Budget Deficit and
Activity-Based Cost Management in Government

Introduction

One of the major announcements of March 2002 must be the extent of the 2001-2002 deficits and how the HKSAR Government intends to cope with it in the next few years. In mid-January 2002, it was emerging that the HK$12.5 billion earning expected from the Exchange Fund was not likely to materialise. The consultant's report has concluded that the budget deficit faced by Hong Kong is indeed a structural one. Fearing the negative economic impact, immediate introduction of sales tax and increases in profits tax were also ruled out by Mr. C.H. Tung, Chief Executive of the HKSAR.

Quite frankly, the extent of the HK$60 billion budget deficit Hong Kong faces is unprecedented and could not be predicted by the average person on the street. As late as 1997-98, Hong Kong had a surplus of nearly HK$90 billion. What has happened? How did such a huge deficit happen? What do we have to do to get back to a balanced budget?

Mr. Antony Leung, when briefing the Legislative Council in December 2001, explained that public expenditure had risen to nearly 24% of Hong Kong's GDP in 2001-2002. Hong Kong has had operating deficits since 1998-1999 and 80% of the Government's operating expenditure is difficult to reduce because it is made up of salary-related and social security expenditure. The growth in government expenditure has far exceeded cumulative growth in GDP since 1997-1998.

Tax more, spend less or Activity-based Cost Management

One way to trim down the budget deficit is to cut civil service salaries. It was estimated that a 1% cut in civil service salary will save HK$1.5 billion. But the government will face stiff resistance from the civil service union who argue that the entire labour market will crumble in a domino effect and the economy will suffer even more because of diminished purchasing power.

The public and the accounting community will come to their own conclusions regarding the validity of such an argument. But taxation and a civil service pay cut are now political and macro economic management issues. We do not intend to cover them in this article. Instead, we will restrict ourselves to discussing how Hong Kong might be able to make use of a managerial accounting methodology to manage costs and expenditure in the public sector.

What is Activity-based Costing and Management?

Activity-based Costing (ABC) has developed into a quantitative management and business modeling technique for organizations. Fullblown ABC business models now use Activitybased Cost as a unit of measurement or a quantitative technique to describe the organisation activities, the resources consumed by those activities and the products and services generated by those activities. Activity Based Management (ABM) also includes the integration of financial and non-financial measurements that help organisations to make operational management and strategic management decisions (refer to Diagram).

ABC turns accountants, who traditionally occupy the back-room or history-reporting roles, into front-line managers. ABC shows which activities are used to produce particular products and services. This allows organizations to demonstrate the relationship between what they do and what they deliver to clients and customers.

This information becomes the quantitative basis on which managers can ration resources, such as money, labour and materials, intelligently. ABC is not just a way to describe cost. It is an unimpeachable operational and strategic management methodology that enables fact-based and quantity-based management decisions.

ABC/M uses in Government

With the prospect of a HK$60 billion budget deficit and the likely budget cut by the Treasury Bureau, heads of government departments and sub-vented organizations will feel the heat. On one hand, there is increasing demand for public services, particularly in the healthcare, education and social welfare areas. On the other hand, budget cuts, or at least a budget freeze, will melt down any hope of getting more money.

Government departments and sub-vented organizations will simply need to figure out how to do more, with less. But where is the starting point for department manager? The tried and trusted cost-cutting method used in Hong Kong is to cut heads, something which is feared by the unions. This method is not very helpful to begin with. How could department managers deal with a 120 percent workload with 80 percent staff size? Some other governments in the world must have faced budget deficits worse than the one faced by Hong Kong. Can we learn from their experience?

Here are some of the more common uses of ABC/M by governments in the more developed countries around the world:

1. Cost recovery: Accurate cost calculation based on ABC data is the basis for full recovery of costs of services performed from businesses and from the public. It is the irrefutable ground for government departments to justify fee increases to the Legislative Council. It also prevents crosssubsidy of services provided by the government.
2. Outsourcing studies: Federal laws in the United States require all government departments to do outsourcing or A-76 Studies. This is to determine which costs will remain or go away if a private sector supplier were to replace part or the entire organisation. The Government already announced that it will privatise the services of the Architectural Services Department. Increasingly, other private sector suppliers will replace many of the services once viewed as exclusive to the public sector domain.
3. Competitive bidding: Department heads in the U.S. government at all levels have found that they are better off playing a proactive role. The ABC business modeling technique does not just improve the efficiency of the department, enabling it to compete with private sector suppliers. Sometimes, accurate ABC information was also used to reverse the decision of consultants who recommend outsourcing. Ironically, many government department heads in the U.S. have used ABC and the A-76 studies to help keep jobs within the government and save their own jobs.
4. Merging and diverging agencies or functions: ABC is process oriented and effective in identifying shared processes and therefore, shared costs. One typical application is to use the ABC business modeling method to identify administrative processes that could be shared or combined in hospitals.
5. Performance measurement: ABC models provide up to 60% of the input to Balanced Scorecards designed to measure and improved performances of government departments. Implementation of such performance measurement techniques will improve the accountability of government departments to taxpayers.
6. Process improvement and operational efficiency: Optimising resources used is an obvious goal and the key to keeping jobs within government departments. Otherwise, services that could be performed more cost effectively by a third party will ultimately be outsourced.

Aligning outcomes to outputs

Government officials often argue that pursuing profit is not the government's role, so government should not concern itself with cost. Universities and other institutional and individual recipients of government funds often view cost cutting or even cost consciousness amongst government officials as signs of government shying away from its responsibility of providing essential services to the public.

Nothing could be further from the truth!

Subvention is not the same as costs. Subvention is the amount of money given by the Government to the universities and other bodies. Cost is a "calculated unit of measurement" often used to evaluate how effectively and how efficiently the universities are delivering the goals they are supposed to deliver.

Sometimes, cuts in resources allocated are helpful in identifying the waste and substantial disconnect between the work or activities performed (outputs) and the strategic goals government departments and sub-vented organizations are supposed to achieve (outcomes). After ABC studies, public sector managers often find that the activities that they spend much time and effort (therefore costs) to perform have very little benefit to the ultimate strategic goal.

In Output/Outcome Analysis, it is true indeed that it is not just costs that count, but whether the activities or services delivered are useful to the outcome. A social service organisation in Hong Kong found that even though it costs less on a per unit basis to produce and distribute a CD that offers advice, single parents actually needed to talk to someone who could lend some sympathy and support.

The personal counseling service is valued, not the very impersonal CD. Without Output/Outcome Analysis, it is easy to imagine the extent to which government services are wasted on activities and outputs that do not help the ultimate goal.

The future - more "bang" per tax dollar

Just as the other more developed countries went through the same economic development cycle, private sector organizations and the HK$60 billion deficit will nudge government organizations in Hong Kong towards understanding costs.

Hong Kong did go through a long period of budget surplus when there was little incentive for government departments to manage costs. The absence of legislation, such as the Chief Financial Officer Act of 1990 in the U.S. did not help either.

What Hong Kong needs now is not irrational expenditure cuts through cutting "heads". What we need is more "bang" per tax dollar through a rational and intelligent way to allocate and manage public resources.

Industry Standard: CAM-I Cross