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Page/Link:Page URL:HTML link:The Free Library. Retrieved Dec 13 2019 fromThe current accounting literature is filled with activity basedcosting ABC articles about cost drivers in manufacturing settings butvery few examples of cost driver applications in service firms orindustries exist. A number of the applications of cost drivers inmanufacturing plants, however, involve service functions rather than amanufactured product. Since cost driver and ABC concepts improve thecost measurement and allocation information for service departmentswithin manufacturing firms, service firms (such as accounting or lawfirms) could also use cost driver and ABC concepts.A change to cost driver techniques will provide better costinformation for service firms as it has for manufacturing firms.Activity based costing will help accounting firms answer questions suchas: What does it cost to prepare a tax return? What is the cost of doingan audit?
How should the common costs be allocated to a particularengagement? Can costs be measured better and used for pricing ofservices?Cost AllocationsCost allocations are arbitrary and cannot be proven correct (orincorrect) because they depend on subjective judgement and not on averifiable cause/effect relationship. Even though arbitrary, allocationsare done in practice because the advantages outweigh the disadvantages.The methodology for making cost allocations involves two separateissues:1. The pools or categories of indirect costs that should beidentified, aggregated and allocated together. The basis over which the costs in any given pool should beallocated.It is the second issue that gives rise to the search for cost driversor allocation bases.A number of criteria are used by companies for evaluating costallocation methods. Most authorities agree allocations should be made onthe basis of the factors that caused the cost to be incurred.
Thiscriterion is most useful for variable costs like direct labor in anaccounting or a law firm. It is less useful for fixed costs-like officerent or building depreciation-that represent a capacity decision by thefirm to provide facilities for a particular level of service.Cost DriversThe most acceptable method of assigning costs to a product or serviceis to select drivers that approximate the underlying behavior of thecosts to be allocated. This causal relationship is generally regarded asthe best method for allocating indirect costs. It is the theory behind'cost driver' methods. A cost driver is used to allocate costsbased on a common measure of the quantity of the resource used by theproduct (or service, department, contract or unit). The cost driverconcept focuses on the activity that drives or causes the consumption ofcost.
This is in contrast to the concept of allocating costs justbecause they were incurred and must be assigned to the products orservices to satisfy external users.Since fixed costs do not vary with changes in activity in the shortrun, there are no 'cost drivers' that reflect usage, and anyallocation is arbitrary. If fixed costs are to be allocated, a firm willneed to develop some common capacity measure for all cost centers.Variable costs vary with a change of activity and it is preciselythis variation, and the activity that causes the variation, that givesrise to the search for cost drivers. For short-term variable costs, suchas supplies or photocopy expenses, cost drivers use a measure ofresource consumption directly proportional to the volume of activity,usually in units, products or hours of service.
Long-term variable costssuch as professional development or continuing education expenses areoften not related to the volume of the units, products or hours ofservice but are instead related to other causal factors. For long-termvariable costs, the types of activities or transactions undertaken areoften used as the cost drivers. It is necessary to: (1) understand theforces that cause the cost to change; and (2)identify and select a costdriver that behaves in the same manner as those variable costs.
Cost Drivers in Service FirmsService firms differ significantly from manufacturing firms in thatthey are labor intensive rather than capital intensive. Most of thelabor 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 pooland then allocated to specific engagements, usually as a percentage ofdirect labor cost. This charge for overhead will distort the total costof the engagement if different types of jobs cause costs to be incurredthat are not in proportion to the number of hours worked or the directlabor cost incurred. If the accounting system arbitrarily allocatescosts to a job rather than allocating costs that reflect the trueinputs, the firm will not be competitive when bidding jobs and will bemeasuring performance incorrectly.Service organizations usually do not use cost driver techniques intheir cost measurement and allocation procedures. A service firm,however, can collect costs by various functions (such as professionaldevelopment, administration or client development) and allocate thembased on cost drivers or activities that cause the costs to vary. Thefirm could then better evaluate the costs of different types of servicesrendered.
Learning Objective. Apply activity-based costing and activity-based management to service organizations.Question: To this point, we have presented ABC and ABM examples in a manufacturing setting.
However, service organizations, such as banks, hospitals, airlines, and government agencies, also use ABC and ABM. Some specialists refer to activity-based costing and activity-based management as activity-based costing and management, or ABCM. In fact, a recent survey indicates that 75 percent of companies that use ABC are in the public sector, a service industry, or a consulting industry. Mohan Nair, “Activity-Based Costing: Who’s Using It and Why?” Management Accounting Quarterly, Spring 2000, 29–33. How can ABC help service organizations get better product cost information?Answer: The same five steps used in manufacturing organizations can also be used in service organizations.
To understand how ABC could be used in a service organization, let’s look at how ABC can be used to determine the cost of loan products at a financial institution. Service Organization Example of ABCImagine you are the chief financial officer of Five Star Bank.
You are interested in implementing an activity-based costing system to evaluate the cost of different loan products, such as auto loans and home equity loans, offered by the bank. The five steps of activity-based costing we presented earlier still apply. Let’s look at how these steps might work when evaluating the cost of bank loans.Step 1. Identify costly activities.Processing loans includes activities such as meeting with customers, reviewing customer applications, and running credit reports.Step 2. Assign overhead costs to the activities identified in step 1.Costs assigned to the activity of reviewing customer applications include items such as wages of personnel reviewing applications, depreciation of computer equipment used to review online applications, and supplies needed for the review process.Step 3. Identify the cost driver for each activity.Activity cost drivers are shown as follows. ActivityCost DriverMeeting with customersHours of meeting timeReviewing customer applicationsNumber of applications reviewedRunning credit reportsNumber of credit reports runStep 4.
Calculate a predetermined overhead rate for each activity.This is done by dividing estimated overhead costs for each activity by the estimated cost driver activity. For the activity meeting with customers, this calculation results in a rate per hour of meeting time. For the activity reviewing customer applications, the calculation results in a rate per application reviewed, and for running credit reports, a rate per credit report run.Step 5.
Allocate overhead costs to products.Overhead is allocated, or applied, to products (auto loans and home equity loans in this example) based on the use of each activity’s cost driver. If a loan officer reviews 30 auto loan applications, an amount equal to the rate per application reviewed times 30 applications is allocated to the auto loans product. Service Organization Example of ABMQuestion: Managers at Five Star Bank are not only interested in product cost information; they would also like to scrutinize the activities involved in processing loans and make the process more efficient. How can the management of Five Star Bank use activity-based management to become more efficient?Answer: Managers and accountants can apply the three steps of activity-based management to Five Star Bank as follows:.
Identify activities required to complete the product. This involves interviewing personnel throughout the company to capture all the activities involved in processing loans. Determine whether activities are value-added or non-value-added. An example of a value-added activity is the quick approval of a loan. An example of a non-value-added activity is time spent waiting for credit reports. Continuously improve the value-added activities and minimize, or eliminate, the non-value-added activities.
Five Star Bank should continually strive to improve its ability to approve loans quickly (a value-added activity). While waiting for credit reports (a non-value-added activity), perhaps the bank can find other value-added activities that bank personnel can perform (e.g., responding to customer questions or processing other loan applications). Business in Action 3.4Activity-Based Costing at Blue Cross and Blue Shield of Florida (BCBSF)Management at Blue Cross and Blue Shield of Florida realized it needed more sophisticated cost information to make better decisions.
Given the highly competitive nature of the health care insurance industry and the need to minimize costs, BCBSF’s management decided to implement an activity-based costing system. Review Problem 3.5Menzies and Associates provides two products to its clients—tax services and audit services.
Cost Drivers Examples In Service Industry
Last year, total overhead costs of $1,000,000 were allocated based on direct labor hours. A total of 10,000 direct labor hours were required last year for tax clients at a cost of $350,000, and 30,000 direct labor hours were required for audit clients at a cost of $1,200,000. Direct materials used were negligible and are included in overhead costs.
Cost Driver Synonym
Sales revenue totaled $720,000 for tax services and $2,200,000 for audit services.Management of Menzies and Associates would like to use activity-based costing to allocate overhead rather than use one plantwide rate based on direct labor hours (perhaps the term “officewide” rate would be more appropriate here). The following estimates are for the activities and related cost drivers identified as having the greatest impact on overhead costs.
Required:. Using the plantwide allocation method, calculate the total cost for each product. (Hint: Product costs for this company include overhead and direct labor.). Calculate the profit for each product using this approach.
Also calculate profit as a percent of sales revenue for each product. Using activity-based costing, calculate the predetermined overhead rate for each activity. (Hint: Step 1 through step 3 in the activity-based costing process have already been done for you; this is step 4.). Using activity-based costing, calculate the amount of overhead assigned to each product.
(Hint: This is step 5 in the activity-based costing process.). Calculate the profit for each product using this approach. Also calculate profit as a percent of sales revenue for each product.
Comment on the results of using activity-based costing compared to plantwide allocation.Solutions to Review Problem 3.5.The plantwide allocation used by Menzies and Associates is based on direct labor hours. The rate is calculated as follows: Estimated overhead cost Estimated activity in allocation base = $ 1, 000,000 4 0,000 hours = $25 per direct labor hourTotal product costs are as follows.Activity-based costing results in a significant increase of overhead costs allocated to the tax product and a decrease of overhead costs allocated to the audit product. The plantwide allocation approach allocates overhead based on direct labor hours, which results in 25 percent of all overhead costs being allocated to tax (= 10,000 direct labor hours in tax ÷ 40,000 total direct labor hours) and 75 percent to audit.
However, ABC shows that tax uses 60 percent of scheduling and data entry resources (= 150 tax clients ÷ 250 total clients), 90 percent of advertising resources (= 45 tax ads ÷ 50 total ads), and 50 percent of computer resources (= 2,500 tax computer hours ÷ 5,000 total computer hours). Thus tax is allocated more overhead costs using ABC than using one plantwide rate based on direct labor hours. Note that total profit of $370,000 is the same regardless of the overhead cost allocation approach used. Using the plantwide allocation approach, $370,000 = $120,000 + $250,000. Using the ABC approach, $370,000 = ($210,000) + $580,000.Management must use this information to make improvements to the company’s operations. It would probably be unwise to eliminate tax services because of the connection they have with audit services (i.e., audit clients may appreciate the convenience of also having tax services available to them). However, management can look for ways to make the process more efficient by focusing on costly activities identified in the ABC analysis.Note that when calculating product costs for service organizations, it is difficult, if not impossible, to calculate a product cost per unit.
Most service organizations do not have an easily defined unit of measure because services vary so much from one customer to another. One alternative is to calculate total profit as a percent of total sales revenue. This allows for a comparison of profitability between different types of services, similar to comparing the profitability for units of product.