Budgeting for Operating Expenses

The capacities discussed in the previous chapters can be actualised only if departments have sufficient resources to operate. Although operating costs are a small portion of total State sector expenditure, they have a significant impact on the performance of government departments. Paying too much for operations would promote inefficiency; paying too little would risk shortfalls in current or future outputs. In conventional public administration, the price is set by fiat and there rarely is a direct or transparent relationship between the amounts paid by government and the volume or quality of outputs. There is substantial probability that before reform, the price was too high; in the reformed New Zealand State sector, by contrast, sustained downward pressure on resources may have increased the risk that some prices are too low. Lack of robust cost information means that it is not possible to conclusively determine whether prices are too high or too low. Getting the price right is one of the outstanding challenges facing Ministers and managers; it is not an easy task.

Governments set the price they pay through formal budget procedures. In conventional budgeting, the price paid for operating departments and other public entities is equal to actual or authorised input costs. When a department offsets some or all of its expenses through user charges, price still equals cost, except that other parties rather than the government pay part or all of the price. Price must equal cost even when, as typically is the case, the price is set too high or too low. If the price is too high - that is, the government appropriates more than is needed to efficiently provide the outputs - the department will either raise costs by spending the extra money or return the operating surplus to the government. If the price is too low, the department will either produce less or reduce the cost of production. The equation "price equals cost" means that the more departments spend, the more government pays. Government can spend less by purchasing fewer inputs or by arbitrarily limiting what it pays for the inputs. In either case, the impact on the volume and quality of outputs might not be known at the time the decision is made.

Public sector reform in New Zealand aims to put the pricing of outputs on a basis that is more akin to market transactions than to standard government operations. In the market sector, price is independent of cost; it is the amount the parties to the transaction agree to accept or pay. Price is linked to outputs rather than to inputs and it can be higher or lower than cost. Nevertheless, the price is deemed to be right because it was set through voluntary exchange; either party can refuse to make the transaction if it is not satisfied with the price.

Getting the price right in the public sector is vastly more difficult because transactions typically are not voluntary, the goods and services purchased by the government typically are not contestable, benchmark prices often are not available and there is a strong political-legal tradition of paying at cost. According to the logic of New Zealand reform, government should negotiate a price for outputs, as is done in market exchanges, and pay on the basis of the volume of goods and services to be supplied. This logic has led it to mirror the market by budgeting and appropriating for outputs. But the applicability of the market model often breaks down because the price paid by government is fixed and therefore may be insensitive to changes in the volume of outputs. Fixed-price budgeting is universal for the operating expenditure of government and, in New Zealand - unlike some other countries - also is applied to certain statutory obligations such as entitlements. When the price is fixed by budget decision, it is not likely to be optimal; that is, it will be higher than is needed to efficiently produce the budgeted outputs, or lower than is required to produce the expected volume or quality.

While inefficient pricing is endemic in government budgeting, the budgeting decisions taken in the reform period may have increased the probability that the price is too low. The reforms may have contributed to the inclination of governments to make these pricing decisions. This tendency can be attributed to several conditions associated with the reforms. First, when the government shifted from budgeting for inputs to budgeting for outputs, it ostensibly freed price from cost, so that the amount it pays no longer explicitly covers the cost of the inputs needed to produce the outputs. Departments are unlikely to bid for additional resources merely by claiming they need more money to pay for inputs. Second, reform of public management has been accompanied by sustained downward pressure on operating expenses. The government has assumed that departments were so inefficient in the past that they can now operate with lower staffing levels and without compensation for inflation. Third, this "doing more for less" in real terms would be more reasonably justified if the government had adequate cost accounting systems to analyse the cost of producing outputs. In most departments, however, managers do not know what the unit cost of outputs is or should be. They have little basis for estimating how these costs vary with changes in the volume or mix of outputs. Fourth, most public outputs are not contested; they are supplied by monopolistic departments. The government does not have benchmarks or competitively bid prices against which departmental operating costs can be compared. Finally, departments are not assured of being compensated for workload increases, including the supply of outputs in excess of the volume anticipated in the budget or the purchase agreement, although there are baseline update processes which provide an avenue for seeking compensation. When the volume of outputs is demand driven the budget and purchase agreement are de facto open-ended contracts for departments to supply as many outputs as are demanded of them at a total fixed price.

What happens when the budget does not get the level of funding right? In some cases, the purchase agreement can adjust for the shortage of resources by contracting for a lower volume or quality of outputs than might be provided if funds were more ample. For example, the chief executive might agree to conduct fewer studies or to reduce the number of inspections carried out at the department's discretion. But when outputs are demand driven and the budget is fixed at an inadequate level, there may be some erosion in the quality of services, such as increased waiting times at airports or less effort put into producing reports for the Minister. Another possibility is that departmental personnel work harder to cope with the demands made on them. One final possibility, and the one anticipated by reformers, is that departments will re-engineer their work processes to increase productivity. But there is no assurance that financially stressed departments will behave in this manner.

Under-funded budgets can adversely affect the government's ownership interest. When the price paid by the government does not cover ongoing costs, a chief executive might make ends meet by deferring maintenance or by spending less on employee development or systems upgrades. The adverse side effects of these adjustments might not be immediately apparent, but they can take a toll in the department's long-run performance.

Although I have not examined whether the government underpays for departmental operations, in conducting this study I met a number of chief executives and senior managers who strongly feel that their department's operating resources were inadequate. When asked how their department had adjusted to this predicament, few responded that services had been curtailed or degraded. The most common complaint was that managers now have to work longer hours to get the job done. The "9 to 5" workday is now several hours longer, with no compensation for the extra work. The complaints seem to be concentrated in small departments where there is limited opportunity to improve efficiency by rearranging work processes.

All departments have reaped significant savings by eliminating deadweight costs of the old central controls. In the afterglow of reform, it is easy to forget that not long ago vast resources were devoted to the ex ante input controls. Operating efficiency has been improved by giving managers discretion in purchasing inputs. Yet it also is true that the reformed system has introduced new operating costs. It is not costless to prepare performance and purchase agreements and to report on performance. Although the new accountability costs may be lower than the old compliance costs, they nevertheless can burden small departments.

Treasury has given serious attention in recent years to costing methods in the State sector. It has worked closely with Customs to develop a new system for pricing various services and it expects to introduce a new system of output pricing for this department that will be sensitive to changes in workloads. Treasury also commissioned a review (Review of Costing Systems and User Charges; Coopers & Lybrand; September 1995) of costing systems and practices in New Zealand departments. While the study focused on cost allocation issues, its findings are relevant to the cost basis for budget decisions. The study found numerous shortcomings in costing systems, but it also identified good practices that have been adopted by some departments and might be suitable for others. Recently new processes were agreed for handling output price increases.

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