Activity-Based Costing: Is it Applicable in Governments?

Posted by Ian Lienert

One of the principal objectives of a performance-oriented budgeting system is to link the results and the funding of budget programs. In order to make well-informed allocative choices in the national budget, it is important to obtain the best possible information on program costs. However, it is costly to obtain detailed and accurate program costing information. Compromises need to be made when choosing between simple methods of costing and more sophisticated models.

Activity-Based Costing (ABC) is an accounting technique initially developed for use in the private sector. With the push for program budgeting, ABC has also been used in the public sector of some countries. Proponents argue that ABC provides full cost information and also addresses the problem of allocating indirect (or "overhead") costs of government programs. However, if recent experience in the United Kingdom’s police service is to be taken as a guide, ABC is too expensive and demanding to be generalized for use in government budget programs.

For a private sector firm, Robert Kaplan (http://www.people.hbs.edu/rkaplan ) argues that traditional cost accounting systems distort cost information by weighting direct labor and materials more heavily than factory support operations, thus giving management inferior information on which to base decisions on pricing, product mix, and process technology. In contrast, ABC is a sophisticated approach that offers business managers accurate information, by delineating support costs and tracing them to individual products and product lines. Designing an ABC system entails collecting data on direct labor and material costs and analyzing the demands made by particular products on indirect resources. However, in the private sector, ABC lost ground in the 1990s after initial enthusiasm for it (see article by D. Katz http://www.cfo.com/article.cfm/3007694).

In the public sector, ABC has been applied to costing at the budget program level or at the level of individual services or activities. At a first stage, ABC costs broadly-defined activities or grouping of work tasks of a similar type. At a second stage, the costs of these activities are allocated to programs (or specific outputs within programs). To ensure accuracy, the cost drivers used in the second stage are based upon the quantity, number and resource-intensiveness of each type of service within a program.

Those who advocate use of ABC in the public sector see it as relevant to performance budgeting in two ways: first, as a tool for better expenditure prioritization; and second, as a means of developing tighter linkages between planned outputs and funding. Supporters of ABC argue that it is essential for the success of performance-based budgeting. Clearly, more accurate program costing improves the quality of expenditure prioritization choices. However, as noted in chapter 4 of Marc Robinson’s IMF book performance based budget (see posting of October 4, 2007 blog-pfm.imf.org/pfmblog/2007/10/making-performa.html), there is a dearth of systematic analysis of experience with ABC and no consensus as to ABC’s success in the public sector.

In the USA, for example, although it has been used by many local governments – and continues to be used at that level and in some federal agencies -- it has also been recognized that ABC is difficult to implement. Several government organizations that experimented with ABC have not continued with it, as ABC has been found to be a very high-cost accounting technology. Installing an ABC system is technically complex, requiring talented personnel and a considerable amount of time and money.

In the United Kingdom, from 2003-04, ABC was a mandatory requirement of England and Wales’ National Policing Plan and was regarded as a key component of the Policing Performance Assessment Framework. It was perceived that ABC would enable accurate comparison between police forces (ABC works best when comparator benchmarks are established) and would provide central assistance to weaker forces. A 133-page Guidance Manual for using ABC in the police was disseminated (http://police.homeoffice.gov.uk/finance-and-business-planning/index).

In an independent review of policing in April 2008 it was however found that ABC, as a comparative tool for improving productivity in the police, did not represent good value for money. Two strong recommendations were made. First, that the U.K.’s Home Office should urgently examine its requirement for each police force to undertake ABC, with a view to this requirement being replaced with an alternative that costs less, is easier to use, and has greater impact on productivity. Second, the police services were encouraged to assess alternative ways of meeting its information requirements regarding the allocation of police funding. The rationale for the recommendations can be found in the Final Report by Sir Ronnie Flanagan which, along with the Home Secretary’s initial response to the recommendations, can be found on http://police.homeoffice.gov.uk/police-reform/flanagan-police-review.

This evidence provides some support to the critics who have argued that in most instances ABC is not appropriate for public sector applications. Is this more extreme view fully justified? Or is there a case for using ABC selectively? For example, could it be successfully applied for the production of relatively standardized services? If yes, should it be largely reserved for use by local governments, where the services are relatively homogenous?

Although these questions remain open for debate, the recent report from the United Kingdom suggests that the putative benefits of ABC need to be strongly justified, given the considerable costs of the setting up and operating an ABC system.

Comments

[ahrainey]

A. GOVERNMENTS ALREADY USE ACTIVITY BASED COSTING (ABC). States, counties and cities in the United States have been using ABC and ABM (Activity Based Management) for years. The Government Generally Accepted Accounting Principles (GAAP) promulgated by the Governmental Accounting Standards Board (GASB) require the use of "fund" accounting. Furthermore, governments use of "performance based budgeting" provides the capability to link "activities" to "goals", "objectives" and "performance measures" or "key performance indicators".

B. THE INFRASTRUCTURE IN FINANCIAL SYSTEMS ALREADY EXIST. The state, county and city based fund accounting based financial systems typically provide governments with the capability to decompose accounting/budget transactions into: (A) FUND; (B) ORG CODES; (C) OBJECT CLASSES (C1) SUB OBJECT CLASSES; (D) PROJECT CODES or FUNCTION CODES. Many "budget modules" allow, when the budget is 'loaded' at the beginning of the fiscal year to construct a "Spending Plan" so that a "Budget to Actual" comparison can b posted and reported monthly and the payroll to b posted by each "Pay Period Ending" (PPE) date.

C. GOVERNMENT MUST ALLOCATE THEIR PERSONAL SERVICES BY PROJECT OR FUNCTION. For PERSONAL SERVICES (PS) each "Full Time Equivalent" (FTE) has their hours loaded into the spending plan. As there are 2,040 to 2,080 hours for a FTE, "Program Managers" (who are expected to use a Project Management software) have the FTE hours loaded into the respective PROJECT CODE or FUNCTION CODE and utilizing a "Time and Labor" module of a payroll or human resources management system, automated time cards require the posting of hours each pay period by PROJECT or FUNCTION. For "Capital Projects" and "Grants" and "Internal Service Charges" this provides an up to date reporting of labor time planned for a project and labor time used for a project in "real time".

D. GOVERNMENT MUST ALLOCATE THEIR NON PERSONAL SERVICES BY PROJECT OR FUNCTION. For NON PERSONAL SERVICES (NPS) each "encumbrance" or "obligation" and "payment" or "outlay" is coded against a PROJECT CODE or FUNCTION CODE. Items like supplies, equipment, consulting services, rent, etc. have their "outlays" or "payments" posted against the respective "encumbrance" or "obligation" that the Program Manager projected as part of her or his "Spending Plan" for the project. For "Capital Projects" and "Grants" and "Internal Service Charges" this provides an up to date reporting of NPS acquisitions planned for a project and acquisitions acquired for a project in "real time".

When there are "matching requirements" for state, county, and city governments, then there is ABC - though Program Managers and Financial Managers may neglect to identify the "Cost Drivers". However, most fund accounting financial systems and time and labor modules in payroll systems have these tools built in. It is the responsibility of "Financial Management" staff to assist governments to use these existing tools.

E. GOVERNMENT MUST RE-DESIGN THEIR REPORTING MODEL. Instead of "managing by exception" (e.g. taking the %s of the fiscal year that have transpired and comparing them to the % of the budget remaining), the public sector financial management staff in every country throughout the world must "management by a spending plan". Every budget that is loaded in the financial systems must be loaded by "Project" and/or "Function". Performance measures for each project must also be a part of the "Spending Plan". If 50% of the fiscal year has transpired, what was the planned level of activity for the project? Is it the "management by exception" 50% target, or is it a number based on "project management" constructs? This is what "Activity Based Management" (ABM) reports will show. They will also show "WHO" is responsible for a TASK and a DELIVERABLE for a "RESPONSIBILITY CENTER".

F. GOVERNMENT FINANCIAL MANAGEMENT MUST "STEP UP" AND LEAD THIS EFFORT. We do not hold the financial management staff accountable for providing management with the "techniques" and the "tools" to use both ABM and ABC. Look at your fund accounting text books, and fund accounting GAAP requirements, and you will find that your fund accounting financial systems already have this information available - if and only if a "Spending Plan" by "Project" or "Function" set up where by PS transactions are posted per PPE date by project or function, and NPS acquisitions are posted by project or function.

ANTHONY RAINEY is an Adjunct Faculty Member of the School of Professional Studies at Trinity College in Washington, DC. He is also a member of the Association of Government Accountants (AGA).

[Muhammad Ali Sheikh]

Hello
How are you? can u tell me the names of firms which are using activity based costing in UK. Or tell me books or websites from where i can find them. i will be very thankful to you.