A White Paper by Cost Technology & SAS

Executive summary

The tremendous value that manufacturing companies realized in early applications of activity-based costing (ABC) sparked efforts to develop its power and extend its functionality to new areas. Today, ABC is a management practice found in diverse organizations, including government. The multitude of functions provided by state and local organizations, including transit and health services, makes them just as complex and diverse as manufacturing companies and, therefore, enables them to truly benefit from a technique that reveals the sources of cost and profitability, non-financial performance.

Applying lessons learned from ABC, government agencies have a clear understanding of where to transform operations to deliver services in a more cost-effective manner, benefiting both clients and taxpayers. Many government organizations cited in this paper have identified substantial cost savings through cost modeling and have realized both tangible and intangible benefits from capturing that value.

Activity-based costing models can be deployed to predict the impact of future activities and can be a central component of many performance management systems. Through the integration of ABC into performance management initiatives, an organization can communicate financial and non-financial strategies to everyone in the organization, measuring performance, developing financial and resource plans, analyzing performance, and creating value. A “collaborative performance management” initiative indicates the inclusion of costing models in determining corporate strategy.

Activity-based costing and collaborative performance management are long-term strategic endeavors. Neither should be approached as a project that will be completed and marked off the “to do” list because it really has no “end.” Rather, it is a journey wherein there will always be room to improve effectiveness and efficiency within any organization. Its unending nature is largely due to the environmental factors that constantly change, bringing new challenges and opportunities.

The transformation of activity-based costing

Activity-based costing (ABC) was first used in manufacturing companies in the mid-1980s as a methodology to accurately compute the cost and profitability of products. Its emergence coincided with global competition in automobiles, electronics and other manufactured goods that increased cost and profit pressures for domestic manufacturers.

ABC revealed significant methodological and computational errors in traditional cost accounting systems. Costs reported by these traditional systems often erred by hundreds, and in some cases, thousands of percent when compared with accurate ABC costs. When these errors were corrected using ABC, it was common to find as many as 80 percent of a company’s products unprofitable. In contrast, traditional cost systems incorrectly reported most products as profitable, failed to communicate opportunities to improve profitability and lulled companies into complacency.

Accurate ABC costs were accompanied by new insights into the drivers of profitability. ABC cost information spurred changes in price, product design, cost reduction, and other strategic and operational changes that led to profit improvement.

Given ABC’s early success in reporting accurate cost information, it is common to confuse ABC with cost accounting systems. Cost accounting originated in the 1920-1930s to enable manufacturing companies to value inventory for financial statement purposes. Only later were these costs used for management decision-making purposes, a function for which they had not been designed. In contrast, ABC sprang from the need to understand the sources of cost, profitability and non-financial performance in complex and diverse modern organizations. The early success of ABC led to significant efforts to develop its power, extend its functionality to new areas and harness new technology. Today, ABC is an analytic tool found in service and government organizations, as well as in manufacturing companies. Service organizations are often just as complex and diverse as manufacturing companies and benefit from a tool that reveals the sources of cost and profitability. ABC helps government agencies deliver services in a more cost-effective manner benefiting both clients and taxpayers.

ABC supplies business intelligence about processes, customers, equipment, and human resources, in addition to products and services. Areas of application include cost-to-serve activities, distribution and logistics, and support services. Activity-based costing models can be deployed with predictive capabilities, and they are the central component of many performance management systems.

Addressing performance management has been a battle cry for government agencies throughout the last decade. From elder care to transportation projects, activity-based costing plays a vital role in measuring the impact of service components on quality delivery. The next section will discuss this intersection of cost and performance.

Bridging cost and performance

Collaborative performance management (CPM) is an approach to measuring, analyzing, reporting and improving performance. It transforms analytic tools from “number crunchers” to interactive multivariate models that are accessed in a collaborative environment throughout the enterprise. People involvement, decision analysis, change management and value creation are the cornerstones of this method. CPM plays an important role in communicating and executing strategy. Government organizations receive new mandates and requirements for service delivery on an ongoing basis from federal agencies and state legislation. What is often missing in the directive is the detail of how to modify the internal processes to satisfy the requirements. Responding to the ever-changing environment, while continuing to meet constituent needs, requires highly energetic and capable management. Experience confirms that most business failure is attributable to faulty execution of plans rather than lack of vision. CPM helps correct this problem by communicating the strategic plan to everyone in the organization, measuring performance, developing financial and resource plans, analyzing performance, and creating value.

The CPM system includes five management methods: strategy map, balanced scorecard, activity-based costing, resource planning and value creation (Figure 1). Figure 1 – Value Creation Diagram These are described as follows:

Strategy map. A strategy map is a way of communicating strategy in a single page that everyone can understand. It is typically broken into four perspectives: customer, internal process, organization health and learning, and financial. The strategy map includes high-level objectives for each of these perspectives in a cause-and-effect framework.

• The balanced scorecard. The balanced scorecard is a set of goals and performance measures derived from the strategy map (and, therefore, linked directly to the organization’s strategic plan). It includes goals and measures in each of the four perspectives to provide balance across all important dimensions of performance. Each organization has a set of scorecards – one for each part of the business and the manager responsible – that are linked to each other and the strategy map. Hierarchically, goals are linked to objectives, which are linked to measures in a weighted cause-andeffect relationship. A balanced scorecard can be descriptive as well as predictive of organizational performance.
• Activity-based costing. As described previously, ABC is an analytic tool providing business intelligence about resources, processes, products and services, customers, and other business elements. It is used to optimize business decisions in terms of cost and profit impact and to provide performance measures for the balanced scorecard.
• Resource planning. Resource planning is a predictive version of activity-based costing. It simulates process capacity and resource requirements based on planned quantities and types of output. It helps answer “what if” questions about the impact of business changes on financial performance.
• Value creation. Value creation is a process to convert analysis into action and action into results. It includes a change management program (leadership, communications, defined roles and responsibilities, training) to enhance buy-in and learning. It also includes a process for executing action plans, analytics to support action plan decisions, tracking of results and communication of success.

Lessons learned: A government perspective

Among government and private industry organizations that implement performance management, achieving a balance between effectiveness and efficiency is a common success factor. Organizations that focus more on one and less the other do not reach the full potential of performance management. An organization can be very effective, but also be wasteful with resources. In contrast, an organization can be so cost-focused that service levels or product quality do not meet constituent expectations and needs. The most successful organizations balance the scales between effectiveness and efficiency – and the use of performance and cost information (including performance indicators) is paramount to this success. Effectiveness and efficiency can be optimized by connecting strategic performance and operational performance. The top of the organization is connected to and aligned with the front-line where operations are run. If everyone from top to bottom agrees and accepts the strategy and how it should be implemented, then the organization can move in a unified fashion to improve overall performance. ABC has proven to be a very descriptive connection between strategic performance and operational performance.

Even with the strategy and measures in place, many government organizations struggle to achieve the requisite cultural transformation. Organizations as a whole must learn to accept and adopt performance management as a discipline. This culture change involves denouncing fears that performance and cost information will be used as a disciplinary tactic; it should not be the reason or motivation for implementing performance management. Rather, the intent should be to give employees the intelligence they need to do their jobs better and make better decisions.

Cultural transformation can be spurred on through great leadership. Some of the most successful implementations of ABC and CPM are in organizations with top leadership spearheading this initiative. They sponsor it and believe in it. Once employees understand this, they are inspired to believe in it themselves – and adopt it. But the top-down push should be met with bottom-up involvement in building a performance management system. It is a collaborative effort. Finally, ABC and CPM are long-term strategic endeavors. Neither should be approached as a project that will be completed and marked off the “to do” list because it really has no end. Rather, it is a journey wherein there will always be room to improve effectiveness and efficiency within any organization. Its unending nature is largely due to the environmental factors that constantly change, bringing new challenges and opportunities.

The impact of CPM: Real-world case studies

The impetus for collaborative performance management is the drive to do more with less that is affecting the public sector in all areas of government. CPM works by helping communicate and execute strategy, as well as by transforming operating performance.

South Dakota Department of Transportation

The South Dakota Department of Transportation (SDDOT) implemented a comprehensive CPM system to help the department achieve its vision of providing cost-effective transportation. CPM helps the department run its operations “like a business.” It is credited with significant improvements in performance including millions of dollars of savings annually. Roxanne Rice, Fiscal and Public Assistance Director of SDDOT, commented on the success of CPM: “Through CPM, employees know how their activities contribute to the mission, vision and SDDOT strategic plan. They are responsible for strategic performance measures and are motivated to contribute to their success. CPM encourages employees to tell us what should be expected with regard to their activities. It gives them the opportunity to make changes to their work that increase efficiency and help them contribute to the goals of the department. Everyone participates in running the department like a business. All of us are knowledgeable about the department and its mission. We have buy-in regarding changes in the way we operate because these changes come from the employees and are based on analysis of their impact on performance. We are able to show our stakeholders how we are doing, what we are doing, why we are doing it and what it costs the taxpayer.” An impetus to implementing CPM at SDDOT was the difficulty managers had in making a decision about the manufacturing of road signs. A vendor offered to make all of the department’s road signs. These signs were currently made in-house, but the option of outsourcing was attractive if the cost were less. Unfortunately, in the absence of an ABC system, the department did not know what it currently cost to make road signs in-house and was, therefore, unable to determine if outsourcing would reduce the cost. Today, thanks to CPM, SDDOT managers have cost and other performance information at their fingertips. They use this business intelligence to reduce the cost of processes, lower the lifetime cost of ownership and operation of specific assets, monitor the effectiveness of the department’s transportation services, maintain the knowledge base even as pertinent staff retire, and prepare performance-based business plans and budgets.

Multnomah County Sheriff’s Department

Through activity-based management, the Multnomah County Sheriff’s Department in Oregon has shifted its standard cost-per-bed formula at its jails to more accurately forecast budget needs and the impact of projected shortfalls. Corrections officials can now identify and understand incarceration costs more accurately than ever before, and administrators can effectively convey the complexity of those costs to county and public stakeholders.

In addition to evaluating activity costs for each type of inmate, officials are also looking at the expenses associated with every step in the county’s booking system. Their analysis will show decision makers how costs escalate as prisoners move through the system, revealing steps in the booking process that might be combined or changed to save money. Shifting the medical evaluation to a point later in the process, for example, could decrease the number of prisoners evaluated and save the county thousands of dollars, since many inmates are released or transferred before ever being assigned housing in the jails. Finally, activity-based management supports what-if analyses, allowing decision makers to simulate real-life scenarios and understand the long-term impact of any potential change. This feature, for example, could predict the budgetary impacts that would result from increasing or decreasing the number of state prisoners in the county’s new jail.

Producing results in a government culture

As discussed above, activity-based costing and collaborative performance management are both strategic indicators for measuring results achieved in government programs and services. The results are most likely to have an impact when the performance management system is designed with results in mind to meet the specific business requirements of each agency. A performance management system with a high propensity for producing results has the following characteristics:

• The system is designed based on a thorough assessment of business needs. This ensures that the analytic components of the system can be used to resolve the agencies specific problems and decision requirements.
• The system is implemented using collaborative techniques wherever appropriate. Collaborative techniques—including worker participation in improving efficiency— enhance buy-in and create enthusiasm for performance management.
• The system is built around integrated technology solutions that make it easy for management to access, report, comprehend, analyze, optimize and track performance information on an ongoing basis.
• The system emphasizes learning to enhance each employee’s knowledge and ability to optimize performance.

‘Government as usual’ redefined

Activity-based costing models and performance measures are excellent sources of information for business intelligence (BI) and advanced data analysis. Governments use business intelligence to assess and report on current performance, trends and areas needing attention across the enterprise. Further use of analytic capabilities with business intelligence can forecast requirements and make decisions to optimize future performance. The application of business intelligence and analytics often results in decision makers spending less time looking for answers and more time determining the right solution.

Government has used business intelligence and analytic methods to:

• Analyze the cost of decision alternatives.
• Prepare outcome-based plans and budgets.
• Measure, track, analyze and compare business practices.
• Analyze the impact of different resource replacement, deployment and maintenance decisions.

Measure, track and monitor strategic goals. According to the National Conference of State Legislators, “Traditionally, government policies and programs discourage a review of priorities, effectiveness and outcomes. This is under attack in our states as the public is challenging how state governments operate, questioning
their efficiency and effectiveness, and expressing distrust of representative government
itself.”¹ There is a growing public perception that government could do a better job of allocating resources to meet constituent needs and eliminating fraudulent payments. Citizens are demanding the same integrated services from government that they receive from the private sector. Business intelligence and analytics help state and local governments transform their operations to deliver the right services, at the right time, with the appropriate resources.

State departments of social services are an excellent example of the value that performance management delivers. Ever-increasing case loads, burgeoning enrollment in entitlement programs and other demands are straining the ability to provide quality service. In some cases, high rates of staff turnover and process inefficiencies make it more difficult to respond cost-effectively to these demands.

Performance management is the remedy for these difficulties. With it, organizations can improve process efficiency, reduce costs, manage knowledge, measure client service and quality performance, forecast the resources needed to meet increasing demands for services, among other key capabilities. It helps organizations meet ambitious service and delivery goals within strict budget constraints.

Developing a road map for success

A successful ABC and performance management initiative is one that provides a positive return on investment (ROI), as well as the intangible benefits of enhanced learning and improved communications. Experience confirms that a positive ROI is most likely to result when the agency’s staff supports the initiative, implementation adheres to a systematic process and technology is used for maximum benefit. People

Support for the performance management initiative is vital to its success. Agency staff must be involved in the implementation process, providing input into the design of the system as well as creating an opportunity to learn about performance management. Staff also needs to be active users of performance management information and tools to have a positive impact on the outcome of decisions. ¹ Fundamentals of Sound State Budgeting Practices, National Conference of State Legislatures, May 20, 2005 Achieving these positive outcomes requires cultural change, buy-in to the initiative and learning at all levels of the agency. This is accomplished via sponsorship at the highest level of the agency, a positive communications program, and assignment of roles and responsibilities for implementation and use. Collaborative implementation methods engage staff at every step along the way and create opportunities for learning. Finding creative ways to communicate the results of performance management provides positive feedback, enhances perceptions of relevance to strategic purpose and reinforces the change process.
Process
An iterative implementation process is essential to the success of any ABC and performance management initiatives. Systems development must be carefully phased, and the analytic methods must be sequenced correctly. For example, it is recommended that activity-based costing precede building balanced scorecards, since balanced scorecards are heavily dependent on ABC as a source of performance measures.
Technology
Technology enables both of these projects. To maximize the value of a performance management system, data must be available. Data can be collected if it does not already exist (e.g., Web surveys). Data is the catalyst for disseminating fact-based information to the work force. Facts are hard to argue with. The following capabilities can help organizations realize the full potential of a performance management system, as well as ensure a low total cost of ownership:

• Data integration: Provides ability to smoothly and seamlessly collect data from disparate systems across the enterprise. Features should include the ability to automate and manage these processes. Data must be first accessed and then transformed into useful information.
• Business intelligence: Allows users (both technical and non-technical) of the system to query, report and drill down into data, information and details. View summarized and detailed data to investigate and analyze performance and cost. Use data integration capabilities to automate data updates to view current and accurate information.
• Business analytics: A scorecard or dashboard is very “thin” if it only provides a status indicator for measures. Status is important to know, but when one asks the question “why,” then analytics can be used to assess the underlying causes. Analytics can be used to prove or disprove cause-and-effect linkages or to forecast future performance, a capability that is especially helpful for budgeting and planning.
• Web user interfaces: A performance management system serves as an enabler for communication and collaboration. An application that is Web-enabled and easy to use is recommended to best achieve this. Web applications serve the purpose of “reaching out to the masses.”

ABC software: Use software specifically designed for ABC modeling and reporting. Using commercially available ABC software lowers the total cost of ownership compared with building customized applications or using desktop software (which both require time and resources to build and maintain).

Summary

Activity-based costing has been transformed from a tool that simply improves the accuracy of cost computations to one that adds immeasurable value to forward-looking government organizations. Leveraging ABC information for performance management initiatives, business intelligence and advanced analytics has elevated its value. Organizations are now able to make smarter decisions about outsourcing, maintenance schedules, caseload shifts and budget requests based on the most complete and robust intelligence.

We are in a new age of opportunity in the government, when organizations truly must respond to the mantra of doing more with less. Fiscal demands for homeland security, emergency management, defense, education and social programs will continue to dominate the spending at the federal, state and local levels. Governments cannot expect to receive funding increases commensurate with the demands for services; therefore, they must shift their thinking about delivery and management if they are to optimize performance.

The mere availability of technology that enables ABC and performance measurement does not ensure that initiatives will be successful. Strong leadership, cultural support for change and reinforcement of the systems’ value through results are the cornerstones of initiatives that last more than one administration or one fleeting year. Finally, smart government leaders will always be searching for ways to improve service delivery while reducing cost. ABC and performance management are additional tools in their toolkit for achieving this goal. Government leaders are tax-paying citizens of these great cities, states and nation, so we can all work to find ways to make the tax dollar go farther and do more, thus assuring a bright future for our children and the next generation of leaders.

The SAS and Cost Technology partnership

SAS and Cost Technology deliver award-winning technology and domain expertise to the government market. Government and private companies alike focus on achieving results, successful implementations and customer satisfaction.

The SAS and Cost Technology partnership is built around:

• SAS® technology. The most complete, incomparable set of software and solutions for data warehousing, mining, cleansing, integration and analytics – including SAS Activity-Based Management and SAS Strategic Performance Management. Supporting all activity-based costing methodologies, SAS Activity-Based Management takes into account bottom-up as well as consumption-driven ABC methodologies. With SAS Strategic Performance Management, organizations can focus on performance, align resources and adapt to meet changing demands.
• Project planning, design, integration and implementation. Cost Technology offers innovative thought-leadership in business performance optimization and business analytics. With technical expertise in SAS solutions and years of experience in implementation services, Cost Technology delivers value to government customers nationwide.
• Government expertise. Created to serve the complex business issues of government customers, SAS and Cost Technology share similar roots. Our dedicated public sector staff understands the business pressures that today’s government faces.