Activity based costing in Service Sector – Part I


For service companies, customer profitability is far more important than product profitability because the costs of providing a service product are usually determined by customer behavior. Take the example of a standard product like a Savings/current account. One customer may make very few deposits, withdrawals or balanced and service requests, and use only electronic channels – ATM and internet. Such a customer imposes low demands on the bank’s resources. A second customer, however, may manage her Savings/current account balance very closely, keeping only the minimum amount on hand, and make many in-person branch withdrawals and deposits. This customer’s account may be highly unprofitable under current pricing arrangements.

Service companies need to identify the differential profitability of individual customers, even those using standard products. The customer almost completely determines the quantity of demands for the organization’s operating activities so, unlike manufacturing companies, the variation in demand for organizational resources is much more customer-driven than product-driven. Customer balances or sales volume are poor proxies for profitability. Small-balance customers can be quite profitable and large-balance customers can be highly unprofitable. And to complete the picture, financial service companies need to integrate information about the transfer price of funds and the cost of risk (e.g., loan loss provisions and reserves, and risk-adjusted cost of equity) when calculating individual customer profitability.

Activity based costing (ABC) helps to find out customer profitability as well as product profitability. Before going deep into it, we must know when to go in for ABC as it is slightly costly affair as compared to other traditional costing methods.

The use of volume-based allocations which is traditional one will provide fairly accurate calculated costs when the following conditions exist.

  • Few and very similar products and service lines
  • Low overhead expenses
  • Homogeneous processes, channels, customer demands and customers.
  • Very very high margins.

How many banks posses those characteristics today? Hardly any.

Five people go to a restaurant. One of them does not want to eat, he orders one cool drink. The others order cocktail drinks, a full meal and a desert. The total bill comes to Rs.5000. Whether this amount will be shared by all? If it is to be shared, then this is the surest way of losing friends. In a sense, ABC is like this. You have to put the resources in the right activity, right pocket. Otherwise, you lose customers.

In Traditional accounting, no. of transactions or volume forms the base for apportioning the total expenses among products. Transaction for a particular activity may be sizable and for another, it may not be so, for e.g., for opening a cash credit account process, activities are more but for opening one simple savings account, it is simpler on KYC basis.  One activity takes much more time and effort as compared to another. So there is differential cost impact.

In another example, a machine manufactures two products. Assuming that the production volume of the two products is the same, using traditional costing methods, the cost of using the costly machine will be factored by two and assigned to the two products. However this might not be correct as one product might require more processing time in the machine than the other. Traditional costing methods always assume a relation between overhead and the production volume. It always fails to take into account the size or complexity of the product. In reality, it is not safe to assume that the manufacture volume of the finalized product is directly proportionate to the product cost as not all overheads vary with the number of units produced. With traditional costing methods, there is always a danger of one product subsidizing another.

In one more case, a company was having ten products and the advertisement and selling costs are apportioned based on volume of sales. When concerned Sales Manager was interviewed, he gave the view that he did not labour much for nearly seven products and orders were automatically coming. Out of the advertisement and selling costs budget, hardly 20% is spent on seven fast moving products. Only for three products, he was compelled to do lot of canvassing by way of advertisements, personal persuasions, and visuals etc.by spending 80% of budget for pushing up sales. In fact seven products cross-subsidizes the three products.

Another good example, we all know that most customers have a better payment history than others. Let’s say ABC assessed cost to chase customer payments is Rs.10, 00,000 a year and concerned bank have 10000 customers. On traditional cost basis, the cost per customer will be Rs.100. ABC dictates that only customers who pay late cause the costs of “chasing customers for late payment”. If 90% of bank customers pay on time, then the remaining 10% alone should receive this cost, i.e.  Rs.1000 per customer. Further when we go deep into the details, some customers had to be reminded many times about late payments and hence their share should have been more than Rs.1000 as compared to others. So application of traditional method which is based total number of customers and total cost of chasing the customers for payment affects customer relationship i.e. 9000 customers who do not want to pay for this activity for which they are not responsible. They will be dissatisfied with this levy though they are right in time for payment. This type of  view could not be obtained through traditional costing methods.

Any sensible marketing man will not sell his product unless he recovers men, material and overhead costs along with some profit. Only in exceptional cases and market catching activities, compromise may be made temporarily on pricing. In the same way, each activity enjoyed by the customer of any firm or bank should pay for the services. Otherwise, in the long run, the firm/bank may incur losses. At least a total income from bundle or complex activities should exceed the cost of the activities though some plus and minuses are there among the activities. Hence ABC is the remedy for this complex business where overhead plays major part and customers in service sectors are demanding only complex or bundle of products  nowadays.

ABC stands out from traditional costing methods especially when:

  • Overhead is high,
  • Products are complex
  • Competition is stiff

C.R. Venkata Ramani

(AICWA)

(This article by Mr. C.R. Venkata Ramani is extracted from his article published earlier in “The Chartered Accountant” magazine.)

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2 thoughts on “Activity based costing in Service Sector – Part I

    1. Dear Rajen,

      Basically I am cost accountant who is practising in chennai/coimbatore. My email id is kpmramani@gmail.com. You can correspond in that email id. ABC is one of the area I am concentrating along with Earned value analysis in software firms.

      venkataramani

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