A2 Basic costing tools This appendix covers some of the basic costing tools that underpin the Guidelines and provides a broad overview of: • costing relationships between resource costs, activities and outputs, including cost pools, cost drivers and organisational structure; • cost classifications to direct and indirect costs, or fixed and variable costs; • costing approaches including full, marginal and opportunity costing; • costing principles and concepts such as relevant costs, allowable costs, consistency and completeness. A2.1 Costing relationships As discussed in Section 3, all costing approaches have similar cost components. As Figure A1 illustrates, the components include resources used and activities performed, which are linked to outputs achieved. There are clear and logical relationships between these components which should be reflected in any costing approach. Figure A1 illustrates the basic structure for most costing systems of an institution or department. These costing relationships, described below, are tied to the five-step costing process in Section 3. Figure A1: Cost relationships and the costing process Resource Costs (Staff, consumables, equipment) Step 3: Assign resource costs to activities Step 2: Identify activities Activities (Course delivery, admissions, reference library, creditor payments, estates management) Cost Drivers (Teaching contact hours, students, library usage, payments, space occupied) Step 4: Link activities to the cost objectives Step 1: Determine the cost objectives Cost Objectives (Courses, research, consultancy, catering) Step 5: Analyse and report results Resource costs The resources consumed by HEIs include: • staff costs; • learning materials, consumables, etc; • utilities, telephone, power, etc; • capital items including equipment. The resources are used to carry out various processes, activities and tasks to deliver the outputs. Resources are deployed within a management and organisational structure designed around groups of activities. Activities and outputs Activities and outputs were discussed in Section 2.4.2. Each output is the product of a number of activities. Some of these are clearly related to the main outputs (for example, the activity of teaching a class), others (such as paying an invoice or ordering a book for the library) are less directly related but still contribute. Potentially a very large number of activities can be costed. Activities or costs which behave in a broadly similar fashion (ie, which respond in a similar way to the same cost driver) are often grouped into activity or cost pools. The extent to which separate activity and cost pools would be appropriate at an institution is a matter of judgement in each case. If an institution wishes to determine the indirect costs associated with research, it is more cost-effective to group similar expenses than to look in detail at each one. For example, central administration costs can be grouped into those that benefit students, those that benefit research, and those that benefit all activities. This avoids considering perhaps hundreds of separate activities and their costs. Cost drivers Cost drivers are the factors responsible for variations in the cost of an activity. For example, there are costs associated with the payment of staff salaries and wages; the driver of these costs may be the number of payroll cheques issued. Because of the grouping of activities and costs into pools, it may not be possible to use actual cost drivers. Instead a distribution basis may be used which identifies a factor representing the true cost drivers in the pool. The basis selected should be the one best suited for allocating the pool of costs to cost objectives, according to either the benefits derived, or a traceable cause and effect relationship, or logic and reason (where neither benefit nor cause and effect can be determined). The allocation should ensure that there is an equitable distribution of costs. Obtaining the volumetric measures for the basis used in allocating costs can involve different degrees of effort. Distribution bases can be determined by: • estimates, such as staff salaries, staff and student FTEs, or space occupied (this may require little calculation); • a cost analysis study, taking into consideration weighting factors, data samples, occasional reviews, or existing measurement systems (this can be used at differing cost and precision levels); • activity-based costing which identifies cost drivers and involves more detail and greater precision. Each institution will form its own views on how precise costing should be. This decision will be influenced by various factors: the resource allocation model in use, the resources in the finance department, the type of accounting system, and existing data and measurement systems (such as space and library usage, and records of financial transactions). Many institutions are changing business processes and benchmarking internal activities. Information gathered for these activities can inform the costing process, and vice-versa. Links Within this basic cost structure, there are relationships between cost items, resources, outputs and inputs. It is important to identify these links so that appropriate costs are attributed to the final output. The five-step approach focuses on the links between costs and activities, and between activities and outputs (or cost objectives). These links are illustrated in Figure A1. Organisation structure In making the links described above, it is necessary to understand the structure of the organisation (which determines where various activities will be identified and costed) and the relationships between different parts. The key point for costing purposes is to understand how support departments relate to the main academic departments. These organisational and costing relationships are illustrated in Figure A2. Figure A2: Organisation and cost structure Total institutional costs (Annual Report) (financial extract) Staff costs Consumables Capital items Principal activities or costs Faculty or Department - A Teaching Research Other services Faculty or Department - B Residences Catering Support activities or costs Recharges Indirect cost model Premises General administration Department administration Student administration Research administration Learning resources (library and computing) For example, when costing the principal activities such as teaching or research, the relevant costs of support departments will be added to the relevant costs of the academic departments. There are also relationships between support departments. The finance department, for example, serves the academic departments but also supports other service departments, and may in turn be supported by them (eg, by personnel). A2.2 Cost classifications There are several ways of classifying costs to assist in cost analysis: for example, as direct or indirect; or as fixed, variable, or mixed. These terms are defined below. A2.2.1 Direct and indirect costs Both direct and indirect costs benefit the principal activities. Direct costs are expenses that are readily identifiable with a particular activity or unit, and as such, can be directly and accurately attributed to it. Examples include specific chemicals needed for a research project, or the salary of a member of staff recruited solely to teach a particular module. Indirect costs cannot be easily identified with a particular activity or unit. Indirect costs are attributed to activities using a form of estimation since tracking the actual usage is often non-productive and too expensive. The same cost may be direct for one activity but indirect for another, depending on the purpose of the costing exercise. For example, the staff salary of the head of department may be a direct cost of the academic department, but an indirect cost of teaching a particular course. Within a particular costing exercise, it is important to treat costs consistently as either direct or indirect to avoid risk of double counting and confusion Key point: within an institution’s framework for costing, there should be a clear distinction as to the treatment of institution-wide expenses as either direct or indirect costs. This establishes the basis for consistent costing throughout the institution. A2.2.2 Fixed, variable and mixed costs For certain management decisions, costs may be classified as fixed, variable or mixed within a relevant range of activity. The differences are as follows: • fixed costs are tied to the time period, generally independent of the level of output; • variable costs are tied to output or usage, generally independent of the time period; • mixed costs have both fixed and variable components. Figure A3 illustrates the relationship of these costs to a period of time, for example, one year. Figure A3: Fixed, variable and mixed costs Fixed Total costs £ Total costs £ Variable Total costs £ Mixed 50 100 50 100 Fixed Variable 50 100 Number of students Number of students Number of students Fixed costs include insurance, executive salaries, rents, and a permanent lecturer’s salary. They are a constant amount even though the number of students for a course changes. The relevant range of activity in this example between 1 and 150 students. Fixed costs are often stepped costs because of the potential increase or decrease with a significant change in volume. If the number of students increases from 100 to 200, the department will add another full-time lecturer and then the total fixed costs take a step up. Variable costs include, for example, the cost of printing teaching materials for each student. The cost is per student and with an increase in students the costs will increase incrementally. Other examples include costs of photocopying or food, and the cost of part-time lecturing hours brought in for a course. Mixed costs contain both fixed and variable components where only some of the costs change with an increase or decrease in activity. An example is telephone costs, where there is a fixed monthly charge plus a variable component driven by the number of calls made. Relevant range of activity means the usage level for which assumptions about the cost behaviour (fixed, variable or mixed) remain valid. In the fixed cost example, the lecturer costs were fixed over the relevant range of 1 to 150 students. A2.3 Costing approaches No single costing approach will be appropriate in all circumstances. The approach chosen will depend on the decision to be made. This section summarises some of the main costing approaches used at institutions. A2.3.1 Full costing Full costing allocates all costs of the institution to activities. Because it covers all costs, it can be reconciled to the financial records (historical or budgeted) of the institution. The worked examples in Sections 4-7 illustrate full costing of institutional and departmental activities. Both absorption and activity-based costing are ways of applying full costing. The end result is that all costs, direct and indirect, of an activity are determined. Key points The benefits of full costing are that: all the costs are included; duplication of costs can be avoided; and decisions are made with an awareness of all costs. Full costing is useful in making certain decisions, for example the price to be charged for external services. Basing prices on full costs helps the institution to avoid unknowingly subsidising external activities with institutional funds. Absorption costing is a technique by which indirect costs are absorbed by adding a factor or percentage to direct costs. For example, in determining the full cost of a research contract, the direct cost for researchers, materials, supplies and travel will be determined, plus an amount for institutional and departmental indirect costs. The indirect cost amount is often a single rate for all activities, based on, for example, salary costs. Absorption costing is often crude, particularly if the proportion of indirect costs in the institution is high in relation to direct costs. However, the method is simple to administer and easy to understand, and may be appropriate when direct costs are of most significance. Activity-based costing (ABC) is at the other extreme of sophistication. It attempts to build up a more detailed understanding of the activities of the institution (principal and support services) and to assign staff and other operating costs to these activities. For example, ABC can help an institution determine the cost of performing the quality assessment process. The institution may have a central department or unit which organises the assessment exercise. Absorption costing is likely to identify the resources consumed by this department, plus a share of institutional indirect costs, as the only costs of quality assessment for the institution. However, closer analysis reveals that other organisational units also contribute activities towards the process. These units may include academics, department heads, support staff, and the computer centre. ABC seeks to identify more accurately the real processes; it costs activities and tasks across organisational boundaries to determine the full cost of these processes. This approach can be applied at varying degrees of sophistication throughout an institution. A2.3.2 Marginal costing Marginal costing identifies fixed and variable costs but bases decisions only on the variable costs of an activity, that is, the incremental increase in costs caused by a marginal increase in activity (such as one additional student in a class). Marginal costing is often legitimately used in decision making when an activity centre has short-term spare capacity. However, it must be used with care since most increases in activity are not truly marginal. At some point, even one additional student will justify an extra room or lecturer, and any increase may also place extra burdens on indirect services such as registry, personnel, and finance. Key point: marginal costing should only be used with care in limited circumstances. Marginal costs have led institutions into difficult situations where decisions have been made on the basis of inappropriate cost information. A2.3.3 Opportunity costing Opportunity costing measures the value of a benefit sacrificed in favour of an alternative course of action. For example, a decision may be made to take a student bedroom out of service for use as an office. The opportunity cost is the year’s student rent lost (plus any potential vacation letting income). The opportunity cost of academic staff who spend time on committee work can be surprisingly high over a year. Opportunity costing will encourage a decision maker to look at alternative uses of the resource, and to consider which option is most beneficial to the department or institution. A2.4 Basic costing principles In all costing approaches, there are a few underpinning principles which help to provide valid cost information. These include identifying relevant costs and allowable costs, and providing consistency and completeness. A2.4.1 Relevant costs A cost is relevant to a particular cost objective (ie, a specific project, department or function) if the goods or services are chargeable or attributable to that cost objective in accordance with relative benefits received. For example, a cost is relevant to a course if: • it is incurred solely to advance the work of the course; or • it benefits both the course and other work of the institution, where proportions can be approximated through the use of reasonable methods; or • it is necessary to the overall operation of the institution and is deemed to be partly attributable to the course. Some costs may be relevant to an objective but so small that it is reasonable to ignore them on the grounds that they are immaterial. A2.4.2 Allowable costs A cost should be allowable to a specific cost output or objective. Whether costs are allowable is usually determined by the institution, or by the terms of a contract or grant. They usually relate to expenses under a contract. A2.4.3 Consistency of approach and treatment of costs Accounting treatment of like cost items should be consistent within each accounting period and from one period to the next. Also, an institution’s method of estimating costs for pricing contracts or services should be consistent with the accounting practices used in accumulating and reporting historical cost. There should be consistency in the classification of costs. This is essential to guard against overcharging costs to activities, non-charging of appropriate costs to activities, and double counting of the same cost item. An example of double counting would be treating departmental secretarial staff as part of the direct cost of a particular research contract while at the same time including them as part of the indirect cost of all research projects. The principle of consistency must be applied to discounts and rebates, as well as to recharges or sales to external parties. Such items should be netted against related expenditure in determining the rates or amounts to be charged to institutional activities (ie, indirect costs should be net of internal and external cost of sales or services). A2.4.4 Completeness A costing exercise should include all the costs and activities of an institution and be reconciled to the institution’s main financial or statistical records. When determining costs associated with a particular cost objective, consideration should be given to the impact of other institutional support activities on the decision to be informed. Conversely, it is important to consider the impact a particular decision may have on other areas in the institution. For example, when deciding whether or not to introduce a new course, an institution will have to consider whether certain lecturers and materials may be needed for that academic unit. The new students enrolling on the course will also have an impact on the student registration department, and may require additional classroom space. Additional student registration staff may be needed to handle the new course, or there may already be adequate staffing. In the latter case, it could be said that the registry has spare capacity and that the new students will be using some of the existing costs of this spare capacity. It is therefore a fundamental concept of costing that all the activities and costs of an HEI should be recognised and accounted for (at a greater or lesser degree of detail) as the starting point for institutional cost analysis. This ensures that no costs or activities are omitted from the analysis, all activities have their costs attributed to them, and costs are not double counted. The easiest way to ensure that all costs are included is to reconcile the financial and other statistical information used in costing to the audited accounts of the institution. Any reasonable cost study should be tied to or reconciled to financial statements so that: • the cost information has credibility; • costs are not lost in the cost analysis; • there is no duplication of costs; • the information is reliable; • the cost information can be documented and audited if required (for example, by research sponsors). For determining the direct and indirect costs of sponsored research contracts and grants, the basis of distribution may be negotiated, but the basis for costs can be audited if tied to the institution’s financial records.