COST ANALYSIS: WHAT DOES THIS COST?
Cost analysis is useful for addressing several key questions that managers ask:
- Will the revenue from a new grant opportunity cover the costs to expand a program?
- Will a program or service benefit from economies of scale? If not, why not?
- How much should we budget for a new staff member? To add a new shift or other group of new staff?
- How much “overhead” or “indirect costs” should we negotiate into a contract with a government?
- What price should we set for a new fee-based service?
- When will we need to add more staff, and how will adding staff affect our cost structure?
- What’s the best way to share costs between departments within an organization? Between organizations? Between units of government?
In February 2016 a federal judge in Albuquerque, NM approved a $1 billion settlement between the Obama administration and nearly 700 Native American tribes. This settlement ended a decades-long class action lawsuit over how the federal Bureau of Indian Affairs (BIA) had distributed aid to tribes since the mid 1970s.
This case came about because of some disagreements over how to measure costs. For more than 150 years the BIA was directly responsible for most of the health care, education, economic development, and other core services delivered on Native American reservations. But then starting in the mid-1970s it shifted its focus from direct service provision to helping tribes become self-sufficient. Instead of managing services, it redirected its resources toward training, technical assistance, and other efforts to help tribes launch and maintain their own services.
To make that transition BIA re-classified many of its activities as “contract support costs.” This change was not just semantic. Funding for direct BIA-administered services was part of a regular federal budget appropriation. That appropriation was stable and predictable. By contrast, funding for support costs on federal government contracts is quite variable and must be renegotiated often. Perhaps not surprisingly, total BIA spending declined steadily under this new capacity-building model.
Tribes across the US argued that by re-classifying many of BIA’s costs, the federal government gave itself permission to slash BIA’s budget without Congressional approval. The tribes’ alleged this simple cost measurement maneuver allowed BIA to operate well outside its authority and to inflict substantial harm on Native Americans around the country. BIA argued that the cost reclassification was a standard accounting change that has happened across the federal government for decades. The case was ultimately settled for far less than the tribes requested, but the federal government did agree to re-classify many contract support costs as direct service costs for which federal funding is far more transparent and predictable.
This case illustrates the central point of this chapter: how we define and measure costs matters tremendously. In this case, cost measurement was not just a technical exercise; it had real impacts on the lives of hundreds of thousands of Native Americans. The same is true for virtually all public services. How we define, measure, and plan for costs affects which services we deliver and how we deliver them.
After reading this chapter you should be able to:
- Define the cost objective and relevant range for the goods and services that public organizations deliver
- Contrast fixed costs from variable costs
- Contrast direct costs from indirect costs
- Allocate costs across departments, organizations, and jurisdictions
- Determine the full cost of a good or service
- Prepare a flexible budget for a program or service
- Calculate the break-even price and break-even quantity for a good or service
- Contrast cost-based pricing with price-based costing
- Recommend management strategies and policies informed by analysis of costs “at the margin”
- Analyze budget variances, both positive and negative
What is Cost Analysis?
If you’ve ever flown on an airplane, there’s a good chance you know Boeing. The Boeing Company generates around $90 billion each year from selling thousands of airplanes to commercial and military customers around the world. It employs around 200,000 people, and it’s indirectly responsible for more than a million jobs through its suppliers, contractors, regulators, and others. Its main assembly line in Everett, WA is housed in the largest building in the world, a colossal facility that covers nearly a half-trillion cubic feet. Boeing is, simply put, a massive enterprise.
And yet, Boeing’s managers know the exact cost of everything the company uses to produce its airplanes; every propeller, flap, seat belt, welder, computer programmer, and so forth. Moreover, they know how those costs would change if they produced more airplanes or fewer. They also know the price at which they sold that plane and the profit the company made on that sale. Boeing’s executives expect their managers to know this information, in real time, if the company is to remain profitable.
Cost accounting (also known as managerial accounting) is the process of creating information about costs to inform management decisions. Managers need good information about costs to set prices, determine how much of a good or service to deliver, and to manage costs in ways that make their organization more likely to achieve its mission. Managers in for-profit entities like Boeing, have instant access to sophisticated cost information that would assist with those types of decisions. But managers in the public and non-profit sectors usually don’t. There are many reasons for this:
- Large parts of the public sector don’t produce a “product,” but they do produce a service like counseling juvenile offenders, protecting the environment, or helping the homeless. Sometimes we know the “unit” of production and can measure costs relative to that unit. In the case of counseling juvenile offenders, we might think about the cost per offender to provide those services. But for services without a clear “end user,” like environmental protection, this analysis is much more difficult.
- Most (usually around 80%) of the costs incurred by a typical public sector organization are related to people. A parole officer will see many different types of parolees. Some will demand a lot of attention and follow-up. Some will need next to none. Some parole officers are comfortable giving each case an equal amount of time and attention. Others are not. This type of variability in how and where people spend their time, and as a result, where labor costs are incurred, can make cost analysis quite difficult.
- Employees often work across multiple programs. A program manager at a non-profit organization might work across two different programs funded by two different grants from two different funding agencies. Unless that program manager allocates their time exactly equal across both programs – and that’s unlikely – we can’t know the exact cost of each program without a careful study of how and where that employee spends their time.
- Public services often share buildings, equipment, vehicles, and other costs. Without a system to track exactly which staff and programs use exactly which resources, it’s difficult to know the full cost to deliver a particular service.
- Good cost analysis has no natural political constituency. Careful cost analysis requires substantial investments in information technology, staff capacity, accounting information systems, and other resources. Most taxpayers and funders would rather see that money spent on programs and services to help people in the short-term, and not on information systems to analyze and plan for future costs.
These are just a few of the many barriers that prevent public organizations from acting more like Boeing, at least with respect to cost analysis.
And yet, good cost analysis is absolutely crucial to public organizations. Public financial resources are finite, scarce, and becoming scarcer. Public managers must understand how and where they incur costs, how and where they will incur costs under different service delivery models, and whether that pattern of costs is consistent with their organization’s mission and objective. In this chapter we introduce the core concepts of cost accounting, and we show how to apply those concepts to real management decisions.
At the outset it’s important to draw a distinction between full cost accounting and differential cost accounting. Full cost accounting is the process of identifying the full cost of a good or service. Differential cost accounting – sometimes called marginal cost analysis – is the process of determining how the full cost of a good or service changes when we deliver more or less of it. Good financial management requires careful attention to both.
Let’s start with a simple example. Imagine a copying machine that’s shared among three departments within the Environmental Health Department of a county government. Those three departments are:
- Food Protection. This includes inspection and licensing of restaurants and other establishments that serve food. This program is designed to prevent outbreaks of food-borne diseases like E. coli, botulism, and Hepatitis A. Staff in this division make make around 500 copies each day, mostly related to documenting restaurant inspections.
- Animals and Pests. This includes animal control, rodent testing and control, and educational programs to promote pet safety and neutering/spaying. These programs are designed to prevent communicable diseases, including rabies, that are most often spread by vagrant animals. Staff in this division make around 250 copies each day, but that number can increase in the event of a outbreak of avian flu or other communicable disease.
- Wastewater. The Wastewater department is responsible for treating wastewater. Staff in this division issue water discharge permits to businesses and industrial operations, and also test water quality near wastewater discharge sites. These programs are necessary to prevent waterborne communicable diseases like cryptosporidium. Wastewater division staff typically make around 100 copies each day, but make up to 1,000 per day when processing complex industrial building permits. They process around six such permits each year.
As a manager you’d want to know what it costs to operate the copier, and how those costs ought to be spread across the three departments. To put this question in the language of cost accounting, we want to know:
- What is the full cost to operate the copier?
- How should we allocate the costs of operating the copier across the three departments?
To answer these questions we first need to know all of the different ways the copier incurs costs. A few come to mind immediately: paper and toner to make the actual copies, a lease or rental payment to take possession of the copier, and occasional maintenance and repairs. A few might be less obvious: electricity to run the machine, space within a building to house the machine, and an office manager’s time to coordinate maintenance and repairs. We can observe many of these costs, but other we’ll need to estimate or impute.
Most public services are delivered “at cost,” meaning they are priced to generate enough revenue to cover the full cost to deliver them, but not more. The late management guru Peter Drucker called this cost-based pricing. By contrast, many for-profit goods and services are sold at prices well in excess of cost. For instance, most wines are priced at 100-200% above the full cost to produce them. A box of popcorn at the movies is usually priced at 700-800% above cost. And so forth. Wine retailers and cinemas will sell these products at whatever price consumers are willing to pay, regardless of what they cost to produce. Drucker called this price-based costing. Virtually all highly profitable businesses design the cost structure of their products and services around what consumers will pay. The opposite is also true. For-profits often sell goods and services at prices well below cost – a so called “loss leader” – in an effort to attract customers. Most public organizations cannot routinely engage in these types of price-based costing tactics and expect to accomplish their missions and remain in good financial position.
The next question is how the departments should share these costs. Imagine, for instance, that they split those costs one-third for each department? This approach is simple, easy, and transparent. But what’s wrong with it? Each department makes a different number of total copies, and each also has a different workflow related to the copier. These departments also have different potential “economies of scale” for copying. Also keep in mind that Animals and Pests needs more “emergency capacity” or “surge capacity” than the other two departments. So if an even distribution is not the most appropriate, then what is? With careful attention to cost accounting methods we can begin to address these and other questions.
Full Cost Accounting
Measuring Full Cost: The Six-Step Method
To answer the question “what does this service cost?” cost accountants follow a six-step process. Each step of this process is driven by policies and procedures that are defined by an organization’s management:
- Define the cost object. The cost object is the product or deliverable for which costs are measured. Service-oriented public organizations typically define cost objects in terms of the end user or recipient of a service. Examples include the cost to shelter a homeless person for an evening, the cost per counseling session delivered to recovering substance abusers, the cost to place a family in affordable housing, and so forth.
- Determine cost centers. A cost center is a part of an organization that incurs costs. It could be a program, a unit within a department, a department, a grant, a contract, or any other entity that’s clearly defined for cost accounting purposes. As a general rule, cost centers work best if they are for homogeneous groupings of activities.
- Distinguish between direct and indirect costs. Direct costs are connected to a specific cost center. In fact, they’re often called “traceable costs.” Examples include salaries for staff who work entirely within a cost center, facilities and supplies used only by that cost center, training for cost center-specific staff, etc. Many public organizations further stipulate that a cost is direct to a cost center only if it can be controlled by that center’s management. Indirect costs apply to more than one cost center. They include shared facilities, general administration, payroll processing services, information technology support, etc. Some managers call them service center costs, internal service costs, or overhead costs because they are usually for support services provided within an organization. The full cost of any service is the direct costs plus the indirect costs.
- Choose allocation bases for indirect costs. One of the main goals of full cost accounting is to distribute indirect costs to cost centers. This follows from the logic that all direct costs require support from within the organization. An allocation basis is an observable metric we can use to measure the relationship between direct and indirect costs within a cost center. For example, a non-profit might allocate indirect costs according to the number of full-time equivalent (FTE) employees within a cost center, or the percentage of the organization’s overall payroll earned by employees within that cost center.
- Select an allocation method. There are two main methods to allocate or apportion indirect costs to cost centers. One is simply to call indirect costs their own cost centers and plan accordingly. For instance, a non-profit could choose to call the executive director its own cost center. In that case it would plan for and report the executive director’s salary, benefits, and other costs as a stand-alone entity, rather than allocate those costs as an indirect cost to other direct service cost centers. A more common approach is to allocate by a denominator that’s common to all the cost centers that incur a particular indirect cost (see below).
- Attach costs to cost objects. One of big challenges for public organizations is that cost objects are usually people, and no two people are alike. For instance, a parole officer might have 30 clients, but each requires a different amount of time, attention, and counseling. When the cost per client varies a lot, the cost accounting system ought to reflect those differences, usually by applying different overhead rates or percentages to different types of clients.
Let’s illustrate some of these concepts with the copier example. To begin, assume that the copier is its own cost center. Services like copying, information technology, payroll, exist to serve clients within the organization, so they’re called service centers. One of the goals of cost accounting is to allocate service centers’ costs to mission centers that are more directly connected to the organization’s core programs and services. In this case we can assume Food Inspection, Animals and Pests, and Wastewater are mission centers that will ultimately receive costs allocated from the copier service center. Given those assumptions about cost centers, we can assume the cost object for the copier service center is the cost per copy.
With those assumptions established we can define direct and indirect costs for the copier service center. Direct costs include paper, toner, the machine rental/lease fees, and machine maintenance. These costs are incurred exclusively by the copier. Electricity, building space, and the office manager’s time are indirect costs. They are incurred by the copier cost center and by other cost centers.
To illustrate, the table below lists some details on the copier’s full costs for FY2015.
|Cost Item||Number||Unit Cost||Total|
|Machine Rental||$500/month||12 months||$6,000|
|Machine Maintenance||$75/month||12 months||$900|
|Total Direct Costs||$19,900|
|Cost Item||Cost Driver/Amount||Unit Cost||Total|
|Building Space||100 sq. ft.||$15/sq. ft.||$1,500|
|Office Manager Time||5 hours||$20/hour||$100|
|Total Indirect Costs||$1,780|
Indirect Cost Allocation: Cost Drivers and Allocation Bases
To find the full cost of the copier cost center we’ll need to find some way to allocate to it its share of those indirect costs. A good cost allocation scheme follows from a clear understanding of an organization’s cost drivers. A cost driver is a factor that affect the cost of an activity. A good cost driver is a reliably observable quantity that shares a consistent relationship with the indirect cost in question. Fortunately, for the copier cost center, we have an intuitive cost driver: the number of copies.
Ideally, we can allocate indirect costs according to their key cost driver(s). An allocation basis is a cost driver that’s common to all the cost centers that incur an indirect cost. For building space, for example, we might find the portion of the total building space that’s occupied by the copier, and allocate a proportionate share of the building space costs to the copier copy center.
For example, this particular county government allocates electricity costs to different cost centers per kilowatt hour (kWh). Sometimes it’s feasible to measure electricity use with this level of precision, and sometimes it’s not. Assume that the copier in question has an individualized meter that measures its electricity use.
This government allocates building space costs per square foot. This assumes it has a reasonably sophisticated way to measure how much space each cost center uses. Allocations by space can be contentious because not every unit uses space in quite the same way to accomplish its mission. For instance, most of the Food Protection staff spend most of their time out in the field inspecting restaurants. They report to the office at the beginning and end of the day, but infrequently during the day. This is quite different from the Animals and Pets center, where most of the staff spend most of their time in the office.
More on Cost Drivers
One of the big challenges in cost accounting is identifying appropriate cost drivers and allocation bases. Each indirect cost item is a bit different and requires a slightly different concept to support an allocation basis. In fact, many public organizations do not allocate indirect costs precisely because they cannot agree on allocation bases that make sense across an entire organization. That said, many of the most common indirect costs can be allocated using simple metrics that can be computed with existing administrative data. Here’s a few examples:
|Cost Item||Potential Cost Driver/Allocation Basis|
|Accounting||Number of transactions processed|
|Auditing||Direct audit hours|
|Data Processing||System usage|
|Depreciation||Hours that equipment is used|
|Insurance||Dollar value of insurance premiums|
|Legal services||Direct hours/Billable hours|
|Number of documents handled|
|Motor Pool||Miles driven and/or days used|
|Office machines||Square feet of office space occupied|
|Management||Number of employees; total payroll|
|Procurement||Number of transactions processed|
These figures also assume the government allocates the office manager’s time to individual cost centers. The office manager can do this if he or she tracks the amount of time they spend on work related to each cost center. Some public organizations have such systems, and those systems are often based on a billable hours concept, similar to that used by other professionals like lawyers or accountants. Many do not.
Also note that the copier cost center does not itself receive overhead from other service centers. We don’t see, for example, that the copier center receives a portion of the county administrator’s salary, insurance expenses, or other organization-wide indirect costs. This is a policy choice. Some public organizations do not require service centers to receive overhead costs, mostly to keep down the rates they must charge their internal clients. Many state and local governments have budgeting rules that state programs that are independently financed, or paid for with specific fees or charges rather than general fund resources, do not need to allocate their indirect costs or receive an indirect cost allocation.
That said, many public organizations do allocate overhead to internal cost centers. In fact, when they do they typically use the step-down method of allocating indirect costs. That is, they allocate organization-wide indirect costs to all cost centers first, then allocate service center costs, including their portion of the organization-wide indirect costs, to the mission centers. With those assumptions in place, recall that:
- Food Protection mission center averages 500 copies each day. Assuming 260 work days/year, that’s (500 copies X 260 days) or 130,000 copies. In this case 130,000 copies is the relevant range, or the amount of activity upon which our cost analysis is based. If we assumed the Food Protection mission center would require twice as many copies, our per unit costs and cost allocations would look quite different. Good cost analysis follows from clear, defensible assumptions about the relevant range of activity that will drive costs.
- Animals and Pests mission center makes 250 copies each day, but makes many more in the event of a communicable disease outbreak. Assuming no outbreak, that’s (250 copies X 260 days) or 65,000 copies.
- Wastewater division makes 100 copies/day, but up to 1,000 copies/day around six times per year when processing complex permits. Let’s assume a typical surge in copies for a complex permit will last for five days. That would mean 240 typical days and 30 “surge days” (i.e. six permits X 5 days/permit). So total copies for typical days are (100 copies X 230 days = 23,000 copies) and surge days are (1,000 copies X 30 days = 30,000 copies), for an annual total of 53,000 copies.
From these figures we can determine the copier will make (130,000 copies + 65,000 copies + 53,000 copies) or 248,000 copies each year. If we divide the full annual cost of the copier by the number of copiers ($21,380/248,000 copies) we arrive at unit cost for 248,000 copies of $.086/copy (i.e. 8.6 cents per copy).
With those full costs established, we must then ask how should the Environmental Health department allocate the full costs of the copier cost center across the three mission center departments? Fortunately, this is easy to do because the copier cost center has a clear cost object (cost per copy) and each department/cost center measures the number of copies it makes. As a result, each department would be assigned copier center indirect costs at a rate of 8.6 cents/copy. Food protection would be assigned (130,000 copies X $.086/copy) = $11,180. Animals and Pests would be assigned (65,000 copies X .086/copy) = $5,590. And Wastewater would be assigned (53,000 copies X $.086/copy) = $4,558. With the right allocation basis it’s possible to allocate any indirect costs in a similar way.
This copier example also shows why the cost center and cost object are so important. For instance, imagine that the copier was defined not as one cost center but as separate cost centers for large copying jobs (say, more than 500 copies) and small copying jobs, or for color copies vs. black and white copies. This would also require different cost objects, such as the “cost per black and white copy” or cost per color copy.” The cost per black and white copy would presumably be less than the cost per color copy, and the cost per copy for large print jobs would presumably be less than the cost per copy for small jobs. Different cost centers, cost objects, and allocation methods can mean substantially different answers to the question “what does copying cost?”
One potential drawback of the step-down method is that it allows “double counting” or “cross-allocation” of service center costs to service centers that are already allocated to mission centers. For example, recall that the annual full cost of the copier service center was $21,380. That full cost incorporated the indirect costs of the office manager’s time to manage the copier. Under the step-down method, the cost of the office manager’s time is allocated to the copier cost center, and the copier cost center costs are then allocated across the mission centers. But what happens if the office manager makes copies? Under this indirect cost allocation scheme the office manager’s copies would not be reflected in the total volume of copies made, and the office manager would not receive any of the copy center’s costs. As a result, the mission centers subsidize the office manager’s copying by absorbing a larger share of the copy center’s costs.
In this particular example those subsidies are probably a negligible amount. But in many other scenarios cross-allocation of service center costs can have a major impact on the full cost of a good or service. For instance, imagine a non-profit organization with three mission centers, a service center for the executive director, and a human resources service center. The human resources service center spends most of its time interacting with the executive director, as is often the case in small non-profits. If this organization uses the typical step-down approach, and it first allocates the executive director’s costs to the other service centers, then the full costs of the three mission centers will include a sizable subsidy for the costs of the executive director-human resource center’s interactions.
To address this problem many public organizations instead use the double-step-down method. After each service center/department’s costs have been allocated once, each center/department’s cost not included in the original allocation are totaled and allocated again. To illustrate, let’s return to the copy center-office manager example above. If this allocation were done with the double-step-down method the office manager’s copies would be included in the total copy figure. The copy center’s would first allocate its costs, excluding the office manager’s copies, to the mission centers. Then in a second step, the office manager’s share of the copying costs would be allocated to the mission centers in a separate allocation. This double-step method minimizes cross-allocation of service center costs.
Keep in mind that there are no national or international standards for how public organizations measure and define their cost structures, also known as their cost accounting practices. Governments employ a variety of state and local-specific cost accounting methods. Non-profits tend to follow the cost accounting conventions prescribed by federal and state grants or major foundations, but those conventions do not equate to national standards. By contrast, financial accounting – or accounting designed to report financial results to outside stakeholders – is dictated by GAAP. That’s why it’s possible to compare a government’s financial statements to that of another government, and a non-profit’s financial statements to that of another non-profit, but not necessarily possible to compare different organizations’ budgets or internal cost accounting systems.
Indirect Cost Allocation: Indirect Cost Rates
Cost drivers and allocation bases work well when the service in question has a clear cost objective and a measurable unit of service. Most public organizations, as described above, don’t have this luxury. Many don’t deliver a service with a measurable outcome. Most public organizations’ costs are related to personnel, and personnel costs are not distributed evenly across clients or cases. Moreover, a growing number of public services today are delivered through partnerships and collaborations where it’s often not clear how costs are incurred, and murkier yet how those costs ought to be allocated across the partner organizations. For these and many other reasons, traditional cost allocation methods often don’t work in the public sector. And yet, it’s still critically important to measure and properly account for full costs, including and especially indirect costs that can be difficult to measure.
To address these problems many public organizations rely on indirect cost rates. An indirect cost rate is a ratio of indirect costs to direct costs. For instance, a city police department might determine that its indirect cost rate is 15%. That means that for every dollar of direct costs like police officer salaries and squad cars, it will incur 15 cents of payroll processing, insurance, procurement expenses, and other indirect costs.
Taking Stock of Costs
Public organizations rarely have the kinds of sophisticated cost tracking and measurement systems that you might find at Boeing or other manufacturers, logistics companies like FedEx, or retail entities like Amazon. So how do budgeting and finance staff begin to understand what a public organization’s services cost? There are three basic methods.
- “Time in Motion.” Public organizations will occasionally send analysts to see where and how employees spend their time. For instance, a city planning department might allow analysts into their office to watch how much time staff spend on different types of permits, appeals, and other activities. After observing the department’s activities for a sample of days over a period of weeks or months, cost analysts can estimate how much time staff spend on each of their different activities, and can then build out cost estimates.
- Self-reported Allocations. Some organizations ask staff to keep track of their own time, much like the billable hours method used by attorneys, accountants, and other professionals. Some of these tracking schemes are quite detailed, requiring time reported in 15 minute intervals. Others are much more general and allow for estimates on much larger intervals like days or weeks.
- Statistical Analysis. Cost accountants occasionally use regression analysis and other statistical tools to estimate the relationship between costs and services delivered. One of the most common is to determine the linear trend, if any, between total expenses and volume of service delivered over time. Variation around that trend (i.e. the residuals from the regression analysis) suggest a potential pattern of variable costs.
Let’s illustrate this with a more detailed example. Surveys show that many local public health departments would like to offer more services related to hypertension outreach and management. Chronic health conditions like heart disease and diabetes are known to be related to high blood pressure, so better management of high blood pressure can affect public health in a substantial, positive way. But many citizens, especially those without health insurance, do not have access to regular blood pressure screening and other services needed to identify and manage hypertension.
Say, for example that Cheng County and Duncombe County would like to launch a new, shared hypertension prevention and management (HPM) program. Neither currently has a formal program in this area, but both offer some of the services through a patchwork of partnerships with local non-profits. Cheng County has roughly twice the population of Duncombe County, and Duncombe County’s per capita income and property values are 30-40% higher than Cheng’s.
What does it cost to deliver this service? As with most public health programs the main costs will be related to personnel, namely public health nurses, outreach counselors, and nutritionists. The program will also require space and other overhead costs. The outreach and education components will require advertising, travel, and other costs. For a service sharing arrangement to work, the two Counties must decide how to share these costs.
Suppose also the counties agree in advance to share the full costs evenly. This approach is simple and straightforward. However, it ignores many of the program’s underlying cost drivers. Cheng has a much larger population than Duncombe, so more of the participants will probably come from County A. Simply splitting these costs “50-50″ means Duncombe will likely subsidize Cheng, an arrangement Duncombe’s leaders might find unacceptable.
So what’s the alternative? Cheng could bill Duncombe for each Duncombe resident who participates in the program. They could use an allocation basis like population or assessed property values. A more cutting-edge scheme might be to share the costs according to the incidence of the chronic diseases the HPM program is designed to prevent. Each of these strategies demands a trade-off. Some are simpler, but at the expense of fairness. Some require cost measurement that might be expensive or infeasible. Others are more feasible, but might place costs disproportionately on the population the program is designed to serve.
To begin, let’s assume Cheng will structure the new HPM as a cost center within the Health Behaviors division of its Public Health department. Let’s also assume also that since HPM’s main “deliverable” will be blood pressure screening, it will define its unit cost as the cost per blood pressure screening performed.
Given those assumptions, Cheng County’s budget analysts estimate that for the first year of operations, the HPM program will serve 400 clients, and its cost will include:
- Direct Labor. This includes seven full-time and one half-time licensed nurse practitioners who can administer blood pressure screening. Annual salaries for these nurses is $67,108. The program will also employ a health counselor who will guide clients on how to manage hypertension through healthier eating and fitness. The counselor’s annual salary is $73,815.
- Direct Non-Labor. Nurses and the counselor will need to travel to visit clients and deliver outreach programs. Staff estimate total travel of 20,120 miles of travel at $.325/mile. The HPM program will also require medical supplies, office supplies, and a few capital items. Budget staff estimate $6,142 of annual direct non-labor costs for each nurse, and $7,566 of direct non-labor costs for the counselor. This difference is due to a heavier expected travel schedule for the counselor. The program will also execute an annual contract, valued at $14,939, with a communications consultant who will develop and deliver a healthy eating outreach marketing effort in both counties. Even though most of these costs are related to labor, here they’re considered non-labor “contractual” costs.
- Indirect Labor. Cheng County’s Health Behaviors Manager will supervise the HPM staff, and Cheng County’s Executive will provide policy direction and other leadership. A portion of both administrators’ salaries are allocated to HPM as indirect labor costs. HPM staff will also incur indirect labor costs like payroll support, accounting and auditing services, and procurement support. Budget staff estimate $10,456 of annual indirect labor costs for each nurse, and $8,519 of direct non-labor costs for the counselor.
- Indirect Non-Labor. HPM staff must also have access to office space, liability insurance, association memberships, and other indirect non-labor costs. Budget staff estimates annual indirect non-labor costs of $4,799 for each nurse and counselor.
With that information and a few additional assumptions, we can begin to detail HPM’s cost structure and compute some indirect costs rates. See the table below.
Is it Allowable?
One of the key questions when computing indirect cost rates is which indirect costs are allowable or reasonable? For example, in some cases it’s unclear whether staff who contribute marginally to a program’s operations – such as development directors, general outreach coordinators, and others – should be included as an indirect cost. Certain types of training might be helpful, but not essential for staff to understand their jobs and deliver the service. And of course, there’s always reason to define indirect costs as broadly as possible, especially if you can recover those costs through some external funding source.
There are no national standards, per se, for what constitutes a relevant indirect cost. Each project, program, and funder is a bit different. That said, the federal government has guidelines on what types of indirect costs it will reimburse. Many states and local governments also use these standards or some adaptation of these standards for their internal cost accounting. You can find more information on those guidelines at OMB Circular a-87: Cost Principles for State, Local, and Indian Tribal Governments. This publication is available at http://www.whitehouse.gov/omb/circulars_a087_2004.