FINANCIAL MANAGEMENT SERIES. Building Better Financial Management Support. Functions, systems and activities for producing financial information

FINANCIAL MANAGEMENT SERIES Building Better Financial Management Support Functions, systems and activities for producing financial information 1

Better Practice The Australian National Audit Office produces better practice guides and handbooks as part of its information services to audit clients. A better practice series has been established to deal with key aspects of the control structures of entities an integral part of good corporate governance. This guide forms part of that series. It addresses the supporting functions, systems and processes required to deliver relevant, timely and useful financial information to managers.p ISBN 0 644 39034 4 Commonwealth of Australia 2

Auditor-General s Foreword The Commonwealth Public Sector is in the midst of a period of unprecedented change. Financial management reforms have been central to this change and include; the adoption of accrual accounting and accrual budgeting, a shift to funding and reporting based on outputs and outcomes, and an increased emphasis on outsourcing as a means of program delivery. To assist in meeting the Government s expectations, as enunciated through these reforms, organisations require sound financial management practices and supporting systems. The timely capture, processing and presentation of financial information in a form which is tailored to user requirements are essential to effective planning, monitoring and decision making. Financial information is a key element in successful organisational performance and is also vital to achieving legal and regulatory compliance, most significantly in the area of financial reporting. Indeed, financial information can be designed and used to meet a variety of demands, both internal and external to the organisation. Our research has shown that a key factor in the success of new financial management processes is the ability of organisations to shift the focus of its finance function away from transaction processing and reporting to a role which is fully integrated into the strategic and daily business activities of the organisation. This new finance function would also have greater capacity for data analysis, interpretation, flexible reporting to support decision making and facilitate more accountable management in an environment of devolved authority. Typically the type of information required by an organisation includes budgetary and forecast information, information on its cost of operations and cost structure, information on resource utilisation and operational performance and information on its financial position at any point in time. The two Better Practice Guides that comprise this series have been designed to assist organisations to develop a sound financial management capability. The first of these Building a Better Financial Management Framework - outlines some of the critical considerations involved in using financial information which are essential to the establishment of a valuable financial management framework. The second - Building Better Financial Management Support - explains some of the mechanics required to deliver this financial information efficiently and effectively. P.J. Barrett Auditor-General 3

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CONTENTS Building Better Financial Management Support Overview of the Guides Part one The finance function 1.1 Introduction 1.2 Transforming the finance function 1.3 Interpretation and analysis of data Part two The financial information system 2.1 Introduction 2.2 Evaluating financial systems 2.3 Establishing data structures Part three Costing systems 3.1 Introduction 3.2 Cost components 3.3 Techniques for allocating costs 3.4 Costing methods Part four Closing the books 4.1 Introduction 4.2 Guiding principles 4.3 Key Processes Appendices Process Improvement Tools Glossary of terms Bibliography 5

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Overview of the Guides This is a companion to the ANAO guide Building a Better Financial Management Framework. The latter guide deals with the conceptual framework for defining financial information needs, presenting financial information, and using financial information to support decision-making. Organisations must establish the capability to support their financial management reform efforts. To this end, this guide deals with some of the critical functions, systems and processes needed to deliver financial information efficiently and effectively to users. Specifically it examines the current trends in the evolution of the finance function the key provider of financial information; the financial and costing systems required to capture and accumulate financial information; and the close the books process, which generates the financial information. This guide, dealing as it does with support processes and activities traditionally undertaken by the finance area of an organisation, is directed primarily at the chief finance officer and the staff who undertake finance functions. It is also intended to provide useful background for line managers seeking to understand the broader impact of financial management reforms in the above areas and who are likely to affect the timing and the nature of the financial information they receive. 7

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Part one The finance function 1.1 Introduction 1.2 Transforming the finance function The finance area Migration of the finance function Effecting change 1.3 Interpretation and analysis of data Adding value to information Proactive support 9

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1.1 Introduction The finance function is the primary provider of financial information. If this function is to add-value it needs to take a greater role in decision support by providing users of financial information with analysis and insights based on a thorough understanding of the business. The finance function encompasses more than the finance area. It includes all activities and processes undertaken which relate to transaction processing, financial reporting, control and decision-making. This will typically involve staff from both the central finance area and from operational areas. The finance function has been a transformed in many better practice organisations over recent years. This transformation has been partly in response to the cost pressures to which all business processes have been subject. It has also been in response to a growing demand from the users of financial information for more value-added information to use in their decision-making. This part of the guide examines the changing role and structure of the finance function. It considers both the changing service mix and skill requirements needed in the transformation process to ensure the finance function remains relevant and cost-effective. It also considers the means by which the finance function can achieve more effective analysis and interpretation of information. 11

1.2 Transforming the finance function The finance function is changing in the public sector. The introduction of accrual budgeting and accounting, requiring implementation of new financial systems, has been a major impetus for change. Organisations should seize the opportunity these changes provide to fundamentally re-examine the role and activities of this key function. In recent years finance functions in better practice organisations have undergone significant change with the following key characteristics: transformation of the role of the finance area away from transaction processing to analysis and decision support. This has been accompanied by a clear shift in resources applied to each activity in terms of quantum and skill levels. progressive migration of analysis and decision support away from the central finance area to business units, maximising the provider s understanding of the business. The finance area The diagram opposite highlights the shift in emphasis within the finance area. First there is a clear trend in better practice organisations to smaller finance areas. This has resulted primarily from greater efficiency in transaction processing by adopting integrated accounting systems and automating processes; and through outsourcing of processes. Benchmarking of the transaction processing activities undertaken by the finance function typically indicates this is where most cost savings can be achieved. The diagram also highlights the need for a change in the skill mix within the finance area, as users of financial information require more sophisticated analysis and decision-support. Resources previously used to process transactions are freed to take on more challenging roles. However, this requires a greater level of qualified finance professionals with appropriate tertiary and professional qualifications. 12

Transforming the role of the finance area As f inancial control is devolved to line areas and transaction processing and reporting processes become more eff icient, the overall resources applied to the f inance function are able to reduce. At the same time there is a greater investment in qualified staff to provide analysis needed to support strategic and operational decision making. 13

Our objective should be to have operating people think of their units in financial terms and to have financial people think of what s happening in finance in operational terms attributed to James Osterhoft of Digital Migration of the finance function It is not just within the finance area that change is occurring. In order to become actively involved in the analysis and interpretation of information by users, providers of financial information need to become an integral part of the management team of the organisation or the business unit that they support. In better practice organisations finance staff spend time with line mangers to see things from the other side of the fence. There is an increasing trend toward embedding qualified, skilled finance staff in operating/service delivery units rather than in a central finance area. These staff take on a business partnering role, providing financial analysis, working with line managers to solve operational problems. This contrasts with the trend toward recentralisation of transaction processing through the use of shared services centres or out-sourcing (refer to box on page 15). Migration of the finance function The traditional f inance area is changing. Decision support staff are moving into operational areas and transaction processing is being centralised, but not in head off ice. 14

Consistent with the proposed changes to the finance area which are outlined above, beyond bean counting 1 recommended the Chief Financial Officer (CFO): have suitable experience and qualifications; provide independent professional advice that improves the quality of information, or its context, for decision makers within the organisation; and be part of their agency s senior management team, reporting directly to the Chief Executive Officer (CEO). Re-centralising transaction processing: shared services centres The trend to devolution of authority of the past decade has generally been accompanied by decentralisation of processes. These included business support processes such as those undertaken within the finance function. Inevitably this led to duplication and also increased the risk of inconsistency through a lack of standardisation. In response, many better practice organisations have established shared services centres as an alternative to out-sourcing accounting processes. In shared services a group of business units create a separate entity within the organisation. Common services including accounting, finance, payroll, collections are assigned to this entity and the entity is perceived and managed as an outside vendor. The concept of shared services centres is simple: bring together functions that are frequently duplicated across business units or locations, and provide these services at a lower cost through achieving economies of scale and removal of duplication. Shared services centres are not re-centralised corporate support functions. They operate as freestanding, autonomous businesses, usually at an independent location, away from headquarters, sometimes in a green field location. They generally involve actual or notional charging for services and are therefore subject to internal and external market forces. More information on shared services can be found on the shared services forum at http://www.akris.com/shared.htm. 1 beyond bean counting Effective Financial Management in the APS - 1998 & Beyond, a publication of the Commonwealth Management Advisory Board, December 1997. 15

Effecting change Transforming the finance function involves major cultural, organisational and process change. The figure below illustrates the areas that need to be addressed in this transformation. People in the new finance function, staff will need different skills; they will need to be more analytical and problem-solving rather than being transaction oriented. Organisation in a business partnering role finance staff work in operating/ service delivery units. However, there is still a need for a central finance policy-making and coordination role. Processes in most organisations transaction processing takes approximately 40% of the finance function time. Unless processes are significantly redesigned real transformation cannot take place. Measures to ensure that new processes are efficient, appropriate performance measures must be in place. Systems are a key enabler for more efficient processes, but their structure and functionality are also critical. Controls the focus must move from corporate cop or organisational purse keeper to risk manager and effective internal control manager. 16

The process of transforming the role of the finance function is not a shortterm exercise and would normally take a number of years to complete. In the first instance some form of business process re-engineering will need to take place. This should include benchmarking to determine the gap between current practice and better practice. The Arthur Andersen Global Best Practices database contains a number of quantitative benchmarks relevant to the finance function. Some of the key metrics from that database are summarised in the following table. Metric Best Common Total finance cost as % of revenue 0.42% 1.17% Total finance headcount as % of total employees 1.98% 3.75% % of Accounting degree qualified staff in finance area - 30% The ANAO produces better practice guides dealing with the re-engineering of accounting processes, including Accounts Receivable, Payment of Accounts, Asset Management. These are available on our web site at http://www.anao.gov.au. 17

1.3 Interpretation and analysis of data As users of financial information become more sophisticated in their understanding of their financial management responsibilities, accountabilities and financial information needs, the new finance function must respond by providing useful analysis and interpretation of data. The transformation of the role of the finance function will release resources from transaction processing and provide scope for increased analysis and interpretation of data before it is delivered to the users. The providers of financial information should seek to embrace the following approaches as part of this expanded role: adding value to information; and being proactive Adding value to information Providers analysis should improve the quality of information available to users, helping them make better-informed decisions. Providers should be interpreting and analysing financial information as it becomes available and advising users on the financial consequences or impact of various courses of action. If appropriate key performance indicators (KPIs) are in place, providers should add value by presenting KPIs in an appropriate format and, in the case of financial KPIs, explaining the possible reasons for movements or providing benchmark comparisons. For instance, if an organisation has a large debtor base, a good KPI may be average debtor days (outstanding debtors divided by period revenue). This could be reported as a trend over time (in graphical format), compared with another division or State or benchmarked with the private sector. Another example is for providers to analyse support costs and advise users which costs are causing the support cost ratio to move in an unfavourable direction. Further examples of ratios and their interpretation are shown in the following table. 18

Ratio Calculation Use/interpretation Employee entitlements Employee benefits payable If trending up, may provide number of employees information for next certified agreement negotiation Total employee costs Employee costs Could suggest opportunity to total expenses expand user pays services or outsource/contract out some non-core services Depreciation impact Depreciation expense Reflects the use of productive net cash from operations assets in delivering services Days sales in debtors Net debtors Trend shows credit control average daily sales success and will be important for improved cash flow, in a devolved banking environment External debtors External debtors As debtors can be readily current assets turned into cash, this ratio is another cash flow indicator External income ratio External income May reflect degree of user-pays total income services Indirect to total costs Total indirect costs Indicates overhead or support total costs cost impact. Should be trending down Corporate costs Corporate support/ Focuses on impact of management costs corporate/national support total costs costs. Again, should be trending down Proactive support Providers should actively pursue and provide analysis. To do this, they need to understand the factors that will have an impact on the financial performance of the organisation (or the business unit which they support) so that the relevant analysis is well informed. This requires a strategic viewpoint and an excellent understanding and knowledge of the activities of the organisation or business unit. Providers may also take the initiative in alerting users to items of financial information which require management action as they come to hand, rather than waiting for the periodic reporting cycle to deliver this information. 19

Case study Proactive involvement of finance staff Group A provides consulting services on a fee-for-service basis. The majority of its work is project-based and must be won through tendering for contracts. The Group has weekly management meetings, and each fortnight these meetings are presented with financial information. At the weekly meetings the Group s managers review time, cost and quality of projects and consider resource needs (staff versus contractors) for ongoing and future projects. Finance staff attend the fortnightly meetings to present and interpret the financial information. In this forum they are able to highlight important financial information and provide additional information as required. Managers are also able to identify additional information needs and receive immediate financial information and advice. The attendance of finance staff at fortnightly meetings ensures all managers financial information needs are identified on a timely basis. It also ensures that financial information provided to managers is relevant to their needs, as the managers are able to provide immediate advice that information is no longer critical or relevant under current operating conditions. For example, managers requested that fortnightly reports be produced at summary level for key line items (that is, financial information the managers considered to be key financial indicators). The summary data is presented with a supporting graph. More detailed financial information is requested by, and provided to, managers when they or finance staff detect a problem, such as a significant deviation from budget. The more detailed information is used by managers to identify the cause of the problem and to decide how to address it. 20

Part two The financial information system 2.1 Introduction 2.2 Evaluating financial systems Conducting a gap analysis Financial system attributes 2.3 Establishing data structures The chart of accounts The general ledger 21

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2.1 Introduction Information systems need to capture and structure data to make it relevant to users needs. This means they must be able to integrate strategic, financial and operational information in a way which supports all management processes, with the ultimate objective of creating transparency across the organisation, and ensuring continuity of information from strategy through to execution. A structured approach to consideration of the information systems that are required by an organisation commences with a review of existing systems. This review should establish whether the existing systems can provide the information required by users. Even where existing systems can provide the information needed by users today, they may not necessarily do so efficiently, or may not be able to respond to future demands. To complete the analysis of existing systems organisations need to consider whether they possess the following core attributes: flexibility multi-dimensionality multi-user access user friendliness speed of response openness robustness and scalability. Having analysed existing systems and determined their suitability, or otherwise, as a platform for providing financial information, organisations need to address the way that financial data is structured and accumulated. This requires consideration both of the chart of accounts and the configuration of the general ledger. 23

2.2 Evaluating financial systems The current generation of financial management information systems (FMIS) reflects the need for flexibility to accommodate users changing financial information requirements, as well as changes in the processes used to collect and access financial data. Evaluation of current (or replacement) systems requires a structured approach focusing on information gaps and systems attributes. Conducting a gap analysis Organisations with legacy FMISs should put in place processes that: evaluate the ability of those systems to capture the required data; identify the data gaps; and develop plans to cost-effectively improve data collection over the short and longer terms. The following template may be used by organisations to categorise the nature of information gaps and to determine the appropriate response to bridging these gaps. Financial information flows Systems capability Meets managers need Nature of gap Cannot deliver Systems gap Does not deliver Capable of delivering No Implementation gap Configured to deliver Knowledge gap Delivers Configured to deliver Yes No gap Configured to deliver No Surplus information The nature of each gap is as follows: systems gap the system is not capable of delivering the required information implementation gap the system is capable of delivering the required information, but has not been configured to do so knowledge gap the system is capable of delivering the required information and has been configured to do so, but users are not aware of how to gain access to that information surplus information information is being delivered to users which they do not need 24

Core attributes of a financial information system Even where systems gaps do not exist, current systems may not possess the characteristics to ensure that systems gaps will not arise in the future. To guard against this outcome, organisations should evaluate existing (and proposed) systems against the following core attributes. Flexibility organisational structures and processes will change over time; it must be possible to adapt the organisation s systems to reflect resulting changes in information requirements. Multi-dimensionality the organisation s systems must allow performance to be broken down into its components, and scenarios to be compared by drilling down through alternative but reconciling hierarchies, for example by organisational unit, output or location, over time. Multi-user access the organisation s systems must be a common source of information, allowing users across the organisation to make decisions on a consistent basis. User friendliness while providing sophisticated functionality for advanced users, the organisation s systems must also be easy for non-financial and non- IT-literate decision-makers to use. In addition, they must be easy to configure and manage. Speed of response the organisation s systems should be dynamic and highly automated to support real-time decision-making and ensure that changing business conditions trigger appropriate, timely responses. Openness however complete the organisation s systems, they are unlikely to provide all of the required functionality; they must therefore allow for integration of third party applications and for future developments. Robustness and scalability the organisation s systems must be able to integrate large volumes of data from diverse sources. They must also be able to handle simultaneous queries from a large number of users dispersed across the organisation. 25

2.3 Establishing data structures It is important to establish data structures from a strategic perspective to ensure that the data meets users financial information needs fully and efficiently. In particular the process must allow data from different dimensions and levels within the organisation to be collected, reconciled and consolidated, to enable alternative views of performance to be produced. Two key determinants of the data structure for an organisation are its chart of accounts and the set up of its general ledger. To maximise the leverage from their systems, better practice organisations generally implement: a simple, universal chart of accounts that applies to all organisational units; and a single general ledger. For this implementation to be effective there must be a clear understanding about operational details such as: the level of disaggregation required (should the data be in the form of individual transactions or aggregated?); the attributes of the data (does the data need to be provided in one view or many views?); the measurement basis (cash or accrual?); and Many systems currently available have the capacity to collect and utilise non-financial data in their general ledger modules. The chart of accounts structure may also need to accommodate this requirement. the relationship with non-financial data (what non-financial data is required, where might it be derived from, and how might it be integrated with the financial data?). The chart of accounts The chart of accounts is the framework for categorising assets, liabilities, revenues and expenses. Many organisations have multiple charts of accounts used by different business units and/or locations. Creating a common chart of accounts establishes a foundation for consistency in terminology and serves to eliminate redundant accounts. The number of accounts and cost centres within the general ledger are significant cost drivers in general ledger processing. They also contribute to 26

complexity, thereby increasing the risk of misclassification and the need for corrective journal entries. There is no right number of accounts or cost centres the principle is to minimise the number to the extent necessary for management and external reporting purposes. This can be partly achieved by reviewing the level of activity in each account over time. An integrated accounting system also permits the use of relatively high level accounts in the general ledger, with more detailed accounts in the subsidiary ledgers. The general ledger Large, decentralised organisations, particularly those with legacy accounting systems, tend to operate multiple general ledgers. Each may have their own charts of accounts and business rules. They may also require some form of consolidation, which is rarely fully automated, to produce entity-wide financial reports. Given the current sophistication of accounting software and telecommunications, it is possible to develop a single general ledger, in effect a single set of books, for all business units. Capturing all transactions and balances, from subsidiary ledgers and directly, into a single ledger permits central control over data integrity and speeds up end of period reporting. In addition to a centralised general ledger, most better performing organisations require data entry at source, preferably, on-line and in real time. They hold operational staff accountable for the accuracy and integrity of the data in the general ledger. There is a philosophy of getting it right the first time, with errors returned to the originator of the data for correction. An integrated accounting system also lies at the core of the financial management information system in most, better practice organisations. These systems provide separate modules of software for the functions of accounting such as general ledger, accounts payable, accounts receivable, payroll, budgeting and financial reporting in a coordinated manner. The data entered into one module are used in others, thereby eliminating duplicate data entry and reducing errors. Over 90% of organisations in the Arthur Andersen Global Best Practices database have fewer than 10,000 accounts of these, almost half have fewer than 1,000 accounts in their general ledgers. In many cases integration eliminates the need for time consuming reconciliations, required when subsidiary ledgers and memorandum accounts are maintained as separate systems. 27

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Part three Costing systems 3.1 Introduction 3.2 Cost components 3.3 Techniques for allocating costs Allocating direct costs Allocating indirect costs 3.4 Costing methods Activity based costing Job costing Process costing Selecting a costing method 29

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3.1 Introduction Cost is a measure of the value of resources consumed in acquiring or delivering a product or service. Understanding costs and the ability to control the cost of operations is an integral part of good financial management. There are a number of levels at which costs can be captured ranging from high level, whole of government reporting to more detailed costing of an activity or process. Budget funded organisations are now required to cost their outputs. This requires determination of the total cost of the outputs produced and the unit cost per output. The subject of a costing exercise, whether it is a branch, a location, an activity, a process or a unit of output, is commonly referred to as a cost object. In the most common application of costing, an organisation identifies the sum total of all costs that relate to the object being measured. This is referred to as full cost. To arrive at the full cost of an object an organisation will determine all relevant costs and classify these into one of two categories those which can be readily identified with and specifically assigned to a single cost object ( direct costs ); and those which cannot ( indirect costs ). The latter are attributed across a number of objects. The decision to classify costs as direct or indirect is a pragmatic one, based on whether it is economically feasible to relate a cost to an object. Once it has been determined what costs are relevant to an object and how they are categorised a decision must be taken on the most appropriate method for capturing, accumulating and assigning costs. The three most relevant methods are process, job and activity-based costing. Each method has its advantages and disadvantages. The choice of method requires a clear understanding of the requirements for, and intended use of, the cost information generated. The second part of this section deals with these issues in detail. Firstly, however, it is necessary to amplify the cost concepts referred to above and, in particular, to address the accumulation and allocation of costs to objects. 31

3.2 Cost components Once an organisation has decided what it wants to cost (the cost object), the next decision to be made is what costs to capture. This depends on the objective of the decision at hand. For most decisions an organisation will be interested in full costs. In a typical public sector organisation the full cost of an object will include: labour costs, including salary costs and associated on costs; administrative and operational costs including travel, rent, repairs and maintenance, cleaning and utility charges; capital costs, including depreciation and capital use charges; and general management and support costs. These costs need to be accumulated in the accounting system and allocated to cost objects. The most accurate results are achieved when as many costs as possible are allocated to a cost object based on a direct relationship. Where there is no direct relationship, or the cost of establishing this relationship would be prohibitive, costs will need to be pooled and allocated across a range of cost objects. Whether costs are allocated directly or indirectly to an object is not necessarily a product of the nature of the expenditure. Nevertheless, the following table includes some common examples of direct and indirect costs within the classifications of labour, materials and other expenses. Category Materials Labour Other Direct Paper in a printing office Professional staff in a legal practice Specialised equipment Food in a cafeteria Counter staff Travel to investigate a claim Indirect Office stationery Chief Finance Officer Cleaning IT consumables Internal auditor Utilities Rent 32

Labour, administrative, capital and other costs incurred by operational areas are the most common source of costs that can be allocated directly to cost objects. Costs incurred in business support processes, such as in the Human Resources area, are the most common source of costs that need to be allocated across a range of cost objects. Business support processes have no direct association with an organisation s outputs and no contact with the final customer. Their customers are the operational areas and their outputs are the services they provide to the operational areas. It is therefore inappropriate to attempt to allocate the costs incurred in business support processes directly to outputs. They are allocated through the use of cost drivers, discussed in the next section. The following diagram illustrates the general approach to allocating direct and indirect costs. A common failing is to attempt to allocate the costs of business support processes directly to an organisation s outputs. 33

3.3 Techniques for allocating costs A balance needs to be sought regarding the allocation of costs. Being too specific is resource intensive; being too general results in inaccuracies, generally causing a great deal of internal dissension, and will not promote the proper management of costs. Allocating direct costs By definition, direct costs can be economically allocated to cost objects. The preferred method to achieve this is by using cost centres established within the organisation s financial management information system. In this way costs can be captured as they are recorded for other accounting purposes. An alternative to cost centre coding is the use of metering techniques. These approaches allocate direct costs to objects based on resources used. Metering can be achieved either through direct measurement of actual resource usage, or by estimating resource usage. The use of cost centres and metering techniques all have their advantages (in terms of relative accuracy) and disadvantages (in terms of relative costs). These are summarised in the following table. Technique Relative cost Relative accuracy Cost centre: Reasonably cheap but depends on Very accurate because of clear costs allocated as they the sophistication of the chart of relationship between costs incurred are captured. accounts and capability of the FMIS. and goods/services provided. Metering direct: Expensive and time consuming. Very accurate because tracks actual costs allocated on the basis Requires investment in time resource usage over time. of resources used for recording system or other example, staff time, CPU metering system to measure time, number of copies. resources used. Metering estimated: Less expensive than direct Potentially less accurate due to costs allocated on basis of metering. fluctuations and variations in usage established pattern of use over time. either over time or at a period in time. 34

Allocating indirect costs Indirect costs, such as those associated with business support processes, are allocated across a number of cost objects. The allocation is based on a relationship established for the indirect expenditure that is common to the cost objects. A common approach is for organisations to determine what drives the indirect expenditure. They identify events, transactions or other occurrences that cause an activity to be performed and expenditure to be incurred. These cost drivers form the basis for allocating indirect costs. Common examples are operational staff numbers, which can be related to payroll processing costs; the number of computers used, which can be related to IT support costs; and the proportion of floor space occupied by operational staff, which can be related to property costs. It is preferable, as in the above examples, that cost drivers are based on a cause and effect relationship. However, more arbitrary cost drivers may be appropriate given the nature and materiality of indirect expenditure being allocated. The range of possible cost drivers is large. Which drivers are used depends on how indirect costs have been segregated. Generally the greater degree of separation of indirect costs into separate cost pools the closer the relationship between the indirect cost and the allocation basis. As the following table shows, separation of Information Technology costs into a number of discrete cost pools and further dissection into activities within each pool provides a greater range of cost drivers. The extent to which indirect costs can be pooled depends critically on the sophistication of an organisation s accounting and costing systems, including the extent to which the capture of data on the cost drivers can be automated. A further important consideration is the materiality of the indirect expenditure compared to the full costs of the cost objects. The cost of establishing the allocation basis must be weighed against the benefit, in terms of the accuracy of the full cost of the objects being costed. This in turn depends on the use to which the full cost information is to be put. Generally, where the information is provided only for internal management purposes, and/or does not impact on key performance indicators, a lower level of precision is acceptable. The choice of allocation techniques should consider materiality of the costs being allocated, the cost of the method, the precision of the output desired and the level of information useful to management. 35

Examples of cost drivers Support process Cost drivers Information Technology No. of users No. of transactions The cost drivers available increase as cost pools and activities are ref ined. Support process Cost pools Cost drivers Information Technology IT operations & No. of users communications No. of transactions No. of devices Volume of e-mail Application support No. of users per application Application Time spent on development development User training No. of people trained Support process Cost pools Activities Cost drivers Information Technology IT operations & Management of local/ No. of users communications wide area network No. of transactions No. of devices Internet facilities No. of files Size of files Communications No. of hardware installations Volume of e-mail Size of e-mail in storage Application support Providing financial No. of users application support Time spent on operational support Providing human resource No. of users application support Time spent on operational support Application New system Time spent in development development development Lines of code Enhancing/maintaining Time spent existing systems Lines of code User training Training users No. of courses No. of people trained Providing help desk No. of users support Time spent on inquiries 36

3.4 Costing methods Determining the method used to collect the cost of an object requires careful analysis of the nature of the organisation s operations in particular, a clear understanding of the requirements for, and intended use of, the cost information. Different industries or organisations employ different forms of costing depending on their circumstances and the nature of their operations. There are five common forms of costing methods: Activity based costing Job costing Process costing Standard costing Batch costing The table on the following page describes each method and gives examples of their application. This guide does not promote one costing method over another. The decision rests firmly with management. However, it is suggested the nature of Government activities lend themselves to either Job or Process costing. Activity Based Costing can be used either as a method in its own right or to enhance the accuracy of information obtained from Job or Process costing. Accordingly, each of these three methods is explored in greater depth in the following pages. At the end of this section points for general consideration are listed to evaluate costing system functionality, together with a decision tree to aid in selecting from the alternatives. 37

Costing Method Description Costing A pplication Methods commonly used in the public sector Activity Based Costing The attribution of resource consumption universally applicable by activities and the allocation of activity directly applicable to the costing costs to cost objects via cost drivers. requirements of service and government entities. Job costing A form of specific order costing in which printing costs are allocated to individual jobs. research/teaching professional services, for example audit services, investigations, consultancies Process costing Costs are initially charged to a sequence chemical production of continuous, repetitive operations or power supply processes and then averaged over the units produced in the period. Methods NOT commonly used in the public sector Standard Costing Uses predetermined standard rates for useful for internal management the consumption of inputs (expressed as purposes, in particular performance a cost per unit of output). Costs are measurement, enables analysis of allocated to cost objects using these variances caused by changes in costs of standard rates multiplied by the standard inputs and/or volume of activity inputs allowed for actual volume of activity achieved. Batch costing A form of specific order costing in which assembly lines (or equivalent) costs are allocated to batches of products. canteens invoice processing What is ABC? Activity based costing Activity Based Costing (ABC) has recently gained wide acceptance in the service sector and has become the preferred method of costing throughout a wide range of commercial and government organisations. The case studies on pages 41 and 42 provide examples of its application. The basic principle of ABC is that the performance of activities within an organisation gives rise to the incurrence of cost and that cost objects consume activities. Accordingly costs are traced firstly to activities and then activity costs are traced to cost objects. While ABC was primarily developed to address the need for a more effective mechanism to deal with the allocation of overhead costs, it should not be assumed this is its only application, for example, ABC can facilitate more accurate output costing. 38

Activities are the tasks performed within an organisation that together result in the delivery of its outputs. The number of activities identified depends on the reasons ABC is being implemented and the degree of accepted risk regarding the distortion of costs. Another consideration is that opportunities for process improvement and the application of meaningful performance measures may be missed if the activity definition is not sufficiently detailed. What are Activities The following example illustrates the dangers of not identifying activities at an appropriate level of detail. The XYZ agency has a Finance Unit of seven people of which two are solely devoted to the Accounts Payable function. The total cost of this function including employment costs, IT support, facilities and management costs is $500,000 per annum. This function has been allocated 100% to an activity described as Processing Accounts Payable Invoices and the driver chosen to allocate the costs of this activity to the consuming organisation units is the number of invoices generated by each operating unit. There are three operating units and the allocation of the costs of the identified activity to these operating units is $250,000, $200,000 and $50,000 respectively. The manager of department A is unhappy with this result and asks that a more detailed methodology is applied. Upon investigation it is apparent that the activities undertaken within Accounts Payable fall into two distinct categories, the processing of overseas suppliers invoices and the processing of domestic suppliers invoices. An analysis of the Payables clerks time is undertaken and two distinct activities are created Processing Overseas Invoices and Processing Domestic Invoices. Because of the complexity of the payment routines the export invoices are three times as expensive to process as the domestic. In addition the bulk of export invoices are generated by operating department C. After incorporating the additional activity and driver information, the respective charges to Units A, B and C are $150,000, $185,000 and $165,000. Staff time is a major cost in most public sector organisations and a key element of ABC is the methodology to trace these costs to specific activities. Ideally the process must be robust and as accurate as possible. Determination of the technique used depends on such factors as the resources (costs and staff time) available, desired frequency of revision, purpose of the ABC implementation and desired level of accuracy. Common techniques for allocating staff time include interviews, workshops, sampling and time recording. Tracing costs to activities In some cases, certain operational staff may be able to assign their time directly to an output, generally however, staff will not able to assign their time to a specific output. In these cases, their time should be traced to activities, 39

and the cost of each activity allocated amongst the relevant cost objects using an appropriate activity driver. Some common examples of cost drivers are shown in the following table. Activity Raising Purchase Orders Processing Suppliers Invoices Answering Phone Enquiries Processing Grant Applications Correcting Input Processing Payroll Cost driver No. of Purchase Requisitions Received No. of Invoices Received No. of Phone Calls No. of Grant Applications Received No. of Input Errors Made No. of Pays Processed Advantages of ABC ABC provides the following advantages: output costs are supported by a schedule of costed activities instead of a conventional expenditure classification analysis; opportunities to examine work processes; identifies non value-adding activities that can be eliminated without effecting the quality or utility of the service delivered; basis of a performance measurement system and a direct link between strategic goals and operational realities; enables cost profiles to be managed; accurate costing data to operational management; and costs that are transparent, understandable and actionable. Disadvantages of ABC The disadvantages of ABC include: activity definition may become too detailed and organisations may build a model that is too complex and difficult to maintain; under estimating the task of collecting activity driver data; specialist software tools are required to provide quality implementations; the model fails to keep pace with organisational change; and implementation is considered a financial management fad and insufficient commitment from operational managers is given. 40

Case Study: Activity Based Costing As part of the its commitment to contestability and performance, the Department of Health and Aged Care has undertaken a series of market based and performance improvement initiatives, including Activity Based Costing (ABC), within the Corporate Service Division. The project involves review of existing costing methodologies, pilot studies in selected areas and the establishment of costing processes to support an accrual based output/outcome framework. The major steps in the processes included: definition of outputs and level of costing information required; information gathering (General Ledger analysis, Time Recording and Storyboarding); development of cost model; analysis and reporting of results; and transition planning and skills transfer. The project has provided the Division with: recognition of the need for full cost information for strategic cost management and performance measurement in a contestable environment; an Activity Dictionary based on outputs received by customers and not on functional areas; full cost information linked to outputs/services for budget negotiation and pricing; ABC functionality in an enhanced Corporate Information System; and attribution of corporate overheads to Departmental Outcomes and Output Groups. The Department has learnt a number of lessons along the way, most significantly: be clear about what information is required and for what purpose; keep the costing process simple and the Activity Dictionary manageable; be disciplined but flexible (for example - storyboarding by a supportive and focused group environment can be used instead of time recording to collect data on work flow and time/effort attribution); ABC is more than an ad hoc costing solution, use it as a management tool as it engages staff upfront and provides them with information that is relevant and meaningful; Incorporate ABC and Activity Based Management in relevant training programs such as corporate planning and leadership development; accrual accounting and budgeting; and adopt a corporate approach (for example - develop, in consultation with staff, clear and relevant policies and procedures for approval by senior management and integrate ABC into the organisation s corporate planning and management processes). 41