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Covering your cost bases

Governance | 1 May 2007

Richard Weaver and Ernese Skinner stress that fully understanding cost bases is essential for sound financial management.

The behaviour of a charity’s costs affects the budget, the annual accounts and particular project work, either to estimate for potential work or to report to funders.

The first step in working out a cost base is to identify the strategic plan for a charity. A strategic plan should be flexible to change and look more than one year ahead. Funding for charities, particularly service delivery, is now frequently channelled through tendering processes and charities need to be clear about what they can offer, what it is going to cost and why a charity should be selected. A good strategy and clearly defined objectives can help focus on the particular benefits a charity can bring.

Sound financial analysis should underpin any strategy and this can only be achieved by understanding a charity’s cost base. Once a charity has its strategic plan in place it should define its financial plans for achieving the objectives it has identified. The financial plan should be a high level look at the types of the funding the charity will require to achieve its strategy and should cover the duration of the strategic plan. The financial plan should consider the income and expenditure likely to be incurred, in addition to an indication of the annual level of reserves and most importantly a cash flow statement. The financial plan should explore a number of scenarios and the key decisions that need to be made in each scenario. Best and worst case scenarios allow the charity to consider whether the current financial position can support the strategy and the extent to which sponsorship or other forms of financial support are necessary.

If the financial position of a charity doesn’t support the strategy then financial planning provides management and trustees with the knowledge they need to identify what needs addressing or what can be achieved within the current financial boundaries. The charity should then consider the risks involved in adopting these strategies and they include operational and reputational risks as well as financial risks.

Once a charity has set its high level strategic plan and determined its activities it should then develop its budgets and plans. Budgets should be linked directly to the strategic plan. Prepared in isolation, budgets will be meaningless and will not make best use of resources. Budgets can either be at department level or project level but in either case there should be agreed budget information to monitor and appraise ownership of the budget by a named individual. Performance against the budget should be monitored on a periodic basis and the individual owning the budget should be responsible for explaining the variances, both good and bad, against the budget. This allows the management and trustees to assess performance and if necessary make strategic decisions, ie if a charity is generating a deficit to react appropriately.

Base comprehension

Whichever model of budget a charity decides to choose, that charity must ensure it fundamentally understands its cost base. The cost base of a charity includes both the direct costs of performing the activities, but also the indirect (or overhead) costs in support of those activities. Direct costs are those costs that can be directly identified with service delivery or project work. Indirect costs are those costs that cannot be directly identified with service delivery or project work but nonetheless are necessary to support the organisation, eg HR or IT. What a charity should do is allocate a fair proportion of indirect costs (or overheads) to the direct costs of projects or services. Without knowing the level of these indirect costs, it is very difficult to effectively budget, monitor performance or make key decisions about future plans or strategy.

Different budgets models can be used but we will consider two – the departmental based budget and the activity based budget. The departmental based budget looks at the entire costs of running each department of the charity with clear distinctions between those departments that are operational and those that provide support services. The departmental budgets will be built upon the basis of the agreed strategies, programmes, or activities that have been decided in the strategic plan. They will include both income and expenditure forecasts – income streams that are secured, as well as those in the process of being applied for.

Expenditure will need to be flexible depending on the success of certain funding applications and identify the staffing requirement; commonly this represents 55-75 per cent of charity expenditure. Other specific costs associated with delivering the agreed strategy that may not be the same year-on-year will also need to be factored in. An apportionment of costs from support functions (eg facilities, finance etc) can then be added to the direct costs of services or projects to provide a true department cost, ie both direct costs and a fair proportion of indirect costs.

Turning to an activity based model one needs to consider a budget in terms of cost drivers. For example, a charity which as part of its strategy offers educational training will need to consider what levels of activity it wishes to achieve and what the cost implications will be. If the strategic plan sets out to run a number of training courses then the costs of training session will include: x number of members of staff for x number of sessions of x number of hours, lecture room for the duration, capable of housing x number of students per session for x sessions, and on costs of delivering programme, eg refreshments. In this case costs are driven by the number of sessions being run which in turn drives the number of students that can be offered training. In addition to the costs identified there will be a number of indirect costs of supporting and administering the training such as the finance function, governance costs and administration costs. These indirect costs will need to be shared between different services or projects to arrive at the full costs to the charity delivering them.

Sharing fairly

The sharing or allocating of costs is a subject that has received much attention in the charity sector and validly so given the findings of a CFDG survey, which highlighted that charities are still not receiving funding sufficient to cover all of the direct costs of service delivery, together with a fair proportion of relevant overheads. While more needs to be done to ensure that funding bodies understand the costs that need to be covered, there is also the likelihood for some charities that they may not fully appreciate the totality of costs that need to be recovered. Charities need to ensure that a fair share of indirect costs are being apportioned either between departments or projects so that the total costs are considered in context.

Some of the most common bases considered for cost allocation are by headcount, time and expenditure. It is important to understand the factors affecting certain costs, whether direct or indirect when building the budget. An illustration of this is utility costs. If a charity had assumed a 3 per cent increase across the board then that charity would now be suffering from the 25 per cent increase in utilities over the past year. Few could have predicted the large rises in oil and gas during 2005-06 but what the example does emphasise is the effect of adding a simple percentage to last year’s budget rather than attempting to consider the likely costs and any external factors that might come into play such as change of utility or service provider, additional staffing affecting usage and different service levels. Charities should not, however, lose sight of materiality. Where utility costs are relatively small in the overall budget, time should not be wasted analysing these costs if there is little impact. To summarise, a charity needs to identify its costs, allocate these costs using cost drivers such as headcounts or time and ensure a fair proportion of all costs have been allocated.

The topic is covered further in Know Your Cost Base, Know Your Charity, a new CFDG publication.

Charities need to know what their total costs are in order to:

• Create accurate budgets and forecasts
• Make applications for funding
• Effectively monitor costs
• Understand the basic funding needs of the charity
• Aid decision making and the allocation of costs to projects/activities

Richard Weaver is a partner at haysmacintyre and Ernese Skinner is policy and campaigns officer at CFDG

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