Costing Public Goods and Services

Objectives You should understand the difference between: direct and indirect costs fixed and variable costs attributed and allocated costs You should be aware of how the following questions are answered:

Costing questions How do costs vary with the level of outputs? What is the cost of an increased level of service provision? What is the cost of a programme, initiative / intervention? What costs should be charged / levied in respect of a particular service?

How will costs change as a result of restructuring government departments? How will costs change as a result of outsourcing the provision of a particular function / service? How will costs change as a result of establishing a shared service arrangement? How cost-effective is a particular intervention / policy Costing questions

Costing The full and fair allocation of costs to outputs is one of the cornerstones of an efficient management control system. The information such systems generate should enable stakeholders and management to make decisions concerning resource use, budgetary implications, output pricing, and the extent of cross- subsidisation. Therefore, such systems can have a considerable effect on the disclosures in service performance reports. [AG-4 the Audit of Service Performance Reports]

Outputs Classes Impacts Outputs Input Costs Processes / Activities Is funding being managed within the constraints set by appropriations? Costing Appropriations How cost effective is the organisation? How efficient is the organisation? How economical is the organisation?

What is a ‘cost’?

A definition = the resources utilised or forgone to achieve a specific objective; usually measured as the monetary amount that must be paid to acquire goods or services. However, when we are defining costs for decision making purposes the required approach is not quite that simple.

The cost of a car On a recent Trade Me auction you successfully bid $6,000 for a 2005 Toyota Corolla. This is well below its list price and you have now been offered $10,000 for the car. What is the cost to you of keeping the car for your own use?

The opportunity cost Although you paid $6,000 for the car (the historic cost), by retaining the car you are forgoing a cash receipt of $10,000 – which represents the real sacrifice, or opportunity cost, of keeping the car for your own use. Any decision that you make in respect of the car’s future should logically take account of this figure.

Sunk costs and future expenditure decisions The terms ‘sunk cost’ and ‘past cost’ can be used interchangeably. A committed cost is also, in effect, a past cost to the extent that an irrevocable decision has been made to incur that cost. Since an organisation has no choice as to whether to incur the cost or not, a committed cost can never be a relevant cost for decision making.

How are costs classified? In attributing costs to a cost object (such as a service, product or activity) they are classified as: Direct Costs – which are related to a particular cost object and can be traced to it in an economically feasible (cost-effective) way. The effect of the cost can then be measured in respect of each particular unit of the cost object. Indirect Costs – are related to a particular cost object but cannot be traced to it in an economically feasible way.

How are costs classified? A passport : Direct Costs = ? Indirect Costs = ?

How do costs change? Costs can also be broadly classified as: Fixed Costs - that stay the same when the volume of activity changes Variable Costs - that vary in accordance with the volume of activity Both types of costs are often associated with an activity, hence the importance to the decision-making process of understanding the quantity and impact of both.

Fixed Costs 0 $ Cost Volume of Activity (units of output) Air New Zealand leases a fleet of aircraft

How do costs react to changes in the level of activity? Fixed Costs  a fixed cost is a cost that remains constant, in total, regardless of changes in the level of activity  costs are fixed in respect of a period of time and within a relevant range  can you provide an example for your organisation?

Fixed Costs Fixed costs are likely to change as a result of inflation or general price increases – but not as a result of change in volume of activity Fixed costs are almost always ‘time-based’ i.e. they vary with the length of time concerned Fixed costs do not stay unchanged irrespective of level of output. They often must increase to allow higher output levels

Fixed Costs 0 $ Cost Volume of Activity (units of output) What if demand for seats increases and Air New Zealand decides to lease more aircraft?

Variable Costs 0 $ Cost Volume of Activity (units of output) Air New Zealand buys fuel for its aircraft the cost per unit of activity says the same

How do costs react to changes in the level of activity? Variable Costs  a variable cost is a cost that changes in total in direct proportion to changes in the level of activity.  can you provide an example from your organisation?  how does that cost vary?

Variable Costs The graph on the previous slide suggests that costs are linear, i.e. normally the same per unit of production irrespective of the number of units produced. In some cases the line is not straight as higher volumes of activity may introduce economies of scale, thus changing the variable costs line as production increases. Alternatively, variable costs per unit may increase if, for example, employees are paid an accelerating bonus for achieving higher levels of output.

Non-linear variable costs 0 $ Total variable cost Volume of Activity (units of output) Direct labour costs where employees are paid an accelerating bonus for higher levels of output

Non-linear variable costs 0 $ Total variable cost Volume of Activity (units of output) Direct materials costs where quantity discounts are available

0 $ Cost Volume of Activity (units of output) Cost (straight line approximation) The Relevant Range relevant range Cost (curvilinear cost function)

Semi-fixed (semi-variable) costs These costs exhibit aspects of both fixed and variable costs Part of such costs are fixed and will not change with level of activity while some parts are variable and vary accordingly with changes in level of activity For example, electricity costs – for heating, lighting and powering machinery. The cost for heating and lighting would remain largely fixed irrespective of production activity, but for powering of machinery, it would increase with the production level.

0 $ Total Cost Volume of Activity (units of output) Semi-fixed (semi-variable) costs Fixed Costs Variable Costs

0 $ Cost Volume of Activity (units of output) Semi-fixed (semi-variable) costs Fixed Costs The slope of this line gives the variable cost per unit of activity

Fixed or Variable? Costs are fixed for a particular period – e.g. a month or a year A particular cost could be fixed in the context of one decision – operating a fleet of aircraft; and variable in the context of another – how many aircraft do we need? Some costs such as labour may be variable if staff are paid on a per unit basis (piece-rate) but may be considered fixed within a given time period if the organisation can not (or will not) lay off staff.

Fixed or Variable? The shorter the time period the greater the proportion of total costs that can be considered as fixed. Always consider the relevant range (the range of volume of activities that a particular business is expected to operate within), the length of the time horizon, and the specific decision situation when classifying costs as fixed or variable.

Costing Goods and Services ABSORPTION COSTING – all costs, both fixed and variable, are assigned to the outputs (or units of service) produced. Each output carries direct labour, direct materials, variable indirect costs and a proportion of fixed costs. VARIABLE (OR MARGINAL) COSTING - only those cost that vary directly with the volume of outputs are treated as output costs. This usually involves direct labour, direct material and variable indirect costs.

A Traditional Costing Model Support Functions Indirect Costs Delivery Functions Indirect Costs Delivery Functions Direct Costs Service Costs Allocation base

Fully absorbed or marginal costing? Bids for new policy initiative funding? The result of a baseline review? Fisheries cost recovery levies? Health sector part charges? Student tuition fees?

Cost-Volume Analysis A residential home for the elderly is funded by the Social Services department. The maximum number of beds at the home at any one time is 20. The total annual cost of running the home (on a fully absorbed basis) is $332,800, or $6,400 per week. Last year there were 16 residents – an occupancy rate of 80%. The cost per resident per week was $6,400/16 = $400 per resident per week.

Cost-Volume Analysis The fixed costs of the home are $4,800 per week and the variable costs are $1,600 a week (i.e. $100 per resident). Therefore, taking four more residents will only cost an extra $400 per week. At full occupancy, the total weekly cost of running the home would be $6,800 ($4,800 + $2,000). And the resulting increased efficiency would result in the average cost per resident per week reducing to $340.

Cost-Volume Analysis However, the annual budget required would increase from $332,800 to $353,600 ($6,800 * 52). However, this year the budget provided is only $343,200. If the home is to fill all twenty places, the average cost per resident will need to fall to $330. This required reduction in costs could be achieved by reducing fixed costs per week from $4,800 to $4,600 or reducing variable costs per resident per week from $100 to $90. Or a combination of the two methods might be used.

Cost-Volume Analysis What actions might the manager of the home take in the light of the budget shortfall? If the home is instructed to take 20 residents this year what are the risks?

An Activity-Based Costing Model Functional Department Costs Direct Costs Service Costs Activity Cost Pools activity measures Activity Cost Pools activity measures Activity Cost Pools activity measures Activity Cost Pools activity measures Activity Cost Pools activity measures Unallocated Costs Activity Rates (cost drivers)

An Activity-Based Costing Model 1.Define activities, activity cost pools and activity measures. 2.Assign overhead costs to activity cost pools 3.Calculate activity rates 4.assign costs to cost objects (i.e. services / outputs)

An Example – the Department of Social Services The Department of Social Services has three functional divisions: Employment Services and Services for Seniors – which supply services directly to the public, and Corporate Support Services – which supplies administrative services to the other two divisions.

Details of the divisions are as follows: Dept. of Social Services – traditional method

The Department of Social Services also uses the services of the government’s central Legal Department that has a staff of 40 and total costs of $2,560,000. As well as the Department of Social Services the Legal Department also provides services to other government departments which all together have a total of 1,000 employees. The cost of the Legal Department are allocated to other government departments on the basis of the number of employees in each department. Dept. of Social Services – traditional method

The total number of employees in the Department of Social Services is 280 and in other departments 1,000 giving a total of 1,280. The allocation for the three divisions of the Department of Social Services is therefore: Employment = 180/1,280 * $2,560,000 = $360,000 Seniors = 60/1,280 * $2,560,000 = $120,000 Corp Support = 40/1,280 * $2,560,000 = $ 80,000 Dept. of Social Services – traditional method

The divisions costs are as then follows: Dept. of Social Services – traditional method

The Departments corporate support costs are allocated to the other two functional divisions using: premise costs = floor space occupied Employment = 50/90 * $180,000 = $100,000 Seniors = 40/90 * $180,000 = $80,000 staff & other costs = proportion of total employees (note these now = $640,000 + $80,000 legal costs) Employment = 180/240 * $720,000 = $540,000 Seniors = 60/240 * $720,000 = $180,000 Dept. of Social Services – traditional method

The costs per client are as then follows: $2,700,000 / 50,000 = $54 $3,225,000 / 15,000 = $215

Dept. of Social Services – ABC method An alternative method is provided by activity-based costing which seeks to allocate costs in a way that better reflects the drivers or causes of those costs. Rather than using the number of employees, the costs of the Legal Department can, therefore, be allocated on the basis of the number of chargeable hours provided to each of the other government departments.

Dept. of Social Services – ABC method A it happens the total charged to the Department of Social Services works out at the same figure of $560,000. However, the charges to the Departments three divisions now reflect the differing proportions of the total 1,8002 hours charged by Legal Services as follows:

Dept. of Social Services – ABC method Similarly, within the Department of Social Services the number of clients served is a better driver of the cost of the administrative support services used by each of the client-facing functions.

Dept. of Social Services – ABC method The revised cost per client is now as follows:

An Activity-Based Costing Model Cost Pools Cost Drivers Inputs Processes / Activities Outputs supportdirect

Summary Public sector managers should have an explicit understanding of the relationship between workloads and resource requirements. They should also have an explicit understanding of the factors that drive resource consumption and costs.

Costing Public Goods and Services Can you give an example of how costing information is used in your organisation? Do you know how that information was produced?