ABC Accounting

January 9, 2015

Activity-Based Costing in Government Internal Accounting

Activity-based costing (ABC) is an accounting method used for internal management to tie costs with the activities associated with those costs. This method allocates indirect or overhead costs in a more accurate manner than traditional accounting methods.

Overhead costs are those costs which cannot be directly traceable to a specific item, activity, or department. An example of overhead cost is an electricity bill incurred for an entire building that is being used to manufacture multiple different products, or is being used by multiple departments. Traditional accounting methods allocate overhead costs of an organization in a simple fashion, usually based on a volume related factor. In the electricity bill example, a traditional method may allocate the cost of the bill between products in a manufacturing building based only on the number of machine hours used, or between departments based on their respective square footage. This allocation does not take into account differing electricity usages by different product machines or by different departments within the buildings.

ABC accounting separates all of the different activities which use resources by an entity and specifically identifies the common factors driving costs for each activity (also called the cost drivers). Cost drivers can include factors such as labor hours for wage costs, machine hours for production costs, square feet of space for rent costs, or miles driven for vehicle costs to name a few examples. Costs must be identified as belonging to a certain activity, then all costs associated with each activity are pooled together in cost pools. Cost pools are divided by cost driver units to arrive at a unit cost per each activity. Once a unit cost for each cost driver and activity is determined, then a product or department can receive accurate cost allocations based upon their usage of cost drivers. Unit costs can also be used for more accurate budgeting and decision making in the future. An in-depth example of activity-based costing in a government agency, the Iowa Department of Transportation, can be found in the Murphy Commission report.¹

Obvious drawbacks of implementing activity-based costing systems are the expense and time required to identify all cost activities of state agencies, their related cost drivers, develop software to accurately track these costs, and train employees to effectively maintain the system. However, existing statewide use of SAP systems in Arkansas could possibly mitigate the startup expenses. Opponents of ABC accounting could address the complexity of implementation, but as addressed by John Turner of the Public Interest Institute, ABC concepts are those that accountants should be familiar with from school.²

Many states use the activity-based costing system within internal accounting of state agency expenditures. Agencies in Texas, Iowa, Virginia, and Utah have switched to ABC accounting methods.^{1 3} North Carolina, South Carolina, Florida, Indiana, Minnesota, and Mississippi all adopted statutes requiring the use of activity-based costing accounting by local governments.²Mark Abrahams of the Abrahams Group assisted Iowa, Montana, Washington, and multiple cities and counties nationwide in incorporating activity-based costing into government operations.⁴

Utah adopted this system in 2008 as part of its Free Market Protection and Privatization Board Act, which was last amended in 2013.⁵ Leonard Gilroy, Director of Government Reform for the Reason Foundation, recommended its implementation for Utah government services so that costs associated with government or non-government activities would be accurately reflected.⁶ The Act also created a Privatization Policy Board to conduct inventories of state agencies and make the determination of whether an agency function is inherently governmental or commercial.⁶ That determination allows citizens to see how much state resources are spent on government versus private activities, and also gives public officials a chance to engage the private sector to perform certain activities instead of the government.⁶

Iowa implemented activity-based costing when it established its Department of Administrative Services in 2003 to manage the resources of the state. Section 8A.505 of the Act requires the department to “establish an indirect cost allocation system based upon standard cost accounting methodologies to allocate direct and indirect costs of state agencies.”⁷ The Department issued Regulation 11.1.4(6), which incorporates activity-based costing into its operations.⁸ Furthermore, under §8A.102-4, a governor appointed director oversees all of the financial and administrative activities of the state, including “developing best practices for the efficient operation of government and encourage state agencies to adopt and implement these practices.”⁷

States which have adopted ABC accounting did so in a manner unique to those states, for each state has differing economies and activities which contains different cost drivers. To be implemented in Arkansas, the state would have to develop a system of allocation and cost drivers unique to Arkansas. Then, like other states, Arkansas would need to create new government positions to monitor its use and ensure that ABC is being implemented effectively. Doing so would provide Arkansas public officials and citizens with more accurate data on where expenditures are going, and would provide officials with a useful tool of budgeting going forward.

Sources:

1. Murphy Commission. 1996-1999. “Making Arkansas’ State Government Performance Driven and Accountable.” <http://www.arkansaspolicyfoundation.org/policy/performance_driven.html>
2. Turner, John H. “Requiring Local Governments to Utilize Full Cost Accounting Methods.” Public Interest Institute 2.1 (1997): 5-7. <http://www.limitedgovernment.org/publications/pubs/limits/limmar97.pdf.>
3. Briner, Russell F., Mark Alford, and Jo Anne Noble. “Activity-Based Costing for State and Local Governments.” Management Accounting Quarterly 4.3 (2003): 8-9.
4. Abrahams, Mark D. The Abrahams Group. N.p., n.d. <http://www.theabrahamsgroup.com/Introduction_Resume.htm>
5. Utah House Bill 75 (2008 General Session) (enacted). Inventory and Review of Commercial Activities. <http://le.utah.gov/~2008/bills/static/HB0075.html>; Utah House Bill 94 (2013 General Session) (amended). Free Market Protection and Privatization Board Act Amendments. <http://le.utah.gov/~2013/bills/static/HB0094.html>
6. Agency Activity Inventory a Powerful Tool to “Right-Size” State Government, Utah Senate Business and Labor Standing Committee Cong. (2008) (testimony of Leonard Gilroy). <http://reason.org/news/show/agency-activity-inventory-a-po>
7. Legis. Serv. 145 (H.F. 534), 80th Gen. Assemb., Reg. Sess. (Iowa 2003)
8. https://www.legis.iowa.gov/law/statutory/acts (Iowa Acts Quick Search: GA 80, Session 1, Chapter 0145)
9. Iowa Admin. Code 11-1.4(8A) (2013).