5  Operating instructions: Cost accounting policy parameters

5.1    Disclosing cost accounting policies

The Act requires departments to:

• identify in the Estimates and other supporting documents the expenses (or forecast expenses) to be incurred for each class of outputs to be supplied by the department (sections 14(1)(a) and 15(1)(c));
• identify in the Statement of Forecast Service Performance the proposed output expenses to be incurred for each class of outputs (section 41(1)(e)(iii)) prepared as part of information on the future operating intentions of the department; and
• compare in the Statement of Service Performance actual output expenses incurred with the output expenses that were forecast in the Statement of Forecast Service Performance (section 45A(c)(ii)) prepared as part of the annual report of the department.

The accuracy and reliability of output expenses are determined by the cost accounting policies that each department has followed. If users of financial reports are to understand output expenses fully, financial reports must inform users of those policies, any changes to them, and what effects those changes of policy have had.

Departments must include a clear and concise statement of cost accounting policies in external financial reports.

The objective of disclosing cost accounting policies is to provide users of financial reports with sufficient information to:

• understand the significance of the output cost information;
• be confident that the information is reliable, relevant and not misleading; and
• determine whether the report is comparable with those of other periods and other departments.

The statement of cost accounting policies in external financial reports must disclose:

• all the significant cost accounting policies used in estimating, accumulating and reporting output costs; and
• any material changes to those policies.

The disclosure must comprise:

• a statement specifying the criteria for distinguishing between direct and indirect costs;
• a statement about the methods of attributing direct costs;
• a statement about the bases for allocating indirect costs; and
• a statement of any changes in cost accounting policies since the date of the last external financial report or, if there have been no changes, a statement to that effect. If the changes made materially affect the cost of individual outputs, there must be full disclosure of:
  • the nature of the changes;
  • the reasons for the changes; and
  • the effect of the changes on individual outputs.

Departments supplying contestable outputs may apply to the Treasury for a modified disclosure.

5.2    Documenting cost accounting policies

Chief Executives must ensure that cost accounting practices are formalised and properly documented, and sufficiently detailed to enable him or her to:

• satisfy his or her obligations under the State Sector Act 1988 and the Public Finance Act 1989;
• satisfy the management information requirements of Chief Executives and departmental managers; and
• achieve the standard required to:
  • satisfy the scrutiny of the Audit Office; and
  • enable the Treasury to assure the Minister of Finance that the output cost information is reliable.

To satisfy these requirements, it would generally be expected that the cost accounting system should be able to produce a reliable average and marginal cost-per-unit of standardised goods and services that are regularly delivered by the department.

When documenting departmental cost accounting policies, the format and level of detail are left to the discretion of each Chief Executive, but the documented cost accounting policies must cover the:

• methods of classifying direct and indirect costs;
• methods of attributing direct costs;
• bases for allocating indirect costs;
• procedures for updating cost accounting policies; and
• procedures for self-reviewing cost accounting systems.

Cost accounting is a formal discipline. Structures and procedures must be followed if information is to be credible and transparent. A proper documentation of this process will include definitions, rules and procedures, and ensure that:

• agreement on major definitions is formalised;
• practices are applied correctly and consistently;
• knowledge can be reliably transferred; and
• audit trails are provided.

5.3 Classifying direct and indirect costs

There are many ways of classifying costs that have proven useful for various purposes. For the purposes of output costing, output purchase contracting and output reporting, cost classification must focus on assigning costs to outputs. This involves the cost accounting policy of distinguishing between direct and indirect costs.

Where costs are treated sometimes as direct, and sometimes as indirect, departments must set out the criteria and circumstances that govern the distinction.

Departments must establish a written policy about how direct and indirect costs are to be distinguished for the purpose of assigning costs to outputs. The criteria used to classify costs as direct or indirect must be based on whether the cost can be causally linked and assigned to an output in an economically feasible manner.

To increase the accuracy and reliability of output costing, departments must review and formalise their definition of direct costs. They must not adopt the convenient approach of grouping direct costs into an indirect cost pool, and then allocating the whole by calling it overheads.

Departments may decide how detailed the classification of costs ought to be, but must disclose separately how each major cost grouping was classified.

5.4    Bases and methods of assigning costs to outputs

5.4.1 Introduction 

The Government allocates resources to departments on the basis of their outputs. Departments must estimate, accumulate and report output costs in a manner consistent with this method of resource allocation.

5.4.2 Assigning expenses

When estimating, accumulating and reporting output costs for external financial reports, departments must assign all operating costs (that is, both direct and indirect costs) to outputs. They must not assign "other expenses", as defined in the Act, and as further discussed in section 6.4 of these Instructions ("Departmental other expenses") to outputs.

5.4.3 Attributing direct costs

Direct costs that are attributed to outputs must be based on actual consumption. Pre-established bases or ratios may be used, if departments are able to prove these fully represent actual consumption.

5.4.4 Allocating indirect costs

Where services are provided to more than one output at the same time, the cost must be divided and allocated to each output in reasonable proportion to its actual consumption.

Departments may accumulate indirect costs into “homogeneous” cost pools. An indirect cost pool is “homogeneous”, if the activities whose costs are included have similar causal relationships to the production of the outputs.

Departments must allocate indirect cost pools to outputs by appropriately measuring resource consumption.

Pre-established rates may be used in allocating indirect cost pools, if departments can prove that these fully represent actual consumption.

5.4.5 Pre-established rates

When a department uses pre-established rates to assign direct and indirect costs to outputs, it must have a written policy for establishing the rates. The rates must be reviewed at least annually, and revised to reflect the anticipated conditions. If the revision occurs during a cost accounting period and there are significant variations, the costs assigned to that period must be adjusted to the amounts that would have been allocated using the revised rates.

5.5 Consistency in applying cost accounting policies

5.5.1 Introduction 

Consistency in applying cost accounting policies enables similar transactions to be treated alike. This improves comparability between estimated and actual costs, and with other periods and departments. Such comparisons provide a basis for financial control, cost accountability and evaluating estimation capabilities.

The following sections provide criteria to ensure that departments are consistent when estimating, accumulating and reporting costs, both within and between financial years.

5.5.2 Consistency

A department's cost accounting policies must be consistent, both for estimating costs for external ex-ante reports and for accumulating and reporting actual costs for external ex-post reports.

A department's cost accounting policies must normally not change from one reporting period to another, and must be applied to all cost items of a similar nature.

5.5.3 Changes in cost accounting policies

A department may change its cost accounting policies during the financial year, only if the new policies better reflect its cost behaviour and underlying activities. When such a change is made, the department must provide full disclosure as that phrase is described in section 5.1 of these Instructions ("Disclosing cost accounting policies").

5.6 Definition of terms

Allocating costs means assigning costs to cost objects using measures that are not directly related to the cost object's level of resource consumption.

Assigning costs means the general procedure for tracing costs to cost objects.

Attributing costs means causally assigning costs to cost objects based upon resource consumption.

Class of outputs is a grouping of similar outputs for appropriation or non-financial reporting purposes.

Cost accounting policies are the rules and procedures that form the basis for estimating, accumulating and reporting output costs for both ex-ante and ex-post financial reports.

Cost objects are the elements to be costed in a costing exercise. They can be a cost centre, an output class, an output, a sub-output or an activity.

Direct costs are costs that can be identified with an output in an economically feasible manner. They are causally related to, and readily assignable to, an output.

Expenses are any expenses incurred by a department, including cost. They are measured in accrual accounting terms.

Homogeneous cost pools are pools of similar costs that have been grouped for the purpose of allocation. The pools contain the costs of activities that have a similar causal relationship to the production of outputs.

Indirect costs are costs that cannot be identified with an output in an economically feasible manner. They are incurred for the common benefit of more than one output.

Major cost groupings are sets of similar costs that have been grouped for the purposes of reporting, and assigning costs to, outputs.

Outputs are the goods and services supplied by a department to an external party, including those that have been agreed or contracted to supply on a contingent basis, but that have not been supplied.