Value for Money: Economy, Efficiency and Effectiveness in the Public Sector

A state road agency is given ₦2.4 billion to resurface 120 kilometres of road. At the end of the year it reports that it has resurfaced 126 kilometres, which is more than planned, and that it has spent ₦2.64 billion. The agency says it has exceeded its target. The auditor-general asks a different question: did the public get value for money?

The agency spent 10% more than it was given, the cost of each kilometre was higher than planned, and no one has checked whether the roads will last. A government body or a charity cannot judge itself by profit, because it has no profit objective. But it can ask whether it is making the best use of the money it has.

That is the idea of value for money (VFM), achieved through the “three Es”: economy, efficiency and effectiveness. This topic explains the three Es, how to measure efficiency and effectiveness quantitatively, how VFM is used as a public sector objective and examined by VFM audit, how to evaluate a project against the three Es, and the problems of the approach.

It builds on the earlier topic on performance measurement in not-for-profit organisations. The next topic covers divisional performance: return on investment and residual income.

The nature of value for money

Government departments must operate within budget limits and charities within the amounts they receive in donations. Their main objectives are not financial. But the money is limited, so they should aim to make the best use of the money available and to create “value” in what they do. This is described as achieving value for money (VFM).

The concept can also be applied in commercial organisations, but is mainly used to measure performance in not-for-profit organisations.

Economy

Economy means keeping spending within limits and avoiding wasteful spending. It also means achieving the result at lower cost, usually by buying inputs of the required quality at the lowest price. If an administrative department pays ₦2 for a pen and pens of the same quality can be bought for ₦1.50, switching saves ₦0.50 a pen (25%) with no loss of efficiency or effectiveness.

Economy is about the cost of inputs. Targets can be set for the prices to be paid for items, and audits can look for significant failures to control prices and for unnecessary expense. Economy is not simply the lowest price: a cheaper input that fails is not economical.

Efficiency

Efficiency means getting more output from the available resources. When applied to employees it is often called productivity. If a tax officer who processes 20 returns a day now processes 25 without loss of effectiveness, efficiency has improved. It is about the relationship between inputs and outputs. Efficiency focuses on the need to make full use of available resources.

Effectiveness

Effectiveness is success in achieving end results or objectives. Efficiency is concerned with getting more outputs from resources; effectiveness is concerned with achieving outputs that meet the aims. The effectiveness of treating a medical condition rises if the proportion of patients treated successfully rises from 80% to 90%. It focuses on using resources for the purpose intended and achieving the organisation’s objectives.

The Es are linked: economy relates to the cost of inputs; efficiency is the ratio of output to input; effectiveness is the ratio of outcome to objective. A body may be economical and efficient but ineffective (cheap, productive and useless), or effective but wasteful. VFM requires all three. (A fourth E, equity, fairness in who benefits, is sometimes added.)

VFM as a public sector objective, measures and problems

VFM objective and VFM audits

Management accounting and reporting systems can give information about VFM: has it been achieved, how much, and in what ways? VFM audits are carried out to establish how much value is being achieved in a department and whether it has improved. Internal audit departments may do this occasionally and report to senior management and to the manager of the department audited, and government auditors audit departmental spending.

VFM applies to any organisation whose main objective is non-financial but whose finance is limited, so it suits the whole public sector. Government is often accused of waste, inefficiency and failure to deliver: the traditional faults of a large bureaucracy. VFM is a way of testing these claims.

Quantitative measures of efficiency

Efficiency relates the quantity of resources to the quantity of output. It can be measured in several ways:

• Actual output ÷ maximum output for the resource × 100%. A theatre that can perform 40 operations a day and performs 35 is 87.5% efficient.
• Minimum input to achieve the required output ÷ actual input × 100%. A weekly refuse round that normally needs 1,000 hours and used 900 is 111.1% efficient.
• Standard ratio ÷ actual ratio × 100%. A standard of 27 pupils per teacher, with 550 pupils and 21 teachers (an actual ratio of 26.2), is 103.05% efficient.

Over 100% means better than the standard; under 100% means worse.

Quantitative measures of effectiveness

Effectiveness compares what has been achieved with the intended result. A hospital theatre may be 87.5% utilised, which is an efficiency measure; but the aim is successful treatment. If the target is for 95% of operations to be successful and the actual rate is 90%, effectiveness is below target, measured as 90 ÷ 95 = 94.7% of target.

Evaluating a project against the three Es

A local authority runs a project to raise employment among young people by 10% in three years. The managers are so keen that the project raises employment by 12% but overspends its budget by 8%. A VFM audit finds that the cost per outcome is slightly below that of similar projects in other authorities.

The analysis:

• economy, controlling spending and using resources best, is doubtful because of the overspend
• efficiency is good because cost per outcome compares well with others
• effectiveness is good because the target was exceeded

The project is efficient and effective, but probably not economical, so value for money is not clearly achieved, unless the budget was unrealistic, which needs further investigation.

Problems of VFM

• Hard to plan. It is easy to assess retrospectively whether VFM was achieved, but harder to set targets in advance showing how it will be achieved.
• Conflict between the Es. Cutting cost (economy) may reduce effectiveness; chasing effectiveness may cost more; high efficiency may reduce quality.
• Measurement of outcomes is difficult and attribution uncertain.
• Quality and equity may be ignored if only quantities and costs are counted.
• Comparisons between bodies may be unfair.
• Behaviour: managers may focus on measured items, and underspend to look economical at year end.

Layouts for value for money

1. Economy: actual price or cost compared with budget or standard.
2. Efficiency: the output-to-input ratio, as a percentage of the standard or maximum.
3. Effectiveness: result as a percentage of the target.
4. Overall: state each E and conclude on VFM, noting conflicts.

Percentages to one decimal place; each answer is rounded once, at the end.

Worked examples

1. Laboratory.
   42 ÷ 48 = 87.5% efficient.
2. Collection round.
   800 ÷ 760 = 105.3% efficient.
3. School.
   Actual ratio 640 ÷ 20 = 32
   standard ÷ actual = 30 ÷ 32 = 93.75%, below the standard (larger classes).
4. Clinic.
   91 ÷ 95 = 95.8% of target effectiveness.
5. Economy example.
   A cheaper supplier cuts the price of an item from ₦1,800 to ₦1,500: a saving of 300 ÷ 1,800 = 16.7%, which is economical only if the quality is the same.

1. Budgeted cost per km.
   2,400m ÷ 120 = ₦20m.
2. Actual cost per km.
   2,640m ÷ 126 = ₦20.95m, which is 4.8% above the budgeted figure but slightly below the ₦21m average of other agencies.
3. Economy. Total spending was 10% over the budget; cost control was weak, so economy was not achieved against the budget.
4. Efficiency. The cost per kilometre is in line with other agencies; and 126 km was done against 120, so output per naira is reasonable.
5. Effectiveness.
   126 ÷ 120 = 105% of the target length, but it should also be checked whether the roads meet the quality standard and last.
6. Conclusion. Efficient and probably effective in quantity, but not economical against the budget. Value for money is not clearly achieved; a VFM review should check whether the budget was unrealistic and whether quality was kept.

Expect variants: a requirement to explain the three Es with examples, a table of measures to calculate and interpret, a case on a charity or hospital, and a requirement to discuss the problems of using VFM as a performance measure.

Common mistakes

• Confusing economy and efficiency. Economy is the cost of inputs; efficiency is output per unit of input.
• Confusing efficiency and effectiveness. Doing things right against doing the right things.
• Using the wrong way round in efficiency ratios. For minimum-input measures, input is in the numerator.
• Concluding VFM from one E.
• Calling the cheapest option economical even if quality falls.
• Ignoring the limits of VFM measures.

Quick revision

• VFM = economy + efficiency + effectiveness (sometimes equity).
• Efficiency: output ÷ maximum; minimum input ÷ actual input; standard ÷ actual ratio. Effectiveness: result ÷ target.
• VFM audits: retrospective; hard to plan; the Es may conflict.

How the marks are earned

• Definitions with examples.
• Calculations on the right basis.
• Evaluation of each E and an overall view.

Practice questions

These are original questions, written in the style of the Skills examination. Work each one before you open the answer.

Recall check: multiple choice

Section B style: written questions

Model answers

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