At its core, activity-based costing (ABC) is about cost management. This is reducing and controlling costs while still creating a quality product. ABC allows managers to identify how various cost objects are using resources differently and to highlight areas for continuous improvement. The literature on ABC focuses mainly on its use in manufacturing settings because it has been so successful in that area. This article discusses the use of ABC in service environments.
Cooper (1996) defined cost behavior as falling into four levels:
Different services may consume very different amounts of a resource in a service firm. The
levels of competition and regulation in a service environment influences the
costing system. More competitive markets require more sophisticated systems that
better match costs to different cost objects. ABC is such a sophisticated
Service firms are becoming more interested in costing accurately in order to make long-
term strategic decisions as well as day-to-day operating decisions. Accurate
costs are necessary to make product pricing, staffing, and resource allocation
decisions. Service customers all require different amounts of resources.
Accurate costs, along with the quantity and patterns of resource consumption,
let managers know the proper price to charge for services. But ABC is hard to
implement in service firms since employees often work on many projects in a day
and for different amounts of time. This makes it hard to trace the resources
used by cost objects.
Applying ABC to Service Businesses
Service companies have had problems coming up with decent
cost accounting systems because they have been modeling them after systems found
in manufacturing firms. The problems with this are that manufacturing firms
place emphasis on valuing inventory, which service firms do not have, and use
standard costs calculated for direct materials and labor. Direct materials and
direct labor are not major cost categories in service firms and it is hard to
calculate standard costs in a service setting. Nonetheless, service firms do need to know accurate costs for
product profitability analysis. They need to find out:
This means that costing in the service sector needs to be forward-looking, and ABC is
a tool for such analysis. There are several service industries where ABC has
started to emerge, and will continue to prove useful.
As the regulation ended in the banking industry, costing became more important as
banks competed with one another. Banking costs are not driven by the volume of
customers, but rather the number of transactions processed. Traditional volume
based costing is obviously inappropriate in this case. Banks are moving to the
concept where the user pays for the cost of the services they use, so that all
users do not share the bill evenly. To do so they must have an accurate
reflection of the cost of services.
Sharma (1992) described step-by-step how banks should implement ABC:
Many banks have already had success applying such division principles. Refer to the
article for specific examples.
Healthcare providers used to be able to increase their prices or service to increase
revenues and profitability. Today Medicare or managed care firms essentially set
revenues with their prospective payment system (PPS). All healthcare providers
can do to improve profitability is make good decisions with accurate cost
information. PPS improved the sophistication of cost accounting systems in
In a survey of hospital administrators about what information they needed to manage
effectively, they said:
of this information is available from an ABC system. There are examples of
hospitals successfully implementing ABC systems in the article.
and Pearlman (1993) believed that hospital’s cost accounting systems evolve in
a four-step process:
viewpoint on hospital cost accounting systems is provided by Ramsey (1994). He
believes that it should serve three purposes:
This industry is also making the move toward better management of costs due to
increased competition. Here workers may spend a long time working on one task
and the time on each task varies greatly depending on the case. The discussion
in this section is mainly about ABC concepts and hospital malpractice insurance.
A study found that a variety of factors drove malpractice costs and that the
risk of malpractice was also tied to geographical locations. With these facts a
malpractice insurance cost per medical procedure was calculated and divided by
the number of that type of procedure for accurate costing.
ABC can be applied in service industries other than those described here. It has
become increasingly important for companies whose markets are becoming more
competitive. Since ABC is really about cost management, using it allows service
companies to reduce and control their costs in order to make correct pricing and
other decisions, and to increase their profitability. It is likely to continue
to become more prevalent in the service industry in the future.
Cooper, R. 1996. Activity-based costing: Theory and practice. In Handbook of Cost
Management, edited by B. J. Brinker,
B1-1-B1-33. New York: Warren, Gorham, and Lamont.
B1-1-B1-33. New York: Warren, Gorham, and Lamont.
Ramsey, R. H. 1994. Activity-based costing for hospitals. Hospital & Health
Services Administration 39(3): 385-396.
Sharma, V. 1992. Determining product profitability. The Bankers Magazine.
Young, D. W., and L. K. Pearlman. 1993. Managing the stages of hospital cost accounting.
Financial Management(April): 58-80.