Fundamental Cost Concepts²

Despite the fact that “a revolution in the practice of cost management” (Cooper and Kaplan, 1999) has taken place, some cost concepts are so fundamental that they have remained in mode. This section introduces some of them, which can be used for costing goods and services produced by government, as well as for planning and control. Since concepts are abstract, numerous examples have been provided to illustrate them. Essentially, since they are derived from the application of economics to real-world situations, there are various cost concepts for different purposes.

Concepts for Costing Goods and Services

Direct costing and full costing are the two basic methods used to calculate the cost of goods and services (cost objects). Direct costing includes only the cost of resources that are easily traceable (attributable) to the outputs, such as raw materials and production workers. Since direct costs are likely to change in response to the volume of output produced, direct costing is also known as variable costing. Efficient production requires support services (overhead), such as maintenance and managerial supervision. These overhead costs are also referred to as indirect cost because they are not easily traceable to individual units of an output. This is why full costing is also known as absorption costing, in which total cost = direct costs + indirect costs.

It is easier to calculate the cost of producing goods than it is the cost of rendering services. Given the tangible nature of goods (e.g., a mobile phone), it is relatively easy to identify and quantify the material inputs used and the labor hours required. The production process tends to be structured, and one is able to visualize the work in progress and, ultimately, the finished goods. Furthermore, what is not sold remains in the finished goods inventory. In contrast, services, such as education and health care, are intangible and cannot be stored in inventories. The service process tends to be less understood and engineered; indeed, to be effective, service has to be flexible and adapted to the needs of the recipient. The server often requires the cooperation (coproduction) of the recipient. Furthermore, in the case of public goods consumed collectively by a community, it is difficult—or not sensible—to divide them in order to set individual fees or taxes that reflect their costs. These complicating factors have to be taken into account when designing cost systems in government.

Unless otherwise specified, the costs discussed in this chapter refer to actual costs—the financial sacrifices made in achieving an objective, such as producing government services. Information on actual costs is sought after because it is considered objective or even true. Actual costs are, however, only as true—or valid—as the cost accounting concepts and procedures that are used. Nevertheless, actual cost information is essential, since it responds to the question of how much it cost. Knowing the actual cost produced by a cost accounting system, however, is only the start. Cost analysis based on the data is required to establish the hidden properties and relationships. For example, an average cost number on its own does not disclose the range or distribution of the underlying cost figures. Furthermore, analysis is often necessary to make raw cost data useful for planning, budgeting, and performance evaluation purposes.

Cost Concepts for Planning and Budgeting

Since planning and budgeting relate to the future, future cost is more relevant than the historical cost that is reported in the financial statements produced by financial accounting systems from past transactions and activities. For example, in the accounts, a piece of equipment may be reported at historical cost, adjusted for depreciation. Its current replacement cost, however—or even better, future replacement cost—is significantly more useful in capital budgeting. A future cost is an estimate, even if the estimate is made by projecting from the current cost or the past cost. For example, the estimation of future labor costs has to take into account such factors as productivity gains or the cost of living adjustments promised in contracts.

One way of estimating future cost is to relate cost to the future level of the activity (cost driver) that will cause cost to rise or fall. In this regard, costs that change in response to the activity level are called variable costs; and those that do not change within a certain range of activity levels are fixed costs. For example, with the number of prisoners considered to be the cost driver of prison costs, food consumption is a variable cost, while utilities (e.g., electricity) represent a fixed cost. Total cost can be estimated by using the following formula: fixed cost + (unit variable cost) x (number of units), or (utilities and other fixed costs) + (food cost/prisoner) x (number of prisoners).

The concept of opportunity cost is applied in decision making. Establishing an opportunity cost entails the selection of an alternative from various available options (e.g., spending more on public safety instead of public education). In that case, the opportunity cost of more public safety is the foregone gain in learning. This simple example shows that while opportunity cost is theoretically sound, it requires imagining the alternative use of resources and speculating the benefits that might be produced. This is difficult to implement in reality. In deference to greater feasibility and objectivity (if not due to lack of imagination), financial accounting remains with actual or historical cost, which economists dismissively refer to as sunk cost.

Good managers are often tempted to make changes in the way services are provided to achieve greater economy or efficiency. For example, in the face of rising labor costs, a municipal government may consider replacing existing garbage trucks with more sophisticated ones, thereby reducing the crew from two persons to one. The more capital-intensive approach would reduce the labor costs associated with the garbage collectors in the sanitation departments. The latter are common costs (i.e., the same regardless of the alternatives) in contrast to the differential costs for equipment and garbage collectors. Only the differential costs and differential benefits—not common costs—should affect the decision outcome. Differential costs, therefore, are sometimes referred to as a relevant cost for decision making.

Barring exceptional circumstances, when changes do take place in government, they are of an incremental nature. Zero-base budgeting that leaves no government activities unexamined is rare; instead, incremental budgeting is practiced far more often. Whereas zero-base budgeting would examine total cost, incremental budgeting focuses on marginal costs; for instance, the cost of adding or dropping a program, or the cost of adding or reducing a certain number of employees. While decision making at the margin is a conservative approach that favors the status quo, it is more efficient and requires less information.

In budgeting—as in performance evaluation (see below)—a very useful concept is standard cost or allowable cost. Budgeting is, in essence, a series of standard cost calculations. Continuing with the earlier example regarding garbage collection, the cost includes labor cost and capital cost. Whereas financial accounting keeps track of actual cost in terms of the amount paid to employees, the determination of standard labor cost necessitates judgments about the desired levels of labor productivity and compensation. In this way, when budgeting is based on standard costs, benchmarks are available for subsequent performance evaluation.

Cost Concepts for Performance Evaluation and Control

When resources are scarce or budgets are tight, managers—on their own initiative or requested by the management—tend to contain cost or even reduce cost. As mentioned by Robinson (2007), using cost information to link funding to results is an essential issue that relates to performance budgeting theory and practice. Robinson continues, “Expenditure prioritization decisions are viewed as a matter of deciding how to allocate money between programs, the starting point is to measure program costs so as to permit a comparison between program costs and benefits.” The issue, however, is which method should be applied to measure program costs to allow a reasonable and expedited comparison.

Cost for performance evaluation can be conducted in three ways. The first method recognizes the tradeoffs between service (in terms of quantity and quality) and costs. The second method of evaluation takes the perspective that lower cost is more favorable than higher cost, recommending cost cutting with little attention to the consequences. The third and more rational approach compares actual costs with standard costs so that significant cost variances are investigated for potential corrective action. The first method makes use of cost analysis; its success, however, relies on operational and financial staff, since the information on quality and quantity is at the operational level. This approach requires in-depth knowledge of the cost composition relating to a particular service, according to a specific quality and quantity. Only the specialists at the operational level would know what impact on the provision of service in terms of quality and quantity would be acceptable. While this approach is recommended, it is difficult to implement in large scale. The second method is rather simplistic and should be avoided, as it tends to sacrifice quality across the board. The third method, within the competency of the finance department, is recommended and is described next.

Total costs are broken down to direct material, direct labor, and overhead costs. Labor cost is simply added for illustration. Total actual labor cost = actual hourly rate x actual number of hours worked; total standard labor costs = standard hourly rate x standard number of hours allowed. The hourly rate standards are usually set by the human resource department for different categories of employees, based on required skills and prevailing market rates, among other factors. Amount of time is allowed on the basis of a combination of objective factors (e.g., work load) and subjective actors (e.g., management expectation of productivity improvement). Therefore, total cost variance = (total actual labor cost) – (standard labor cost). While the total cost variance may be used to evaluate the general manager, it is not appropriate to evaluate the production manager, since he/she could only influence the efficiency of operations. A labor efficiency variance is found, therefore, equal to [(actual hours worked – standard hours allowed) x standard hourly rate]. Applying the same principle of holding managers responsible for their controllable cost, the human resource department is informed of the labor rate variance, which is equal to [(actual rate – standard rate) x actual hours worked].

In addition to responsibility accounting—holding managers accountable—another advantage of this approach is efficiency. That is, a manager’s attention is immediately directed to the discrepancy between what happened and what should have happened. If the variance is significant (i.e., excessively large), the manager is prompted to take remedial action. Obviously, too high an actual cost relative to the allowable amount (unfavorable variance) is undesirable from a financial standpoint, and it should be investigated and corrected; neither is too high a favorable variance—actual cost being low compared to the standard. The manager should examine whether quality is being compromised due to, for example, using less-skilled workers on a lower pay scale and cheaper materials at lower prices. In other words, an effective cost performance evaluation system will allow, or require, managers to use their qualitative judgment to interpret cost data.

Conclusion

In essence, the word “cost,” excluding the adjectives to describe it further, is not useful in practice. Doing so has resulted in a confounding variety of cost concepts. In actual fact, true cost only exists to the extent that (1) a valid cost concept is used and (2) reliable numbers are collected to measure that concept. In theory, the above analysis and examples have shown a variety of cost concepts to enable cost accounting and analysis to meet several purposes. These purposes include scorekeeping, directing management attention to problem areas, and decision making, particularly resource allocation in planning and budgeting.

For basic scorekeeping, the applicable cost concepts are actual costs which are calculated by using financial accounting principles. While generally accepted accounting principles on the accrual basis require full or absorption costing, direct costing is regarded as appropriate for planning and control. In planning and budgeting, the concepts that are useful are future cost, differential cost, marginal cost, and allowable or standard cost. For attention-directing purposes and performance evaluation, standard costs provide the benchmarks for evaluating actual costs, so that significant cost variances are investigated and reduced as appropriate.

Developing Countries

Developed Countries

Numerous attempts in Australia, Canada, New Zealand,⁸ the United Kingdom, and the United States have been made to raise awareness about the rising costs of government and to measure those costs. These instances illustrate the stages of developing government cost systems. The contents of each case are briefly described below, details for which are available in an unpublished technical note, entitled “The Nature of Public Services and Implications for Cost Systems,” which has been submitted to the State of São Paulo. The note presents a large number of studies to measure specific service areas, such as elementary and secondary education, health care, penitentiary administration, and social work.⁹ It also provides citations to the studies mentioned below.

Raising Awareness

The Chartered Institute of Public Finance and Accountancy (CIPFA) issued in 2011 a series of publications, entitled “counting costs” to encourage governments to create a “cost conscious culture” such that “cost considerations automatically feature in everyone’s actions across the organization.” CIPFA was responding to the findings of the UK Audit Commission for local governments that legislators did not have a good understanding of costs. CIPFA emphasized that cost analysis is not an end in itself, but that it is applied to influence decision making. The document, therefore, explains cost concepts and techniques, and endorses six international costing principles, originally intended for business. It also suggests that managers assess their understanding and use of cost information, as well as their relationship with the finance staff.

In 1985, the U.S. General Accounting Office (GAO) released a study, “Managing the Cost of Government: Building an Effective Management Structure,” in support of the Hoover Commission’s accrual budgeting proposal. The GAO raised the concern that the failure to disclose full costs, in fact, resulted from structural deficiencies in current budgeting and accounting systems. The GAO proposed that the federal government measure outputs and inputs, as well as use budgeting and accounting principles that match the delivery of services with the cost of the services.

Costing Services and Activities; Setting Standards

In 1984, the Government Finance Officers Association (GFOA) of the United States and Canada published Costing Government Services: A Guide for Decision Making by Joseph T. Kelley (1984). Kelley used actual cases to illustrate cost analysis to improve the decision making of North American municipal officials in considering new services, setting prices required to recover costs, and determining the amount of subsidies of self-financed municipal services.

A number of U.S. government agencies responded to the GAO’s call to produce the cost information mentioned earlier. In 1990, a GAO survey found 59 cost systems (using the “resource consumption” definition of cost) in five U.S. federal agencies (Department of the Interior; Department of Health and Human Services; General Services Administration; Department of Agriculture; and Department of the Army). The problem of lack of uniformity in concept and practice in cost accounting in American federal agencies was dealt with through laws and regulations in the 1990s. In the early 1990s, the U.S. Congress passed two laws requiring government agencies to produce cost information. To realize the goals of the above legislation, in 1995, the Federal Accounting Standards Advisory Board (FASAB) issued Statement of Federal Financial Accounting Standards Statement No. 4, entitled “Managerial Cost Accounting Standards and Concepts for the Federal Government.” To facilitate the implementation of the above standard, the Joint Financial Management Improvement Program (JFMIP), in 1998, issued “System Requirements for Managerial Cost Accounting.”

Since the U.S. Government carries out so many of its programs and activities through other entities, the Office of Management and Budget (OMB) establishes cost accounting principles and standards to be followed by state and local governments, higher education institutions, and nonprofit organizations. These documents permit contractors and grantors to charge the federal government on the basis of allowable costs and full costs. Allowable costs are those for which the federal government is willing to pay. Many of the cost standards pertain to the allocation of indirect costs to federal contracts and grants.

In Australia’s State of New South Wales, the Office of Financial Management in the Treasury, issued two Policy & Guidelines Papers, “Service Costing in General Government Sector Agencies” and “What You Do and Why: An Agency Guide to Defining Results and Services” (New South Wales Treasury, 2006; 2007). These administrative directives require the identification of results, so that it would be possible to define service costs. In our view, the guidance was not sufficiently operational to be practical, as the guides are concentrated in explaining how to define the chain of outcome/output/activity relationship without being specific about how to calculate the cost of the service itself, leaving to each entity the responsibility to develop its own cost system.

Activity-Based Costing and Accrual Budgeting

The adoption and upgrade of cost information systems in U.S. federal agencies in the last 20 years was influenced by the issuance of the FASAB and JFMIP documents mentioned earlier, as well as by the advent of the activity-based costing (ABC) technique.¹⁰ The GAO report to Congress in 2007 noted that “implementation and use vary widely across 10 federal agencies.” In 2009, the Association of Government Accountants carried out a survey of 10 federal entities—mostly components of federal departments—that “had implemented MCA [managerial cost accounting] and were successfully using the information available to program managers” GAO, 2009: 5. Table 6.1 indicates the nature of the cost systems and how cost information was reportedly used.

Table 6.1

Using Managerial Cost Information in U.S. Federal Agencies

Source: Adapted from Figure 1 of AGA (2009).

Table 6.1

Using Managerial Cost Information in U.S. Federal Agencies

Item	Out of 10 Cases
Characteristics of system
Activity-based costing system adopted	9
Systems less than 10 years old	6
Uses of information
Budget formulation	10
Cost control	9
Performance measurement/reporting	9
Informing decisions about reimbursements and fee setting	9
Program evaluations	5
Assistance with making economic choices/business decisions	7
Improve contract negotiations and contract oversight	2
Cash recovery analysis	3
Reward managers for cost effective approaches	5

Source: Adapted from Figure 1 of AGA (2009).

View Table

Table 6.1

Using Managerial Cost Information in U.S. Federal Agencies

Item	Out of 10 Cases
Characteristics of system
Activity-based costing system adopted	9
Systems less than 10 years old	6
Uses of information
Budget formulation	10
Cost control	9
Performance measurement/reporting	9
Informing decisions about reimbursements and fee setting	9
Program evaluations	5
Assistance with making economic choices/business decisions	7
Improve contract negotiations and contract oversight	2
Cash recovery analysis	3
Reward managers for cost effective approaches	5

Source: Adapted from Figure 1 of AGA (2009).

In 2004, the GFOA updated its 1984 guide to costing government services. Most of the fundamentals remained unchanged, except for the analysis which became more quantitative and activity-based and was central to the new guide. The guide objectively stated the advantages and disadvantages of ABC. The main advantages were more accurate cost data and a better understanding of activities in terms of value-added and nonvalue-added activities. The key disadvantage was the high cost of obtaining the data. In 1999, the Florida legislature required this state’s departments to report the unit cost of providing services; otherwise, their appropriations would be reduced by 10 percent.

Since the beginning of the 1990s, the United Kingdom has been implementing accrual accounting and budgeting initially in departments and, subsequently, at the whole-of-government level. Departments are required to produce resource accounts.¹¹

In summary, there have been many uncoordinated efforts to find the cost of government services and to develop systems to capture those costs. Following private-sector examples, some governments have begun to use ABC, the literature of which features various initiatives. Due to the lack of accessible public information, however, it is impossible to assess how many of these initiatives began with a bang and ended with a whimper.

Selection of Pilot Departments

Since the objective of the pilot project was to generate insight to develop a state-wide system, it was essential to select departments that had diverse characteristics. These characteristics included size, significance, organizational complexity, and complexity of service delivery processes. Size could be measured in terms of amount of annual spending, number of clients served, and number of staff members. Larger departments would likely be more significant, but significance could also refer to social impacts and, therefore, political sensitivity. For example, prisons were significant because over-crowding conditions produced unrest by inmates. This led to social pressures on improving prison conditions and debates on whether to build more prisons or outsource their construction and operation. Organizational complexity is, in part, indicated by the number of levels in the organizational hierarchy and the number of reporting relationships. Service complexity is reflected by the extent to which capital equipment is used and the requirement of skilled personnel. The last point was important because the higher the required skill level, the staff (e.g., medical doctors) would have greater professional authority to order resources (and drive up costs). As will be discussed in greater detail, the four pilot departments were Secretary of Health, Secretary of Education, Secretary of Penitentiary Administration, and the Casa Foundation.

Understanding the Production of Services

Since costs arise from using resources to produce and distribute government services to their recipients, it made sense to understand the resource consumption patterns, so that costs could be attributed (attached) to the resource consumed. The production function in microeconomics—expressing outputs as a function of such inputs as capital and labor—was a good starting point, although it was too abstract a function upon which to build an operating information system. Field investigations, therefore, were proposed to better understand these pilot departments in terms of their structure, function, and operational characteristics, particularly the services they delivered and the resources used to provide those services. Caution, nevertheless, should be heeded against pushing the engineering approach to an excessive extent; that is, detailing the service production process to identify activities only to the necessary extent for costing those activities. This advice was based on the awareness that the more detailed the activity specifications, the more finely and arbitrary it would be to allocate costs so as to attribute the costs to those activities. Furthermore, we had to remind project sponsors and participants that the primary goal and output was the cost information of services. Operations research on service produced, while necessary, should be regarded as a means and not an end. Since the economist’s production function could be drilled down to infinitely detailed engineering specifications, this phase of the projection had to be constrained in time and resources so as to leave adequate time and resources for the even more critical cost accounting and analysis phases.

Construction of Service Profiles

At the time of planning the pilot projects, the State of São Paulo was initiating a project at its Secretary of Planning department to change the traditional line-item budgeting to an output-oriented program budgeting system. Since a key objective of the cost system would be to supply data to the budget system, the hope was that the two projects would be synchronized so that there would be synergy between them. That is, the program budget structure would guide the identification of service outputs, and the cost system project would provide the basis for setting standard costs for services. While linking the two projects made sense, it was also risky in that the cost system project would be adversely affected by delays and other unfavorable developments in the program budget project. A contingent plan was to deduce the pilot departments’ service profiles by elaborating their functional classification in a hierarchy of several levels, down to the level where cost data would be produced. For example, elementary and secondary education would consist of regular education, special education, and vocation education. These educational programs would have common, as well as unique, services. This exercise would lead to a profile of services that is sufficiently detailed to give a complete scenario of services provided, although not so detailed as to require arbitrary cost allocations.

Developing Prototype Cost Accounting Modules

A government accounting system includes components such as cost accounting, financial accounting, budgetary accounting, and others. The cost accounting modules for the pilot departments could be developed by using a number of approaches: (i) the service profiles are considered to be the primary database and costs derived from the financial data systems are assigned to these services; (ii) from the financial data systems, total cost data are generated and then allocated to services or other cost objects; and (iii) a commingling of the previous two methods. Since the cost accounting subsystems at the pilot stage are not part of the on-going operating system, they are considered to be prototype modules.

Regardless of the approach taken, it would be necessary to decide on an acceptable definition of cost. Even though financial accounting principles require cost to be measured as full cost, influenced by the thinking of “different cost concepts for different purposes,” the State of São Paulo project had considerable flexibility in choosing applicable cost concepts and related measurement methods to achieve the planning and control objectives. Nevertheless, the introduction of accrual accounting into Brazil had the tendency to at least raise issues with defining cost in terms of cash outlay. It was also clear that, while various definitions of cost could be tried in the pilot project, the alternatives should be narrowed so that the same cost accounting policies and procedures would be adopted in the state-wide implementation.

Furthermore, regardless of the approach taken, it would be necessary to have some degree of integration of financial and nonfinancial data from separate and disparate databases. Financial data would derive from budget execution and financial accounting systems. Nonfinancial data would come from the personnel payroll system and the system for tracking the purchase, requisition, and inventory control of numerous types of materials. If the cost of capital consumption (i.e., depreciation expense) would be included in the calculation of overhead, the fixed asset accounts would be involved as well. Since these data systems were not designed with the calculation of cost of service in mind, considerable adaptation and modification was anticipated. For example, the labor cost of a teacher entails the combination of salaries, bonuses, if any, and fringe benefits such as insurance. Since the essence of the cost system project was to find the cost of service, his or her service could be expressed in terms of number of classes taught, and if the classes had an unequal number of students, some other measures of service might be devised. In general, data dis-aggregation was expected to be a major undertaking.

Finally, the calculation of service costs requires factual knowledge of how resources (and, therefore, their associated costs) are deployed to produce services. Since the production of a particular service (e.g., a surgery) requires personnel with particular skills, and a specific mix of materials in an environment of required equipment, it is often the case that such complex and qualitative information resides in the heads of knowledgeable specialists. The extensive involvement of managers (e.g., chiefs of medical services, school principals, etc.) would be necessary to construct an accurate picture of how resources are utilized and costs are incurred. The solicitation of cooperation of managers, therefore, was included in the project design.

Cost Manual

The design of a government cost system entails the resolution of many conceptual and organizational issues. These issues would undoubtedly be debated and, hopefully, consensus or authoritative decisions are reached. Since the pilot project was launched to generate ideas and experiences, a Cost Manual was proposed to codify the results of the discussion and experimentation process. The Cost Manual would have the following general contents:

• Goals of the cost system with regard to planning and control

• Policies:

  • Governance: stakeholders, authority, and responsibility

  • The role of a cost system in the government process

  • Relationship between cost system and other information systems

• Standards:

  • Cost definitions and concepts

  • Guidance for cost accounting and analysis

  • Use of cost information

• Procedures:

  • Cost identification, tracing, and allocation

  • IT support for data collection and production of reports

While the experience of individual departments was valuable, it is essential to standardize processes and procedures for state-wide application. The major output of the project, therefore, was the Cost Manual to assist in the establishment of norms. Box 6.1 shows a summary of 10 cost standards, which are elaborated in the Cost Manual.

Preparation and Analysis of Cost Reports

It was intended that the first stage be to calculate the cost of services provided at the cost-center level (e.g., hospitals, schools, prisons). The expectation was for the Cost Manual to guide implementation by means of a standardized methodology throughout the state. This process would involve obtaining data in preexisting corporate information systems to be correlated with data that was specially collected with regard to the services of the pilot departments. Definition of the services needs to be aligned with the services identified in the PPAs in accordance with the new program-based budgeting approach. SEFAZ would be responsible for regulation, supervision, and quality control of the cost data generated, and the project manager would be responsible for validating the data and producing the cost reports. Initially, priority was given to producing quarterly summary reports to support decision making with an emphasis on improving budgetary and financial management.

Developing Consensus on Project Scope

The State of São Paulo is the largest state in Brazil, with a gross domestic product (GDP) in 2011 of approximately US$865 billion (R$1.349 trillion) and a population of 41.4 million people. This corresponds to 31.4 percent of the Brazilian GDP. The state is responsible for providing a significant number of services, such as primary, secondary, and college education; health care; public security; penitentiary services; social assistance; and investment in infrastructure such as roads, local airports, housing, and water and sewage systems. The state budget executed in 2011 was US$85 billion (R$160 billion), of which 92 percent was financed by its own taxes and fees.

The initial stage of the technical assistance project, provided by the IMF and FIPE, was concentrated in the definition of the scope of the project, objectives, and selection of the cost methodology to be applied. In April 2011, SEFAZ organized a workshop to develop consensus on cost methodology. The workshop drew participation from officials from SEFAZ, Department of Planning and Regional Development (Secretaria de Planejamento e Desenvolvimento Regional (SPDR)), Department of Public Management (Secretaria de Gestão Pública (SGP)),¹² and the pilot departments of Health, Education, Penitentiary Administration, and the Casa Foundation, with FIPE and IMF as consultants. Representatives of the federal government contributed the experience of implementing the federal cost system.

The workshop mobilized the key stakeholders at the state level, discussed national and international experiences, and built consensus on the objectives and strategy to be pursued. The approach was to build up the strategy collectively, favoring a gradual approach and taking advantage of the efforts and progress already made in compiling financial information. The discussion focused on formulating a proposal that should be useful, feasible, and sufficiently robust and standardized to allow generalizing the cost methodology to all entities of the state. The result of the workshop is summarized below.

In its first stage, the public sector cost system of the State of São Paulo aims to calculate the cost of services provided by cost centers that attend the population directly (hospitals, schools, and prisons, among others), using standardized methodology focused on direct appropriation on cost objects and using data from the existing information systems. Due to the conceptual and operational complexity of the cost system, implementation will be gradual and based on pilot projects. Initially, priority will be given to the production of quarterly reports to support high level decision makers and with emphasis on improving budget and financial management. It is important that the services to be cost are aligned with the activities defined in PPA and the subsequent managing for results framework. The Department of Finance is responsible for regulating, supervising, and providing quality control of the cost information, and the budget execution managers for collecting and validating cost information and producing cost reports.

At the outset, the following criteria were proposed and consensus was sought to determine the success of the cost system project: (i) there would be a good match between cost concepts and methods for the defined purpose of the cost system; (ii) it must be feasible to produce the desired cost information; (iii) the cost information would actually be used by intended users; (iv) the cost information would be found to be useful for intended purposes; and (v) the pilot projects would lead to the development of cost systems in other parts of the government so that the cost system would be sustainable over time. The six steps are described below.

Using Existing Corporate Systems

The cost system made maximum use of the available data in government information systems. After substantive investment, the State of São Paulo implemented various information systems that contain data that were potentially useful in generating cost information (SIAFEM, SIGEO, SIAFIS-ICO, and SIMPA, among others).¹³ For this reason, financial and nonfinancial data already available were used as much as possible to speed up the production of cost information and to avoid duplicating efforts and wasting of resources. Although the available financial information regarding the stages of budgetary expenditure (commitment, liquidation, and payment) were different from the concept of cost, the project concluded that it would be possible by applying standardized accounting adjustments to transform the budgetary financial data at the verification or liquidation stage to cost information (see Table 6.5 for more details on the adjustments). The current data, however, were not classified by service and cost center. These parameters had to be included in the structure of the chart of accounts (CoA).

Table 6.2

Skills Needed for Implementation of the Cost System

Source: Authors’ elaboration.

Table 6.2

Skills Needed for Implementation of the Cost System

Technical skills

Personal skills

Technical knowledge of cost accounting: applicability of the concepts of costing, cost techniques, cost analysis methods Familiarity with the service in accordance with standard operating procedures systems, socioeconomic characteristics of customers, service providers, inputs and products, quality assessment methods Domain of statistical analysis, familiarity with software packages and capacity to interpret cost results

Creativity and ability to analyze new situations Leadership skills or the potential to develop them Professionalism and ability to work together with colleagues trained in other disciplines Good written and oral communication skills Ability to negotiate and overcome resistance to achieve results Project management competences: manage people and deadlines

Source: Authors’ elaboration.

View Table

Table 6.2

Skills Needed for Implementation of the Cost System

Technical skills

Personal skills

Technical knowledge of cost accounting: applicability of the concepts of costing, cost techniques, cost analysis methods Familiarity with the service in accordance with standard operating procedures systems, socioeconomic characteristics of customers, service providers, inputs and products, quality assessment methods Domain of statistical analysis, familiarity with software packages and capacity to interpret cost results

Creativity and ability to analyze new situations Leadership skills or the potential to develop them Professionalism and ability to work together with colleagues trained in other disciplines Good written and oral communication skills Ability to negotiate and overcome resistance to achieve results Project management competences: manage people and deadlines

Source: Authors’ elaboration.

Table 6.3

Budget 2011 of the Pilot Projects

(In Million Reals)

Source: Budget 2011.

^aExcluding obligatory transfers to municipalities, debt service, and judicial sentences.

Table 6.3

Budget 2011 of the Pilot Projects

(In Million Reals)

Entity	Personnel	Goods and services	Investment	Total	Percent
Penitentiary Administration Department	1,498	665	513	2,676	3
Education Department	12,168	6,697	747	19,612	21
Health Department	2,583	9,039	766	12,388	13
Casa Foundation	455	345	25	825	1
Subtotal pilot projects	16,704	16,746	2,051	35,501	38
Total budgeta	48,996	34,447	10,182	93,625	100

Source: Budget 2011.

^aExcluding obligatory transfers to municipalities, debt service, and judicial sentences.

View Table

Table 6.3

Budget 2011 of the Pilot Projects

(In Million Reals)

Entity	Personnel	Goods and services	Investment	Total	Percent
Penitentiary Administration Department	1,498	665	513	2,676	3
Education Department	12,168	6,697	747	19,612	21
Health Department	2,583	9,039	766	12,388	13
Casa Foundation	455	345	25	825	1
Subtotal pilot projects	16,704	16,746	2,051	35,501	38
Total budgeta	48,996	34,447	10,182	93,625	100

Source: Budget 2011.

^aExcluding obligatory transfers to municipalities, debt service, and judicial sentences.

Table 6.4

Cost Model of the Department of Penitentiary Administration

Source: SEFAZ and SAP.

Table 6.4

Cost Model of the Department of Penitentiary Administration

Level 1 - entity	Level 2 - cost center	Subcategories of the cost centers		Level 3 - services
Department of Penitentiary Administration	Prison units	Provisional detention unit		Food, housing, education and training, healthcare, social assistance, counseling, legal assistance, security, social reintegration
		Penitentiary	Male prison
			Female prison
			Maximum security prison
		Progression unit
		Resocialization center
			Custody and psychiatric Treatment
		Program of Social Reintegration and Citizenship
		Central administration activities

Source: SEFAZ and SAP.

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Table 6.4

Cost Model of the Department of Penitentiary Administration

Level 1 - entity	Level 2 - cost center	Subcategories of the cost centers		Level 3 - services
Department of Penitentiary Administration	Prison units	Provisional detention unit		Food, housing, education and training, healthcare, social assistance, counseling, legal assistance, security, social reintegration
		Penitentiary	Male prison
			Female prison
			Maximum security prison
		Progression unit
		Resocialization center
			Custody and psychiatric Treatment
		Program of Social Reintegration and Citizenship
		Central administration activities

Source: SEFAZ and SAP.

Table 6.5

Adjustments from Budgetary to Cost Information

Source: Machado (2005).

Table 6.5

Adjustments from Budgetary to Cost Information

Budget expenditure executed
	Expenditure liquidated
	Expenditure commited but not liquidated
Adjustments in budgetary expenditure
(-)	Expenditure commited but not liquidated in the current period to be liquidated in future periods
(+)	Expenditure commited in previous periods and liquidated in the current period
(-)	Expenditures of previous periods paid in this period
(-)	Stocks of goods to be used in future periods
(-)	Cash advances to be executed in future periods
(-)	Capital expenditure commited but not liquidated
Adjustment in capital expenditure
(+)	Consumption of stock of products used in the period
(+)	Spending incurred related to cash advances in previous periods
(+)	Depreciation, amortization, and exhaustion
= Cost

Source: Machado (2005).

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Table 6.5

Adjustments from Budgetary to Cost Information

Budget expenditure executed
	Expenditure liquidated
	Expenditure commited but not liquidated
Adjustments in budgetary expenditure
(-)	Expenditure commited but not liquidated in the current period to be liquidated in future periods
(+)	Expenditure commited in previous periods and liquidated in the current period
(-)	Expenditures of previous periods paid in this period
(-)	Stocks of goods to be used in future periods
(-)	Cash advances to be executed in future periods
(-)	Capital expenditure commited but not liquidated
Adjustment in capital expenditure
(+)	Consumption of stock of products used in the period
(+)	Spending incurred related to cash advances in previous periods
(+)	Depreciation, amortization, and exhaustion
= Cost

Source: Machado (2005).

Project Structure and Support of Technical Assistance

Considering the complexity and dimension of the cost system, a governance structure articulating different levels of stakeholders was defined. The governance model included several committees at the strategic, tactical, and operational levels. It also defined the roles of key stakeholders in the conceptual and operational support (IMF and FIPE as technical assistance providers) and pilot projects (Figure 6.1).

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Governance Model of São Paulo’s Cost Project

Source: Authors’ elaboration.

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The skills needed to implement the cost system were identified. Technical and personal skills were essential for the successful implementation of the cost system (see Table 6.2). SEFAZ allocated full-time financial analysts to the cost project. The IMF allocated one resident advisor for two years and made periodic short-term expert visits to provide guidance to the implementation and conceptualization of the project. FIPE allocated a team of academics and experts on a part-time basis to support the field work and preparation of studies and definitions of the cost system. At the end of 2014, SEFAZ created a formal Cost Division within the Accounting Department and allocated additional financial analysts. The pilot entities also assigned part-time staff in their accounting and financial divisions to work as counterparts of the cost project. At a later stage, staff members from the State of São Paulo IT Company (Empresa de Processamento de Dados do Estado de São Paulo (PRODESP)) in charge of information technology (IT) development were involved during the discussion of the proof of concept of the IT solution.

Relationship of the Cost System with the Program Budgeting System

One of the main characteristics of the State of São Paulo cost system is the link between the cost services and the activities defined in the PPA. This was intended to expand the usefulness of the cost system and provide information for planning, performance evaluation, and budgeting (not only for financial control).

The PPA is the main instrument for medium-term planning. It is structured by programs and provides information, such as (i) entity responsible for the program; (ii) outcomes, outputs, and inputs; (iii) activities; (iv) projects; and (v) programs. Indicators are defined at the program and activity levels. The cost project, however, identified that a uniform understanding of results, objectives, and indicators were not harmoniously applied. The cost project helped to rediscuss the structure of some programs, as was the case of the Department of Penitentiary Administration. Figure 6.2 shows the relationship between cost information and the PPA. Ideally, the services to be cost should be the same as those actitivies of the PPA; however, this was not the case in most of the pilot entities.

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Link Between the Multiyear Plan and the Public Service Cost System

Source: Authors’ elaboration.

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Figure 6.3 shows the conceptual model of the cost system. Cost information (X) should be generated by relating financial information with nonfinancial information (number of services). The project defined the cost concepts, based on detailed investigation on available cost literature and studies about the specific reality of each pilot entity. It has also prepared an inventory of the information systems available and the information required to calculate costs.

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Cost System Conceptual Model

Source: Authors’ elaboration.

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Four Pilot Case Studies

The selection of pilot projects was based on size, diversity, and availability of cost information. The pilot project budget covered approximately 38 percent of the total budget expenditure of the State of São Paulo in 2011 (Table 6.3).

The first pilot was Casa Foundation because of its previous experience with cost information. It had about 146 units that served approximately 11,000 juvenile offenders and was operated by 13,000 employees. Each youth received five meals a day, education (by the Department of Education), health care (by the Department of Health), counseling, social assistance, housing, and security. Casa Foundation produces information on the running costs of each youth by cost center.

The SEE was the largest employer in the state, with 5,350 schools providing primary, secondary, adult, and youth education for 5.1 million students. While basic information of the characteristics of schools was available, cost information was not.

The SS was the most complex entity of the state, with 3,148 units including 1,199 specialized clinics, 125 specialized hospitals, and 494 general hospitals. The size and complexity of the health sector required long debate on the services to be measured and cost centers to be studied. For example, the list of the national health system included more than three thousand procedures, the number of which was considered impractical to manipulate during the initial stage of the project.

The other pilot selected was SAP because of its similarities with Casa Foundation and, since the penitentiary units and services are very standardized. The SAP was responsible for managing 148 units, including one maximum security unit, 75 prisons, 36 provisional detention centers, 22 resocialization centers, 8 centers for progressive incarceration, and 6 penitentiary hospitals. The SAP provided security services, housing, health care, education, training, rehabilitation, counseling, and legal support to approximately 167,000 inmates who occupied 97,000 available beds. Overcrowding, therefore, needed to be carefully considered when analyzing cost information.

Field Work and Identification of Cost Centers and Services

The first activity was the application of a questionnaire to detail the services provided, map the organization structure, and identify systems and information available. The questionnaire enabled the project team to understand the reality of each organization, with its limitations, traditions, systems, and processes, and learn what information was available and feasible to obtain, as well as how managers made decisions. The FIPE applied the Ishikawa methodology to map the activities grouped in families of services. This analysis of the services led to a set of family of services that better represented most of the activities.

The survey was essential to understand the cost methodologies and information available in the State of São Paulo. It identified cost methods used, information available to support budgeting and planning, and systems used for processing financial and nonfinancial information. The survey also found the types of services provided and goods produced; main clients or customers; and how managers used financial and cost information; as well as the principal difficulties faced in collecting and analyzing cost and financial information. Alternatives were adopted in cases where certain information was not available. The survey was conducted with the idea of having a systematic and standardized approach for application in all the public entities of the State of São Paulo, rather than adopt a methodology that was custom-made for each type of entity.

Table 6.4 shows the cost matrix of the Department of Penitentiary Administration. Level 1 identifies the entity as a whole; Level 2 identifies the cost centers with different characteristics, and Level 3 defines the main services. To avoid excessive detail, the project adopted the concept of families of services (i.e., the most aggregated level of services that represents most of the services provided). In the case of the penitentiary, the main services were security, health care, education and training, food, housing, social assistance, legal assistance, and counseling. In addition to these penitentiary services, a program exists to assist prisoners with their reintegration into society. The administrative cost of SAP, as a whole, was taken into account, although it was not distributed by cost center or service. Figure 6.4 shows the relationship of those services and the PPA program, essential to allow that the cost be aggregated at the program level as well.

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Services Provided by the Department of Penitentiary Administration and Link to Programs at the PPA

Source: SPDR and SAP, PPA 2012/2015.

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Another important step was to define the accounting adjustments that were necessary to convert budgetary information into cost information. The SIAFEM system is an accounting system that is capable of integrating budget, financial, and accounting information. It is structured in a way that enables it to identify which classes of the CoA need to be utilized when an expenditure or revenue is inserted. Since cost concepts differ to some extent from budget concepts, some adjustment had to be introduced. Given that the SIAFEM system adopts a modified cash accounting system, some cost concepts, such as depreciation and cost of future liabilities (e.g., pensions and other social benefits), are not covered at this stage. Once accrual accounting is fully implemented, the State of São Paulo will need to revisit this. Table 6.5 schematically describes the main types of adjustments.

Analytical Work to Support the Development of the Cost System

The ambitious proposal to have a standardized cost methodology for the entire public sector required a substantive volume of knowledge and studies to support project decisions. The project developed the documentation detailed in Box 6.2.

Proof of Concept by the IT System

Of note was the specification of the methodology to process available data and transform them into cost data. Figure 6.5 shows a high-level scheme of the proof of concept (POC) adopted in the cost system. The purpose of the POC was to test, in reduced scale, the capacity to identify cost data and automatically calculate it. This was done prior to modifying the current IT systems so as to test the viability of the proposal.

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High-Level Scheme: Proof of Concept

Source: Authors’ elaboration.

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The SEFAZ performed a proof of concept between November 2013 and June 2014 to validate the feasibility of the cost system on the basis of its existing public financial management systems.¹⁴ The proof of concept was carried out by SEFAZ with the participation of FIPE and PRODESP. Its objectives were to (i) develop a prototype of the information system with a limited functional scope and the capacity to process information from the original systems, allocate costs for each cost center and each service, and generate reports using basic filters (time periods, cost centers, and services);¹⁵ and (ii) confirm that reports generated by the prototype contain timely, significant, and reliable information that can be used for cost analysis within an adequate processing period and with adequate disaggregation of information.

The scope of the proof of concept was broadened considerably in 2014, at the institutional level as well as regarding the coverage of expenditure items. It included original processes to adjust and allocate costs for each cost center and service, in relation to personnel expenditures and a limited set of remaining expenditures in two SEE regional directorates of education and two SAP penitentiary coordination offices.¹⁶ During its implementation, seven hospitals under the Department of Health were added, and the scope was broadened in SEE to include all 95 regional directorates of education, which managed 5,300 educational establishments (schools). The objective was to cover 80 to 85 percent of all costs in each sector, including the costs of personnel, public utilities (water, electricity, and telephony), cleaning services, and services specific to each sector, such as laundry and catering in the health care sector. The FIPE documented the processes and actions performed in the entities, including the parameters used to allocate some expenditures by services, such as the parameters for laundry in hospitals. Figure 6.6 shows the blueprint of the prototype for the cost system.

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It Blueprint of the Prototype for the Cost System

Source: State of São Paulo IT Company (Empresa de Processamento de Dados do Estado de São Paulo (PRODESP)).

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Cost Reports and Cost Analysis

The preparation of cost reports and cost analysis are the most incipient activities and need more work to be finalized. The SAP has already initiated a cost study of its operations, but subsequent to completion, the conceptual model of non-financial information, in other words not related to cost information, was produced. Non financial information includes, for example, the number of inmates, number of students and capacity of each school. Classified as cost centers were 147 units (prisons, rehabilitation centers, progression center, provisional detention center, hospitals, and maximum security unit). Initial running costs determined some wastage. The high costs in some units were fixed costs. It was not possible at the time, however, to identify cost by type of service provided (security, food and housing, education, training, legal assistance, and counseling, among others). Available information in SIAFEM has made it possible to obtain data on actual expenditures in each administrative unit, although this could not be characterized as cost information at the time. The reason was the incapacity to attribute administrative costs to the services and determine goods and services consumed.

The common practice of computing average cost carries a risk of misinterpretation. For example, other things being equal, overcrowding in a prison lowers its average cost because of the larger number of inmates to share the same fixed costs. The low average cost might be an indicator of a low quality of service and not of efficiency. A cost report without consideration of the quality of the service provided has serious limitations.

A cost report template was developed (Figure 6.7). The example presents expenses for each prison modality, then decomposes the expenses by specific category of prison—the progression center—and finally decomposes by service. Although the information on expenditure incurred by cost center could be useful for budgetary purposes, it tells little about the cost of services. Cost analysis is intended to answer questions such as: Does the size of prisons influence cost? How does overcrowding impact cost analysis? Is it possible to define a range of cost variation in which the cost of standardized cost centers or service is considered adequate? This is a stage that requires further development.

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Example of Cost Reporting of the Department of Penitentiary Administration

(MALE PENITENTIARIES: LEVEL OF OCCUPATION - PERSON PER VACANCY)

Sources: SEFAZ and Yamazaki (2012).

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The same is applicable in relation to the use of the cost information in the decision making process. As the reports have not been stabilized and the quality of the information needs some fine tuning, they have not yet been distributed to the main decision makers, such as the State Governor and Secretaries of State. It is expected that by the end of the system implementation period in 2016, periodic information will be produced, influencing the discussion with regard to the efficiency of the cost centers over time, comparison of costs among similar cost centers, and identification of good practices that can be replicated elsewhere.