In a previous post (How to Manage Cross Charges) I wrote about the issue of charging between teams, departments and companies when an employee of one entity works on a project that belongs to another.
I put forward the view that a charge must reflect the project and revenue-recovery risk that the project-owner faces, and the employment risk that the employee’s entity faces (paying the employee’s costs and keeping the employee busy). Both entities must obtain some advantage from the ‘deal’.
So how should cross charges be calculated?
Well, do they need to be fixed? Do we really need a formula? Why not let the laws of supply and demand fix a price? After all, you’re sometimes in a position where you’re keen to sell your team at any price, and at others, you need an exciting financial incentive to do so. Aren’t teams little businesses within businesses that must respond to market forces as if they’re free agents? If it’s cheaper for B to look outside the company instead of employing AC, then why shouldn’t he do so?
This can work well, if you have the time and the administrative back-up to manage all the ‘contracts’ that your team leaders make, and if you can define all the rules and penalties that apply to each kind of default.
If team A isn’t busy, then its team leader will be happy to sell time at almost any price. If team A is busy, then AC’s price will be higher.
But there are a few issues with this liberal ‘free market’ method:
- It tends to create an adversarial rather than a cooperative ethos, which can ultimately be damaging to the organisation as a whole
- It is complex to administer
- We don’t always want the rules of the market to apply. If B chooses a cheap external alternative to AC, whilst AC sits idly on the bench, is that really in the interest of the company overall?
- It involves frequent arbitration by management, which is tiresome
- It discourages openness, since if price depends on demand, a manager will obtain an advantage from concealing the true state of demand for his staff
However, it has its attractions, too. It places more commercial control in the hands of buyers and sellers. A and B are both buyers and sellers at different times, buying skills at the best price the market allows, and selling them at the best price the external market supports. It’s an orthodox free-market concept.
Alternatively, you might adopt a ‘cost-plus’ approach, cross charging at standard project cost plus a margin (of say, 50%). This has the merit of simplicity, reduces the frequency with which both parties will resort to arbitration, and still rewards the ‘seller’ for his risk in employing his staff, whilst rewarding the ‘buyer’ with a margin on his sale to his client.In short, you must make a pragmatic decision about how best to calculate cross charges, balancing the attractions of the free market approach with the adverse effects of competition and the complexity of administration.
On balance, I favour the cost-plus approach.
Internal Cross Charges
So far we have described only cross charges between companies or departments for client-oriented work. In these cases, there is usually scope for the sharing of gross margin between the supplying entity and the buying entity. However, what about cross charges for internal projects? This can also happen frequently. What kind of projects are these?
- Product or concept development projects where the commissioning company or department expects revenues to flow from whatever the project delivers. In this case, an ‘asset’ is being created. In these cases, the company may choose to capitalise the expenses associated with the project on the balance sheet.
- Entirely internally-oriented projects (for example, a group financial system implementation project) that benefit the group as a whole but do not create revenue opportunities. In these cases, the company may choose to write off all expenses associated with the project.
- Service provision by one company or department to another. A good example here might be ‘sales support’ provided by one company or department when another is short of sales support resources. In these cases, also the company will write off all associated expenses.How much should the supplying entity charge to the buying one?
As we discussed in respect of client-oriented cross charges the ideal situation, though one that may be impossibly hard to administer, is that market forces should prevail. If there is an excess of supply then prices to the buyer might be low. If there is a dearth of supply, then they might be high.
However, for practical purposes, it’s more sensible to avoid the games and deceptions involved in running an internal ‘free market’, and instead set some guiding principles. However, the difficulty that arises with internal projects is to decide whether the starting basis should be revenue rate (we may have the concept of ‘standard fee rates’ to work with even if the work is not for an external client) or standard project cost.
Both cases are unlikely to be attractive as they stand. A ‘buyer’ is unlikely to want to pay full market rates for internal staff, and a ‘seller’ is unlikely to want to receive only standard project cost and make no margin.
Partially relevant to this (but only partially because management accounts can differ in their policy from tax accounts) is the issue of how such work would be valued in accounting terms. Moreover, relevant to this is the issue of whether the work is intercompany (in which case transfer pricing rules might apply) or interdepartmental.
In practice, it makes best sense to have a fairly simple rule based on project cost plus a margin, say 20% or 25%. It is to some extent an arbitrary decision, but whatever method you choose you must make it:
- Easy to understand
- Easy to administer
- Effective in terms of motivation