Costs Behaviour and Costing Methods

Costing is the process of identifying and allocating the cost of inputs (resources) to outputs (services). There are many different costing methods. Unit costing is one method that can be used for VFM Reviews

Unit Costing
We all recognise that absolute costs can increase year on year; but what exactly are we getting for our money? Are we providing more services? Or are the services we provide just getting more costly? Without linking what we spend (input) to what we provide (output) we do not know how cost effective we are. Measuring the cost per unit produced (unit cost) is therefore one way that we can define Value for Money. By comparing the unit cost of the service over time we can track our progress on cost effectiveness. Comparing unit costs with other similar organisations we can assess our relative efficiency. The calculation of unit cost is very simply represented by taking the total cost of a service and dividing it by the number of service units provided. Total cost Number of cost units = Unit Cost

It sounds simple, but to be meaningful we need to understand our costs and how they behave and also be able to identify units that most meaningfully measure the performance of the service. Cost Centres All services have budgets or cost centres that are made up of the same elements. For example, the Markets service budget for 2006-07 looks like this: Markets Budget 2006-07 Employees Premises Transport Supplies and Services Third Party Payments Support Services Total Expenditure Income Net Expenditure 000 108,860 10,120 6,810 16,270 47,520 19,650 209,230 (125,000) 84,230

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This is called the Total Cost of the service because it includes all direct costs (like employees and supplies) and indirect costs (like support services). Knowing how costs behave will help in understanding our unit costs. Costs may be fixed or variable, direct or indirect. Some examples from the markets service might be: Direct Storage fees for market equipment Employee costs for putting up stalls Indirect Office accommodation for supervisory staff Debtors recharge per invoice raised

Fixed Variable

Variation in output may be associated with a change in inputs depending on the type of cost. In other words, the more services you provide, the more it will cost. For example, increasing the number of markets held would mean additional hours worked and therefore increased employee costs. Certain costs are fixed and would not vary directly with output. For example, storage costs for the stalls when not in use would not vary with number of markets held. Outputs Identifying units produced may not always be straightforward. Not all services have separately identifiable jobs; many may provide continuous services; some may provide a mixture of services. We need to be selective and find the most meaningful measure for each service. Example Unit Cost: Markets Service - Figures used for illustration only The Markets Service provides 141 pitches for market traders. Occupancy achieved over the year is 78%. Total expenditure 2006-07 budget Occupancy in days 50 weekly markets x 141 stalls x 78% Cost per day per stall 209,230/5,499 market days 209,230 = 5,499 days

= 38.05 per stall per market day

This example is a very simplistic one. It assumes that this cost centre provides only one service. However, the unit cost calculation may need to be refined further: The cost centre for Markets may include some direct costs for different types of market (Christmas, French, Gardeners etc). Costs could be

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analysed to each market type and this may provide significantly differing unit costs. Markets are held at different locations in the districts and so the costs could be broken into smaller cost centres to represent each location, which again could show differing unit costs. Maximum occupancy would achieve a unit cost of 209,230/7,050 = 29.68. Driving up occupancy could therefore reduce unit costs. Income may be netted off to produce the net unit cost e.g. 84,230/5,499 = 15.32 There may be a mix of services with different measures within a cost centre e.g. providing a market stall service and inspecting other markets.

Usage of Unit Costing Once we know what our unit costs are, what can we do with them? We can measure cost effectiveness by looking at unit costs year on year. We can set unit costs as a target, with the aim of maintaining the unit cost. We can compare our performance against other councils. Unit costing is easier to understand in the context of manufacturing making a car for example, where the unit of output is a single good sold on at a price. For the council outputs are not just quantitative but can also be qualitative and complex. The primary motivation for our managers is delivering a high-quality service that meets the needs of the public. However, it would be wrong to see the emphasis on unit cost as being in conflict with the need to continually improve service standards. The most efficient organisations manage to combine low unit costs and satisfied customers. Public sector managers, like their private sector counterparts, need to see driving down unit costs as intrinsic to delivering a high-quality service. Given the publics growing awareness of council tax levels in particular, this is especially so for local authorities. Public Finance 30th June 2006 High-quality services are those that are highly productive. If we do not seek to increase productivity, we are short-changing service users, since we are forgoing the opportunity to release more investment to frontline services Frequently Asked Questions Q: My support service charges have increased and pushed up my unit costs. This is outside my control.

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A: Support services are charged to each service based on measures which are designed to reflect use. Knowing how and why a support service has been charged to your service should help explain why it has changed. Speak to your service accountant to find out more. If you have processed more payments, for example, the charge for the creditors service will increase. It may be that a particular support service cost has increased overall because of more investment (for example IT). This should result in an improvement in service quality which should ultimately improve customer satisfaction or productivity. Q: We have invested in new equipment which has increased our unit cost for this year only. A: Costs associated with investment in equipment are correctly charged to the service. Investment in equipment will result in maintaining or improving the quality of service delivered. Explaining a one-off blip in unit costs and following by a return to the expected or improved trend, together with maintained or improved quality measures, will demonstrate the effectiveness of the service. Q: We now get charged for capital charges on IT investment, which wasnt there before. A: All costs that are charged to services are done in line with best practice. This is so that we can show the total cost of each service. Changes in accounting practices do sometimes cause significant changes in costs between years. It may be helpful sometimes to recreate costs to put them on the same basis and so to show the reason for the change. Ask your service accountant about this. Q: My caseload has fallen below what I had expected and this has pushed up my unit cost. A: Output will inevitably vary over time. Being aware of your costs and how they relate to output will help react to this. Over the long term, reduction in caseload should allow resources to be redirected. An increase in caseload can reduce unit costs in the short term but may demonstrate the need for additional resources. Q: The service unit cost has been kept at the same level as last year. Does this mean I can count it as an Efficiency Gain? A: If you are producing more for the same or lower cost , and you can demonstrate that the quality of your service has been maintained you can include it as an efficiency gain.

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Q: How do I know whether a cost is indirect or direct? A: Direct costs can be directly assigned to a particular service, process or department. An example would be pay costs which represent the time spent on a particular task. A non-pay cost might be supplies which are charged to a service based on usage. Indirect costs cannot be directly assigned and are usually applied as a percentage. As a general rule, most of the budgets you control are direct costs. However, if you are in doubt ask your service accountant.

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