Output Management by scj97663

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									                                                                                 D/DLOHQ/WLC/10/6
                                                                                      21 March 2003



                          Investment Appraisal, Output Costing &
                                   Whole-Life Costing
Objective

1 To explain the differences between Investment Appraisal, Output Costing and Whole-Life
  Costing and how they may be used by the Department to improve decision-making.
  Investment decisions will increasingly be effected by the move to resource accounting
  and whole life costing and, therefore they must be taken in the context of the new
  currency used.

Background

2 The development and introduction of the three distinct types of costing techniques have
  emerged as a response to different business management requirements. Government
  Accounting states that “Investment Appraisal (or more generally option appraisal) is an
  important part of good financial management, and it should always be applied to major
  capital developments.” Project CAPITAL (the implementation of Resource Accounting
  and Budgeting) was set against a vision of “a Department managing its resources at all
  levels on an output basis”. To achieve the vision, CAPITAL aimed “ to integrate
  commercial accounting, output costing and management planning into a single
  management regime….” Resource Accounting also introduced the charge on capital and
  depreciation. These are dealt with in the Resource Accounting Policy Manual – JSP472.
  Soon after, the Strategic Defence Review called for the introduction of Whole-Life Costing
  (WLC), which was aimed at the costs of procurement and logistics so that the cost of
  equipment was examined through out its life, not just at its introduction.

Costing information for better decisions

3 Costing, in its own right, is not a value added activity in the MoD. It has value only insofar
  as it helps managers to take better decisions. In the Department there are four main
  categories of decision where better costing information should improve the quality of the
  decision, namely:

        a.   Strategic planning: eg what is the impact of increasing this defence capability or
        what can we do to reduce expenditure on this equipment by say £400m over the next
        10 years?
        b.    Investment decisions: eg which of these options is the best value for money? Is
        the preferred option affordable?
        c.     Output costing and output management: eg what is the cost of this Customer
        Supplier Agreement (CSA)? What happens if we flex the volume of demand by 5% in
        the first year? Where should we focus our improvement programme?
        d.      Cost management and forecasting: what do we need to charge for this service to
                cover our costs? What would be a reasonable charge from contractors? What
                are the forecast costs of this equipment maintenance programme?




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4 Although there can be overlaps between these types of decision, each will require
  different information in terms of scale and range, timeframe, cost components, accounting
  principles and degree of accuracy. The characteristics and linkages between the major
  types of costing information are discussed below.

Strategic planning

5 Costing at the strategic level is aimed at addressing questions such as how much of the
  Department’s resource control total is consumed in supporting strategic capability. Such
  as, for example, Deep Strike, and what the options are for reducing spending in this area
  by £xmillion over the next y to z years? Answers to some questions can be found directly
  through data held in the financial accounting systems. For example, the costs of
  operations are usually recorded against specific codes, whereas the cost of some
  functions (or intermediate outputs, such as training) can be readily related to the
  organisational structure. However, management responsibility and hence costs of
  defence equipment capability beyond the initial procurement phases (CADM) are shared
  by DPA, DLO, Front Line Commands and Personnel and Training Commands.

6 The WLC Project has developed the prototype Options and Affordability Toolset (OATS)
  that summarises the Cost Of Ownership statements (COOs) for defence equipment
  projects and allows these to be summarised and reported by DEC, force element or
  organisation. OATS has been designed as a database rather than as a traditional
  accounting hierarchy and therefore has the flexibility to incorporate developments such as
  “Defence lines of development” or “enabling components”, so long as the relationships
  can be identified and expressed clearly.

7 Strategic Planning assumptions are high level and, as such, require only high-level
  “roughly right” costings to support them. But as plans cascade down towards the delivery
  end of the organisation i.e. BLB and/or Agency, and the time horizon switches from the
  long to medium and short term, so the granularity of costing, and the depth of planning
  assumptions required to support it should increase as reflected in the Through Life
  Management Plan (TLMP). The objective of WLC is to support the more strategic
  decisions about projects, where there are long lead times; it should prompt the right
  questions in good time, when it is more useful to be “roughly right” now, rather than
  “precisely wrong” later.

Investment decisions

8 The introduction of Resource Accounting and Budgeting (RAB) has not changed the way
  in which value for money is assessed. Value for money is measured in a cost-
  effectiveness analysis, which in MoD’s case has been expressed as the Combined
  Operational Effectiveness and Investment Appraisal (COEIA). The COEIA relies on a
  forecast of resource flows and other benefits. These are discounted to give a net present
  value or more appropriately, a net present cost. It should be noted that IA is constructed
  to support a major decision and, as such, will seek to highlight differences between
  potential options. Consequently, it will present information at a common price base,
  excluding VAT and other transfer payments and ignoring costs that are common between
  options irrespective of their materiality. As a result, the IA itself will not directly address
  the question of affordability.



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9 JSP 5071 sets out the Department’s policy on investment appraisal and evaluation and
  specifically requires not only the value for money assessment but also the consideration
  of affordability, including affordability in resource (RAB) terms. The construction of the
  Cost of Ownership profile facilitates this analysis and, when combined with OATS data,
  offers an overall context against which long-term affordability judgements can be made.

10 In the case of Defence equipment, the key planning assumptions underpinning both the
   creation of the IA and the COO will be held within the Master Data and Assumptions List
   (MDAL) of the TLMP. However, in order to facilitate through-life management and to
   support the Equipment Planning process, the TLMP and COO should be updated as part
   of the annual planning process.

11 The IAB Sec has published guidance2 that enables the Investment Approvals Board (IAB)
   to approve projects on a RAB basis as well as the COEIA. This guidance covers both
   defence equipment and other infrastructure (eg estates and IT); and also capital
   expenditure by the Department directly and via PFI/PPP schemes. The RAB approval
   adopts the same principles as Whole-Life Costing.

Output costing and output management

12 The CAPITAL vision was for a “Department managing its resources at all levels on an
   output basis”. This included an expectation that outputs would be identified, costed and
   used as part of a system of Customer Supplier Agreements, that would be a key part of
   the planning round. To date, few CSAs contain clear expressions of outputs and costs;
   fewer still articulate the relationships between costs, activities and outputs; and very few,
   if any, form the basis of quasi-contractual negotiations. From STP03 onwards, however,
   all STPs are to be supported by CSAs, except for overheads and centrally provided
   services. There will be a structure of 4* CSAs between TLBs plus 2* CSAs between
   HLBs or management groupings.

13 All costs in supplier budgets should be attributed to a CSA agreed with customers. So
   far, TLBs have addressed the task in varying ways, reflecting their approaches to output
   costing. The DLO and CINCFLEET have taken a whole-TLB approach, implementing an
   activity based costing system known as Metify. Activity Based Costing (ABC) uses the
   costs and relationships in the underlying processes and activities to relate changes in
   volumes of activities to changes in output costs. This enables Metify, in common with
   some other ABC tools, to be able not only to model from inputs to outputs but to run the
   model in reverse, modelling changes in outputs and expressing these in terms of input
   costs. This has the potential to strengthen the STP process.

14 Where TLBs have based the output costing on the STP, and where the output focus is on
   defence equipment, it is possible to use the same source information for both output
   costing and as a basis for the COO. However, there is a need for the clear distinction
   between the two analyses to be recognised. The output cost model works at DFMS Chart
   of Accounts (CoA) Level 2 (ie around 40 lines of data) for a single TLB (or sub-set)
   detailed across the 4 year STP period or less. Whilst the COO covers six high-level
   operating cost categories, extending from the present through to the out-of-service date,

1
    MOD Guide to Investment Appraisal and Evaluation
2
    Smart Approvals – Instructions and Guidance on IAB and Delegated Approvals, Edition 7, September 2002


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                                                                                              21 March 2003



    and covers all material stakeholders across all of MOD. The detail of other stakeholders
    needed for WLC may be unnecessary in the output costing models. Forecasting costs
    and activity volumes in detail beyond the STP period is a pointless exercise; and building
    large unwieldy models is resource intensive without improving the quality of decision-
    making.

15 Output management implies not only planning, but also review of actuals. The current in-
   year management (IYM) processes will normally require a consideration of outputs in
   order to understand variances, as part of the monthly routine, but the use of output
   costing opens up the possibility of reviewing planned output costs against actuals. Output
   costing is not strictly required for in-year management, but it will open up scope for further
   analysis. Experience elsewhere suggests that it will be better to review output costing
   variances no more than twice a year, since there will be too much “noise” in the data.

16 In contrast, there is no plan at present to record WLC actuals, until the process has
   settled down. A further difference between output costing and WLC is the treatment of
   overheads. Within a TLB or HLB, output costing will typically try to identify the full cost of
   the output, including overhead costs of the HQ. In contrast, the COO template omits
   overhead costs, where there is no clear relationship between the overheads (eg Central
   TLB costs) and specific defence equipment. It is reasoned that overheads should be
   omitted from the COO on the grounds that:

                      a. decisions on specific equipment are            not   dependent     upon      the
                         apportionment of these overhead costs;
                      b. the increased accuracy of the full costs is spurious at this level and
                      c. overhead costs are better managed down through mechanisms other than
                         defence equipment planning.
17 In order optimise the synergies between Output Costing and WLC there would be, ideally,
   a Departmental framework. This would allow TLBs to develop the detail as they needed
   for local decisions, but would structure the output costing models so that information
   could be shared across TLBs and with other processes. This does not mean that there
   should be a single system. On balance, it would be more practical to co-ordinate more
   closely the development of output costing and WLC, rather than to try to create a single
   all-encompassing model. In the DLO the proposed development of output costing using
   “Tier 1 (Platform) ” and “Tier 2 (System or Equipment)” IPTs is a helpful further
   convergence of output costing and WLC.

Cost management and cost forecasting

18 In most businesses there is a constant need to examine and manage costs at the local
   level and to forecast costs of projects. These activities can typically be distinguished from
   the output costing discussed above by the level of detail required. Examples of the
   costing in this category would be the detailed activity based costing centred on individual
   processes, services or manufacturing plants.            Various management accounting
   techniques are available to assess product costs and to underpin pricing regimes.
   Detailed cost forecasts will also be required for project management and in contract
   negotiations.




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19 The Department, understandably, does not have a single one-size-fits-all approach to
   these costing activities, although in the case of cost forecasting a range of models,
   employed by DPA/Pricing Forecasting Group (formerly SPS), is being validated by D
   Scrutiny & Analysis for use to support investment decision making and project
   management. Given the wide variety of the models used there is no standard way in
   which they can be linked to other costing and planning processes.

20 For some areas it may be possible to use the General Ledger (in the financial accounts)
   or to use the output costing models, particularly to shape the questions and to identify
   areas to focus on. However, one-off decisions, cost reduction exercises and more
   detailed decision support will need more information about the controllable cost items and
   will typically need to make decision-specific assumptions about which costs are fixed and
   which are variable.

Key Differences

21 The following table summarises some of the key differences between the four types of
   decision taking discussed above.




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                                                                                                           21 March 2003



                  Strategy                 Investment                Output                    Cost management
                                           decisions                 management                and forecasting
Scale and         Departmental scale       Departmental; in          Business unit eg          Process, element
focus             expressed in terms       some cases wider          Agency or IPT to          of business unit or
                  that decisions are       economic issues are       understand the full       part of a platform.
                  being based eg           also relevant. The        costs of the unit’s       Local focus
                  platforms, force         focal point is the        outputs set out in a      typically.
                  elements or defence      project                   CSA.
                  capabilities
Timeframe         From STP period (4       From today’s date to      Short to medium term      Various depending
                  years), through EP       out of service            eg next budget year       on decision eg
                  period (10 years), to    (including disposal       to STP period.            planning period,
                  long term up to 30       period).                                            contract duration.
                  years
Cost              Related to the           The IA should include     All costs of the          May omit common
components        resource control         all material costs, but   business unit plus the    costs and
                  framework eg             distinguishing            costs that are            overheads on
                  Resource DEL and         between options           communicated into         marginal cost
                  Capital DEL. Costs       needs may ignore          that unit eg the costs    decisions. Likely to
                  could exclude            common costs. The         of accommodation or       focus on areas on
                  overheads when           affordability             overheads should be       to the decision is
                  decisions on marginal    assessment should         passed through to the     most sensitive.
                  changes are being        be based on the           business unit to give     Specific rules apply
                  explored eg defence      RAB-based WLC             a full cost. This         to PSC
                  equipment costs          cost of the               should be related to      calculations.
                  could exclude Central    investment, related to    the resource
                  TLB or other generic     the control               accounts
                  support functions        framework.
Accounting        RAB basis for            Cash for the IA;          Using the same data        Calculating costs
principles        elements related to      excludes tax and          as the STP as the         from first principles,
                  the control              transfer costs.           reference point for       concentrating on
                  framework. For           Affordability needs to    the planning process.     the areas that are
                  periods beyond the       be assessed in the        In year management        going to be most
                  STP, constant prices     context of the control    will require actuals as   decisive. Primarily
                  are easier to            framework ie RAB.         well as budget.           cash based, but
                  understand                                                                   care must be taken
                                                                                               to reflect RAB
                                                                                               implications.
Degree of         “Roughly right” within   The IA accuracy           Detailed enough to        Detailed enough to
accuracy          the timetable for the    needs to focus on         create sensible           take the related
                  decision and the         those areas to which      relationships between     decision on a
                  materiality levels.      the decision is most      activities, costs and     sound footing.
                                           sensitive. Careful        outputs. Accurate         Sensitivity analysis
                                           assessment of             enough to prompt the      may help the
                                           affordability required    correct management        decision making
                                                                     behaviour.                process.
Other             Consistency is           Needs to follow           Typically built using     May be adjusted for
                  important along with     Treasury guidance         activity based costing    risks (eg PSC) and
                  clarity in the           where IA is               software & has strong     probabilities (eg
                  assumptions              concerned.                requirement for           cost modelling)
                                                                     business
                                                                     understanding input.



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