Funding public services based on output unit costs is a great idea. However, it only works for selected government services. The idea that the entire government budget should be based on output unit costs is therefore misguided. This series of four blog pieces looks at why this is a tool with strictly limited application in government.
An example of unit cost budgeting is provided by the way in which, in many countries, the bulk of the government funding received by public universities is based on their educational outputs. Governments give the universities, say, $6000 per year for each full-time undergraduate medical student, $4000 per year for science or engineering students, $2000 per year for humanities and law students, and so on. The different amounts set for different categories of student reflect cost differences (you need more equipment and facilities to teach science students than to teach humanities students).
Funding based on unit costs creates a powerful link between performance – specifically, the quantity of output delivered – and funds provided. It is broadly equivalent to setting explicit output targets calibrated to the funding level. Unit cost-based funding also has other advantages, including placing different service provider units (in this example, different universities) on an equal footing. It’s therefore easy to see the attractions of this approach.
Funding based on unit costs has been applied to a range of other government services in many parts of the world. In Scandinavia and elsewhere, government schools are funded on this basis. So-called “performance-based funding” of primary health services is largely based on this principle. Many countries also use variants of the unit cost funding model – based on output categories known as “diagnostic-related groups” – in the funding of public hospitals. All these types of arrangements aim to harness the power of a market-like mechanism to promote better government performance.
It is hardly surprising, then, that there are people who think that this is an approach that should be applied across the entirety of government, so as to serve as the basis for the formulation of the whole government budget. Closely related to this is the oft-repeated assertion that, to be effective, performance budgeting must be based on unit costs – as one scribbler recently put it, that “true performance budgeting requires the determination of the unit cost of delivering outputs.”
This makes it important to think about the conditions under which output unit cost budgeting can work and, conversely, those where it will not.
There are two characteristics shared by the public services which are most amenable to funding based on unit costs, both of which are highlighted by the university funding example.
The first characteristic is that each of the output categories used to set specify funding levels is relatively “standardized.” In our university funding example, this means that the activities and inputs required to teach, say, an engineering student are broadly the same for each and every engineering student, and are very similar across different universities. This makes funding based on the standard amount of $4000 per full-time student year workable.
The second characteristic that facilitates unit cost budgeting is that it is possible for the government to decide in advance how many units of output it will fund each financial year – in this case, how many science, engineering, humanities and other students it will finance across the entire government university system. Deciding the output quantity makes it possible for the government to budget based on unit costs while capping its spending on the outputs concerned. This is of great importance for government’s control over aggregate expenditure and, therefore, its ability to achieve its deficit and other fiscal targets.
When we think about the workability of unit cost budgeting in other areas of government, we need to keep these two characteristics – standardization and output quantity control – in mind. Their importance will be highlighted in the next two blog pieces.
But before turning to those matters, we need to note that real-world unit cost funding arrangements are in practice more complex – in some cases, much more complex – than the highly simplified example presented above. As we will discuss in the fourth and final piece in this series, these complexities are one of the reasons why this is a tool which is only suitable for selective application.