Cost Management in the Public Sector: A Case for Functional Cost Analysis

By Kee, Robert C.; Robbins, Walter A. | The Journal of Government Financial Management, Summer 2004 | Go to article overview

Cost Management in the Public Sector: A Case for Functional Cost Analysis


Kee, Robert C., Robbins, Walter A., The Journal of Government Financial Management


The 1990s saw state and local government treasuries becoming flush with tax revenues as a result of a booming economy. What seemed to be an uninterrupted increase in tax receipts was used to support a proliferation of public programs and services. However, by the close of that decade and during the beginning of this decade, several events severely affected state and local government budgets. The implosion of the dot-corn economy, the terrorist attack on the World Trade Center, subsequent bankruptcy by several major U.S. corporations and the recession all contributed dramatically to shrinking tax revenues. Perhaps more than at any other time in modern history, state and local government officials now struggle to provide programs and services in a climate of declining resources.

Given the current fiscal crisis of many state and local governments, administrators are forced to critically evaluate the services they provide, as well as the means used to provide them. Despite reduced tax revenues, the fundamental objective of state and local governments is to deliver social goods and services that meet the needs of their constituents. However, this objective must now be achieved with fewer resources. Consequently, government administrators are confronted with the need to manage the cost of social goods and services to deliver them as efficiently and effectively as possible. Goods and services must be produced with as few resources as technically feasible.

In the private sector, the need to reduce the cost of products has been an ongoing problem for decades. A variety of cost management techniques has been developed, such as activity-based cost management, total quality management and just-in-time, to name a few. Each of these techniques has proven successful in eliminating waste, inefficiency and nonvalue-added activities in a firm's operations. However a deficiency of each of these techniques is its inward, or internal, focus. That is, these techniques focus on the firm's operations and how they are used to create its products. External aspects of a product, such as customer concerns with price, quality and timeliness, are ignored. Consequently these cost management techniques become less useful once non-valued activities are eliminated and external considerations become more important in future cost reductions.

Functional cost analysis is a relatively new cost management technique that overcomes the limitations of other techniques. This method incorporates a customer perspective into the cost analysis of a product or service. Consequently, managers better understand the functions of a product or service and the value customers place on each function. The internal and external focus of functional cost analysis provide a means of determining precisely where cost reductions are needed and can be used to stimulate ideas for their reduction. Also, functional cost analysis enables managers to identify proposed cost reductions that erode the value that customers place on a product and, thereby, avoid cost reductions that are counterproductive.

Heretofore, the application of functional cost analysis has largely been restricted to the private sector. However, it is equally applicable to public sector entities in the production of social goods and services. This article reviews functional cost analysis and discusses its application to the public sector. A public transit system is used for illustrative purposes. We demonstrate how the technique may be used to identify areas of possible cost reductions.

Functional Cost Analysis

Functional cost analysis is derived from value engineering or value analysis.1 Value engineering originated in the U.S. during the 1960s and was used by firms such as General Electric and Chrysler.2 However, much of its subsequent development and application has occurred among Japanese manufacturing firms. Value engineering attempts to analyze the functions performed by a product or service in an effort to design and produce the item at the lowest possible cost.

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