements

• Monitor customer satisfactions with DIAMOND services

• Initiate customer support

• Manage service contracts with customers

• Promote Services

• Communicate service role and service plans to customers

• Facilitate and communicate Release Policy

• Maintain customer base DIAMOND Facts and Figures

Number of users 100.000

Number of messages 10 per user per day Average message size 130 kb

Points of presence 62 Countries with server presence 47

Number of servers 400

Figure: DIAMOND fact and figures (Intranet Philips, October 2003)

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Service Description

Each registered user has a personal mailbox. The functionality offered includes:

• Ability to create and reply to messages

• A single Philips directory

• Archiving of mails

• Facilities to support mobile and remote users

• Encryption and signature authentication

• Task management

• Delegation of mail management

• Calendar and scheduling

Figure: Service description DIAMOND (Intranet Philips, October 2003) Business Benefits

Global e-Mail system, interconnecting geographically dispersed locations and supporting tens of thousands of users. Accessible through the Philips Global Network (PGN TCP/IP network) or dial up connections. Availability and performance monitored and managed on a 7x24x52 basis. Service includes resolution of all problems associated with the hardware and software of the DIAMOND infrastructure.

Architecture

Service provision is globally split across three regions, the active service center following the sun. The DIAMOND mail topology is implemented with five regional domains, which are connected through a mesh topology. A hub and spoke design is implemented within ach domain.

The backbone design supports customer requirements in terms of traffic volume, reach and customer locations, and takes account of user profiles, distribution of user locations and quality requirements.

The design specifies the exact choice, placement and sizing of the hardware and software building blocks. State-of-the-art hardware and software is installed to provide a high-availability service. The deployment includes all system management functions.

BASIC Service OPTIONAL Service

Corporate Messaging directory •Mailnames and adress •Extranet mail names and directory for users on notes adress directory service to

support extranet on

Notes/Domino infrastructures

Mail •Mailbox (< 50 MB) •Mailbox extensions of 50 MB

•Access via Notes Client •Extranet Notes/Domino

•SMTP mail connections mail services for participating

members in an exranet Calendar & Scheduling •Personal diary

•Group Calendar & Scheduling

providing group scheduling, time management and task management

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Figure: DIAMOND E-mail Routing (Intranet Philips, December 2003) Tariff Base

C/IT charges user organizations a flat fee according to the number of mail-users per Funloc in the DIAMOND directory. This tariff covers:

• Use of the centrally managed DIAMOND system

• Use of the Notes mail backbone, the mail servers and all software licenses

• Connection to the Internet

• A mailbox of up to 50 Mb (Mailbox sizes above 50 MB are available for an additional fee per 50 MB/user/month)

• A Notes ID with electronic keys to provide authentication and electronic signing

• Publication of e-Mail addresses in a single, global directory Service Ordering

The service can be requested by any Philips organization through the Group and User Management (GUM) tool.

Service Level Agreement

A Service Level Agreement with the managed-operations supplier AtosOrigin, plus underpinning contracts with Lotus, IBM, HP, Legato and Tivoli, governs the out-sourced part of the DIAMOND service. Availability and performance of service components is monitored and managed on a 7x24 hour’s timeframe. Resolution of any problems with the hardware equipment and software is managed globally.

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Service Support Organization

The Service Support organization is consistent for e-Mail, SameTime and PEACE. First contact for the user experiencing problems is the local Helpdesk. The Helpdesk decides whether it is a client or an infrastructure problem. Infrastructure problems are raised with the Service Provider and a severity status assigned. The Service Provider is obliged to solve the problem within a defined time frame.

Figure: Service Support Organization (Intranet Philips, December 2003) Conclusion

This chapter should have helped to get common with IT within Philips, the C/IT organization and the delivered services by the GSU. IT within Philips comprises the application of technology to commercial, financial and industrial business processes. Six different boards and committees support IT at top level. The GSU, one of the two standing organizations, delivers a portfolio of IT services of agreed level of quality at (below) market prices to Philips businesses. The GSU is responsible for service management and service improvement projects. The portfolio is described by the other standing organization, the Office of the CIO. The Office of the CIO has not been discussed in detail as it is out of the research scope. The deliverables of the GSU are, CAS, CODE, DIAMOND, PGN and IT Security. DIAMOND has been described in detail as it is within the research cope of this graduation assignment. DIAMOND is Philips standard, company-wide electronic messaging environment that supports a number of e-mail. Delivered to 100.000 users. The next chapter will discuss the different cost allocation methods in order to choose one and design a model.

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Chapter 4 Cost Allocating Methods

This chapter highlights on the methods to allocate costs to answer the research question: “Which cost allocation methods used best meet to the GSU Management requirements (full transparent cost reporting system, minimal cross-subsidies, most suitable driver for billing services)”. Besides this it is also important to know that cost allocation is an inescapable problem in nearly every organization and in nearly every facet of accounting.

Cost Types

In financial accounting terms two types of costs exist (Drury, 1998):

Direct costs: These costs can directly be assigned to a product or activity (the organization’s results).

For example: dedicated servers for applications, software and consultants.

Indirect costs: These are overhead costs, which are not directly assignable to a product or activity: For example: management, communication and human resource

Besides direct and indirect costs, costs can also be fixed or variable:

Fixed costs: These costs remain constant over wide ranges of activities for a specified time period.

Variable costs: These costs vary in direct proportion to the volume of activity; that is, doubling the level of activity will double the total variable costs. Consequently, total variable costs are linear and a unit variable cost is constant.

Purposes of Cost Allocation

There are four essential purposes of cost allocation:

• To provide information for economic decisions

• To motivate managers and other employees

• To justify costs or compute reimbursement

• To measure income and assets for reporting to external parties Allocating Costs

Three methods are widely used to allocate the costs of support departments to operating departments:

• Direct allocation method

• Step-down method

• Reciprocal method

The direct method, allocates support department costs to operating departments only. The second method, step-down, allocates support department costs to other support departments and to operating departments. The third method, reciprocal, allocates costs by including the mutual services provided among all support departments.

The direct method and the step-down method are less accurate than the reciprocal method when support departments provide services to one another reciprocally.

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There are different cost allocation methods to perform a cost analysis. The methods differ in which costs are calculated and how costs are allocated. The following is a description of six different selected cost allocation methods.

Traditional Costing Systems

Traditional cost accounting systems use bases like direct labor hours and machine hours to allocate to products and the expenses of indirect and support activities, including engineering changes, setups, and parts of maintenance. This instead of using more realistic cost drivers. However, direct labor and machine hours often do not adequately represent the percentage of indirect resources consumed by a certain cost object in a certain period. As a result, product/service cost distortion occurs as the system focus on products and not activities related to the product/service.

Traditionally, the costs of manufacturing a product have been categorized as direct material, direct labor and overhead. Traditional cost systems, also called volume based cost systems (VBC systems) trace overhead costs to the product based on the assumption that products cause the costs. Very few allocation bases have historically been used. The most common allocation base used in VBC is direct labor hours. The amount of overhead allocated to a batch of products increases linearly with the volume produced. So, it is assumed that as volume of output increases, direct labor hours increase in a linear fashion.

Nowadays, traditional cost accounting systems are rapidly disappearing mainly due to the changing manufacturing environment, traditional. Traditional accounting systems were developed at a time when direct labor was a large percentage of the total product costs. Changes in manufacturing technologies, such as the just-in-time philosophy, robotics, and flexible manufacturing systems decreased the direct labor component of production and increased overhead costs. In today’s manufacturing environment, direct labor accounts for only 10% of the costs, whereas material accounts for 55% and overhead 35%

(See Figures below). As a result, product cost distortion occurs due to allocating overhead costs to the products arbitrarily on the basis of direct labor hours used by each product. Cooper (1988) reports several situations that can cause distortions to occur, such as production volume diversity, complexity diversity, material diversity, and setup diversity.

Figure: Traditional cost price accounting

To ABC or not to ABC?

To ABC or not to ABC?

Public Version

Figures are Fictive

To ABC or not to ABC?

Management Summary

Preface

Table of Contents

Chapter 1 Introduction

Chapter 2 Research Set-Up

Chapter 3 Philips Corporate Information Technology & Services

Chapter 4 Cost Allocating Methods