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The ABC of efficiency – activity based costing is back in favour

Campbell McLundie, a partner at business advisers and accountants Scott-Moncrieff, makes the case for a bold new commercial approach to costing.

In a climate where public sector bodies are facing increasing financial scrutiny, and are under growing pressure to deliver more services and even more value for money, innovative financial management techniques could assist in the call for greater efficiency. The pot is shrinking, and how funds are allocated can often make a huge difference – to the bottom line, but also to jobs and services.

Activity-based costing is one such financial management technique. ABC fell out of favour in the 90s, or as some may say, ‘the good times’. But it is making a comeback, albeit with a bit of a makeover. First and foremost, ABC represents a commercial approach to the financial workings of an organisation – and so it requires a certain way of thinking and openness to new ideas – more often seen in corporate boardrooms than in the halls of the public sector. In short, a new climate needs a new approach.

Traditionally, resources within the public sector are managed through financial budgets organised around organisational structure rather than services. When pushed to provide a cost for a service the public sector body can quantify any direct costs involved but not how its highest costs – staff and facilities – have been applied in the delivery of the service. This relates to both those directly involved in front line services and support services.

At its simplest, activity based costing drives efficiency by allocating costs based on the use of resources in the delivery of distinct services. And it’s back in favour as public sector bodies require greater transparency of how its resources are being used on activities and how effective these activities are in delivering required outcomes.

At the heart of ABC, and possibly why it’s not been in favour within the public sector, is its bold commercial approach to costing. To measure the cost of a service and take into account resource costs, the resource used must be measured – which often means recording time spent. Timesheets allow accountability for what people are actually doing, and for this cost then to be allocated to services. This is a challenge for the public sector, and for those that wish to use ABC or take a similar approach, a culture change is definitely required.

At a time when local authorities and other public sector bodies are making big decisions about services, including in some cases making cuts, it is crucial that these decisions are made on the basis of the correct information. Two activities that absorb the same direct costs can use very different amounts of resource, if one requires much more manpower or marketing time for example, and for this reason, working out exactly how much this service costs the organisation is crucial. Activity based costing could throw a spotlight on services that look cost effective but are actually a drain on the purse when seen in the light of manpower expended weighed up against the number of people who use the service.

Under activity based costing, front line services themselves can become ‘customers’ or ‘clients’, serviced by the central functions of the organisation. This in turn can focus attention on how much support services are costing and whether there are more efficient means by which these services can be delivered.

It makes sense that an efficient organisation would not remove services without understanding what that service actually costs – yet this is all too common. If a public sector body was competing to deliver these services on the open market, understanding its costs would be at the heart of the business plan. Again – the commercial approach.

So, with reduced funding levels, activity based costing can ensure the public sector gets more bang for their buck, create heightened awareness of what activities actually cost, and help consolidate functions by identifying what drives the cost.

For organisations that want to move to activity based costing, there are some basic functions that need to be put in place. Potentially, some new software will be required for time recording, or a new cost accounting system. Structures for internal charging will need to be put in place, and above all, a cultural shift is needed.

Although there is not necessarily an ethos of profit making within the public sector, a more commercial approach to costs creates better judgement.

Going further, some public sector bodies are now looking at commercial activities to offset the cost of services to the public purse, and ABC creates the right environment in which this can be achieved.

This isn’t to say that activity based costing is as easy as ABC; but the significant impact that it can have on spending and service decisions are certainly compelling reasons to take a look.