Internal Service Funds

The Very Short Story: I’m not a big fan of internal service funds: there is almost always a better way to achieve your budgeting and/or accounting goals that is simpler and more transparent.

The Slightly Longer Story. Many agencies strongly avoid using internal service (IS) Funds. (And this includes my Alma Mater, the City of San Luis Obispo: based on a website review of its most recent annual comprehensive financial report, it continues to not use any IS Funds.)

For example, rather than setting up an IS Fund for information technology services like some agencies do, San Luis Obispo allocates these costs through its cost allocation plan. The end result is the same (a reasonable allocation of shared, organization-wide support costs, which is especially important for General Fund cost recovery of services to enterprise operations) but with a lot less organizational effort.

Like many agencies, San Luis Obispo takes this approach in allocating costs for all internal support services. It doesn’t view allocating copier costs (or vehicle maintenance costs) as being conceptually any different than allocating costs for the City Manager’s Office (or City Attorney, Finance, or Human Resources). I’m not aware of any agencies that account for these kinds of organizational support services in IS Funds (although many distribute these kinds of costs through indirect cost allocation plans). However, the concept of cost recovery for these services is no different than for any other internal support costs (including those most often accounted for in IS Funds).

Here are some specific reasons for limiting the use of IS Funds (and using cost allocation plans instead) except where they are truly the best management (not accounting) solution:

• Operating departments generally don’t like them: they result in varying charges to their budget that they don’t control. A lot of organizational energy can get consumed in dealing with their concerns.
• It’s a lot of work to correctly capture the “use” data and set fees if your goal is to reflect “actual” costs on a fee basis “like a business.” (And if you’re not going to devote the effort needed to do this correctly, why bother to do it at all?) For example:
• Vehicle Maintenance. Developing and setting standard, per unit charges for oil changes, lube, tire rotations, and tune-ups; and then charging departments based on how many of these individual services were actually performed for them.
• Print Shop: Developing and setting standard fees various for various services, such as black and white reproduction, color, and binding; and then charging departments based on how many of these services were performed.
• Information Technology. Developing and setting standard fees various for various services, such as training, new workstation set-up or software installation; and then charging departments based on how many of these services were performed. (See sidebar summary of an excellent article by a new CIO on the drawbacks of IT charge-back systems in delivering great customer service. My experience tells me that his insights apply to almost any internal service).

On the other hand, rather than this resource-intensive accounting for activity and unit costs, many agencies don’t do this at all: they charge fixed amounts each year based on an allocation methodology. Of course, this is no different conceptually than a cost allocation plan, but a lot more work from a budgeting and accounting perspective.

Stated simply, if your ability to get financial management resources is limited (which is the case for every agency I’ve ever worked for or consulted with), then don’t you want to ensure that you are using them for the highest priority, “value-added” services? If you’re doing detailed accounting for printing or postage costs, then you don’t have the resources to do something else that might have a more meaningful community and organizational impact.

• It almost always results in a misleading picture of overall agency costs. In budget documents, IS Funds are either ignored (in which case a large part of the organization might be overlooked); or more commonly, they are included in agency-wide totals, resulting in an overstatement of costs (since the same costs are conceptually included in both the operating department budgets as well as the IS Fund). This is why generally accepted accounting principles eliminate IS Funds at the government-wide level.
• IS Funds are also used sometimes in accumulating long-term resources for capital replacements, like vehicles, IT software/hardware or facilities. If this is the goal, then it makes more sense to create capital project funds for these, such as fleet, IT or facility replacement funds, where transfers are made into these funds and costs expended from them. (This avoids the “doubling-up” of costs with internal service funds and the accounting is much simpler).
• One argument for IS Funds is that they improve organizational accountability (and thus, hopefully, productivity) and resource allocation by better linking services with fees. Maybe, but I’m from Missouri on this one.

In fact, it may obscure problems. If the vehicle maintenance staff is doing a poor job of meeting my department’s needs, I’m not sure how this gets improved by directly charging-back my budget for it. (In fact, it seems to just add insult to injury.)

The underlying issue isn’t how my budget is being charged, but whether I have reliable transportation to meet my service needs – and whether this is being provided efficiently and cost-effectively. This should just be straightforwardly addressed as the management (not accounting) problem that it really is. And since the IS Fund needs to recover its costs, if there are efficiency and effective problems, it seems to me that the end-result (without addressing the real problem) is simply to increase internal “per unit” charges rather than addressing fundamental customer service and productivity concerns.

In short, IS Funds are often the result of looking for an accounting solution to fix something that isn’t really an accounting problem at all.

In the final analysis, IS Funds are just a cost allocation tool. They don’t result in additional agency resources (although they may result in a better allocation of resources, but that’s a leap of faith that I’m not likely to easily make, either). If there are equally reasonable ways of allocating costs that get you the same basic result, why use a harder one?

In summary, there may be cases where an IS Fund really is the best accounting approach in helping solve a management problem. But I think these are far fewer than actual practice. In deciding to set up an IS Fund (or keeping one), the primary policy considerations should be:

• Will this result in much better management of the operation?
• Will the end service delivery be significantly better or cheaper simply because of the way we account for it?

If the answers are “yes,” then by all means set up the IS Fund. But if the answers are “probably not” (or no), then save your car fare and allocate your limited financial management resources to something else where you can answer “yes.”

Quoted article:
Hey, No Charge! A CIO discusses elimination of the City’s charge-back system for IT services

In an article in e-government magazine in 2005, Michael Armstrong discussed his experience as a new CIO in the City of Des Moines, Iowa, in creating a more customer-focused, enterprise-wide IT organization.

He discovered a number of problems, including “an aging mainframe environment and an IT operation that had lost respect from the rest of the organization. I also found an excellent charge-back application – the most sophisticated application we had. It did exactly what it was supposed to do, did it very well – and everyone hated it.”

After talking with stakeholders, he concluded that the charge-back system “came to symbolize much that was wrong with the IT operation in Des Moines.” He believed that “building an organization dedicated to excellence required that IT be strategic, that technology be an integral part of organizational infrastructure. IT must operate politically on equal footing with other back-office departments such as finance and human resources. If these departments don’t charge for their services, why should IT?”

In thinking about abandoning the charge-back system and discussing this with Finance, he found that Accounting and Budgeting were the main beneficiaries of the charge-back system. In looking for other ways to meet their goals, the Finance Director agreed that “an existing, indirect cost allocation system could distribute costs sufficiently across the enterprise for their purposes.”

He concludes that while there are some drawbacks (“We no longer have a demand throttle”), he would make the same decision again “in a heartbeat … it was the right decision for our vision and our organization.”