Features: November 19th, 2002

The Case for Activity Based Costing in the Public Sector

By Mike Sherratt

Although Activity Based Costing has been with us for nearly two decades now, we have recently witnessed a rise in adoption by public sector organizations. They are embracing this as their primary costing, measurement and management tool. It is increasingly being used to address Best Value. But how does it work?

Best Value requires that all public services organisations should provide services that not only meet but surpass the expectations of those they seek to serve, and are comparable with the best of those on offer from other public sector providers and the private sector. This presents three main challenges for public sector organisations. Firstly they must determine the true cost of the services that they provide; secondly, they must ensure that the processes by which these services are delivered are as efficient as they can be; and thirdly, they must establish ways of comparing those costs with those of their peers in both the public and private sector. For all of these challenges activity based costing techniques provide the key and here is why.

What is Activity based Costing?

ABC is built on the premise that the business of any organisation can be broken down into a number of discrete activities that often cross functional and departmental boundaries. Organisations consume resources when performing each of these activities and the majority of the organisation’s costs can easily be assigned to one, or in proportion to a number, of these specific activities. Although knowledge of the cost of activities that occupy staff would seem an obvious advantage to management, such fundamental information is usually available only to those organisations and managers who have embraced a system of ABC.

Once the total cost for each activity has been established, this cost can then be allocated to products, services or outputs (cost objects) in relation to their consumption of that activity. Thus, each product, service or output is only assigned costs for the activities that go into producing it, giving an accurate picture of true cost.

ABC derives the total cost of a cost object by aggregating all of the costs incurred in the provision of that product or output. Basic questions ABC attempts to answer include…

What activities are undertaken to provide a product or output?

How often, and by whom, are activities performed?

What resources are consumed when undertaking activities?

How much does it cost to provide a product or output?

What value-adding and non-value-adding activities are undertaken?

It seems that organisations experiencing rapid change, intense competitive pressure or close monitoring by an independent regulator are particularly appreciative of the benefits that ABC analysis can provide. But why is this?

Traditional product costing systems were devised many years ago when most companies manufactured a narrow range of products and direct labour and materials formed the significant element of total costs. Overhead costs were relatively small, and allocated to products using a volume related measure such as direct labour hours or machine hours. This was done on the assumption that overheads vary with direct costs. Such a stable operating environment has been subject to fundamental change in all sectors since the late 1970’s/early 1980’s. Significant contributory factors include…

  • Today’s organisations tend to provide a diverse range of products, services and outputs
  • Fewer costs can be classed as direct
  • Overhead costs are significant
  • Many overhead costs are non-volume related
  • Technology is constantly changing

Supporting financial management in public and private sectors

The above illustrates the need for a system that produces more accurate product, service and output costs. It is against this background that ABC emerged and it is clear that the factors described above are as relevant to the public sector as to manufacturing organisations. Today, the line between the financial management processes in public sector agencies and commercial businesses is beginning to blur. Budget cuts have resulted in fewer available resources, and the common theme today under the Best Value regime can be viewed in simple terms as ‘more for the same, or the same for less’ with an increasing workload accommodated by a reduced staff base.

Traditionally, public sector financial monitoring arrangements have concentrated on the cost of resources rather than the activities and outputs produced by these resources. Under Best Value however, public sector bodies are being held increasingly accountable for performance targets and managers need to ensure that spending decisions are tied to strategic goals. In order to manage the public sector like a business, its managers need the same tools that businesses have used for years to better understand their costs and performance. Responding to government policies, implementing cost containment measures and the increasing emphasis on output and outcome measurement is as challenging to managers in the public sector as anything facing those in the private sector.

It is now accepted that output and outcome measurement is an integral part of modern government. It is the driving force behind the creation of targets and decisions taken to influence service delivery. The emphasis is on a results-based government and the development of business-like work practices, including privatisation, outsourcing, and competitive tendering, as well as focusing on outcomes. It is generally agreed that reliable performance information can help public sector bodies develop policy and manage the resources at their disposal in the most cost effective manner possible. Further, reliable information is required to report performance to central government and the general public, thereby promoting accountability for the use made of public resources.

Under the traditional model the success of financial management is generally measured in terms of containment of expenditure within budget rather than measures of service delivery or activity outputs. Through the introduction of ABC, the traditional budget model can be significantly revised to produce more meaningful performance measures and targets.

Wider benefits

It is clear that the benefits of ABC represent more than the provision of detailed financial information. If undertaken correctly, ABC provides a critical examination of operating procedures through staff participation. Areas of weakness and options for improvement can be identified and costed with accuracy.

The costs generated may be used for benchmarking activity with other service providers, but the main benefits to be accrued from ABC go beyond this. What is more significant for managers is the use that is made of the information, highlighting those activities that add value to the organisation and those that do not. Although it is unlikely that non-value adding activities could ever be entirely eliminated from operations, there is scope to identify them, reduce them and redirect resources into activities that add value to the customer and the organisation.

For full benefits to be realised, ABC needs to be part of a regular reporting mechanism that will itself aid the objective of continuous improvement. What is clear is that the ‘Profit Motive’ that drives many private sector organisations to seek out ABC initially is not what ensures long-term commitment to its use. Instead, the perceived focus on containing costs is soon eclipsed by the wider benefits of ABC, namely the ready supply of information required to inform improvements in service delivery.

ABC at work in the public sector

ABC is employed by a logistics organisation within the MoD to understand what drives cost and to undertake initiatives aimed at reducing the cost of outputs by 20% over 5 years.

A City Council in Scotland uses ABC to understand what drives cost in the Revenues Division and to demonstrate improvements against statutory performance indicators.

A Police Force, instrumental in the planning and design of the National ABC Model, have applied ABC, not only to meet the requirements for National benchmarking and best value, but also to provide a better understanding of service costs to feed into future policing plans and drive efficiency savings.

Mike Sherrat is the Chief Executive Officer of ALG Software. www.armstronglaing.co.uk