Integrated Technology Services (UK) Ltd

Mike Johnson
University of Dundee
In November 1999, a consultant was employed to review and document the planning and control
systems of Integrated Technology Services (UK) Ltd (ITS-UK), to ensure that these were effectively
meeting the needs of the business and to provide a basis for staff training.

ITS-UK is the British subsidiary of Integrated Technology Services International (ITSI), a technology
company, based in the north-east USA, which has history of developing and providing technology
solutions to major international corporations and the US Government. It has focused on science and
technology as a core strength with a significant Research and Development (R&D) expenditure. It is
also noted for its extensive employee share ownership scheme, to encourage staff business
awareness.

The UK operations are based on two main activities:

1. Consultancy services to a range of businesses;

2. Computing and telecommunications outsourcing support to companies, particularly the oil and
gas industry, but increasingly to other industries and to the public sector.

The latter activity has been in response to the business opportunities created by a variety of industries
that have preferred to focus on their 'core competencies' and outsource some of their internal support
functions to external providers, particularly in information technology and accounting. The Government
has also reinforced the trend by the compulsory tendering of many of its internal services in
competition with outside providers.

At the same time, outsourcing of information technology (IT) services has developed in the USA,
where the parent company has progressed. Project management has been a particular strength within
the corporate body, developed over its 30 year history. This expertise has also been used to
advantage by its UK subsidiary, with the readily available facilities of US based staff, when dealing
with multi-national corporations.

ORGANISATIONAL STRUCTURE

ITS-UK is structured into three groups of activities:

ƒ Consultancy business as a small separate unit

ƒ Outsourcing Services on a matrix organisational basis

ƒ Staff services, such as Finance, Commercial and Human Resource and Administration
EXHIBIT 1

The Balanced Scorecard

Financial
Perspective

Customer Internal Business

Perspective Perspective

Innovation &
Learning Perspective

Outcome measures - results of strategy

Driver measures - leading indicators

FIGURE 1

Consultancy

This is the oldest established business unit of ITS-UK. It is relatively independent with a separate
client base from that of the outsourcing business, though there is some commonality as its
consultancy is essentially for systems applications and integration. It shares the staff services with the
rest of the company, with an occasional requirement for the services of the other groups, such as the
Infrastructure department, on an advisory basis.

Outsourcing Services

As with many modern service providers, the functions are divided into those that deal directly with t he
client, known as the front office, with the back office delivery managers in charge of departments that
provide the actual support staff, as follows:

ƒ Marketing department is a small group, which has the responsibility to find new business.
Staff will ead initial customer requirement reviews and contract negotiations, along with
appropriate resources from other departments.

ƒ Client Account Managers head small departments who are in direct ongoing communication
with the customer, once the contract is approved and work is ready to commence. They are to
ensure that the contractual requirements are properly followed to meet customer expectations.
This, in practice, is largely to meet the following criteria:

a) That proper resources are provided from the main groups of Applications Infrastructure
and E-mail, to meet contract specifications, e.g. the right number of the appropriately
qualified systems engineers, as defined in the contract.

b) That excess resources are not allocated to the project, due to support staff lack ofcontract
understanding.

The departments are structured on the basis of client requirements. An oil and gas group was
originally developed to support one particularly large client, from which many of the staff were
transferred to ITS-UK to carry on the work that they had previously provided. This original
 group was later divided into two, to reflect the two division structure of the oil industry, the
upstream exploration and production and the downstream marketing and refining. The
Operations South group covers all other industries and local government departments.

ƒ Applications department provides the technical resources to develop and support clients' IT
applications systems.

ƒ Infrastructure department provides the technical resources to implement and support all
computer hardware, telecommunications and networking requirements. It also includes a
front-line help-desk support which is the first point of call for any customer call, such as
computer, telephone or application system problems.

ƒ E-mail is a specialist group that provides electronic mail services to customers.

Planning is a critical function for each of the Applications, Infrastructure and E-mail delivery managers,
both with the marketing managers for early warnings as to staff requirements and with client
management for ongoing needs. This latter feature has been difficult to achieve due to regular
contract change requests by the major clients. The overall organisation is of a matrix nature, where
the service delivery managers (SDM's) provide some 750 people to a broad range of contracts. Some
staff may be permanently assigned to a major client, whilst others could be working on several
different contracts in a single week.

BUSINESS CONTROLS OVERVIEW

Expansion in Outsourcing had been rapid, with an emphasis on drive and initiative, to some neglect of
a detailed controls framework. The main financial performance measure is the net margin. This is set
by corporate headquarters as 6%, which effectively is the prime objective if ITS-UK. Contacts with
clients tend to be agreed on a gross margin basis, but which obviously must be carefully set, usually at
least 20%. This has been deemed to be the minimum required contribution to cover overheads and
profit, though questions were being raised as to the appropriateness of this level as the net margin of
6% is becoming increasingly difficult to achieve, with some of the following points raised as
contributory factors:

1. Following the early, large, long term contracts, which were relatively simple to administer,
overhead costs have risen disproportionately due to:

ƒ many small contracts, which administratively are often as expensive as much larger ones;
overall lower net margins are therefore a natural outcome of the decreasing size of average
contracts;
ƒ lack of standardisation of contract terms leading to complex administrative and financial
controls, e.g. billing
ƒ arrangements have to be individually monitored, as computer systems have been unable to
fully accommodate all the variations.

The 20% gross margin target is therefore contributing increasingly more to overheads than to profit.

2. A further reason for lowering profitability is believed to be that the drive for market share, which
had taken precedence over gross margin, has resulted in 'loss-leaders' which were not living up to
expectations. One particular large contract, started with a 15% gross margin, in the expectancy of
leading to other more lucrative work, but has not yet proved to have done so.

3. The mechanism of charging the IT person's time to the contract, through a timesheet, is not being
properly controlled. Staff may work on a number of small contracts in a week, possibly for the
same client, which is not always obvious to the person concerned. Time is therefore often
incorrectly charged, which results in a waste of administrative effort to correct, along with client
dissatisfaction. A particularly difficult situation is where a variety of different types of contracts may
be in force with a single client company. A systems engineer may work on a fixed price contract
on one day so that time charged to the contract will be for internal ITS-UK purposes only, i.e. it will
not affect the charge to the client. Then on the following day, he may be supporting a reimbursable
(time and materials) contract, when time charged is reimbursed by the client. If these times get
 mixed up, the consequences can be significant. A lack of contract understanding therefore may
be leading to costs, that should be chargeable to the contract and paid by the client, are not being
identified as such. These costs will therefore remain as a charge against ITS-UK's profits.

4. The increasing complexity of the matrix organisation may be leading to wastage. Ideally,
resources should be provided to meet client's needs as and when needed. In practice, this
flexibility can only be met if there are readily available staff resources at any time, which would
inevitably lead to reserve people. However, such standby staff have a price, who generate no
income, if not used.

A response to the above problems has been to improve financial planning and budgetary controls.
Before looking at these two control mechanisms, the nature of the various contractual arrangements
must be understood.

CONTRACTUAL RELATIONSHIPS

ITS-UK receives its income through the provision of technology services, which are governed by
various contractual relationships with the client. This commercial relationship will tend to depend upon
the balancing of risk and reward.

The reward to the contractor will be influenced by the amount of perceived risk, that is, the higher the
risk that the contractor is expected to meet, then the higher the reward that the contractor will expect
to receive. In practice, where risk is deemed to be high both for its frequency and impact, the customer
normally bears this risk, supporting a standard cost reimbursable (or 'time and materials') type of
contract. For low risk projects, the contractor is more likely to bear the risk with a fixed cost type of
contract preferred. An example of the former may be an innovative oil construction computer control
system in a frontier zone, whilst ongoing systems support may typify the latter.

A third major category has emerged in recent years, where various concepts of sharing risk and
reward have been created, to be known as incentive or target cost contracts, frequently as part of long
term 'alliancing' relationships.

All three types of contracts are found within ITS-UK, with the target cost tending to dominate the larger
contracts and therefore comprise a significant element of the sales revenue. An example of such a
contract is shown in Exhibit 2.

EXHIBIT 2

Planning Process Overview

Identify objectives

I.D potential strategies Long-term

planning
process
Evaluate strategic options

Select alternative actions

Implement plan as budget

control Annual
Monitor actual results features budgeting
Process
Respond to divergencies

FIGURE 2
Target Contract Example (Selected items from internal contract brief)

Contract Scope: Provision of outsourcing arrangements for the Information Systems and
Records Management Functions at Company X.
Contract Type: 1999, Ceiling price with sharing of any underruns only, plus Discretionary
Services project work to be remunerated on a time and materials basis
(agreed rates listed separately).
Ceiling Price for 1999: £784,000
Underrun Sharing: Company X share:40% ITS-UK share:60%
Performance Award: From -5% to +5%, payable quarterly.
Note - basis for cost calculations is actual cost to ITS-UK plus an agreed mark up of 12%.
Calculation of contract profits to ITS-UK at varying levels of actual chargeable costs:
Actual ITS-UK contract cost for target contact = £784,000/1.12 = £700,000

Therefore the base for 1999 is that ITS-UK will receive revenue of £784,000 for a cost of £700,000,
i.e. a profit (mark-up) of £84,000. This mark-up is payable, regardless of actual cost.

For a sample of lower resultant costs, profit share will be as follows:

£
Sales Revenue
Actual Cost 500,000 600,000 700,000
Mark-up 84,000 84,000 84,000
Share of Underrun (60%) 120,000 60,000 0
704,000 744,000 784,000
less Actual Cost 500,000 600,000 700,000
Profit on Contract 204,000 144,000 84,000

The profit to contractor will be adjusted per the performance award and any costs that are not
recoverable, according to contract.

CONTRACT COSTS

Each client, covering several contracts, or sometimes a single major contract, is treated as a profit
centre, to include all costs that are specific to the contract, plus indirect cost allocations, and their
revenues. It is crucial to the profitability of all target and time and materials contracts to be as clear as
to what is recoverable in the contract, i.e. that which will be paid by the client. The contract should list
all categories of support staff and probably their rates, along with all services and equipment. For
example, if 50% of an accountant is recoverable per a large contract, but 75% of an accountant's time
is actually used to support the contract, 50% will be charged to the client and the other 25% will have
to be absorbed by ITS-UK, i.e. as a general overhead cost, directly charged against ITS-UK's own
profits.

These recoverable costs are often known as 'direct cost' which is not as normal per cost accounting
terminology, where an accountant's time, partially allocated to a contract, would be regarded as an
indirect cost.

An example of a small contract build-up, for quotation purposes is as follows:

EXHIBIT 3

Contract details for Bid Preparation

Labour Salary per FTE's (see

annum note 1)
Services Delivery Manager 35,000 0.02 700
Systems Engineer 26,000 0.92 23,920
Desktop Technician 22,000 0.1 2,200
Customer Support Analyst 16,000 0.13 2,080
Total Salaries 1.17 28,900
Staff Benefits (22%) 6,358
Total Labour 35,258

Training (£1,500 per FTE) 1,755

Overheads (£3,750 per FTE) (see note 2) 4,388
Other Direct Costs (hardware maintenance 5,700
costs - components will be listed)
Head Office (5% of direct labour) 1,445
Contingency (10% of direct labour) 2,890
Total 51,436
Add Margin 25% 12,859
64,295

Note 1 - FTE - Full-time equivalent person, e.g. 0.5 FTE is half a person's workload.

Note 2 - includes commercial, finance and admin. support (on a pro-rata headcount basis, plus office
consumables, telephone and internal IT support). How these are identified to the client will depend on
the type of contract. For a fixed price contract, these will be internally recorded costs only: for a target
or reimbursable contract, these items will all be specifically agreed with the client, for client's account.

PLANNING

For business planning purposes, the time horizon tends to be shorter than for most organisations.
Business had been expanding rapidly, with the only real constraint being resources, where there has
been a shortage of technically skilled IT people. The larger contracts tended to be for three to five
years, so that a high degree of security exists for the levels of income from the major clients in the
medium term. Otherwise, the annual budget cycle tends to predominate, to meet corporate objectives,
with a general plan for the longer term, mainly focusing on the larger contracts plus a general business
view for potential markets.

BUDGETING

Until recently, the budget had been prepared on a programme basis, i.e. by client, and for the total UK
operations, to support corporate planning requirements. Control therefore could only applied to these
levels, effectively the client as the profit centre, with the back office groups being excluded, to any
detailed extent. The overall results, which were not meeting profit expectations, led to the realisation
that further controls were required. From this year, the budget has also been structured by all
responsibility centres, that is, to include the back offices as expense centres.
An example of the new budgetary structure, with illustrative numbers, is shown in summary below:

EXHIBIT 4

Outline of the 1999 budgeting and reporting format (£000)

Cost Categories Marketing Client Applications Infrastructure Total Contract

Management
Labour:
Staff 20 67 350 250 687
Agency 150 100 250
Sub contracts 80 200 280
Other costs 20 25 140 150 335
Total Cost 40 92 720 700 1,552

In practice, each of the cost categories will be analysed by individual item, per the ITS-UK chart of
accounts:

ƒ Labour is broken down by category of job function and numbers of each (FTE's- full time
equivalents), such as the client Management above as:

Salary FTE's Labour cost

Client Manager
£60,000 0.3 £18,000
Service Delivery
£37,000 1.0 £37,000
Direct labour £55,000
Staff benefits (22%) £12,100
Total labour £67,100

ƒ Agency staff are similarly analysed

ƒ Subcontracts are individually identified. These are often a substantial part of the main
contract, such as the provision of specialist geophysical services to an oil company, but which
is deemed, by the oil company, to be part of the general systems support by ITS-UK. This is
part of the oil industry's general policy to limit the number of contractors with which it directly
communicates. In the above example, the £80,000 Applications sub-contract may be for
specialist services, which will be managed by the Applications Service Delivery Manager on
behalf of the total contract, so will be accountable to the Client Manager for its performance.

ƒ Other costs- these are the recoverable costs of the contract. They are individually identified in
the budget, such as hardware maintenance, software licences, telephone and travel costs.

The concept is that, for each profit centre (or contract) cost item, the department responsible for that
cost will be identified, leading to a bottom line number for each manager, for which he or she will be
held accountable. For Applications and Infrastructure, the two main expenditure areas, where any total
cost is expected to impact the contract in any way, the manager concerned must discuss and agree
this with the client manager. In the above example, the Applications manager is responsible for a
budget of £720,000, the limit for which he can spend without any agreement with the Client Manager,
providing services meet the contractual specifications.

Budget Preparation

The following steps are observed:

1. The year's programme is agreed, essentially:

ƒ Confirm the continuation of existing contracts.

ƒ Clarify contract renewal expectations, for contracts that will be up for renewal in the budget
period.
• Agree scope of any new business.

2. All departmental managers prepare their budget costs, by person and cost detail, for each contract
or new business category.

3. Results are consolidated by contract, or new business category, by budget co-ordinator.

4. Service Delivery Managers then review their results with each of the Client Managers, for
agreement as to conformance with contract and to ensure that derived profit margins are as
expected.

5. Once agreed, all results are consolidated, along with staff service departments, to produce a draft
operational budget for Outsourcing Services, for review by the Group Manager to ensure that
corporate objectives are met.

6. Adjustments may be made, as required (they usually are!).

MANAGEMENT REPORTING

Quarterly reports are transmitted to the head office, for the major contracts, overall actual cost position
and full year forecasts. For major international clients, a world-wide consolidation is undertaken for
overall ITSI support, i.e. global support for global companies; an increasing expectation of such
clients.

Internal monthly reports are reviewed by the Operations Manager with his client and service delivery
managers. An example of a section of the report is shown below for July 1999, for one particular major
client (one profit centre) with six different contracts:

EXHIBIT 5

Service Delivery Report for July 1999 (extract)

Contract Profit Contract/Project YEAR TO DATE JULY

Centre Revenue Project Gross PBT1
Costs
£ £ £ %
1010 4255 Exoil Chemicals London Office 210,000 160,769 49,231 23.4
1019 4255 Exoil Chemicals E-mail 45,000 42,100 2,900 6.4
1032 4255 Exoil Chemicals Clydeside 280,000 223,500 56,500 20.2
1033 4255 Exoil Refinery Fife Terminal 320,000 258,123 61,877 19.3
1059 4255 Exoil Refinery E-mail 53,000 54,256 -1,256 -2.4

1072 4255 Exoil Refinery Projects 180,000 131,456 48,544 27.0

4255 Exoil Oil & Chemicals 1,088,000 870,204 217,796 20.0

Note 1 - PBT = Profit before Tax; being gross, it also excludes overheads.

Supporting these reports would be cost details on the budget basis, i.e. each cost identified per the
service delivery department, so that actual costs would be reported alongside the budget numbers,
per Exhibit 4 structure. In practice, this is very limited in its use. The computurised accounting system
(a modern integrated 'enterprise' reporting system) has the facility to accomodate the input of budget
data, but it requires the budget to be prepared at a very detailed level for input, which is very time
consuming and has not yet been adequately implemented. Comparisons are therefore made on a
manual basis, e.g. by downloading the relevant actual data in the budget format. For example, if the
budget identifies a training cost for Applications staff on Exoil Oil & Chemicals, actual data will be
extracted manually from the system for direct comparison. This type of work is partially performed, but
the problem is the heavy use of resources to prepare the reports; a good example of the increasing
overhead costs deemed necessary to support the overall business, but which is cutting into the overall
net margin.

The gross margin of 20%, per Exhibit 5, was in line with expectations, though only just so; the E-mail
operations need to be reviewed, as a minimum. The 20% margin was effectively a contribution to
overheads and net profit, with the former of these of increasing significance, as previously discussed.
The real significance to these overheads is not obvious in these reports, merely a realisation that a
20% gross margin may not be sufficient to meet the 6% corporate net target.

The full company financial status is only produced on a quarterly basis. The latest report (Exhibit 6)
shows that the absorption of the overheads from the staff services, plus time allocated by the senior
staff of the outsourcing operations that does not directly relate to any of the contracts, such as forward
planning and marketing, results in a net margin of 3.1% (£2.3 million over £75.0 million sales), an
unsatisfactory situation. This position is also down from the total company actual results of 1998, as
illustrated below.

EXHIBIT 6

Profit Statement Summary 1999 Full Year Forecast versus 1998, as at 1 July 1999.

1999 Full year Forecast 1998 Actual

Outsourcing Consultancy ITS-UK ITS-UK
Sevices
£ million £ million
Sales Revenue 75.0 10.2 85.2 80.5
Cost of Sales 60.0 7.9 67.9 63.6
Gross Profit 15.0 2.3 17.3 16.9
Admin. & other expenses 12.7 1.5 14.2 12.9
Net Profit 2.3 0.8 3.1 4.0

Further details of the 1998 reported results are shown in Exhibit 7

EXHIBIT 7

INTEGRATED TECHNOLOGY SERVICES (UK) LTD

SUMMARISED PUBLISHED ACCOUNTS

PROFIT AND LOSS ACCOUNT FOR 1998

£ millions
Sales Revenue 80.5
Cost of Sales 63.6
Gross Profit 16.9
Administration, selling & other expenses 12.9
Profit before Tax 4.0
Taxation 1.2
Net Profit after Tax 2.8
BALANCE SHEET AS AT 31 DECEMBER 1998

£ millions
Fixed Assets 10.5
Current Assets
Stock 0.2
Debtors 33.5
Cash at bank 2.1 35.8
less Creditors - amounts falling due within one year 28.5
Net Current Assets 7.3
Total Assets less Current Liabilities 17.8
Creditors - amounts falling due after more than one year 2.0

Net Assets 15.8

Capital and Reserves 15.8

Questions

Following the review of the planning and control systems of Integrated Technology Services (UK) Ltd
(ITS-UK), the Group Manager James Gunn has asked you, the consultant, into his office to discuss a
number of points arising. He is accompanied by the Operations Manager.

Mr Gunn opened the meeting, "We have some concern with the net profit margin as the sole
performance measure of our business. It is not necessarily the actual percentage of 6% that is giving
us trouble, maybe it is a suitable figure as many of our competitors are facing even tighter margins,
but it is the concept. Frankly, we are not clear as to why this is the sole measurement criteria, surely
there are other ways of measuring how well our business is performing. We believe that we have a
good business and the market is there for future growth, but maybe there are other ways of looking at
how well we are doing. We are not financial people, so we look to you to help. We would therefore like
you to look into this and prepare a report on the merits of this net margin measure and any suitable
alternatives that we can propose to our corporate managers.

The other item that we want you to review is the budget process. Here, we believe that we have a
good system, but we need to get it running properly. The problem is that it is going to take more
resources to do so, probably an extra accountant for some £35,000 per year, plus benefits and
support costs which will come to nearly £50,000. We therefore need a good case to go to head office
to justify this and we would like you to come up with that justification."

Required:

1. Prepare the report on the net margin, as requested by the Group Manager
[50 marks]

2. Prepare a justification of the budgeting system, covering the principles of the budget, its
features and advantages, in general, along with the specific advantages for ITS-UK, to meet
the needs of local management.

[50 marks]