Using activity based costing in service industries.

The current accounting literature is filled with activity based costing |ABC~ articles about cost drivers in manufacturing settings but very few examples of cost driver applications in service firms or industries exist. A number of the applications of cost drivers in manufacturing plants, however, involve service functions rather than a manufactured product. Since cost driver and ABC concepts improve the cost measurement and allocation information for service departments within manufacturing firms, service firms (such as accounting or law firms) could also use cost driver and ABC concepts. A change to cost driver techniques will provide better cost information for service firms as it has for manufacturing firms. Activity based costing will help accounting firms answer questions such as: What does it cost to prepare a tax return? What is the cost of doing an audit? How should the common costs be allocated to a particular engagement? Can costs be measured better and used for pricing of services? Cost Allocations Cost allocations are arbitrary and cannot be proven correct (or incorrect) because they depend on subjective judgment and not on a verifiable cause/effect relationship. Even though arbitrary, allocations are done in practice because the advantages outweigh the disadvantages. The methodology for making cost allocations involves two separate issues: 1. The pools or categories of indirect costs that should be identified aggregated and allocated together. 2. The basis over which the costs in any given pool should be allocated. It is the second issue that gives rise to the search for cost drivers or allocation bases. A number of criteria are used by companies for evaluating cost allocation methods. Most authorities agree allocations should be made on the basis of the factors that caused the cost to be incurred. This criterion is most useful for variable costs like direct labor in an accounting or a law firm. It is less useful for fixed costs--like office rent or building depreciation--that represent a capacity decision by the firm to provide facilities for a particular level of service. Cost Drivers The most acceptable method of assigning costs to a product or service is to select drivers that approximate the underlying behavior of the costs to be allocated. This causal relationship is generally regarded as the best method for allocating indirect

costs. It is the theory behind "cost driver" methods. A cost driver is used to allocate costs based on a common measure of the quantity of the resource used by the product (or service, department, contract or unit). The cost driver concept focuses on the activity that drives or causes the consumption of cost. This is in contrast to the concept of allocating costs just because they were incurred and must be assigned to the products or services to satisfy external users. Since fixed costs do not vary with changes in activity in the short run, there are no "cost drivers" that reflect usage, and any allocation is arbitrary. If fixed costs are to be allocated, a firm will need to develop some common capacity measure for all cost centers. Variable costs vary with a change of activity and it is precisely this variation, and the activity that causes the variation, that gives rise to the search for cost drivers. For short-term variable costs, such as supplies or photocopy expenses, cost drivers use a measure of resource consumption directly proportional to the volume of activity, usually in units, products or hours of service. Long-term variable costs such as professional development or continuing education expenses are often not related to the volume of the units, products or hours of service but are instead related to other causal factors. For long-term variable costs, the types of activities or transactions undertaken are often used as the cost drivers. It is necessary to: (1) understand the forces that cause the cost to change; and (2) identify and select a cost driver that behaves in the same manner as those variable costs. Cost Drivers in Service Firms Service firms differ significantly from manufacturing firms in that they are labor intensive rather than capital intensive. Most of the labor cost can be traced directly to the firm's output of services. The rest of the cost is usually charged to a single overhead cost pool and then allocated to specific engagements, usually as a percentage of direct labor cost. This charge for overhead will distort the total cost of the engagement if different types of jobs cause costs to be incurred that are not in proportion to the number of hours worked or the direct labor cost incurred. If the accounting system arbitrarily allocates costs to a job rather than allocating costs that reflect the true inputs, the firm will not be competitive when bidding jobs and will be measuring performance incorrectly. Service organizations usually do not use cost driver techniques in their cost measurement and allocation procedures. A service firm, however, can collect costs by various functions (such as professional development, administration or client development) and allocate them based on cost drivers or activities that cause the costs to vary. The firm could then better evaluate the costs of different types of services rendered. If the results are significantly different from the traditional cost allocation approach accounting firms use, it would help in evaluating past performance and make cost predictions of future engagements more meaningful.

Methodology ABC System implementation is performed in five major steps. The main objective these steps are to trace overhead cost. Step 1: Review financial statements The objective of this step is to identify the companys direct costs, overhead costs, and capital costs. This information can be obtained from the companys profit/loss (P&L) statement and balance sheet. The P&L statement is used to identify direct costs and to estimate overhead costs, while the balance sheet is used to estimate capital costs. Step 2: Identify main activities During this step, the main activities that consume overhead resources, such as preparing bids or billing customers, are identified. A flowchart of the companys business process (which starts, for example, with customer inquiry, and ends with final payment) is a very helpful tool in systematically identifying the activities. Perhaps, system implementation is best undertaken with the inclusion of relatively few major business activities. Then, as needed, the ABC system can be refined by splitting these activities into more specific categories or introducing additional activities to the analysis. Step 3: Determine overhead cost for each activity After the main activities are identified, the cost of each should be calculated. To properly trace overhead costs to activities, tools such as first stage cost drivers and cost pools, or Expense-Activity-Dependence (EAD) matrixes can be used. Step 4: Select operating cost drivers Once the overhead cost of each activity is determined, these costs are then traced to cost objects, such as services, processes or customers. Operating cost drivers, also called second stage cost drivers, are commonly used to perform this task. When selecting cost drivers, factors such as the accessibility of data required by a particular cost driver and the degree of correlation between the consumption of the activity and the cost object, should be considered. Step 5: Calculate operating costs for cost objects Once cost drivers are selected, operating costs are traced to the cost objects. Operating cost drivers or Activity-Product-Dependence (APD) matrixes are helpful in tracing costs from activities to cost objects.

Example:

The Hawkeye National Bank

ABSTRACT: The U.S. Bureau of the Census projects that by 2006, the service sector will employ 74 percent of the workforce. This case illustrates why a major segment of the service sectorbanksneeds accurate cost information to make strategic decisions, and how more refined accounting systems help fulfill this need. Hawkeye National Bank is a hypothetical bank that has suffered falling profits despite a shift in customer base toward retail customers, which the current information system reports are more profitable than business customers. Following a step-by-step approach, you will develop the Bank's average cost of serving a retail customer account and a business customer account, under (1 ) the Bank's traditional single allocation base system, and (2) a (pilot test) activity-based costing system. You will analyze these results to determine how and why costs reported by the activitybased system differ from the costs reported by the traditional system, and what this difference means for the Bank's business strategy. Finally, you will consider how the Bank's managers can use the new, more refined activity-based cost data in strategic decision making, including controlling costs and developing more profitable business strategies. INTRODUCTION: The Hawkeye National Bank began operations in the mid-1980s. The bank quickly grew by providing checking account services to many small businesses that preferred to do business with a "local" bank. Although Hawkeye initially offered checking account services for individual accounts (retail customers), the bank primarily focused on serving its business customers. During the economic slowdown of the early 1990s that weakened the local economy, growth in business customer accounts began to decline. In response, Hawkeye's senior management adopted a new strategy, focusing on increasing the number of retail customer accounts. By aggressively marketing individual retail accounts, Hawkeye continued to grow. Today, the Hawkeye National Bank strives to maintain a stable base of business customers, while actively competing for an increased market share of retail customers. Recent income statements (Exhibit A) reveal a decline in the bank's profits. The bank's primary (noninterest) expense consists of salaries and employee benefits. Most full-time employees' first priority is providing services to customers; these employees conduct their administrative responsibilities during slack times. The Bank schedules additional part-time employees to work during peak demand times, from 11 AM-2 PM and Friday afternoons. Flexibility in scheduling part-time employees means that the bank's staff is lean and fully utilized. Hawkeye's CEO, George Harrison, believes that this staffing arrangement allows the bank to provide speedy customer service, while operating at practical capacity. (That is, the bank's staff is fully utilized in efficient operations, after allowing for bank holidays and other scheduled staff activities such as training.)To counter falling profits, Hawkeye's directors took two actions last year, both aimed at increasing the bank's retail customer base. First, Hawkeye established a service call center to respond to customer inquiries about account balances, checks cleared, fees charged, and other banking concerns. Second, Hawkeye's directors authorized year-end bonuses to branch managers who met

their branch's target increase in the number of customers. However, even though 80 percent of the branch managers met the targeted increase in customer accounts, the Bank's profits continued to decline. CEO George Harrison does not understand why profits are declining, given that the Bank is serving more customers. Hawkeye's southeast regional manager, Jerik Carsten, has also noticed that while small retail customers flock to the bank, the number of business customers is barely stable.Jerik Carsten suspects that Hawkeye's costing system may be part of the problem. Hawkeye developed its simple costing system when the bank began operations in 1985. The bank does not trace any costs directly to individual customers. It simply treats all (noninterest expense) operating costs identified in the Income Statement in Exhibit A as indirect with respect to the customer line. The bank allocates these indirect costs to either the retail customer line or the business customer line, based on the total dollar value of checks processed (which is readily available because each branch must provide the dollar values of daily transactions for internal control). For the current period, Hawkeye processed a total of $95 million in checks, of which $9.5 million was written by retail customers, and $85.5 million was written by business customers. This costing approach was fairly typical of banks and other financial institutions at the time Hawkeye developed its cost system. In college, Jerik learned about an alternative costing approach called activity-based costing (ABC). However, the examples he remembered involved manufacturing firms. He wondered whether Hawkeye could develop an ABC system, with the business account customer line and the retail account customer line as the two primary cost objects. Jerik approached George Harrison with this suggestion. George was skeptical, exclaiming, "Our profits are going down the tubes and you want me to spend money developing a new accounting system?" However, Jerik persisted, and George eventually authorized a pilot ABC study using three local branches of the bank. The ABC implementation team included Jerik, the managers of each of the three bank branches, a bank teller, and a representative from the customer service call center. The team began by identifying the activities Hawkeye National Bank performed. To start a simple pilot study, the team identified the three most important activities: 1.Paying checks 2.Providing teller services 3. Responding to customer account inquiries at the customer service call center If this pilot study turned out to be successful, then the team planned to refine the system by conducting a more detailed activity analysis the following year. The ABC team began by determining the costs that are associated with each of the three activities. The team quickly discovered that, as is typical in service industries like banking, labor (personnel) costs dominate. The ABC team asked each employee to fill out a short questionnaire to find out how the employee spends his or her time. The team then followed up with an in-depth personal interview with each employee. The ABC team used this combined information to estimate the percentage of time each employee spent on each of the three activities: (1) paying checks, (2) providing teller services, and (3) responding to customer account inquiries. The team then estimated the other (nonlabor) resources that each of the three activities consumed. For example, they traced to

the "responding to customer account inquiry" activity: (1) the cost of toll-free telephone lines at the customer service call center, and (2) depreciation on other equipment and facilities the call center personnel use. Similarly, the ABC team estimated the percentage of time the bank's information system was used for check processing and providing teller services (vs. other uses such as compiling periodic financial statements), to determine how much of the equipment's depreciation to assign to the activities "paying checks" and "providing teller services." To complete the pilot study in a timely fashion, the ABC team based their estimated activity costs on last year's actual data, which were already available. If the pilot study succeeded, then the ABC team planned to develop budgeted indirect cost rates for each activity the following year. The advantage of budgeted rates over actual rates based on the prior year's data is that budgeted rates (budgeted cost associated with the activity divided by the budgeted quantity of the activity's cost driver) can incorporate expected changes in costs and operations. After examining the three branch banks' indirect costs (that is, the cost items making up the branch banks' noninterest operating expenses), the ABC team classified the annual costs in each activity's cost pool (hereafter, all numbers are in thousands) as shown in Exhibit B. EXHIBIT A Hawkeye National Bank Consolidated Income Statement For the three years ending December 31, 20x5

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a

Net interest income equals interest income less interest expense. The bank's primary income is from interest-bearing checking accounts. Noninterest income includes fees charged for various services, such as checking account fees charged if the account balance falls below the required minimum level. Noninterest expenses are all of the bank's operating costs, including those associated with paying checks, providing teller services, and responding to customer account inquires.______________________________________________________________________ Exhibit B

_____________________________1 An activity's cost pool is simply a grouping, or aggregation, of all the individual costs associated with that activity. The bank's ABC team created separate activity cost pools for the costs associated with each of the three activities: (1) paying checks (2) providing teller services and (3) responding to customer account inquiries.

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a

These indirect costs are part of the $3,806 "noninterest expenses" in the bank's 20x5 Income Statement in Exhibit A. The rest of the noninterest expenses in the Income Statement shown in Exhibit A pertain to other operating costs that are excluded from the pilot ABC study, such as the CEO's salary. (The costs listed in l; Exhibit B era indirect. with respect to the retail customers and business account customers)