Chapter 6 Service costing Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-Smith Prepared by Kim Langfield-Smith

Outline What are service organisations? Differences between service and manufacturing businesses Value chains in service firms, retailers and wholesalers Service production environments Activity-based costing for services Case study: Service costing at Adelaide Bank When should firms estimate their service costs? Flow of costs in service firms Costing in retail and wholesale businesses Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-Smith Prepared by Kim Langfield-Smith

What are service organisations? Organisations that deliver help, utility or care, providing an experience, information or other intellectual content where the majority of the value is intangible rather than residing in any physical products Service organisations dominate many economies private sector, public sector, not-for profit sector Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-Smith Prepared by Kim Langfield-Smith

Differences between service and manufacturing businesses Most services are intangible Service outputs are often heterogeneous Services are often consumed as they are produced Services are perishable and cannot be stored Some services entail some minor physical or tangible aspects Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-Smith Prepared by Kim Langfield-Smith

Other aspects of services Retailers and wholesalers are part of the service sector They have different characteristics to most service firms Provide tangible goods as well as services Services are produced outside the service sector Most manufacturing firms provide a service component to their product Upstream and downstream segments of the value chain may produce services Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-Smith Prepared by Kim Langfield-Smith

Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-Smith Prepared by Kim Langfield-Smith

The value chain in service firms Upstream activities and costs Only large service firms may have research and development (R&D) and design activities Downstream activities and costs Marketing and customer support Production and delivery activities and costs Production and delivery may occur simultaneously Direct labour may dominate and materials may not be significant Upstream and downstream costs may be regarded as overhead costs for service costing purposes Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-Smith Prepared by Kim Langfield-Smith

Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-Smith Prepared by Kim Langfield-Smith

The value chain for retailers and wholesalers Upstream activities and costs R&D and design unlikely to be relevant Purchasing activities important Production activities and cost The sales transaction and (sometimes) distribution are included Sales and distribution may occur at the same time Downstream activities and cost Marketing activities, delivery and customer support are important Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-Smith Prepared by Kim Langfield-Smith

Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-Smith Prepared by Kim Langfield-Smith

Service production environments Professional service firms Staffed by professional staff who provide individual services to customers There are relatively few customers, despite having large numbers of staff The front office is more important than the back office Service delivery involves people, more than equipment, and the emphasis may be more on the how the service is delivered rather than what is delivered Examples: medical, legal, accounting, management consulting and architectural businesses (cont.) Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-Smith Prepared by Kim Langfield-Smith

Service production environments (cont.) Mass service entities Involve many customers, each one requiring limited staff time and limited customisation Staff are mainly non-professional Most of the value is in the back office not the front office The service may involve equipment, and focus more on what is delivered rather than how Examples: bus and train companies, airline companies, post offices, electricity suppliers, telecommunications companies and public service organisations (cont.) Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-Smith Prepared by Kim Langfield-Smith

Service production environments (cont.) Service shops Fit between professional and mass service businesses in terms of the number of customers, staff time and degree of customisation Examples: hotel chains, banks, cafés and restaurants, print shops and car repair workshops Some service entities have aspects of mass service and professional service types Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-Smith Prepared by Kim Langfield-Smith

Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-Smith Prepared by Kim Langfield-Smith

Job costing systems for professional service firms Professional service firms have limited material or equipment and produce no inventories Professional firms suit a job costing environment Few clients and jobs The production process for each client is unique Labour cost can be traced directly to individual services in an economic manner Job billing rather than job costing may be used Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-Smith Prepared by Kim Langfield-Smith

Process costing systems for (some) mass services Services are produced in large quantities, so individual tracking of costs is not feasible Production processes are repetitive; there is limited room for customisation Various services consume similar resources Substantial indirect labour Costs tracked directly to production processes Process costing will not provide accurate tracking of costs to services, where the scope for discretion in service delivery is high Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-Smith Prepared by Kim Langfield-Smith

Hybrid costing systems for service shops and (other) mass services Suitable for some service shops and some mass service entities Varying degrees of customisation, standardisation of processes and traceability of costs Costing systems will vary on a continuum from job costing to process costing Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-Smith Prepared by Kim Langfield-Smith

Activity-based costing for services Service entities often have high direct labour costs that can be traced directly to services Overhead costs can be allocated to services using cost drivers The greater the proportion of overhead costs the greater the potential for inaccurate service costs more benefits may be gained from accurate activity-based costing, versus conventional costing systems Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-Smith Prepared by Kim Langfield-Smith

Case study: Costing services at Adelaide Bank Job costing—investment advisory services Professional labour costs Traced to jobs using an hourly rate Hourly rate based on annual salary plus on-costs, divided by billable hours Overhead costs Includes upstream and downstream costs Identify the overhead cost driver, often professional labour Predetermined overhead rate per dollar of professional labour (cont.) Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-Smith Prepared by Kim Langfield-Smith

Case study: Costing services at Adelaide Bank (cont.) Why estimate the cost of investment advisory services? A basis for setting fees To assess the profitability of each service To determine which service to promote, refine or withdraw To control costs Job billing may be used rather than costing to determine fees Charge out rates per billable hour; includes an allowance for overheads and required profit margin (cont.) Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-Smith Prepared by Kim Langfield-Smith

Case study: Costing services at Adelaide Bank (cont.) Process costing—ATM services Three processes The provision of ATM service facilities Initial transaction processing by front-end processor Back-end processing Few direct costs for the ATM transaction Substantial indirect labour costs in front-end and back-end processing Substantial equipment-related costs Degree of completion and transferred-in costs not relevant (cont.) Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-Smith Prepared by Kim Langfield-Smith

Case study: Costing services at Adelaide Bank (cont.) Why estimate ATM services? To set fees Assess the profit or loss associated with each transaction Information for control The cost per transaction should be used with caution in decision making Includes a high proportion of indirect costs which do not behave on a per-unit basis (cont.) Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-Smith Prepared by Kim Langfield-Smith

Case study: Costing services at Adelaide Bank (cont.) Hybrid costing Some services are a mix of standardised processes and customised features Which costs should be included in service costs? Upstream and downstream costs to suit managers’ decision-making needs Costing systems may cost only some services, based on decision-making needs Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-Smith Prepared by Kim Langfield-Smith

When should firms estimate their service costs? No external reporting requirements to estimate individual service costs Service costing systems will be implemented where benefits exceed costs Cost and benefits are influenced by Complexity of the costing system Accuracy of the service cost information Relevance of service cost information to managing resources and creating value (cont.) Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-Smith Prepared by Kim Langfield-Smith

When should firms estimate their service costs? (cont.) Relevance to creating value and managing resources Managers can use service costs to assess service profitability, decide what service to produce/offer, set prices/fees, and to plan and control costs Complexity, accuracy and relevance of service costing will vary across different types of service environments Service costing may be undertaken infrequently and selectively to meet managers’ needs Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-Smith Prepared by Kim Langfield-Smith

Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-Smith Prepared by Kim Langfield-Smith

Service costing in practice Job costing is common in professional service firms and some service shops Costing systems in service firms tend to focus on the costs of responsibility centres Firms may choose to cost only some services to support management decisions The benefits of a costing system (or an individual costing exercise) should be compared to the costs of setting up the system Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-Smith Prepared by Kim Langfield-Smith

Flow of costs in service firms No inventory to value, so external reporting requirements not relevant Individual service costs are usually not accumulated in the general ledger Costs are shown as line item operating expenses, not cost of goods sold (COGS) in income statements (cont.) Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-Smith Prepared by Kim Langfield-Smith

Flow of costs in service firms (cont.) 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) Consist of accumulated costs of jobs, where fees are not realised Only production costs can be included Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-Smith Prepared by Kim Langfield-Smith

Costing in retail and wholesale businesses Two distinct aspects Tangible goods are sold There is a wide range of goods Inventories and COGS are recorded in the accounting ledger Inventories must be valued at the end of an accounting period at the lower of cost or net realisable value (cont.) Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-Smith Prepared by Kim Langfield-Smith

Costing in retail and wholesale businesses (cont.) Cost of goods sold Cost of beginning inventory + purchases – cost of ending inventory How may managers use COGS? Assess the profitability of various product lines and responsibility centres Guide product pricing Upstream and downstream costs may be included to provide a more comprehensive estimate of COGS for decision making (cont.) Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-Smith Prepared by Kim Langfield-Smith

Costing in retail and wholesale businesses (cont.) A range of services may also be provided to customers as part of the sales transaction and at other points on the value chain For accounting purposes, these costs are expensed in the current accounting period For management decisions, these service costs may need to be identified to help manage resources Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-Smith Prepared by Kim Langfield-Smith

Summary Most service outputs are intangible, heterogeneous, consumed as produced, perishable and cannot be stored The type of service costing system may depend on the service environment Job costing may suit professional services Process costing may suit mass services Overhead costs may include upstream and downstream costs Unlike in manufacturing, service costs are solely to support managers’ decision making Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-Smith Prepared by Kim Langfield-Smith