Unit 6 - Service Costing PDF

So far we have been discussing costing of products in a manufacturing firm. In unit 6 we will use the same principles of costing already discussed and apply it in a service firm. This unit should not be confused with the support department cost allocation that we discussed in unit 3....

So far we have been discussing costing of products in a manufacturing firm. In unit 6 we will use the same principles of costing already discussed and apply it in a service firm. This unit should not be confused with the support department cost allocation that we discussed in unit 3. 1 In unit 5, we discussed Activity based costing, a contemporary costing system that assumes cost is driven by both the volume and non-volume drivers. ABC has two major perspectives – the costing view and the management view. It also allocates costs to objects using four hierarchies of cost, which is unit, batch, product and facility. Although ABC has a more detailed analysis of cost when compared to the traditional costing system, its implementation must be based on a cost-benefit analysis. 2 Like manufacturing firms, service firms are also important because they provide important services to the society, for example in the Pacific Islands, most of the firms are service oriented. Moreover, we will also be discussing the major differences between service firms and manufacturing firms. In order to create customer and shareholder values appropriate costing systems will be used to cost services appropriately. 3 After studying this unit, you should be able to achieve the following LOs. These LOs are also provided in the study organizer so please take sometime to go over them while studying the unit and when you have completed the unit, revisit these LOs again to see if you can be able to do what is being required by these LOs. 4 In the definition of service firms, it is very clear that the focus is on the intangible rather than the tangible. For example, in any hotel, it’s output is on the experience that they provide to their clients. If clients have very good experience, they will always come back to the same hotel in the future. 5 These are the four major differences between service and manufacturing firms. Service firms’ outputs are intangible, while manufacturing firms’ are tangible. Service firms’ outputs are often not the same, unlike in a manufacturing firm that can produce homogeneous products. For example, a dentist’s output can be more than one; crowing a tooth, installing false teeth, filling a tooth cavity, removing plaque etc. In a service firm as soon as the service is produced, it is also consumed, unlike in a manufacturing firm a product is produced, then it is consumed when the product is sold, so there is a lag between production and consumption. In the case of a dentist, when a tooth cavity is filled, that service is also consumed at the same time because the cavity has disappeared when the dentist keep filling it until its completion. Once the service is complete, there would be no left over services therefore the services are perishable. Unlike in a manufacturing firm, there will always be a work in progress. However, there are some service firms that might have work in progress such as law firms that have cases that take more than a year before it is completed. 6 Now that we have established the differences between the service and manufacturing firms, we will now be be discussing the costing of the services. However, before we do this, we will consider the various ways of classifying service costs to help managers with their analysis. Service costs can be classified in terms of behaviour to analyse cost as variable or fixed. This is important because it will help the managers to see which costs will change and which ones does not change when the activity level changes. Costs can also be classified in terms of their traceability. In this case it is important to identify the cost object. Any costs directly related to the cost object are direct; while those indirectly related to the cost objects are indirect. This is important when it comes to calculating the cost of the object. Direct costs are traced; while indirect costs are allocated using some allocation base. In terms of controllability, costs can either be controllable or uncontrollable. This classification is important for performance measurement of the manager and the department. In a value chain, costs can either classified as upstream or downstream. In addition to these classifications, there is also a production cost. If you consider the value chains of a service firm and a merchandising firm, you will realise that product or delivery and production or sales transaction are in the same chain, which highlights that the production and consumption of the service is done simultaneously. 7 This exhibit shows the differences between the three costing systems of Job costing, Hybrid costing and Process costing in terms of service entity, service features and production environment. 8 When it comes to estimating service costs, different service types will use different costing method. Professional services are not the same; in other words they are customer based. For example when clients apply for a bank loan, each client will have their own specific loan requirements. So when it comes to costing that kind of service, it will cost differently. So to cost these kinds of services, a job costing system will be used. When services are mass produced or homogeneous, there is very little or no difference in that kind of service, so a process costing is a relevant costing system to use. In the case of a bank, the ATM service is an example of a mass service. There are some services that has components of both job costing and process costing. In other words some parts of this kind of service is customised while other part of the service is non-customised or homogenous. Therefore the costing that is appropriate to use is called hybrid costing. 9 Apart from Job, Process, or Hybrid costing, Activity based costing system can also be applied to cost services. ABC system is appropriate to use in service firms because of the presence of OH costs. In service firms the major direct cost is the direct labor cost; all other other costs are regarded as OH costs. So the challenge is to choose the appropriate cost driver to allocate the OH costs. Also there are more OH costs in mass produced services than professional services because mass services do not use labor services as in professional services. So if there is a bigger portion of OH costs in mass services that uses process costing, then there would be greater inaccuracy of estimating service costs because process costing is an average cost. This is where ABC would be helpful as it will analyse the allocation of cost in a detailed manner using the four hierarchies of cost. 10 The service cost calculated using the various costing system previously discussed is used for assessing service profitability by comparing the costs and revenues and considering strategies to increase profitability; deciding on the services to produce, refine or withdraw by analyzing service profitability and identify the appropriate mix of services to maximize profit with the available resources, setting service fees by adding a mark-up to the cost; and planning and controlling costs by comparing costs. 11  No inventory to value, so the influence of external reporting requirements is not relevant Individual service costs are usually not accumulated separately in the general ledger Costs are ‘hidden’ in operating expenses, not in cost of goods sold (COGS) in income statements Service costs not usually integrated into the accounting ledger, so overapplied or underapplied overhead not relevant Some service firms do need to account for work-in-process (AASB 102) – Major engineering projects, consulting projects that extend beyond an accounting period – Consist of accumulated costs of jobs, where fees have not been billed to clients – Only production costs can be included 12 In summary, we establish the point that service firms provide essential services in most economies and the information on service cost is vital to enhance customer and shareholder values. We also discussed that there are differences between service and manufacturing firms. The costing systems that can be used to cost services are process costing if the services are mass produced and are homogeneous; job costing if the services provided are heterogeneous, hybrid costing if the service provided has components of process and job costing systems and ABC for a more detailed analysis of service costs. The usefulness of service cost is to assess profitability, deciding which service to produce, refine, or withdraw, setting fees and planning and control cost. 13