Assignment 6: Cases on Cost Analysis and Government Decisions This week’s module on Brightspace includes the following report: Rivenbank, William C., David N. Ammons and Dale J.

C h a p t e r 6

Measuring and Improving Efficiency

In recent years, local, state, and national governments have focused much effort toward making government more efficient. Efficiency is the “accomplishment of objectives at minimal cost.”1 In other words, effi- ciency is the amount of resources used to produce an output. Efficiency is frequently measured in terms of the cost for each unit of output. Cost analysis can be a powerful tool to improve the efficiency of government programs. In this chapter, we will introduce four tools for measuring and improving the efficiency of government programs:

• Unit cost analysis;

• Standard cost analysis;

• Intergovernmental unit cost comparisons; and

• Activity analysis.

UNIT COST ANALYSIS Unit cost is the cost per one unit of a good or service. Examples of unit cost include: the cost of refuse collection per household per year, the cost per tree planting, and the cost per arrest. Unit cost can be a useful tool to measure improvements in efficiency. For example, a park main- tenance crew might use the maintenance cost per acre to measure the ef- ficiency of new maintenance techniques. A very high unit cost might in-

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dicate inefficiency, while a very low unit cost could indicate that insufficient personnel and equipment is being used.

How to Calculate Unit Costs. The unit cost is simply the total cost divided by the number of units of output. Several key points should guide a unit cost calculation. First, the costs included in the numerator should be those costs incurred to produce the units of output in the de- nominator. For example, if a village is calculating the cost per tree plant- ing, the costs of labor, materials, and equipment in the numerator should be for the specific trees counted in the denominator. Second, a unit cost benchmark that is used to evaluate managerial performance should only include those costs that the manager can control. Thus, it should not include allocations of costs that the manager has no control over. Third, the output used for the denominator should be a variable that most closely reflects the goals of the service. For example, if the goal is to maintain parkland, then cost per acre maintained should be used rather than cost per tree planted. Fourth, the units of output in the denom- inator should be comparable. For example, if the cost per tree planting is being compared across years, the average height of the trees planted in each year should be similar. Otherwise it is very difficult to deter- mine whether a change is unit cost is due to a difference in efficiency or tree size. Finally, when comparing unit costs over time, it is necessary to remove the effect of inflation from the cost data. (Chapter 5 shows how to adjust data for inflation.) Exhibit 6-1 shows the unit costs of the motor pool in Mercer County, New Jersey.2

How to Read Unit Cost Data. If not used carefully, unit cost data can be misleading. Although higher unit costs are often associated with inefficiency and high total costs, it is very possible that a program with higher unit costs is more efficient and has lower total costs. When inter- preting unit cost data, it is important to look behind the scenes to under- stand why unit costs have changed. The key questions to ask when in- terpreting unit cost data are:

1. Has there been a change in the quality or amount of service pro- vided per unit? In other words, is more or less service being pro-

82 ! Cost Analysis and Activity-Based Costing for Government

vided to each customer, or has there been a significant change in quality? If more service is being provided per unit, then an in- crease in unit costs may not indicate inefficiency, but the higher costs of providing more service. It is even possible that the ser- vice is more efficient if the same total amount of service is consol- idated into fewer units of service. For example, when a purchas- ing department consolidates purchase orders for repeated purchases into a blanket purchase order, the unit cost per pur- chase order will increase even though paperwork is reduced and efficiency is improved.3

2. Is another variable affecting unit costs? It is possible that a change in unit costs is due to another variable that is not in- cluded in the unit cost ratio. This variable could be a change in the environment that affects unit costs. For example, the unit cost of clearing snow may increase from one year to another due

Measuring and Improving Efficiency ! 83

Exhibit 6-1 ! An Example of Unit Costs

Cost Item Cost

Personnel Costs

Salary $626,404

Longevity $22,350

OT $55,000

Benefits (25%) $161,969

Total Personnel $865,723

Other Expenses

Parts, Tires, etc. $172,000

Special Services $99,000

Other $25,565

Total Other $296,565

Grand Total $1,162,288

Vehicles 489

Per Vehicle Maintenance Cost $2,377

to higher snowfall in the second year, not a decrease in efficiency.

A change in the clientele or usage of a program can also cause a change in unit costs. Exhibit 6-2 shows an example where a change in the participation rate in a recycling program has an opposite effect on two different unit cost measures.4 As the participation rate increases, cost per household shows an in- crease in unit costs (suggesting less efficiency), while the cost per ton shows a decrease in unit costs (suggesting more effi- ciency). The unit cost per household increases as the participa- tion rate increases because workers require more time to collect more material in each neighborhood and require more frequent trips to unload the truck at the recycling facility. The cost per ton decreases because it takes less time and less driving to collect each ton of recyclables because more houses are participating. Unit costs can be misleading because the output variable chosen for the denominator in the unit cost ratio does not give a com- plete picture of costs.

3. Are fixed costs a significant proportion of the total costs? and if so, What effect do the fixed costs have on unit costs? It is very

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Exhibit 6-2 ! Two Unit Cost Measures that Show Different Pictures of Efficiency

important to consider the effect of fixed costs on unit costs be- cause unit costs can be misleading when they contain fixed costs. When a significant portion of the total costs are fixed costs, it is difficult to know whether a change in unit costs is due to a change in efficiency or a change in quantity. This is because both a change in efficiency and quantity can affect unit costs when there are significant fixed costs.

If there are no fixed costs (i.e., all costs are variable) unit costs provide a convenient way to compare the total cost at two different quantities. Without looking at the unit cost, it is diffi- cult to determine whether, for example, $14 for 8 gallons of gas- oline is better than $25 for 13 gallons. Unit costs make this com- parison simple: $1.75/gal. versus $1.92/gal. When all of the costs are variable costs, the unit cost shows clearly whether an increase in total costs is due to an increase in quantity or a de- crease in efficiency. Exhibit 6-3 illustrates this. The top diagram of this exhibit shows the total costs of two alternatives. One al- ternative is an increase in total costs from A to B1. The second al- ternative is an increase from A to B2. Although B2 has higher to- tal costs than B1, the unit costs shown in the bottom diagram reveal that this B2 is a better alternative because it has lower unit costs than B1.

If a unit cost only contains variable costs, then it can be a good measure of efficiency because the unit costs will change if there is a change in efficiency and remain the same if a change in total costs is due to a change in quantity. However, if a unit cost contains fixed costs, it is difficult to know whether a change in unit cost is due to a change in efficiency or quantity. Unit costs that contain significant fixed costs will tend to decline as the quantity increases because additional units bear a portion of the total cost. Exhibit 6-4 shows how an increase in unit costs could be due to either a change in efficiency or a change in quantity. This exhibit shows two alternatives with the same increase in unit costs. One alternative is an increase in unit costs from A to B1. The second alternative is an increase from A to B2. Although both alternatives have the same unit cost, the increase in unit costs to B1 is caused by a decrease in quantity, while the increase to B2 is caused by a decrease in efficiency.

Measuring and Improving Efficiency ! 85

Two ways of avoiding the misleading nature of unit costs that include fixed costs are to: 1) look at the change in total cost rather than the change in unit cost, and 2) exclude fixed costs and measure only the unit variable cost.

4. Is there excess capacity or the need to expand capacity in the near future? Excess or deficient capacity is also an important consideration when interpreting unit cost data. In some cases, high unit costs may be due to a recent expansion in capacity and may suggest excess capacity that is being underutilized, while unusually low unit costs may suggest the need to expand capac- ity in the near future. When capacity is expanded, unit costs will

86 ! Cost Analysis and Activity-Based Costing for Government

Exhibit 6-3 ! Unit Costs and Variable Costs

experience a sharp increase and then decrease as the capacity is used up.

STANDARD COST ANALYSIS A standard cost is a unit cost in normal or optimal conditions.5 In other words, a standard cost is what the unit cost should be. In the government sector, standard costs are usually set by each individual government. The standard is based on either historical data or the judgment of indi- viduals familiar with the organization’s costs. Standard costing6 is ap- propriate for repetitive services, such as processing tax payments, in which the work performed is the same for each unit of service.

How to Do Standard Costing. In order to use standard costs to pin- point inefficiencies in a budget, first a standard cost is determined for each line item in the budget. Then, these standard costs are multiplied by the actual quantity of each line item to calculate a flexible budget. A flexible budget is a hypothetical budget that shows what the dollar value of each line item would be in an efficient scenario.7 Finally, the flexible budget is compared with the actual budget to pinpoint ineffi- ciencies in specific line items. Standard costing involves three basic steps:

1. Determine standard costs.

2. Calculate a flexible budget by multiplying the standard unit cost by the actual quantity of each line item.

Measuring and Improving Efficiency ! 87

Exhibit 6-4 ! Unit Costs and Fixed Costs

3. Use variance analysis to compare the actual and flexible budgets.

Exhibit 6-5 shows an example of a standard cost analysis for a garbage collection service.

Step 1: Determine Standard Costs. The first step in a standard cost- ing analysis is to determine standard costs for each line item in the bud- get. First, knowledgeable individuals estimate the amount of resources necessary to produce a level and quality of output that meets the orga- nization’s objectives. Second, the cost of each resource is estimated. Third, the total cost of each cost component is divided by the output to calculate a standard unit cost for each component.

There are three approaches to setting standard unit costs. One ap- proach is to make the historical average the standard. This approach is easy to determine, however it incorporates past inefficiencies and may demotivate employees to surpass the standard. A second approach is to make normal operating conditions the standard. This approach does not incorporate past inefficiencies; however, it requires more detailed analysis and more subjectivity as to what are considered normal condi- tions. A third approach is to make optimum conditions the standard. This approach moves the bar up to the highest level and incorporates no

88 ! Cost Analysis and Activity-Based Costing for Government

Exhibit 6-5 ! How to Do Standard Costing

inefficiencies. The disadvantage, however, is that it might demotivate employees by setting a standard that is impossible to maintain. Exhibit 6-6 summarizes the strengths and weaknesses of the three approaches to setting standard costs.8

Step 2: Calculate a Flexible Budget. The second step is to calculate a flexible budget by multiplying the standard unit cost by the actual quantity of each line item.

Step 3: Do a Variance Analysis. The third step is to use variance analysis to compare the actual and flexible budgets. Variance analysis can be used to examine whether differences between the actual and the flexible budget are due primarily to one of the following:

1. Change in the quantity of output (i.e., the demand for the service);

2. Change in the quality or amount of service provided for each unit;

3. Change in efficiency (i.e., change in the amount of labor and ma- terials used for each unit of output); and/or

4. Change in prices (i.e., wage rates and material prices).

INTERGOVERNMENTAL UNIT COST COMPARISONS An alternative to benchmarking unit costs against an internally gener- ated standard is to compare unit costs with other governments who provide the same services. In an effort to improve the performance of

Measuring and Improving Efficiency ! 89

Exhibit 6-6 ! Approaches to Setting Standard Costs

Standard Costs Based On: Strengths Weaknesses

Historical averages • Uses actual performance data

• Easy to determine

• Incorporates past inefficiencies

• May demotivate employees to surpass standard

Normal operating conditions • Reflects current performance

• Past inefficiencies are not automatically included

• Requires detailed analysis • Requires subjective judg-

ment to define “normal” conditions

Optimum conditions • No past inefficiencies built into standard

• Lowest unit cost

• May demotivate employees by setting a standard im- possible to maintain

local government services, several programs have been developed to collect and compare performance measurement data and cost data across governments.

The International City/County Management Association’s Com- parative Performance Measurement Program assists more than 130 cit- ies and counties in the United States and Canada to collect and analyze performance and cost data. Governments that participate in the pro- gram can compare their performance and cost data to the full sample or a subset of comparable jurisdictions. (http://www.icma.org/performance)

The North Carolina Local Government Performance Measurement Project (NCBP) currently includes 14 cities in North Carolina. The NCBP was initiated in 1995 and is one of the most advanced compara- tive benchmarking projects. Appendix E includes a copy of the NCBP form used to collect cost accounting data. (http://ncinfo.iog.unc.edu/programs/perfmeas/)

The South Carolina Municipal Benchmarking Project was pat- terned after the NCBP and includes 19 cities. (http://www.iopa.sc.edu/eJournal/Benchmark2.htm)

The Kansas City Performance Measurement Pilot Project began in January 2000 and includes 11 cities and counties. (http://www.marc.org/performance/home.htm)

Ontario Municipal CAO’s Benchmarking Initiative (OMBI) was initiated in 2000. OMBI plans to integrate activity-based costing data with performance data from participating jurisdictions. (http://www.ombi.ca/index.asp)

The Municipal Performance Measurement Program (MPMP) col- lects performance and cost data from all local governments in Ontario, Canada. The program is an outgrowth of an earlier program initiated in 1996 by the Province of Ontario Ministry of Municipal Affairs and Housing. Unlike the other comparative performance measurement pro- grams, participation in MPMP is mandatory. (http://municipalbestpractices.ca/reference/index.asp)

Caveats When Comparing Unit Cost Data. The following caveats9

should be considered when comparing unit cost data across governments:

1. Differences in cost accounting can create problems when com- paring costs across governments. Some governments may in-

90 ! Cost Analysis and Activity-Based Costing for Government

clude only direct costs while others may include both direct and indirect costs. In addition, governments may differ in what indi- rect costs they include. For example, some governments may not include general government overhead, pension costs, and depreciation in their indirect costs. Further, governments may differ in the allocation bases that they use and the method that they use to allocate indirect costs. For example, some govern- ments may use a single-step allocation while others may use a step-down or reciprocal allocation. These problems can be avoided if all the participating governments follow a standard cost accounting methodology.

2. Governments may have acquired capital assets at considerably different times. If the governments both include significant de- preciation expenses in their costs, then a comparison of costs should be done carefully because inflation can distort a compar- ison of their depreciation expenses (see Chapter 5 for a more complete discussion).

3. Governments may differ in their geography, climate, cost of liv- ing, population density, and societal makeup. Each of these fac- tors can influence the cost of providing identical services. For example, garbage collection costs per household will likely be higher in a county with a low population density than in a county with a high population density because of the greater distance between houses.

4. Governments may differ in their level (i.e., state, county, munic- ipality) and type (e.g., general-purpose, special-purpose).

5. There may be significant differences between the same service performed in different governments. For example, one govern- ment may only pick up garbage at the curb, while another gov- ernment may pick up garbage at a resident’s backdoor (which requires more labor-hours). One way to avoid this problem is to note significant differences in service and divide the sample into two comparison groups: governments with curbside pickup and governments with backdoor pickup. However, this may not be possible if the differences become numerous and complex.

Measuring and Improving Efficiency ! 91

6. Output measures do not necessarily provide information on outcomes and quality of the service. Although one government may have a lower cost per unit of output for job training services than another government, its service may have lower quality and effectiveness than the comparison cities. In other words, its greater efficiency may have been at the expense of effectiveness and quality.

7. Unit cost comparisons do not show a government how it is per- forming compared to an ideal standard, but only show how it is performing relative to its peers. If comparable governments also possess the same inefficiencies, then a unit cost comparison will fail to spot areas of improvement.

ACTIVITY ANALYSIS A traditional approach to increasing efficiency is to cut budgets – reduc- ing the amount of labor and materials while maintaining the same level of output. While this approach will increase efficiency in the short run, in the long run, costs may return to previous levels as employees tire of the unusually fast pace. Another approach is to uncover the inefficient or unnecessary activities that cause the costs. If these activities can be made more efficient or eliminated, then efficiency can be improved per- manently. This second approach is called activity analysis.

Activity analysis (or value analysis) focuses on the activities that an organization performs. The first step in an activity analysis is to draw a detailed diagram of the steps involved in providing a service. This dia- gram is sometimes called a process flowchart. Each activity in the process is then classified as either a value-added or nonvalue-added activity. A value-added activity is an activity that increases the value of a service to the customer. A nonvalue-added activity is an activity that does not in- crease the value of a service to the customer. For a snow plowing ser- vice, a value-added activity would be the actual plowing of the streets. A nonvalue-added activity would be vehicle repair because the activity of repairing vehicles does not improve the clearing of snow. In other words, if vehicles were so reliable that vehicle repair could be elimi- nated, the loss of this nonvalue-added activity would not decrease the value of the snow plowing service. Since nonvalue-added activities consume resources, if they can be eliminated, resources can be saved

92 ! Cost Analysis and Activity-Based Costing for Government

without taking away from the goal of the service. Overall efficiency is improved by continually finding ways to eliminate nonvalue-added ac- tivities and improve the efficiency of value-added activities.10 Appen- dix F provides additional guidance on performing an activity analysis.

Endnotes

Measuring and Improving Efficiency ! 93

1. James E. Sorensen, Glyn W. Hanbery, and A. Ronald Kucic, “Managerial Accounting,” Budget Formulation & Execution, 2nd ed. (Athens, Georgia: Carl Vinson Institute of Government, 1996), p. 452.

2. This table is adapted from State of New Jersey, Department of Treasury, Achieving Excellence: A Guide for Local Officials and Taxpayers To Identify Cost Savings and Improve Local Services (October 1996), p. 57.

3. This example is adapted from Joseph T. Kelley, Costing Government Services: A Guide for Decision Making (Chicago, Illinois: Government Finance Officers Association, 1984), pp. 62-63.

4. This chart is adapted from Jim Morris and Wayne DeFeo, “Fully Understanding Costs,” Practical Recycling Economics (New Brunswick, New Jersey: Rutgers, the State University of New Jersey, 1999), p. 42.

5. This section on standard costing is based on Bruce R. Neumann, James D. Surer, and William N. Zelman, Financial Management: Concepts and Applications for Health Care Providers, 2nd ed. (Dubuque, Iowa: Kendall/Hunt Publishing Company, 1997) and Robert N. Anthony and David W. Young, Management Control in Nonprofit Organizations, 5th ed. (Burr Ridge, Illinois: Irwin Publishers, 1994), pp. 194-196.

6. The term “standard costing” is also used to refer to a “method of estimating the historical cost of a capital asset by establishing the average cost of obtaining the same or a similar asset at the time of acquisition.” Stephen J. Gauthier, Governmental Accounting, Auditing, and Financial Reporting: Using the GASB 34 Model (Chicago, Illinois: Government Finance Officers Association, 2001), p. 651.

7. Another use of the term flexible budget is a budget “which authorizes varying levels of spending depending on demand or revenues.” This is in contrast to a fixed budget, which establishes a fixed spending cap that cannot be exceeded without special authorization. Gauthier, Governmental Accounting, Auditing, and Financial Reporting, p. 304.

8. This table is adapted from Neumann, Surer, and Zelman, Financial Management, p. 332. 9. These caveats are based on H.M. Coombs and D.E. Jenkins, Public Sector Financial Management

(London, England: Chapman & Hall, 1994), pp. 25-28; Leon E. Hay and Earl R. Wilson, Accounting for Governmental and Nonprofit Entities (Chicago, Illinois: Irwin Publishers, 1995), pp. 591-592; and the GFOA Recommended Practice, “The Use of Trend Data and Comparative Data for Financial Analysis (2003).” This section includes some caveats not discussed in the GFOA Recommended Practice.

10. This section is based on Atkinson et al., Management Accounting (Upper Saddle River, New Jersey: Prentice Hall, 1997), pp. 62-69.

C h a p t e r 7

Setting Fees and Charges

This chapter begins by briefly looking at the advantages of fees and user charges.1 Following this is a review of the fee-setting process. The first step in setting fees is to determine whether a fee is appropriate for the service. The second step is to determine the primary purpose of the fee, because the purpose will determine the method that should be used to set the fee. For example, if the primary purpose of the fee is to recover the full cost of a service (or subsidize a percentage of the full cost), then one should determine either the direct and indirect costs or the fixed and variable costs of the service. However, if the primary purpose of the fee is to recover the cost of additional users of a service, then one should determine either the marginal costs or fixed and variable costs of the service. The final step after performing the cost analysis is to consider any significant market factors, political factors, and broad policy goals that may influence the amount of the fee.

ADVANTAGES OF FEES AND USER CHARGES Fees and user charges2 comprise about 16 percent of total state and local government revenues.3 Fees and user fees have a number of important advantages. They generate revenue and send important signals on user demand, they enable a government to control how a service is used and carry out public policy, and they provide a means of financing that is fairer than taxes.

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Revenue. User fees can be an effective way to generate revenue. Fee increases are usually more politically popular than tax increases. Fees can also help a government to diversify its revenues so that the government is not overly reliant on particular sources of revenue. In ad- dition, user fees that cover the total cost of a service enable a govern- ment to expand a program without increasing taxes or the costs to indi- vidual users because the additional users pay for the expansion.

Information. In addition to revenue, fees also provide important information to the government on the demand for a service. For exam- ple, monthly parking spaces that are sold quickly at a high fee indicate that there is a high demand for parking. The demand for a service after a fee is set equal to the cost of a service can tell policy makers whether res- idents are willing to pay what it costs to provide a service.

Control How a Service or Resource is Used. Fees can also be used to control how customers use a service or resource. For example, even a small fee on water can prevent users from wasting this resource. Li- brary fines encourage users to return books to the library so that they can be shared by others.

It is also possible to use fees to smooth out peak demand for a ser- vice by charging higher fees during peak periods. This would encour- age customers to use a service at non-peak times and may reduce the need for long lines and extra staff during peak periods.

Carry Out Public Policy. Since user fees influence behavior, they can also be used to carry out public policy. For example, if a govern- ment wants to encourage its citizens to recycle more, it might charge a fee based on the volume of garbage that a resident puts at his or her curbside. If a government wants to decrease automobile emissions, it might lower bus fees and increase car registration fees.

Fairness. Another advantage of fees is that they are fairer than taxes in that those who use a service pay for it. If a service is financed by taxes, all of the taxpayers must pay for it whether they use it or not. In addition, it is possible for nonresidents to use the service even though they do not pay taxes to support it. Fees avoid both of these inequities. One disadvantage with fees, however, is that they may wipe out inten- tional subsidies for low-income residents, unless special adjustments are made.

96 ! Cost Analysis and Activity-Based Costing for Government

HOW TO SET FEES The process of setting fees involves answering four basic questions: (1) Is a fee appropriate for this service? (2) What is the primary purpose of the fee? (3) What is the full cost of the service? and (4) How do market factors, political factors, or broad policy goals affect the amount of the fee? The government’s policy on fees and charges should provide a guide to answering these questions.

Develop Policy on Fees and Charges. The Government Finance Officers Association (GFOA) and the National Advisory Council on State and Local Budgeting (NACSLB) both recommend that govern- ments develop a formal policy on setting fees and charges, which should have the following characteristics:

• Includes a requirement to review all fees and charges;

• Identifies how fees and charges will be set and what factors will be taken into account;

• States whether the gove

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