Activity Based Costing in Service Industry

The Toyota example illustrates how ABC can be used to assign indirect costs in a manufacturing
setting. ABC can also be useful in service industries, particularly when different types of customers
require different levels of service. Although service providers do not have manufacturing overhead
they incur many indirect costs, such as rent, supplies, supervision, advertising, and administrative
expenses. How should these indirect costs be assigned to different services and customers? Should
they be spread evenly across the number of customers served or assigned based on some other
volume-based cost drivers or non-volume-based cost drivers? A volume-based cost system is
appropriate as long as every customer or client places a similar demand on the company’s resources.
In many service industries, however, some customers and clients require more attention and a
higher level of service than others.

Consider, for example, two customers who use the same bank. One always uses the ATM for
deposits and withdrawals, pays his bills online, and receives his bank statements by e-mail. The
other customer comes into the bank once per week to make deposits, pays her bills with checks, and
receives her bank statements by regular mail. She also has a safe deposit box at the bank, calls
frequently to check on interest rates, and makes an appointment twice per year to speak with the
bank’s investment advisor. Which customer is more costly to serve? Why?

This example illustrates how different activities can drive cost in a service setting. The goal of an ABC
system is to assign indirect costs to customers or services based on the underlying activities they
require. The main difference between ABC in manufacturing and nonmanufacturing settings is that
volume is generally expressed in terms of units of service, or customers, rather than physical units.
As with our previous ABC analysis, we begin by identifying and classifying activities using the activity
hierarchy. Exhibit 4–7 shows how the activity hierarchy would be applied to several service
industries, such as entertainment venues, restaurants, and airlines.

As a more concrete example, think about all of the activities that a university must perform to
provide a service (education) to students. For this example, we will assume that the student is the
customer. (Just remember that the customer is not always right in this setting!)

Facility- or university-level activities include all activities that are performed at the university level
that benefit all programs and students, such as providing world-class facilities (classrooms, the
library, computer lab, etc.), supporting sports teams, and maintaining campus security. University
administration would also be included in this category.

A product or service-level activity relates to a product or service the university offers, such as a
degree program or a particular course. Developing courses and launching a new degree program are
examples of product or service-level activities.

Batch or group-level activities are performed for a group of customers (students) all at once. A
lecture given to a section of students is an example of a group-level activity, where the batch size is
equal to the number of students in the section.

And finally, a unit- or customer-level activity is one that is performed for each student individually.
These activities will vary in direct proportion to the number of students. Grading exams, advising,
and registering students are examples of customer-level activities that are performed for each
student.

Let’s consider a hypothetical example. Anywhere State University (ASU) serves 20,000 students at a
total cost of $5,000,000 per semester. For simplicity, we assume that each student is enrolled in the
same number of credit hours per semester. Otherwise we would need to measure volume in terms
of student credit hours or full-time equivalent (FTE) students.

In a volume-based cost system, the total indirect cost of $5,000,000 would be spread across the
20,000 students enrolled at the university, resulting in an average cost of $250 per student
($5,000,000 ÷ 20,000 = $250). This average rate implies that that every student places similar
demands on university resources. Do you think this is a reasonable assumption?

Now assume that ASU serves two types of students: graduate students and undergraduate students.
Although undergraduates make up about 90 percent of the student population, the university offers
just as many graduate degree programs as undergraduate degree programs. There are fewer
graduate students in each degree program and graduate classes are taught in much smaller sections
than undergraduate classes. To better understand the cost of serving these two types of students,
accountants at ASU have conducted an ABC analysis and identified the following key activities:

∙ Providing classrooms and other facilities (university-wide)

∙ Developing degree programs (service-level)

∙ Teaching classes (group-level)

∙ Serving students (customer-level)

This example and the Toyota example presented earlier in the chapter illustrate how ABC can be
used to determine the cost of products and services that vary in terms of how they are designed,
manufactured, and delivered to the customer. By assigning indirect costs based on the underlying
activities that go into making a product or providing a service, ABC should provide a more accurate
representation of how much the product or service costs. However, to reap the benefits of ABC,
managers must use the information to fundamentally change the way the company does business.
The next section describes several cost management tools that managers can use to manage or
reduce costs, as opposed to simply measuring costs in a different way.