Cost accounting: does it apply to government?

Schneider, Gary P. ; Bruton, Carol M.

ABSTRACT

This paper discusses cost accounting and its multiple uses in a governmental setting. The paper includes discussions about the applicability of cost data for outsourcing decisions, measuring efficiency, performance appraisal, auditing, and allocation of scare resources. The paper then discusses the implementation of cost accounting. The paper argues that there are multiple, valuable uses for cost data in governmental settings.

All too often the financial accounting function including the financial statement preparation receives much more attention than the cost accounting function. It is easy to justify an expense for financial statement preparation because it is required by external forces. For example, GASB 34 on capitalizing infrastructure, there is no question that it will be done and get done. Resources will be expended to comply. Try selling the importance of cost accounting in a governmental setting. Expenses for improvements to the cost accounting system are all too often deferred. However, cost accounting information can be more important for the long run survival of the governmental unit than financial accounting. Costs can become so out of hand that one day you show up to work and find you have been outsourced; and you didn't even have the chance to reduce your cost structure to avoid the outsource.

INTRODUCTION

Cost accounting, in its simplest form, is knowing how much something costs. For example, a city knowing how much it costs to make a photocopy, to book an inmate to the jail, to build a stadium, or for a round of golf at the municipal course.

In the following sections we argue that cost accounting information is helpful for outsourcing decisions, measuring efficiency, performance appraisal, auditing, and allocation of scare resources. We also provide a discussion on the implementation of cost accounting.

OUTSOURCING DECISIONS

Outsourcing is the term used for contracting out services that were previously performed in house. Outsourcing is a popular and controversial topic these days. The private sector is increasingly taking over public sector activities. Whether we like it or not, outsourcing is increasing. Governmental units are outsourcing education, ambulance services, repair and maintenance services, garbage pickup, landfills, and food services among other things. In the private sector, BP Amoco just outsourced their accounting function to PricewaterhouseCoopers for $1.1 billion.

If you are in charge of a governmental service, how will you respond when the city manager/mayor/city council suggests outsourcing your service? It could be the print shop, the fire fighting, ambulance services, police, auditing, accounting, etc. You may be thinking that fire and police would never be outsourced. Would you ever have thought BP Amoco would have outsourced its accounting function? Note the services the military outsources today that they would not have considered outsourcing several years ago. Services such as food, engineering, base security, research and development, and repair and maintenance are contracted out today.

Do governmental units have the cost information they need to determine which is the better value, outsource versus in house? It may be cheaper, it may not. The governmental accountants and auditors need to be ready with the costs of their own departments to protect their own positions. There may not be pressure today to outsource because the economy is good and cost cutting is not a major issue, but what if there is a dip in the economy? Are you ready to respond?

MEASURING EFFICIENCY

Prior to 1992 the city of Indianapolis experienced deficits with increasing expenditures. In 1992 the new mayor pledged to reduce the size of government, hold taxes, and re-invest in the city's infrastructure (Cooper & Kaplan, 1999, p. 48). The mayor noted that while the private sector attempts to improve services while reducing costs to stay competitive and remain in business, the public sector generally spends more money each year without necessarily increasing service or quality. The mayor wanted to make government smaller, to make it more responsive, and to make its managers think about value, the cost and quality of services delivered to its customers, the citizens (Cooper & Kaplan, 1999, p 49). Among other things, the mayor put the "pothole repair contract" out to bid, and requested the accounting department to derive the costs for the internal bid. In the process of costing "pothole repair" the city realized many inefficiencies, including the size of the team used to repair potholes and what the team did with their idle time. They fixed these inefficiencies and were able to keep the contract in house.

PERFORMANCE APPRAISAL

Without cost accounting data how are you going to appraise the performance of the print shop manager, the police chief, the fire chief, the accounting department manager, the audit department manager? Are the employees controlling costs? Cost accounting data is necessary for performance appraisal. Cost accounting requires the calculation of standard costs that can be used for comparisons to actual data to determine the quality of the work. Without standard costs, there is no comparison, except to a prior period, in which the inefficiencies will already have been compounded.

AUDITING

Cost accounting data aids the auditors in their search for discrepancies. A common audit technique is to compare actual results to "normal" results. This is frequently referred to as "analytics" or "analytical review". How do the auditor's know what "normal" is without accurate cost data? Frauds usually start out small and undetectable, and then grow. How do we know the difference between the "real" growth, and the growth due to fraud? If we have accurate costing information we can compare the dollar amounts to "reliable" data, and not simply to last year's numbers, which have the fraud in them also.

ALLOCATION OF SCARCE RESOURCES

Without accurate cost data, how do you know how to allocate the budget among the governmental units? How do you know which unit needs the money? And, how do you know how to allocate the budget within the unit? For example, within the transportation division, how do you know how much of the budget to give "maintenance" versus "new construction". How should money be spent among road reconstruction and enhancement, repaving, resurfacing, or pothole filling?

Cost accounting will provide accurate data illustrating the needs of the units. For example, if pothole repair requests more employees, you have accurate information on the labor required to fix the potholes, the approximate number of potholes, and whether the existing staff can handle the load. Resources are allocated where they are needed in lieu of going to the strongest negotiator.

SPECIFIC EXAMPLES WHERE COST ACCOUNTING MAY BE USED

Trash Collection

Most cities contract out their trash collection; some cities handle it in house. Are taxpayers better off if it is contracted out? You may have an immediate strong reaction to this question. But, is your reaction based on fact? Do you have the numbers and the facts? Or, is it based on emotion? Would the customers have better service? You may say no, but it may be yes because of the pressure to keep the contract. How do you know how efficient the city trash collection operations are? How do you know how well the manager is managing the trash collection? How do you know what "normal" costs are in order to distinguish abnormal costs when auditing the data? The cost accounting data will provide information to answer all of these questions.

Landfills

San Diego County sold its landfills to a private contractor. How do you know if a governmental unit would profit from selling its landfills? You may have a "hunch". Is it based on fact? Are you ready to back up your hunch with numbers and facts? Do you have a cost accounting system in place to know the costs? Timing is important. Do you have the cost accounting information now? When a city manager/mayor/city council requests the cost information for the landfills, they will want the information now. Are you ready? They will want the cost information right away. You need the cost accounting data to know how efficient the landfill operations are, how well the manager is managing the landfills, and to know what "normal" costs are in order to distinguish abnormal costs when auditing the data.

Water and Sewer

Should part (or all) of water and sewer services be outsourced? You could outsource the maintenance, the billing, and the collections among other things? Telephone, cable TV, trash collection, and landfills are provided by the private sector, why not water and sewer? Don't rule it out. You need accurate cost data to know how efficient your operations are, to be able to measure the performance of the managers, and to know what "normal" costs are in order to distinguish abnormal costs when auditing the data.

The Print Shop

If Kinko's proposed providing all of the copying and printing needs for the governmental unit for $X are you ready with a response? How do you know how efficient the print shop operations are? How do you know how well the manager is managing the print shop? How do you know what "normal" costs are in order to distinguish abnormal costs when auditing the data?

Central Stores

If Walmart proposed providing Central Stores services for a governmental unit for $X are you ready with a response? After all, Walmart has state of the art software and methodologies to provide products to customers. You need cost accounting data to know how efficient the central stores operations are and how well the manager is managing the central stores. The data will also provide the "normal" costs are in order to distinguish abnormal costs when auditing the data.

Golf Courses

If a private party proposed to take over managing the city's golf courses are you ready with a response? How do you know how efficient the golf course operations are? How do you know how well the manager is managing the golf courses? How do you know what "normal" costs are in order to distinguish abnormal costs when auditing the data? Cost accounting information will provide this data needed for decision making.

Public Sports Stadium

Public sports stadiums are controversial. Many sports franchisees' are making money at public expense. The franchisee obtains substantially reduced rental agreements from the public stadium to retain the team. As a result, the public stadium loses money at the expense of the taxpayer. Should public sports stadiums be sold to private parties?

If the stadium is not sold to a private party, what aspects of the stadium should be contracted out? Should you contract out the food, the maintenance, the security, and/or the parking? Why or why not? You need justification for which services the governmental unit provides and which services are contracted out? Cost accounting will provide this information.

Libraries

Could libraries be owned and operated by the private sector? Don't laugh, someone could come up with a way to generate revenue. For example, name the library "Microsoft library", similar to how stadiums are named after businesses to generate revenue. Who would have thought of this lucrative revenue source 20 years ago?

If you do not believe libraries could be owned by private parties, how about operated by private parties? Accurate cost accounting data is necessary for the decision. Accurate cost accounting data is also necessary to gage the efficiency of the current operations and for audit data.

Parks

Could parks be owned and operated by the private sector? Could park maintenance be contracted out? Certainly. Cost accounting data may be used for outsourcing decisions, measuring the efficiency of past operations, performance appraisal of the personnel, auditing, and budgeting, among other things.

Animal Shelters

Could animal shelters be owned and operated by the private sector? Could the operation be contracted out? Are they being operated efficiently? Cost accounting data will answer these questions.

Summary

Quality cost accounting systems can benefit the city in numerous ways. Accurate cost accounting is imperative for outsourcing decisions, measuring the efficiency of the governmental unit, performance appraisal for management, the budgeting process to allocate scare resources, and audit applications.

IMPORTANCE OF COST ACCOUNTING IN GOVERNMENT

All too often the financial accounting function including the financial statement preparation receives much more attention than the cost accounting function. It is easy to justify an expense for financial statement preparation because it is required by external forces. For example, GASB 34 on capitalizing infrastructure, there is no question that it will be done and get done. Resources will be expended to comply. Try selling the importance of cost accounting in a governmental setting. Expenses for improvements to the cost accounting system are "put off into the future". However, cost accounting information is more important for the long run survival of the governmental unit. Costs can become so out of hand, one day you show up to work and you are "outsourced". You didn't even have the chance to reduce your cost structure to avoid the outsource. Unlike financial accounting, cost accounting information is flexible. You are not constrained by GASB 34, or any GASB for that matter. You can provide the information how you want, in the form you want with some minor exceptions of cost information that is mandatory to include in the financial statements.

HOW DO YOU PROVIDE ACCURATE COST INFORMATION?

The basics of costing a product, service, customer or activity are (1) Direct Materials which are items that are directly traceable to the product, service, customer or activity. An example is a score card used by the golfer on a golf course. (2) Direct Labor which is the cost of wages of employees who are directly involved converting the materials into a product, or providing a service, or helping a customer, or activity. An example is the golf pro for the golf course. (3) Overhead which includes the Indirect Materials, Indirect Labor, Supplies, Depreciation (trucks, building, lawn mowers), Human resources, Payroll, Information Systems, Utilities, Insurance, Repairs & Maintenance, etc. Indirect materials is the cost of materials that are not directly traceable to the product, service, customer, or activity, however, they are used in the process. An example is the soap for the ball washers. Indirect labor includes the cost of labor that is not directly involved in manufacturing the part, or providing the service or activity, or serving the customer. Examples of indirect labor include the salaries of golf course maintenance workers and supervisors. You exclude "headquarter" expenses, the rationale is that these expenses remain whether the division exists or not.

ALLOCATING OVERHEAD

At the first of the year, you do not know what overhead will be for the year, so you must estimate it, and allocate it on some arbitrary basis. Possible allocation bases include:

Direct For example, if, at the first of the year, you think total
Labor overhead will be $30,000 for the year, and you will spend
Dollars: $15,000 on direct labor for the year, you would allocate
 $30,000 / $15,000 = $2.00 for each direct labor dollar.

Direct For example, if, at the first of the year, you think total
Labor overhead will be $30,000 for the year, and you will have
Hours: 1,500 direct labor hours for the year, you would allocate
 $30,000 / 1,500 = $20 of overhead for each direct labor
 hour.

Machine For example, if, at the first of the year, you think total
Hours: overhead will be $30,000 for the year, and you will use
 2,000 machine hours during the year, you would allocate
 $30,000 / 2,000 = $ 15 of overhead for each machine hour.

ACTIVITY-BASED COSTING (ABC)

The above methods resulted in one overhead rate, for example $2.00 for each direct labor dollar. ABC costing results in many overhead rates for the different categories of overhead. For example, you may allocate indirect materials based on number of products, services, customers, or activities provided. Then, allocate indirect labor based on direct labor hours. Allocate supplies based on number of products made, or services provided, or number of employees.

Example:

Overhead item Allocation Method
Indirect materials Number of services provided
Indirect labor Direct labor hours
Human Resources Number of employees
Payroll Number of employees
Supplies Number of employees
Depreciation Total fixed assets
Repairs & Maintenance Total fixed assets

ABC Costing provides much more detailed cost information. This more detailed information is much better for decision making. However, this method is more time consuming than the other three methods.

IMPLEMENTING COST ACCOUNTING

To implement cost accounting in your governmental unit you should first interview people inquiring about what they do. In this process you come up with a list of activities. Gather data from the existing accounting information. Look at payroll records to see how people spend their time; be prepared for these records to not be as detailed and accurate as necessary. Select your cost allocation basis such as hours worked, pounds of material, number of employees, or total fixed assets. Then assign the costs to the activities.

In summary, you must identify the resources that each object consumes, estimate the cost of each resource, and then sum the costs across all resources used.

THINGS YOU MAY DISCOVER

Managers may change their focus from the number of hours spent doing something (fixing potholes) to a total cost approach that includes unproductive time, excess equipment, real estate, inventory, and other overhead items (Cooper & Kaplan, 1999). You may discover how small labor costs are compared to material costs and overhead costs. Expenses will require more justification in the future. For example, maybe the governmental unit keeps extra vehicles in case a vehicle breaks down or needs maintenance. For these situations, it would be cheaper to rent vehicles, rather than have extras around (Cooper & Kaplan, 1999). Unproductive time will be highlighted and converted to productive time. For example, previously when equipment was being repaired the crew sat idle. Now they will find other tasks that need to be done that can be completed during that time (Cooper & Kaplan, 1999).

OTHER USES OF COST DATA

Now that you have spent all of this time gathering accurate cost data what else can you do with the data? In the following sections we discuss break even point analysis, target net income, sales mix, budgeting, variance analysis, pricing decisions, and outsourcing decisions.

Break Even Point Analysis

Break Even Point analyzes the number of units required to be sold to earn zero net income. Following is an example of Break Even Point Analysis for a golf course. Given the cost of a golf course, how many players have to play each year to break even such that revenues minus costs is zero.

Break Even Point = Fixed Cost / (Greens Fee per Golfer - Variable Costs
per Golfer)

As can be noted from the above, you will need to divide each of your costs into either a variable costs or a fixed costs. If the costs vary with the number of golfers they would be included as variable costs. If the costs are fixed with the number of golfers they would be included as fixed costs. For example, a score card would be a variable cost because one card is used by each golfer, or group of golfers. The water for the course would be a fixed cost. Even if there are no golfers, you still have to water the course.

Target Net Income

Target Net Income is used to calculate the number of units that need to be sold to achieve a designated net income. For example, if a golf course needs to show a profit of $20,000 for the year, how many golfers do we need to show that profit?

Profit = Sales - Fixed Costs - Variable Costs
= (Greens Fees per Golfer X Estimate of Number of Golfers) - Fixed Costs
- (Variable Costs per Golfer X Estimate of Number of Golfers)

This information can be used in determining green fees and in controlling costs.

Sales Mix

Sales Mix is useful for deciding which products to provide or which products to promote. For example, should you allow both commercial and residential customers to use the landfill? Which is the more profitable customer? Which customer should you encourage? The results would consider the costs and revenues of the commercial customer versus the costs and revenues of the residential customer and determine which is the more profitable.

Budgeting

The cost accounting data may be used in the budgeting process. The budgets will be more accurate and useful in decision making.

Variance Analysis and Management by Exception

Variance Analysis and Management by Exception is the process of comparing the actual cost data with the standards cost data and investigating the situations where actual costs are greater than the standard costs, termed unfavorable variances. The cost data is used to determine the standards. For example, you could determine the standard water usage for a certain month at a golf course. If the actual usage for the period is greater than the standard usage, an investigation is warranted. This investigation may reveal a broken valve, which could then be fixed. Without the standards and the investigation, the broken value may exist for months costing the governmental unit hundreds of dollars.

Pricing Decisions

The cost data may be used for pricing decisions including the green fees for a golf course, water usage, and sewer usage among other things.

Outsourcing Decisions

The cost data may be used for outsourcing decisions as we discussed earlier.

SUMMARY

Governmental units do collect cost data. However, it is typically not collected in a form that is relevant for decision making. Resources and time are not allocated to cost accounting as readily as they are allocated to financial accounting and financial statement preparation. This paper illustrates the many important uses of cost accounting and improving this function is imperative for the future of governmental units.

REFERENCES

Cooper R. & Kaplan R. 1999. The Design of Cost Management Systems, Second Edition, Upper Saddle River, NJ: Prentice-Hall.

Gary P. Schneider, University of San Diego

Carol M. Bruton, California State University San Marcos