COSTING GOVERNMENT GOODS AND SERVICES A Seminar by Dr. Clifford McCue Associate Professor School of...

COSTING GOVERNMENT GOODS AND SERVICES

A Seminar by Dr. Clifford McCue

Associate ProfessorSchool of Public Administration

Florida Atlantic university

Introductory Disclaimer

This presentation is meant to convey general and explicit ideas consistent with the manner in which they would be discussed in a traditional classroom setting

Some ideas and slides were lifted without change or attribution from other presentations and material from the web

Since it is not meant to be disseminated or used outside of the intended purposes for this Webinar, ideas and actual slides used in this presentation are not cited as to their original sources or presentations and should not be used for any other purpose than relaying information within this setting.

We will cover in this course The difference between financial, managerial, and cost

accounting;

COSTING GOVERNMENT GOODS AND SERVICES

This Webinar is about BASIC issues and GENERAL principles It does NOT profess any specific legal or statutory

requirements Consult your particular jurisdiction for any and all

requisite mandates or injunctions

Basic Costing Principles

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Comparison of cost, management and financial accounting

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Meanings

Financial accounting Cost accounting Management accounting

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Financial accounting

Provides information to users who are external to the government

It reports on past transactions to draw up financial statements

Their format is typically determined by law and accounting standards established by the professional accounting policies (GASB/GFOA)

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Cost accounting

Is concerned with internal users of accounting information, such as division/operations managers

The generated reports are specific to the requirement of the management

The reporting can be in any format which suits the user

Management accounting

Comprises all cost accounting functions The accounting for product and service costs,

management accounting extends to use various internal accounting reports for planning, control and decision making

Cost and management accountingVs.


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Management (cost)accounting


Nature Records material, labor and overhead costs in product or jobReports produced are for internal management and control

Records government transaction eventsExternal financial statements are produced

Accounting system

Not based on the double entry system

Follows the double entry system

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Accounting principles

No need to use accounting principlesAdopt any accounting techniques that generates useful accounting information

Use Generally Accepted Accounting Principles for recording transactions

Users of information

Used by different levels of management or departments responsible for respective activities

Used by external parties: bond rating companies, citizens, elected officials, etc.

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Operation guidelines or standards

Based on management instructions and requirements

Conforms to local ordinances, state law, and GAAP

Time span Reports are prepared whenever neededThey may be prepared on a weekly or daily basis

Reports are prepared for a definite period, usually yearly

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Time focus Future orientation: forecasts, estimates and historic data for management actions

Past orientation: use of historic data for reporting and evaluation

Perspective Detailed analysis of programs/activities of the government

Financial summary of the whole organization, including all funds

Cost accountingvs.


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Cost accounting

Objective To provide information for planning and decision making by the management

To ascertain and control cost

Basic of recording

Concerned with transactions related to the future

Based on both present and future transactions for cost ascertainment

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Cost accounting

Coverage Covers a wider area: financial accounts, cost accounts, etc.

Covers matters relating to ascertainment and control of cost of programs, services, or activities

Utility Only the needs of internal management

The needs of both internal and external interested groups

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Cost accounting

Types of transactions

Deals with both monetary any non-monetary transactions, covering both quantitative and qualitative aspects

Deals only with monetary transactions, covering only quantitative aspect

Costing Government Activities

Not surprising, we actually know what it costs to run a government, both what we anticipated to spend and what we actually spent. What we anticipate to spend: Budgeting What we actually spend: Financial reporting (CAFR)

So what is the Costing Issue

The issue is assigning costs to programmatic levels within departments. Typically we can isolate costs for specific items within

a department, normally identified on the accounting ledger (object of expenditure code).

But that does not really help us identify costs associated with a specific program, activity or function.

So what do we need to do?

The fundamental issue in cost accounting (notice how we did not mention management account – that can only be done once the cost accounting system is in place) is determining at what level of the organization do you want to relate costs to goods and services provided? For example, the budget assigns costs to the

departmental level, and some budgets, such as a program budget, can assign costs to specific programs – but what about overhead costs?.

How to choose a cost center

A cost center is often a department/agency but for costing purposes it should drill down to the activity level. The manager and employees of a cost center are responsible for its costs but are not typically responsible for revenues or other financing decisions, like investment decisions.

Cost centers include each governmental department/agency that generates a good or a service to its customers. Other examples of cost centers include the human resource department, the IT department, the accounting department, and so on.

Cost centers are not limited to departments/agencies. There might be several cost centers within a department. For example, each program within a department could be a cost center. Even a special machine in Public Works could be a cost center.

Cost centers are usually associated with the topic of decentralization, responsibility accounting, and planning and control.

Cost Centers

Cost centers are used for two reasons: planning and controlling costs in government.

Cost centers help identify ways for departments/agencies to improve performance (financial) by staying within their budgets.

Cost centers provide a vehicle to analyze all expenses for a particular ACTIVITY and finding ways to decrease the costs in the future.

The job of a cost center is to control costs and increase performance.

Costing Techniques

The basic types of cost estimates

Outline

Introduction Costing Techniques Using Costing Techniques Comparison of Techniques ABC Summary

Introduction

The three essential cost estimating techniques (or methodologies) are: Analogy Parametric Build-Up

Other topics we will discussed in relation to the three essential techniques are: Expert Opinion Extrapolation from Actuals

Costing Techniques Analogy Parametric Build-Up Other Topics

Costing Techniques Overview

Costing Techniques provide the structure of your cost estimate They’re what enable you to predict future costs based

on historical data Techniques rely on statistical properties, logical

relationships, and emotional appeal Three essential types

Analogy: “It’s like one of these” Parametric: “This pattern holds” Build-Up: “It’s made up of these”

Analogy - Method

Comparative analysis of similar systems Adjust costs of an analogous system to estimate the

new system Adjustments could be based on:

Programmatic information Physical characteristics Performance Government vs. Commercial practices Contract specifics Economic trends

Analogy - Application

Used early in the program life cycle Data is not available to support using more detailed

methods Not enough data exists for a number of similar systems, but

can find cost data from a single similar system The best results are achieved when

Similarities between old and new systems are high Adjustments can be quantified Subjective adjustments are minimized

Can be used as a cross check for other methods

Analogy – Advantages /Disadvantages

Advantage Can be used early in programs before detailed requirements

are known Difficult to refute if there is strong resemblance

Disadvantage Introduces subjectivity in the adjustment Difficult to obtain cost/technical data on old/new systems

for comparison No objective test of validity

Analogy – Fighter Example

Attribute Old System New System

Engine: F-100 F-200

Thrust: 12,000 lbs 16,000 lbs

Cost: $5.2M ?

Q: What is the unit cost of the F-200?

A: $5.2M * (16,000/12,000) = $6.9M

Tip: The mischief in analogy most

often arises in the adjustment. Why do we so readily believe a linear

relationship which passes through the

origin?

Parametric Estimating - Method

A mathematical relationship between a parameter and cost Parameter may be physical, performance, operational,

programmatic, or cost Uses multiple systems to develop relationship Allows statistical inferences to be made

Parametric could also be called Cost Estimating Relationships (CERs), Rates, Factors, Ratios

Parametric could also be called Cost Estimating Relationships (CERs), Rates, Factors, Ratios 0

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200

0 200 400 600 800 1000

Parametric Estimating - Application

Use of Parametrics Requires a good database which is relevant to the system

being estimated Excellent for use early in program life cycle before a

detailed design exists Used as the design progresses to capture changes

Good as a cross-check for other methods

Parametric Estimating –Advantages/Disadvantages

Advantages Can be easily adjusted for changes by modifying input parameters Sensitivity Analysis - Can show how changes to certain

parameters impact the cost Objective measures of validity Statistical measures for risk

Disadvantages Difficult to ensure consistency and validity of data Must constantly review relationships to ensure that relationships

reflect current status of relevant programs, technology, and other factors

“Black box syndrome” with pre-existing CERs, commercial models

Parametric Estimating - Example

CER for Site Activation as a function of Number of Workstations: Site Act ($K) = 82.8 + 26.5 * Num Wkstn

Estimated based on 11 data points for installations ranging from 7 to 47 workstations

Build-Up - Method

Estimating is done at lower levels and results rolled up to produce higher-level estimates Often the lowest definable level at which data exist

Elements of this method could include Standards Time and Motion Studies Well defined work flow Variance Factors Parts List Lot Size and Program Schedule Considerations Program Stage Support Labor

Build-Up could also be called Engineering Build-Up, Industrial Engineering (IE), Catalog/Handbook

Build-Up could also be called Engineering Build-Up, Industrial Engineering (IE), Catalog/Handbook

Build-Up - Application

Used when you know detailed product/service information at the lowest level (i.e., hours, material, etc.)

Used in a environment where labor can be accurately estimated

Build-Up – Advantages/Disadvantages

Advantages Easy to see exactly what the estimate includes Can include Time and Motion Study of actual process Variance Factors based on historical data for a given program

or a specific manufacturer Disadvantages

Expensive and requires detailed data to be collected, maintained, and analyzed

Detailed specifications required and changes must be reflected Small errors can be magnified Omissions are likely

Build-Up - Example

Problem: Estimate hours for the sheet metal element of the signage for traffic division Similar to other sign manufacturing which has a 20%

variance factor (actual to standards) and a support labor factor of 48% of the labor hours

The standard to produce the sheet metal element of the new signage is 2000 touch labor hours

Solution: Apply factors to the standard touch labor hours 2000 hrs x 1.2 = 2400 labor hours Add the support factor of 48% to get the total hours estimate

of 2,400 x 1.48 = 3,552 hours

Other Topics

Expert OpinionExtrapolation from

Actuals

Expert Opinion - Method

Uses an expert or a group of experts to estimate the cost of a system One-on-one interviews Round-table discussions Delphi Technique

Expert Opinion could also be called Engineering Judgment, Round Table, or Delphi Technique

Expert Opinion could also be called Engineering Judgment, Round Table, or Delphi Technique

Expert Opinion - Application

Only used when more objective techniques are not applicable

Used to corroborate or adjust objective data Cross check historical based estimate

Use for high level, low fidelity estimating Last resort

Tip: Expert opinion is the least regarded and most dangerous

method, but it is seductively easy. Most lexicons do not even admit it as a technique, but it is included here for

completeness.

Expert Opinion – Advantages/Disadvantages

Advantages Good cross check of other estimate from Subject

Matter Expert (SME) point of view Allows perspective to an estimate that may be

overlooked without SME Disadvantages

Completely subjective without use of other techniques Low-to-nil credibility

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Quantity

Cost

Extrapolation from actuals is not a method, it is a subset of some methods Using actual costs to predict the cost of future items of

the same system Extrapolation is used in several areas, which

include: Averages Learning Curves Estimate at Completion

Extrapolation from Actuals

Extrapolation from Actuals could also be called Averages, Learning Curves, Cost Improvement Curves, Cost/Quantity Curve, Estimate at Completion (EAC), and Earned Value (EV)

Extrapolation from Actuals could also be called Averages, Learning Curves, Cost Improvement Curves, Cost/Quantity Curve, Estimate at Completion (EAC), and Earned Value (EV)

Extrapolation fromActuals - Application

Best application is for follow-on production units/lots

Requires accurate cost database At an appropriate level of cost detail Validate and normalize data

Extrapolation fromActuals – Advantages/Disadvantages

Advantages Utilizes actual costs to predict future costs Can be applied to hours, materials, total costs Highest credibility and greatest accuracy Many government bodies require or encourage the use of this technique

Possible complications: Unknown events affecting bookkeeping of actuals Changes in cost accounting methods Contract changes affecting actuals Configuration changes, process changes all have impacts

Disadvantages: Extrapolating beyond a reasonable range

Using Costing Techniques

Estimate Requirements Top Down vs. Bottom Up Cost Element Structure (CES) Technique Selection Checking Results Documentation

Estimate Requirements

Why are we developing this estimate? What will it be used for? Milestone A, B, or C decision Developing a budget Developing a “ball park” or rough order of magnitude

(ROM) estimate Comparing alternatives Evaluating proposals

Top Down vs. Bottom Up

There are two general ways to structure an estimate Top Down Bottom Up

Top Down is generally associated with the Parametric or Analogy techniques

Bottom Up frequently uses more than one method at the lowest level but is generally associated with the Build-Up technique

Cost Element Structure

Determine what needs to be estimated and develop an appropriate Cost Element Structure (CES) CES Dictionary defines what is included in each element Characteristics associated with cost elements that are

routinely used to classify costs • Program Phase: Development, Production, O&S• “Color of Money”: RDT&E, Procurement, O&M• Funding Source• Non-Recurring or Recurring• Direct or Indirect

Technique Selection

Review available techniques Compare alternatives Select or develop appropriate technique Identify primary and secondary techniques

Each costing technique has strengths and weaknesses and can be applied at

different times in the life cycle of a cost estimate

Each costing technique has strengths and weaknesses and can be applied at

different times in the life cycle of a cost estimate

Checking Results

Cross Checking your results greatly increases credibility Example: A parametric-based estimate can also show an analogy as a

“reasonableness test” Doesn’t necessarily result in the exact same number, but should be a

similar number (same order of magnitude)

An independent* estimate is more detailed than a cross check and attempts to get the same result using a different technique Example: Use the results from one commercial software estimating

package to validate the results of another

*Note: “Independent” has many meanings. The most stringent meaning is in Title 10 USC Section 2434 and involves an organization out of the chain of command of the acquiring agency. A looser meaning is an estimate done by an organization unbeholden to the program manager in funding or accountability. The loosest meaning is a separate estimate.

Documentation

Within reason, more information is better than less

Any information that is used in the analysis must be included in the documentation

Documentation should be adequate for another cost analyst to replicate your technique

Like they used to tell you in math class….

If You Don’t Show Your Work,You Don’t Get Any Credit!

If You Don’t Show Your Work,You Don’t Get Any Credit!

Comparison of Techniques

Comparison – Advocacy Advocates of Build-Up drink beer and say:

More detailed = more accurate Analogy is prey to invalid comparisons Parametric is too “theoretical”

Advocates of Analogy drink bourbon and say: Like things cost like amounts Build-Up is prey to omission and duplication Parametric is “diluted” by less applicable systems

Advocates of Parametric drink wine and say: Most thoroughly based on historical data Analogy is just a one-point CER through the origin! Build-Up is prey to omission and duplication

Hey, it’s a joke, lighten

up!

Hey, it’s a joke, lighten

up!

Refining a Costing System

More Direct-cost tracing

Indirect-cost pools

(More homogeneous)

Better cost-allocation bases

Activity-Based Costing System

No. ofSetupHours

LensesNL

LensesCL

LensesOther

CostAllocationBase

ProductCostObjects

No. ofShipments

Parts-Square

feet

SetupDesign ShippingActivityIndirect CostPool

Activity-Based Management

ABM describes management decisions that useactivity-based costing information to satisfy

customers and improve profits.

Product pricing and mix decisions

Cost reduction and process improvement decisions

Design decisions

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