1. Industry Drivers Example

Page/Link: Page URL: HTML link: The Free Library. Retrieved Dec 29 2017 from. The current accounting literature is filled with activity based costing ABC articles about cost drivers in manufacturing settings but very few examples of cost driver applications in service firms or industries exist. A number of the applications of cost drivers in manufacturing plants, however, involve service functions rather than a manufactured product. Since cost driver and ABC concepts improve the cost measurement and allocation information for service departments within manufacturing firms, service firms (such as accounting or law firms) could also use cost driver and ABC concepts. A change to cost driver techniques will provide better cost information for service firms as it has for manufacturing firms.

Activity-Based Costing & Service Industries. And insurance companies are just a few examples of service businesses. A service industry is a business. For example, how much it costs to treat.

Activity based costing will help accounting firms answer questions such as: What does it cost to prepare a tax return? What is the cost of doing an audit?

How should the common costs be allocated to a particular engagement? Can costs be measured better and used for pricing of services? Cost Allocations Cost allocations are arbitrary and cannot be proven correct (or incorrect) because they depend on subjective judgement and not on a verifiable cause/effect relationship.

Even though arbitrary, allocations are done in practice because the advantages outweigh the disadvantages. The methodology for making cost allocations involves two separate issues: 1.

The pools or categories of indirect costs that should be identified, aggregated and allocated together. The basis over which the costs in any given pool should be allocated. It is the second issue that gives rise to the search for cost drivers or allocation bases. A number of criteria are used by companies for evaluating cost allocation methods. Most authorities agree allocations should be made on the basis of the factors that caused the cost to be incurred. This criterion is most useful for variable costs like direct labor in an accounting or a law firm. It is less useful for fixed costs-like office rent or building depreciation-that represent a capacity decision by the firm to provide facilities for a particular level of service.

Cost Drivers The most acceptable method of assigning costs to a product or service is to select drivers that approximate the underlying behavior of the costs to be allocated. This causal relationship is generally regarded as the best method for allocating indirect costs. It is the theory behind 'cost driver' methods. A cost driver is used to allocate costs based on a common measure of the quantity of the resource used by the product (or service, department, contract or unit). The cost driver concept focuses on the activity that drives or causes the consumption of cost. This is in contrast to the concept of allocating costs just because they were incurred and must be assigned to the products or services to satisfy external users.

Industry Drivers Example

Since fixed costs do not vary with changes in activity in the short run, there are no 'cost drivers' that reflect usage, and any allocation is arbitrary. If fixed costs are to be allocated, a firm will need to develop some common capacity measure for all cost centers. Variable costs vary with a change of activity and it is precisely this variation, and the activity that causes the variation, that gives rise to the search for cost drivers. For short-term variable costs, such as supplies or photocopy expenses, cost drivers use a measure of resource consumption directly proportional to the volume of activity, usually in units, products or hours of service.

Long-term variable costs such as professional development or continuing education expenses are often not related to the volume of the units, products or hours of service but are instead related to other causal factors. For long-term variable costs, the types of activities or transactions undertaken are often used as the cost drivers.

It is necessary to: (1) understand the forces that cause the cost to change; and (2)identify and select a cost driver that behaves in the same manner as those variable costs. Cost Drivers in Service Firms Service firms differ significantly from manufacturing firms in that they are labor intensive rather than capital intensive. Most of the labor 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 pool and then allocated to specific engagements, usually as a percentage of direct labor cost. This charge for overhead will distort the total cost of the engagement if different types of jobs cause costs to be incurred that are not in proportion to the number of hours worked or the direct labor cost incurred. If the accounting system arbitrarily allocates costs to a job rather than allocating costs that reflect the true inputs, the firm will not be competitive when bidding jobs and will be measuring performance incorrectly. Service organizations usually do not use cost driver techniques in their cost measurement and allocation procedures.

A service firm, however, can collect costs by various functions (such as professional development, administration or client development) and allocate them based on cost drivers or activities that cause the costs to vary. The firm could then better evaluate the costs of different types of services rendered. If the results are significantly different from the traditional cost allocation approach accounting firms use, it would help in evaluating past performance and make cost predictions of future engagements more meaningful. An Example of Cost Drivers in an Accounting Firm The data in Table 1 show the direct labor costs of the professional staff for a typical accounting firm. This example could easily be extended to a firm of lawyers, engineers, architects or other types of professional service firms. In this example, there are only three levels of professional employees: junior accountants, senior accountants and partners.

The average wage rate for each level reflects the years of experience, the contribution to the firm and the ability to generate additional business for the firm. This firm provides only four types of services: auditing, taxes, management advisory services (MAS) and write-up (WU) work. The total annual direct-labor payroll for the professional staff is $3,000,000 and is by far the largest single cost incurred by the firm. The amount of time spent by each class of employee and the related TABULAR DATA OMITTED direct labor cost for each type of service is also shown in Table 1. In addition, the amount of time and the cost for each class of employee for professional development, for administration and for client development is shown. These categories could be expanded, depending on the type of firm and what cost categories or cost pools are relevant.

The typical firm records the amount of time each employee works on each engagement so the assignment of the direct labor costs to the particular jobs is straightforward. The results for this firm are shown in Table 2. In addition, the other costs incurred by the firm are shown in Table 2.

Beginning with Indirect Labor (the office and personnel managers, the library and computer personnel and the para-professionals) and going down to the Malpractice Insurance, the direct costs are allocated, if possible, to the specific jobs. For example, most of the cost of the para-professionals can be assigned the same way as the professional staff's time. Some costs can be partially assigned to the specific engagements, such as the Supplies & Copying, but the remainder of the cost goes into the Unallocated Costs column. Some costs, such as the Office Costs TABULAR DATA OMITTED or the Malpractice Insurance, cannot be reasonably allocated to any particular jobs.

The total direct costs that can be assigned or allocated to the specific jobs are shown in Table 2. In addition, this firm then allocates the overhead, the Total Unallocated Costs, to the jobs using the cost of the direct labor charged to the job. In this example, the overhead allocation rate is calculated as follows: Overhead Rate = Total Overhead Cost Total Direct Labor Allocated = $1,482,700 $2,220,000 = $.66788 per Direct Labor Dollar The overhead rate is then multiplied by the direct labor cost charged to each job to arrive at the allocated overhead.

The allocated overhead is then added to the direct cost of the jobs to arrive at the total cost of each category of service. Dividing the total cost of each service category by the number of jobs gives an average cost per engagement. Using this approach shows the average cost TABULAR DATA OMITTED of an audit engagement ($37,379), a tax engagement ($2,018), a MAS engagement ($25,976) and a write-up engagement ($8,715). The firm then multiplies the total cost by a profit factor to get the desired return for the partners. For this example, if the firm multiples total cost by 1.25 (a mark-up of 25% above total cost), then the average price of an audit engagement would be $46,724. Using a cost-driver approach, the firm would still allocate all of the direct costs of the engagements as shown in Table 2. The cost driver for the direct costs is the engagement.

Instead of collecting all of the unallocated costs into a large pool and allocating that pool using direct labor costs, the firm would look for causes of the additional costs incurred and use these cost drivers to allocate the costs. In this example, the firm used the seven cost pools shown in Table 3. The firm then searched for cost drivers to allocate the costs in each pool to the engagements or activities that caused them. This firm used the cost pools of Professional Development, Administration, and Client Development and the functions of Audit, Taxes, MAS and Write-up work as separate cost pools. Most of the remaining direct labor costs can be directly assigned to the Professional Development, Administration, or Client Development areas because these are the activities that caused the costs to be incurred. Other costs such as the Library/Tax Service and the Computer can be partially assigned to the Administrative function and some to the Audit, Tax, MAS, or Write-Up areas because these were the activities that 'drives' these costs.

However, there are some costs that cannot be reliably allocated to any of the costs pools and they are included in the Unassigned Balance. The totals of each pool are calculated and then the firm searches for cost drivers that will assign the costs to the jobs in the best manner. Firmsusing the ABC approach will spend a great deal of time determining the cost drivers that best reflect cause and effect of activities and costs incurred for their firm. For this example, the cost drivers chosen are listed at the bottom of Table 3. Substituting the cost allocation using the cost drivers for the Overhead Allocation based on direct labor costs (shown in Table 2), gives significantly different results as shown in Table 4.

Table 4 starts with the Total Direct Cost of each engagement as developed in Table 2. Allocating the Professional Development costs by the number of employees in each area allocates the $130,000 in this pool very differently than the general overhead approach. The number of employees is the cost driver.

The $165,000 aggregated in the Audit function cost pool is charged only to the auditing jobs and is a different approach than using a standard overhead rate applied on the basis of direct labor cost and charging the costs to all jobs. The Unassigned Balance, made up primarily of fixed costs, is allocated on the basis of direct labor costs but can be allocated using any common denominator the firm finds useful. Using cost drivers leads to significantly different total costs for the average engagement in all areas, as shown in Table 5. Correspondingly, the amount charged for each job will be significantly different if the firm continues to use a standard markup of 25%. In this example, the charge for the average audit would be $41,480 using the cost driver approach and $46,724 using the total overhead approach. Conclusions If service firms are operating near TABULAR DATA OMITTED TABULAR DATA OMITTED capacity and if all types of jobs are priced at total cost plus a constant markup on cost, then the cost allocation method will make little difference to the profitability of the firm as a whole.

Total revenues and total costs will remain the same. However, most service firms can easily expand or contract their capacity by increasing or decreasing the number of employees. Since most service firms normally are not limited by a capacity constraint, then the cost allocation method can have a significant effect on the types of engagements the firm seeks, how much to bid based on a better measure of activity driven costs and in performance evaluation. Using cost driver techniques for allocating costs better utilizes the relationship between activity and costs incurred. ABC costing requires firms to focus on and understand the relationships between costs and activity. Cost driver methodology allows firms to satisfy the reasons for performing cost allocations, including performance evaluation and pricing, by using cause/effect relationships.

Pirrong is a CMA and is a licensed CPA in the state of Idaho. He has a doctorate from Arizona State University (1972) and is a Professor of Accounting at Boise State University. He has published several articles and monographs and has contributed to several text and reference books.