Activity-Based Costing in Service Organizations: A Guide

Introduction to Activity-Based Costing in Service Organizations

Activity-based costing (ABC) operates on a conventional approach that applies a two-stage allocation process and identifies specific cost drivers. In the first stage, the system identifies the key activities and assigns overhead costs to each activity in proportion to the resources used. For each of these cost pools, cost drivers are then identified. In the second stage, the assumed overhead cost driver is assigned proportionally to the final outputs of the cost pool. The most important aspect of a well-designed ABC system is that activities and resources are assigned to cost items based on their actual use.

In service-based organizations, the ABC system must reflect the actual physical structure of resources, activities, and cost items. It is necessary to undertake a precisely executed and correct analysis of operations rather than of the cost figures in the general ledger. Design is therefore critical in an ABC system, because each organization uses different levels of resources when performing different activities with different types of cost items. Service organizations must exercise caution in depicting their operations as an accurate representation of their specific structure. Management must be careful not to adopt examples from other organizations literally, despite the fact that consultants and industry interest groups promote comparative information (Dowless, 1997). It is most important that organizations understand themselves explicitly before comparing their results to those of others.

A good design will also attract the definition of strategic goals and measures within the organization. Most service-based organizations — such as those in banking, telecommunications, insurance, rail, or distribution — have their own unique economic and physical structures that must be accurately depicted in an activity-based costing system.

Implementing an Activity-Based Costing System

It is important to conduct a pilot run prior to implementing activity-based costing across an organization. Without proper piloting, organizations are likely to overshoot their budget and waste time and resources on collecting and analyzing data for the ABC model. This can result in frustration and, ultimately, non-implementation of the system.

It is important for the implementation staff to seek top management's support (Accounting For Management, 2011). They should then identify the key data required. The organization should approve smaller, quick projects first — such as a single process or a pilot unit. If successful, management can undertake broader implementations and eventually make ABC a priority for other sectors of the organization.

The implementation staff should develop a computer-based ABC system that can be used on an infrequent basis for strategic decision-making. This model should be simple and upgradeable, drawing on data that is already available or easily collected. In practice, a simple model tends to be far more accurate than many traditional cost allocation methods. The input fields must be supported by the existing information system.

Smaller service-based firms should creatively seek reasonable activity cost drivers from their data through collaborative efforts. The team's greatest task is to identify which parts of selected activities are most expensive. Close attention to detail is essential at this stage, as many activities may carry hidden costs.

It is recommended that the implementation team comprise the most knowledgeable staff available, who will apply what is required of them and strictly follow established procedures for successful implementation of ABC (Andersen, 1999). A common mistake in the implementation process is placing managers on the team, as they are unlikely to obtain sufficient information from accountants or other analysts.

Cost Measurement Problems for Service Organizations

Implementing an ABC system is a resource-intensive process in a service-based organization, and it is therefore expensive to maintain once it has been put in place. This is largely due to the effort required to collect, check, and enter information on various activities into the system.

Additionally, ABC can produce product margin figures that do not match those produced by manual costing systems. Because managers are accustomed to traditional costing systems in their day-to-day operations, these discrepancies can create confusion.

Data from ABC systems can easily be misinterpreted and must be used carefully when informing decisions. Before making any significant decision based on ABC data, managers need to identify which costs are relevant to the situation at hand.

Reports generated by ABC systems are not consistent with generally accepted accounting principles (GAAP). Consequently, firms may be required to maintain multiple cost systems for both internal and external reporting purposes.

ABC can also present difficulties in the initial data collection stages, often due to a lack of differentiation between relevant and irrelevant information. This may result in the use of obscure data that has not been employed in traditional systems, introducing doubt and uncertainty into the process.