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CHAPTER TWO BACKGROUND TO FULL COST RECOVERY

Introduction

2.1 The purpose of this Chapter is to set the context for FCR and look at some potential scenarios if it is implemented by the public sector in Scotland. The report draws upon two main sources:-

• A literature review; and
• A limited number of interviews with key players from such organisations as SCVO and COSLA. Their names are given in Appendix 2.

In various places throughout the Chapter we have drawn our own inferences from the material and have tried to be explicit when this has been done.

The context

2.2 The Scottish Compact (Scottish Executive and SCVO, 2003) outlines the commitments between the Scottish Executive, its agencies, Non Departmental Public Bodies and the voluntary sector. A key commitment under the resources theme of the Compact is that:-

"The Executive will pursue its interest in promoting a healthy voluntary sector through public funding based on clear measures of performance. It will:

• Recognise the need for full cost recovery in bids for service contracts."
  (Ibid, p. 7).

This essentially means that the voluntary sector can realistically price services by including overhead costs when bidding for public sector contracts.

2.3 The Executive's review of Policies to Promote the Social Economy acknowledged:-

"The need to allow social economy organisations to include the relevant portion of overhead costs within their bids for service contracts and to identify any further obstacles to development" (Scottish Executive 2003).

Underlying this is a desire to move the sector nearer to sustainability.

2.4 This recognition by the Executive has been supported by the release of a joint statement, on behalf of central government, local government and SCVO, within the wider remit of the strategic funding review. A key issue identified as a priority for action was the move towards "full cost recovery", so that voluntary organisations could realistically cost their services, and funders recognise that, to make organisations sustainable, a legitimate proportion of overhead costs should be included in funding agreements.

2.5 This is seen as a key action needed to meet the aims set for the funding review (Scottish Executive, 2005). These are to:-

• Promote sustainability of the voluntary sector;
• Support the sector to make best use of resources available to it;
• Demonstrate the impact and effectiveness of the sector;
• Promote effective partnership working between, and across, the voluntary and public sectors; and
• Ensure that funding policies and practices promote equality and inclusion of marginalised or disadvantaged groups.

Accordingly FCR is seen as having the potential to deliver on a varied and complex agenda. So what exactly is FCR?

What is full cost recovery?

2.6FCR in principle means that when an organisation provides a service for a public body then it should be able to recover, not just the direct costs of delivering that service, but should also be able to reclaim the relevant proportion of overhead costs. These costs include:-

• Premises and associated costs;
• Central functions, such as finance, human resources and information technology;
• Governance and strategic development;
• Provision for inflation and depreciation;
• Provision for the costs of future regulatory changes; and
• General fundraising (if applicable).

2.7 It has traditionally been normal practice for voluntary sector organisations to cost activities based on the direct cost of delivery alone. These costs include salaries of staff directly involved in the project, telephone, postage and premises. However, the extra costs sustained by organisations in their day to day operations (for example management and accommodation overheads) have often not been included. Whilst one reason for this may be the difficulties that some in the sector have in working out the total costs of service delivery, it also reflects a reluctance of public sector funders to pay for what were seen as non-project related costs, for example management.

2.8 However, given that overhead costs are a legitimate expense in the day-to-day operations of any enterprise (be that public, private or voluntary sector), it suggests that many voluntary organisations have been undervaluing their services and jeopardising their own long term sustainability.

2.9 Several key factors are now driving the demand for FCR from the sector. These include:-

• A desire to see voluntary sector salaries rise in line with those in the public sector, given that often staff in both sectors may be doing similar jobs so that there is a need for comparability if staff are to be recruited and retained. As salaries account for the largest proportion of voluntary sector expenditure then this can be a considerable cost pressure;
• The loss of relief on water charges by Scottish Water. While this has been retained for some voluntary organisations, utility costs have increased significantly for many;
• A move by some local authorities to charge commercial rents. Given that many organisations had previously had caps on rent (if they paid anything at all) this has increased the overhead costs to organisations;
• Three year contracts that, whilst generally welcomed, may make no allowance for increases to match inflation (thus eroding in real terms the value of contracts); and
• Voluntary organisations having to pay a variety of charges to such bodies as the Care Commission and Disclosure Scotland, without which they would not be able to operate.

All of these factors have increased the cost base of the sector and have accordingly increased pressure to cover these costs through FCR.

2.10 All of these factors have resulted in many in the sector within Scotland seeing FCR as the way forward if the sector is to be able to maximise its revenue, grow and therefore meet its clients' current and future needs.

Emerging action on full cost recovery

2.11 The publication in 2002, of the Treasury Cross Cutting Review ( HM Treasury 2002) gave FCR greater prominence. The Review noted the concern of many voluntary and community sector organisations that funders were often unwilling to finance overhead costs as they believe that other sources of finance were, and should be, available for this purpose, although what these sources were was not specified (ibid, Section 6.3)..

2.12 It noted that there was no reason why service providers should not include the relevant portion of overhead costs within their bids for service contracts. It went on to state that "there is no reason why service funders should be opposed in principle to the inclusion of relevant overhead costs in bids" (ibid, p. 25). Indeed there is general acceptance within Scotland of the principle of FCR, that is that those who provide services should be paid the full costs incurred in delivering these. However, when the detail of what this actually means is considered then this general acceptance tends to break down.

Barriers to Full Cost Recovery in practice

2.13 Despite the production of guidance on the recovery of overhead costs, there has been a general failure of government departments and local authorities to implement FCR principles in England. A recent report by the National Audit Office (National Audit Office, 2005) highlights this issue. This section draws upon this report, which suggests that government funders in England have made only limited progress on meeting FCR. Of 13 departments surveyed, eight were prepared to cover overhead costs, though their approaches were variable. Approaches taken included:-

• Requirements for providers to specify and account for overhead costs in detail;
• Adding a small proportion of direct funding to be used for overheads rather than assessing actual overheads. This might be seen as marginal FCR; and
• Using undefined terms such as a "financial contribution" towards overheads, or a "legitimate proportion" of overheads.

2.14 The report notes that, generally, departments were aware of the principles of FCR and supported the idea, but did not always know how to apply the principles in practice. Some departments treated it as something that could be adapted depending on the situation, while others felt that it was not appropriate in all situations. It would seem that a similar situation exists in Scotland. For example, interviewees pointed out that although the Executive provided funding for Citizens Advice Bureaux ( CAB) through Citizens Advice Scotland, this funding did not take account of inflation. CABs were therefore being expected to make efficiency savings in spite of the Executive's support for FCR. This will be developed in more detail in the case studies (Chapter 6).

2.15 The Audit Office also found that there were some English government departments where, after two years, there was still the belief that they did not have to cover organisations' core costs and indeed would not do so. This was explained as being a result of insufficient knowledge of the applicability of FCR or because they used "formula funding" (paying a flat rate per customer served) which did not cover an organisation's full costs.

2.16 In addition, it was claimed that third sector organisations still believed that it was common for funders to refuse to pay certain overhead costs. Funders asked for details of overhead costs and then selected those that they were willing to pay. This was viewed as being at odds with the treatment of private sector companies who were not quizzed about overheads. It was argued that this showed that there was not a level playing field between the private and voluntary sectors when potentially competing for public service contracts, even though in theory there should be. As such FCR was seen to be exacerbating differences between voluntary and private sector providers.

2.17 The National Audit Office noted five main barriers to the effective application of full cost recovery. These were the:-

• Lack of cost information;
• Lack of agreement on which costs should be funded;
• Lack of clear and practical guidance;
• Inconsistency in practice at a local level; and
• Strings being attached to funding.

We shall now explore each of these in turn.

2.18 The lack of cost information was seen as a barrier for the voluntary sector, with organisations having difficulty costing the "overhead" part of the service accurately. This could have been as a result of a lack of financial expertise, staff or management information. In many respects building this expertise requires the recruitment of suitable staff with the correct knowledge and skills The difficulty is that these appointments could have an impact on overhead costs, although this may be a risk that has to be run. An alternative might be for organisations to come together to share support services.

2.19 The lack of agreement as to what should be funded was also a problem. In principle it could be argued that any cost that is necessary to allow an organisation to deliver services should be eligible for inclusion in the FCR equation. Despite this, some public sector organisations were unsure, for example, if a proportion of public relations and marketing activities should be included within overhead costs. There were also issues with training costs with some funders being only willing to pay for training that was directly associated with service delivery.

2.20 The Review suggested that there was a lack of clear and practical guidance on FCR. A standard approach across both the public and voluntary sectors would be needed to ensure that costing overheads was done in a consistent manner. While some work has been done by the Association of Chief Executives of Voluntary Organisations ( ACEVO, 2005), it was believed that more practical and focused examples were needed, possibly that produced by the Chartered Institute of Public Finance and Accountancy (2003) ¹. However, the later public sector interviews ( Chapter 5) showed that this was not widely known. Some representative organisations also produce guidance for their members (for example Community Care Providers Scotland (2004).

2.21 There was also felt to be a problem of consistency at a local level, especially between local authorities and the voluntary sector. This may reflect the differences in the funding relationships between central and local government and local government and the voluntary sector. In the first instance central government requires local authorities to carry out certain legal functions and provides funding for these purposes, with the risk that inadequate funding will impact upon service delivery. The relationship between local government and the voluntary sector, especially in areas where there is also private sector involvement (such as community care) is that between a purchaser and provider. The two situations are different but linked. For example, funding to local authorities is tightly controlled from the centre. This squeeze on spending then feeds into the contracting relationship with service providers, with local authorities being free to bargain on price. However, if FCR is to be implemented then the fear is that the ability to bargain may be constrained because of a requirement to cover what are defined as FCR eligible costs. Indeed some in local government see an apparent contradiction. For example, local government is allocated new statutory functions by central government the costs of which, it is argued, are often not fully funded but are expected to be met, in part, from efficiency savings. However, under FCR one scenario is that local government could be expected to pay voluntary organisations their full costs, without any explicit recognition by these organisations of the need for "efficiency savings".

2.22 The final issues raised, as a barrier to the successful implementation of FCR, was the "strings attached" approach. In this case funders were looking for "match funding", with the voluntary organisation itself covering management and other overhead costs. This was seen by some as essentially the status quo and could be interpreted as the voluntary sector subsidising public service delivery. However, whilst there are undoubtedly barriers to the implementation of FCR, its introduction is claimed to bring benefits. These will now be considered.

Potential benefits of Full Cost Recovery

2.23FCR is widely believed to be a key component in the drive towards a sustainable voluntary sector. SCVO define sustainability as :-

"The ability of an organisation to maintain its activities over time. This might involve financial sustainability via the diversification of income and innovative use of its asset base, but also workforce sustainability by ensuring that the sector can continue to attract and employ both a paid and unpaid workforce" (quoted in Scottish Executive, 2003, p.8).

2.24FCR can help in the achievement of this by allowing organisations the ability to cover all of their costs thus providing financial sustainability. This may, however, come at the cost of being reliant on certain public sector funding streams that are not guaranteed over the long term. Policy priorities change over time and reliance on funding for certain areas of service delivery could leave organisations vulnerable to the changing policy agenda. This would seem to be potentially a serious problem for small to medium sized organisations that deliver a limited range of services.

2.25 The Strategic Funding Review (Scottish Executive, 2005a) identified the key benefits of greater financial sustainability for the voluntary sector as being:-

• Increased security and retention of staff;
• Greater stability;
• Increased access to other funding streams;
• More effective longer term planning;
• Being able to compete effectively for resources; and
• Having the ability to get more involved in key areas of policy and provision in Scotland.

2.26 These would be supported by increased benefits to the service funders. Key benefits would include:-

• More effective use of funding;
• Increased options for service provision; and
• Improved value for money and better services as voluntary organisations focus on service delivery (as there is less need to spend time fund raising and securing other contracts).

In addition it could be argued that funders will be far clearer about the costs of providing a service so that strategic funding decisions can be made on the basis of a level playing field.

2.27 In theory, therefore, it is argued that there is a compelling case for FCR, with key benefits in terms of improved service provision as well as greater stability for the voluntary sector. However, it may be that the prognosis, were FCR to be introduced, might not be quite as optimistic as this. Accordingly in the next section we explore one possible FCR implementation scenario: cost neutral.

The cost neutral Full Cost Recovery scenario

2.28 It is possible to identify a number of FCR scenarios. The one that is explored here is that FCR is cost-neutral. This was discussed with the interviewees. Their views form a key part of this section, although the interpretation of these is our responsibility.

2.29 The cost neutral scenario is the argument that seems to be implied by the Scottish Executive. This assumes that over the medium to long term FCR could become cost-neutral. This assumes that a short term increase in costs (for the current level of service) associated with a move to FCR will be ironed out over time by:-

• Reorganisation within the voluntary sector, as individual organisations consider:-

• Reorganisation within the public sector as:-

2.30 Under this scenario, the implementation of FCR would impose no additional costs on the public sector in the medium to long term. Such a scenario is, however, treated with a degree of scepticism by many of the public sector interviewees. Indeed it would seem to contradict the reasons for trying to introduce FCR which is to pay more to the voluntary sector to cover the costs of service provision that are currently funded by other means.

2.31 If, however, FCR is introduced and is not to cost the public sector any more, then one consequence, identified by the interviewees, would be a greater move towards using competitive tendering for statutory services, which may be the only way for the public sector to meet both its efficiency savings and the FCR commitment. Ironically such a move may be detrimental to parts of the voluntary sector as, in a competitive market, voluntary organisations might be displaced by more efficient contractors, some of whom might be from the private sector. No doubt the sector could argue that, under Best Value, local councils have a duty to consider both cost and quality. However, many of the interviewees often felt that the voluntary sector:-

• Found it difficult to "sell itself" in Best Value terms, often seeing its role as delivering a specific service rather than marketing itself more strategically;
• May be more expensive than commercial competitors, so that public bodies have little choice when awarding contracts if they themselves are to avoid being taken to task by the auditors;
• Is seen as being little different to commercial providers. This is a particular issue for the large national organisations that have few locality links and which elected members may have limited interest in; and
• Works within a system that values cost above all else. This is a frequent criticism levelled at Best Value. In theory this should be a way of the sector being able to differentiate itself from other providers. In practice, as Chapter 4 makes clear, the experiences of Best Value of the Focus Group attendees is that it is driven by cost with very little regard being paid to other factors.

2.32 The risk for the voluntary sector under this scenario is that FCR is introduced and the additional costs are covered by delivering services through a more efficient provider, which may not always be a voluntary organisation.

2.33 Essentially the above is arguing that the cost neutral scenario, almost by definition, does not exist. If public bodies, are to be faced with additional costs as a result of FCR then they will try to recoup these. It seems likely that those who will lose out will be the less efficient private and voluntary sector organisations and those that are providing non-statutory services. The winners may be the more efficient providers in both the private and the voluntary sectors.

2.34 A variant of this scenario is that FCR is introduced in a cost neutral way as public bodies continue to fund the sector at the same level but accept a lower level of service as a consequence. This implies that those who will suffer will be the service users who will either be denied the service totally, will have to wait longer to access it or will only be able to use it for shorter hours. Thus despite a commitment to FCR the sector might be told that there is no more money. It may then continue to provide the same level of service as it want to protect service users. The only way out of this impasse might be for the sector to withdraw from providing services.

2.35 Some evidence for these scenarios comes from the perceptions of public sector interviewees that some voluntary organisations see FCR as giving them a blank cheque. Accordingly it seems very unlikely that public bodies will simply pay whatever they are asked for when told that this represents the full costs of service provision. In such instances there may be three possible outcomes:-

• A detailed scrutiny of these full costs, after which a decision will be made to pay those felt to be "legitimate". This might be combined with pressure to achieve economies in certain areas if costs are felt to be excessive;
• Moving to greater use of competitive tendering. In this case there would be no need for any detailed scrutiny of costs. In effect it would be up to individual voluntary organisations to decide whether to put in average or marginal costs or indeed no overhead costs at all. These are the type of pricing decisions made by private sector organisations. For example, it may be that it is felt worthwhile using only marginal cost pricing if there is a desire to enter a new market; and
• A negotiation takes place over the price, during which both parties must decide what an acceptable price is, with estimated costs being used to inform the buyer's decision, in the absence of disclosure. The seller may similarly decide what is the lowest price they will accept in the light of financial stability.

2.36 It may also be the case that FCR will not be applied uniformly across the sector, or across different types of funding situation. For example it may be that grant aid will be subject to FCR whereas competitive tendering will not.

Conclusions

2.37 In principle FCR is a simple concept. It is this simplicity that is no doubt responsible for there being general support for it in theory. Its implementation is likely to be more problematic. In particular:-

• There is a view that the voluntary sector has difficulty in calculating the true costs of its activities. Not only does this make it difficult for it to calculate what its full costs are but it means that the public sector is unwilling to accept without question any statement of "full costs". In such instances the way forward would seem to be for an agreed price to be one that is acceptable to both parties. However, the current unbalanced relationship between the public and voluntary sectors may make reaching such agreement difficult. Yet if such agreement is to be reached then there is a need to build positive partnerships between the public sector funder and the voluntary sector provider. One way of bringing this about might be to involve the provider in policy discussions with the funder and the development of a longer term funding relationship that is sustainable to both parties;
• Efficiency savings mean that public bodies are likely to be unwilling, as they see it, to sign a blank cheque to cover the costs of the voluntary sector. Accordingly, given that the most likely FCR scenario is that costs will increase, it seems probable that councils will look to recoup these costs by asking voluntary organisations to make efficiency savings or will offer the same amount of money in return for a lower level of service. This may come about through scrutiny of costs or through strategies that avoid the need to get into this level of detailed examination. Alternatively, the public sector may itself reorganise when faced with having to cover the full costs of service delivery;
• The main avoidance strategy may be to make greater use of competitive tendering. This will allow easy comparisons of the differing cost efficiencies of organisations that are tendering to deliver the same quality of service. Some voluntary organisations might then lose out to private contractors, although the reverse could also apply; and
• One way of avoiding this, within the context of Best Value, would be for the sector to sell itself more pro-actively, or deliver services better and for the public sector to use Best Value in a way that considers more than just costs. Indeed this is what Best Value is supposed to cover, although the experiences of some in the sector are that it tends to focus upon cost (Chapter 4). Despite this, some interviewees felt that in some services the cost differences between the cheapest and the most expensive provider are such that no amount of selling the benefits of contracting with the voluntary sector could overcome the cost disadvantages.

The relative importance of these issues will be explored in the later sections of the Report.

2.38 It is, therefore, clear that there is a considerable gap between the political will to implement FCR and the details of how this could then be implemented. The idea that FCR will solve the funding problems faced by voluntary organisations is perhaps unrealistic as funding will still take place in the context of:-

2.39 However, FCR may have the potential to increase short-term sustainability and could reduce the cross subsidisation of public service provision. Yet it seems debatable if this is something that will be applied generally across the sector. FCR may be something that could have a differential impact on different parts of the public and voluntary sectors. At this stage it is difficult to assess who will be the winners and losers. Indeed this seems likely to be something best examined through further research.

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