There is a growing desire among organizations—including public sector government organizations—to understand their costs and the behavior of factors that drive their costs. However, there is also confusion over how to understand costs and how to distinguish competing cost measurement methodologies (e.g., activity-based costing, standard costing, project accounting, etc.). The result is that managers and employees are confused by mixed messages about which costs are the correct costs. Upon closer inspection, various costing methods do not necessarily compete—they can coexist, be reconciled, and be blended.
In order to overcome the overgeneralizations of traditional costing systems—which are excessively simplified and typically distort cost allocations and the resulting hidden indirect cost visibility—organizations have been adopting activity-based costing (ABC) systems. These systems are based on cost modeling that traces an organization’s expenses, both direct and indirect, to the products, services, channels, and customers that cause those expenses to be incurred. For public sector organizations, it is citizens or other government agencies that are being serviced instead of customers but the rest holds true.
In recent years, government organizations have begun to look to private industry for ideas on how to improve their business practices and their efficiency in resource use. Activity-based cost management (ABC/M) is one of the most important tools being introduced in the effort to achieve these ends.
ABC/M provides information that governments need
ABC/M provides fact-based data. In the absence of facts, anybody’s opinion can be a good one. Usually the biggest opinion wins, which may be the opinion of your supervisor or the supervisor of your supervisor. If leaders make decisions based on intuition or misleading data, your organization is at some risk. ABC/M provides valuable information that can be used to make a broad range of decisions, from outsourcing to operational planning and budgeting.
ABC/M has often met with a mixed response in its initial stages, despite widespread discontent with traditional accounting mechanisms and its proven track record elsewhere. This four part article series describes what ABC/M is intended to do—and what it is not—in the hope that such enlightenment will help in applying ABC/M principles to the critical problems now facing the public sector. ABC/M in government is an idea whose time has come, simply because it makes sense.
Political pressures to hold down costs
Public sector organizations at all levels and of all types are facing intense pressure to do more with less. National, state, county, municipal, and local governments in almost all the countries in the world currently feel some sort of fiscal squeeze. This includes departments, administrations, branches, foundations, and agencies.
The pressure on spending has many sources. It can come from politicians aiming to win taxpayers’ approval or directly from taxpayer special-interest groups. There is pressure to compete with other cities to attract homebuyers or with other counties, states, or nations to attract businesses. Regardless of where the pressure is coming from, the message is: better, faster, cheaper—hold the line on taxes, but don’t let service slip.
Meeting this daunting challenge often requires governments to:
- determine the true and actual costs of services;
- implement process improvements;
- evaluate outsourcing or privatization options (e.g., is it better to deliver internally or purchase from external organizations?); and
- align activities to the organization’s mission and strategic or policy plan.
The solution for governments under pressure cannot be to simply uncover new sources of revenue or to raise tax rates again. Some have succumbed to these quick fixes only to meet with a downward spiral as businesses and families increasingly move to more economically attractive locations. Governments must get a handle on their problems. Holding the line on raising taxes will need to be more than a hollow campaign slogan; it may become an absolute requirement to retain the tax base. This restriction creates more reasons to understand costs. Efficiency and performance—once reserved for the private sector—will increasingly be part of the language of the public sector.
The pressure on the public sector is undeniable. People want government to work better and cost less. To do so, public sector managers will have to change their way of thinking about the true costs and value of the services they provide.
An excessive focus on functions
Can municipal or state government accountants inform their managers with accuracy on how much it costs to fill a pothole, process a construction permit, or plow a highway of snow? These are output costs, not input expenses. Without ABC/M, these costs cannot be calculated.
The reference to the cost of outputs will repeatedly resonate throughout this article series. It is inescapable. The need to consider outputs—not simply the level of manpower, equipment, and supplies—is what is forcing the awareness and acceptance of ABC/M. At a very basic level, ABC/M is simply a converter and translator of expenditures restated as outputs and, more specifically, the costs of outputs.
ABC/M answers fundamental questions about what things cost and why. Other examples of output costs are the cost per each type of processed tax statement or the cost per each type of rubbish disposal pickup. ABC/M serves as a calculation engine that converts employee salaries, contractor fees, and supplies into outputs. All organizations do work or purchase it and all work has an output. The topic of outputs is a critical aspect of ABC/M.
A dilemma for many government agencies, branches, administrations, and departments is their fixation with determining budget levels for spending without many foundational facts. From the budget requester’s perspective, an annual budget negotiation is usually an argument to retain or increase the level of resources relative to the existing level. A budget should reflect the proper level of resource spending to match demand on work required. An advanced application of ABC/M data is to use its calibrated consumption rates from past periods to apply against the future volume and mix of expected outputs and services to determine the future level of resources required. Hence, ABC/M enables better budgeting. Fortunately, the focus within the public sector has begun to shift from budget management to performance-based results measurement.
A fixation on inputs
The actual or planned spending levels reported by the general ledger or fund balance accounting system eventually emerge as the primary financial view for each of the functional managers. This has become the typical way that functional managers think about what level of spending can satisfy the needs of people relying on them for good service.
The traditional accounting structure mirrors the hierarchical organizational structure. Each function is a cost center of sorts, and the accountants consolidate the functional expenses into totals with elegant roll-up procedures. But is managing a cost structure all about focusing on the supply side of resources, which is basically the organization’s capacity to serve? Or should the focus begin with reacting to the demands for work placed on the organization from service recipients and customers? ABC/M brings visibility and understanding to the latter, fulfilling the needs of the service recipients and customers consuming the organizational outputs. It focuses on the demand side for resources.
Removing the blindfold: outputs, not just resources and expenditures
Expenses and costs are not synonymous. To simplify semantics, resources are used and expenses or expenditures are incurred when money is exchanged with third-party suppliers and employees. In contrast, costs are always “calculated” costs that restate and transform the expenses as work activities or as outputs. Expenses and costs equate in total, but are not the same things.
Figure 1 illustrates how management’s limited view can be fruitfully extended beyond the resource/expenditure level. Traditional financial management systems focus on the expenses of labor, supplies, and so on, rather than on what work within processes is performed and the outputs resulting from using these resources. ABC/M makes visible what has been missing in financial reporting.
Figure 1: expenses and costs are not the same thing
In many cases, the accounting system calculates indirect expenses, commonly referred to as “overhead,” or supports costs and arbitrarily allocates them based on broad-brushed averages (such as the number of units delivered) to the final outputs of the organization. This basis for how the cost allocation is distributed is usually convenient for the accountants but does not reflect the unique and relative relationship between resource consumption and the final outputs, much less the work processes involved. That is, different types of outputs uniquely consume work activities in varying ways, but the arbitrary averaged cost allocation does not reflect it. Hence, some outputs are over-costed and others must be under-costed because it is a zero-sum error situation.
This is the first article (Part 1 of 4) in a four-part series based on the book, Activity-Based Cost Management in Government by Gary Cokins (Second Edition; Management Concepts, 2006, ISBN 978-1-56726-181-3).
