Activity-Based Costing in Service Organizations: A Guide

Introduction to Activity-Based Costing in Service Organizations

Activity-based costing (ABC) operates on a conventional approach that applies a two-stage allocation process and identifies specific cost drivers. In the first stage, the system identifies the key activities and assigns overhead costs to each activity in proportion to the resources used. For each of these cost pools, cost drivers are then identified. In the second stage, the assumed overhead cost driver is assigned proportionally to the final outputs of the cost pool. The most important aspect of a well-designed ABC system is that activities and resources are assigned to cost items based on their actual use.

In service-based organizations, the ABC system must reflect the actual physical structure of resources, activities, and cost items. It is necessary to undertake a precisely executed and correct analysis of operations rather than of the cost figures in the general ledger. Design is therefore critical in an ABC system, because each organization uses different levels of resources when performing different activities with different types of cost items. Service organizations must exercise caution in depicting their operations as an accurate representation of their specific structure. Management must be careful not to adopt examples from other organizations literally, despite the fact that consultants and industry interest groups promote comparative information (Dowless, 1997). It is most important that organizations understand themselves explicitly before comparing their results to those of others.

A good design will also attract the definition of strategic goals and measures within the organization. Most service-based organizations — such as those in banking, telecommunications, insurance, rail, or distribution — have their own unique economic and physical structures that must be accurately depicted in an activity-based costing system.

It is important to conduct a pilot run prior to implementing activity-based costing across an organization. Without proper piloting, organizations are likely to overshoot their budget and waste time and resources on collecting and analyzing data for the ABC model. This can result in frustration and, ultimately, non-implementation of the system.

It is important for the implementation staff to seek top management's support (Accounting For Management, 2011). They should then identify the key data required. The organization should approve smaller, quick projects first — such as a single process or a pilot unit. If successful, management can undertake broader implementations and eventually make ABC a priority for other sectors of the organization.

Implementing an Activity-Based Costing System

The implementation staff should develop a computer-based ABC system that can be used on an infrequent basis for strategic decision-making. This model should be simple and upgradeable, drawing on data that is already available or easily collected. In practice, a simple model tends to be far more accurate than many traditional cost allocation methods. The input fields must be supported by the existing information system.

Smaller service-based firms should creatively seek reasonable activity cost drivers from their data through collaborative efforts. The team's greatest task is to identify which parts of selected activities are most expensive. Close attention to detail is essential at this stage, as many activities may carry hidden costs.

It is recommended that the implementation team comprise the most knowledgeable staff available, who will apply what is required of them and strictly follow established procedures for successful implementation of ABC (Andersen, 1999). A common mistake in the implementation process is placing managers on the team, as they are unlikely to obtain sufficient information from accountants or other analysts.

Implementing an ABC system is a resource-intensive process in a service-based organization, and it is therefore expensive to maintain once it has been put in place. This is largely due to the effort required to collect, check, and enter information on various activities into the system.

Additionally, ABC can produce product margin figures that do not match those produced by manual costing systems. Because managers are accustomed to traditional costing systems in their day-to-day operations, these discrepancies can create confusion.

Data from ABC systems can easily be misinterpreted and must be used carefully when informing decisions. Before making any significant decision based on ABC data, managers need to identify which costs are relevant to the situation at hand.

Cost Measurement Problems for Service Organizations

Reports generated by ABC systems are not consistent with generally accepted accounting principles (GAAP). Consequently, firms may be required to maintain multiple cost systems for both internal and external reporting purposes.

ABC can also present difficulties in the initial data collection stages, often due to a lack of differentiation between relevant and irrelevant information. This may result in the use of obscure data that has not been employed in traditional systems, introducing doubt and uncertainty into the process.

According to Clark & Mullins (2001), the implementation of ABC is commonly met with resistance at the management level. The problem lies in identifying suitable cost pools and related activity cost drivers. Management also resists the process because of cost implications — the process is expensive and time-consuming, encompassing the cost of capturing the internal accounting model and the time required to involve and train staff. The remedy here is the adoption of a custom-designed ABC system tailored to the organization's specific needs.

Comparing ABC in Service-Based and Manufacturing-Based Organizations

A second similarity is that the adoption and familiarity with ABC follows a comparable pattern across both sectors. Service-based organizations providing services with differing overhead rates benefit from activity-based costing, just as manufacturing-based organizations with multiple products that place different demands on overhead do.

Furthermore, accurate cost assignment to each sale allows organizations in both sectors to assess the profitability of each client and ensures that customers pay appropriately for the products or services they consume. The system enables organizations to track client profitability by monitoring the performance of external parties.

Overhead costs are incurred for different reasons across both sectors, and the ABC system identifies the costs of all activities carried out by the firm. The method accurately allocates indirect and direct costs to goods and activities based on actual consumption.

Service-based organizations have difficulty developing ideal ABC systems in part because they tend to adopt systems designed for non-service-based organizations. One key difference is that non-service-based systems focus on valuing products and use standard costs for direct materials (Ruhl & Hartman, 1998). Direct materials and labor costs are not required in service-based costing systems, making it impossible to calculate standard costs in the same way. Service firms also have little concern for the precise cost of goods in profitability analysis.

Manufacturing-oriented organizations — particularly larger ones — are more likely to implement ABC than smaller service-oriented organizations, which tend to rely on traditional costing methods or have not yet adopted ABC. These service-oriented firms apply ABC in smaller numbers and lack the diverse product portfolios that would make ABC particularly beneficial. Manufacturing companies, by contrast, typically have vast resources and large specialist teams, making ABC adoption more practical.

Service-based organizations frequently apply the traditional costing approach, which uses a two-stage method for assigning indirect and support expenses to product or service costs. This method involves collecting support expenses in cost pools and then distributing them to production units based on volume drivers. The connection between indirect costs and volume drivers used in this approach often produces inaccurate cost figures. Manufacturing-based organizations, on the other hand, tend to use a more advanced ABC system that delivers comprehensive and accurate results, allocating costs to resources based on the activities they support and linking those costs directly to products.

In addition, service-based organizations use departmental overhead rates rather than plant-wide rates (Accounting For Management, n.d.). These departmental rates do not accurately assign overhead costs when the organization offers a wide variety of services. The departmental approach relies on volume as an allocation factor, which can distort costs. Manufacturing-based organizations, by contrast, use plant-wide rates that assign overhead costs across all products without depending solely on volume-related factors.

Another difference is that manufacturing-based organizations allocate costs based on characteristics of each unit — including the number of direct labor hours required, the cost of purchasing materials, and the number of days occupied by a customer (Drury, 2007). Service-based organizations, in contrast, focus on the activities required to deliver each service, based on each service's consumption of those activities. Using ABC, overhead costs are traced to services by identifying the specific resources consumed.

Service and manufacturing organizations also differ in how they analyze production expenses. In service-based organizations, the demand for support is driven by product volume mixes and differences in customer specifications. The analysis considers the expense structure of each department and examines the factors creating demand for the activities that department performs. Manufacturing-based organizations, by contrast, adopt a cost-pull, quantity-based approach that isolates consumption from value.

The dynamic manufacturing industry, driven by newer technologies, tends to reduce the direct labor component of production while increasing overhead costs. When direct labor and overhead together account for a minimal percentage of total costs, assigning overhead based on direct labor hours can distort product costs and complicate profit maximization decisions. Service-based organizations, by contrast, do not need to reduce labor costs to manage overhead, and profit maximization based strictly on resource availability constraints is less directly applicable.

The greatest obstacle to implementing ABC in service-based organizations is often a lack of appreciation for its benefits. Many service firms neglect ABC because they find it complex and difficult to implement, and the systematic approach required is demanding and time-consuming. Installing ABC without adequate implementation planning typically leads to failure. Manufacturing-based organizations, however, tend to find implementation more straightforward due to the clear advantages the process offers in that industry context.