By Ernie Ting, MBA ‘90
A common situation is a client facing a serious budget deficit, asking the team to provide advice on how and where to cut program or administrative costs.
The key to the project is to understand the organization’s finances. There are at least two substantially different approaches to analyzing costs-“top-down” and “bottom-up.”
Using both, at least to some degree, is helpful to identify any errors or omissions in the cost analysis or source documents.
This approach can be started quickly by gathering up copies of the organization’s budgets - including operating, capital, and fundraising budgets for the current year, past year and any proposed budgets for the next fiscal year. Detail by individual program, location and organizational unit, expense categories, and tracking of budget versus actual should be displayed. These internal documents should be compared to the organization’s public financial statements and the most recent report of its auditors.
Generally both the audited financials and the internal budgets should show a breakdown of revenues and expenditures by program/activity. Obvious (but not necessarily the best) places to look for savings are large programs and large expense items. Top-down approaches tend to focus on “exceptions”-explaining year-to-year changes in costs or revenues, looking for ways to close program deficits, etc.
This approach may be pursued by interviewing both managers and line staff to understand the activities of concern in some detail. It is generally useful to observe relevant operations, if possible, as manager and staff descriptions of an activity are often reflections of desires rather than actual practice. Of particular concern is information about how activities are structured, what staff and material resources go into delivering a service, how professional time is consumed during a workday, economies of scale due to equipment, setup time, coordination and supervision requirements, and learning curves.
A costing approach that fits into a bottom-up analysis is the incremental cost method. In an incremental cost analysis, you strive to understand what are the driving external events and internal decisions that cause major costs to be incurred. In each case, you assess the total costs if a certain event occurs or decision is made (e.g., open a new location, eliminate a program) compared with a baseline cost.
It may seem logical to view a project as a straightforward matter of finding ways to reduce costs. However, it is generally more useful to recast the problem as one of better managing costs-cost reduction alone may not be the best approach to achieving financial and organizational health. Paring dollars from the budget is only desirable if the dollars saved exceed any value or income lost.
The overall objective is cost-effective use of resources.
Objective: Cost Effective Use of Resources
Focus on understanding how each dollar spent does — or does not — contribute to:
Suggested areas for cost cutting may not necessarily be the best areas. Look into these, but go beyond the obvious, and look for more effective alternatives.
It may be tempting to focus heavily on programs that appear to be “losing” the most money. However, perform a quick analysis before presuming that accepted statements about program surpluses and losses are reasonable budget-cutting guidance.
Be careful about using any information that purports to show whether an individual activity (department, program, location, etc.-sometimes referred to as cost “objects”) is covering its costs. Any surplus or deficit information that is drawn directly from public financial statements or the nonprofit’s financial accounting system is likely to employ allocations of certain costs that can actually mask an activity’s true financial health.
To determine whether an activity-for example, a particular service offered by the nonprofit -is breaking even, you need to assess what it costs to provide that service. There are many different methods that are used to develop a service cost, and each has certain strengths and weaknesses.
There are several terms that are relevant to this analysis-“direct costs,” “indirect costs,” “overhead costs,” and “lumpy costs.”
The important point about a service with lumpy costs is that the cost of providing service may not be captured well with a single, average dollar figure. The effective cost to the organization of even a small increase in service level may vary wildly depending on how close it is to exhausting the capacity of one or another input, the size of the lumps, whether the service is growing or shrinking, whether the cost of lumpy inputs is changing - and how quickly.
With all costing methods, direct costs are included in the computation of a service’s cost. Any costs that are completely attributable to a given service, and can be feasibly measured, should be the first element in its service cost.
The treatment of lumpy direct costs, as well as indirect and overhead costs, are more problematic. If they are a relatively small proportion of the total costs under consideration, you can calculate a “full cost” in the way that is suggested in the Bridgespan paper. This full cost method allocates a portion of the indirect and overhead costs to each of the individual services of a nonprofit, and adds the direct and allocated costs together to arrive at “the” average cost per unit of a service. This method has the distinctive advantage of simplicity, but it can result in a unit cost figure that is too high - and cause managers to put the brakes on options that would be cost-effective given any “sunk” costs that have already been incurred and that cannot be saved in the near term. (See Horngren and Chabot Space and Science Center example.) With lumpy costs, the full cost method could also result in a cost per unit that is too low.
Other costing methods that handle lumpy, indirect, and overhead costs with more subtlety are better suited to nonprofits that have major fixed costs (labor contracts or other long-term employment agreements, long-lived equipment, facilities, owned land and buildings, large overhead) or offer service on a “multi-part” basis; e.g., one fee for entrance to a museum, another for attendance at a particular program.
While the full cost method has the distinct advantage of “objectivity,” the incremental cost method requires more detailed analysis and judgment. The objective is to characterize the “cost structure” of the overall organization and its individual programs of interest. The discussions in Porter and Horngren suggest criteria for identifying the key cost drivers in an organization. Such an understanding can help you identify ways that the organization can reduce costs by downsizing, reallocating resources, or redesigning its offerings or operations.
Additional methods for discerning the cost structure of an organization are described in Horngren (328-335).
Conditions Favoring the Use of Different Service Costing Methods
Direct Cost or Full Cost Methods
Activity-Based Costing
Incremental Cost Methods
Other costing methods such as activity-based costing (ABC) represent a mid-ground between a full bottoms-up approach (e.g., incremental costing) and a tops-down approach (e.g., full costing). A typical ABC analysis allocates indirect costs in a tops-down manner, but distinguishes four layers of costs and uses multiple allocators to more closely mimic the cost structure of an organization.
Used extensively in larger businesses, ABC has the advantage of a “formula” approach while being considerably more versatile than simple direct or full-cost methods. However, ABC tends to require a major investment of time and effort to develop-and we therefore don’t recommend a full-blown ABC analysis for ACT project teams.
Deliverables should have immediate applicability for helping to manage costs.
Typical deliverables from an analysis include:
General Cost Accounting
Horngren Datar and Foster, Cost Accounting: A Managerial Emphasis (12th Edition)
Full Cost Methods
Susan Colby and Abigail Rubin, Costs Are Cool, online at The Bridgespan Group.
Incremental Cost and the Concept of Relevant Information
Ernest S. Ting and Associates, Introduction to Incremental Costing Methods, online at Esta-Consulting.
Cost Structure and Cost Driver Concepts
Michael E. Porter, Competitive Advantage, 62-88.