FullCost: Why integrate budgeting and rate setting
WHY BUDGETING AND RATE SETTING SHOULD BE AN INTEGRATED PROCESS
Budgeting is integrally linked to the organization's rates. Using the same data -- the cost of its products and services -- an internal service provider can also calculate rates (unit prices, like the cost per engineering hour).
Obviously, rates are essential for internal service providers that charge (fee-for-service) for some or all their clients for any portion of their purchases.
But rates are valuable to all organizations, with or without chargebacks. Even if an organization does not publish a price list, it establishes an implicit rate when it promises a certain level of service for a given budget. Explicitly calculating and publishing rates is vaulable for the following purposes:
- Rates are used to estimate the cost of incremental work that arises mid-year.
- Rates are essential to a demand-management (portfolio management) process that constrains clients to spend no more than the resources provided in a budget. If the organization's budget is treated as a checkbook managed by clients, then rates are needed to decrement the checkbook as work is delivered and to know what remaining funds will buy.
- Rates also communicate valuable information to clients. They represent the true cost to shareholders/taxpayers/donors of all purchase decisions. With this information, clients can decide whether or not it's economic to buy a product or service.
- Rates provide the best basis for competitive benchmarking (outsourcing comparisons).
Rates, like budget items, must represent the full cost to shareholders/taxpayers/donors of each product and service. If they do not, then some clients will be overcharged (and the organization will appear uncompetitive) and other clients will be undercharged.
Where rates are set too high, some products will appear uncompetitive. Clients will ultimately find another way to get the work done (decentralization or outsourcing), leaving the department with only lines of business that are losing money.
Meanwhile, when other products are under-priced, clients tend to buy more than is economically wise and waste money on poor investments. As the organization sells more at a loss, support systems become strained and negative variances grow.
Furthermore, if prices are not based on accurate full costs, the organization is vulnerable to unfair comparisons to outsourcing for the over-priced portion of its catalog.
Thus, rates must be based on the true, full cost of products and services -- just as is the budget.
Using the same data and cost model to calculate both an investment-based budget and rates has two major advantages.
First, a separate analysis is a lot of unnecessary work. Consider the analysis of unbillable time, the proper amortization of all indirect costs, the separation of Subsidies and Ventures, management scrutiny for frugality, volume forecasts (the divisor in the rate equation), etc. There's no advantage to doing all of this twice.
Second, if rates don't match the budget, clients may get budget approved to spend on the internal service provider, and later find that their budget won't buy what they thought it would.
Meanwhile, staff may find themselves collecting insufficient revenues to pay their costs (running at a loss), or making a profit and exposing themselves to criticism for overcharging customers.
It's important to charge rates during the year that add up to the total costs promised in the budget.
Therefore, rates should be extracted directly from the budget data. Doing so requires very little additional effort.
The conversion of data from a budget to rates involves a few adjustments.
- Reimbursable costs (pass-throughs) are removed.
- Rates which include the cost of internal "subcontractors" (entire project or service-delivery teams) are summed.
- Overhead costs are removed to calculate an internal rate (at which managers within the organization sell to one another). This internal rate is also used for ventures, since it's inappropriate to charge the "bank" overhead for loaning you money; additionally, it's dangerous to burden ongoing overhead on a one-time source of funding, such that when the venture is completed, other rates must go up.
By using the same full-cost data, an organization can be confident that its rates are fair, defensible, directly comparable to benchmarks like outsourcing, and consistent with the costs described in the budget.
Anecdote: Operational Planning
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