Langfield Smith 8e IRM Ch06 PDF

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CHAPTER 6 SERVICE COSTING ANSWERS TO REVIEW QUESTIONS 6 The distinguishing features of service organisations relate to their outputs. Service organisations deliver help, utility or care, or provide an experience, information or other intellectual content. The majority of the value that they create i...

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CHAPTER 6

SERVICE COSTING ANSWERS TO REVIEW QUESTIONS 6.1

The distinguishing features of service organisations relate to their outputs. Service organisations deliver help, utility or care, or provide an experience, information or other intellectual content. The majority of the value that they create is intangible. According to Australian government industry classifications, the service sector spreads across twelve different industries. Examples of these include the provision of communication services, such as telephone and internet access, accommodation, food and beverages, and transport. In contrast to manufacturing most service outputs exhibit the following features: 

intangible



heterogeneous



cannot be stored



consumed as they are produced.

(a)

Provision of electricity, gas and water are services, even though they may involve the provision of tangible goods that can all be stored and consumed later. However, they are stored by the provider and are typically consumed as they are delivered to the customer.

(b)

The outputs of information media and telecommunication services are intangible, cannot be stored, are consumed as they are produced and, depending on competitive strategy, may be more or less heterogeneous. The product being consumed is knowledge and communication facilities. Information media is most likely to be homogeneous but telecommunication services can be homogeneous or heterogeneous.

(c)

Education and training services more clearly demonstrate all of the common features of service outputs.

6.2

Retail and wholesale businesses are included in the services sector although they do not conform exactly to the definition and distinguishing features of service organisations described in Question 6.1 above. While they do provide tangible goods for resale, many of them also provide services such as finance, delivery and after-sales service.

6.3

In a library, the salary of a tenured or permanent staff member is a fixed cost. The salary of a sessional or part-time staff member is a variable cost. The cost driver for the sessional staff member is the number of hours per week and the number of weeks per year that they work. The library management can use this information to compile a budget for staffing costs that takes into account the changing demand for staff according to time of year, time of day and other circumstances such as school holidays and the annual leave arrangements of permanent staff that need to be covered.

6.4

An accounting firm will have direct costs such as the time an accountant works on a case, the time that support staff work on specific cases and the stationery and mailing costs for each case. Indirect costs include heating, lighting, cleaning, office equipment and office furniture. Advertising and other promotional activities are also indirect costs relating to the accounting firm. Management may use this information to evaluate the financial performance of the firm.

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6.5

The value chain is a set of linked processes or activities that begins with acquiring resources and ends with providing (and supporting) products (i.e. goods and services) that customers value. Another definition provided by Porter (1985, p. 34) suggested that: The value chain disaggregates a firm into its strategically relevant activities in order to understand the behaviour of costs and the existing and potential sources of differentiation. A firm gains competitive advantage by performing these strategically important activities more cheaply or better than its competitors.

The segments in the value chain for a service organisation are shown in the table below. Segment

Description

Research and development

Activities undertaken to identify potential new services or service production processes

Design

Activities to design new services or service production processes

Production and delivery of service

Activities to produce and deliver the service. For many services, these occur simultaneously, since many services are consumed as they are produced.

Marketing

Activities undertaken to ‘position’ the service in the market, as well as selling and promoting the service.

Customer support

Activities that support customers after the production/delivery of the service

Using a major airline such as Qantas or Virgin Blue as an example, the value chain can be illustrated as follows. Segment

6.6

Examples

Research and development

Market research undertaken to identify demand for a special flight and accommodation package to Russia for the 2018 Football World Cup.

Design

Determining and locating various levels of accommodation at different locations; determining departure and re-arrival locations and times within Australia; arranging availability of aircraft and flight crews and confirming landing and handling arrangements in Russia.

Production and delivery of service

Booking and ticketing arrangements; facilitating the check-in procedures prior to departure; providing the flights themselves; transfers from airport and booking into accommodation in Russia; undertaking similar activities for the return journey.

Marketing

Determining appropriate packages and prices, promoting the packages to existing and potential new customers.

Customer support

Since the service is consumed with the trip, there are no obvious examples of ‘after-service’ activities for this example. Surveying customer satisfaction levels is not really supporting the current service, but may be useful in identifying similar opportunities in the future.

In manufacturing, product costs comprise direct materials, direct labour and manufacturing overhead. Direct materials and direct labour, as direct costs, can be traced to the cost object. Manufacturing overhead, as an indirect cost, is allocated. In some service organisations, these cost categories exist in much the same manner. However, many service organisations have little or no direct materials, and their main cost element is direct labour. All other costs are treated as indirect or overhead costs, including minor materials and consumables used in delivering the service. In service organisations, upstream and downstream costs may also be included in overhead costs, as costing of services is not influenced by accounting standards.

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6.7

Retailers can focus on their purchasing activities to create competitive advantage by: 

cutting out ‘middlemen’, i.e. dealing directly with manufacturers. This enables them to reduce their costs and therefore offer their products to customers at a lower price (while maintaining their profit margins)



using their direct relationship with manufacturers to: improve the quality of the goods that they buy



6.8



obtain products that are a little different from those available elsewhere (maybe different features or colours)



negotiate lower prices with the manufacturer. (This may also have been possible through the ‘middlemen’, although the benefits of these quantity discounts would not necessarily have been passed on to retailers).

Key features and examples, together with appropriate costing systems are shown below. Organisation

Key features

Examples

Costing system

Professional service firm

Mostly professional staff (often in large numbers) but relatively few customers.

Accounting and legal practices.

Job costing.

Emphasis is on how service is delivered rather than what is delivered. High degree of customisation and staff discretion in the service production/delivery.

Management and other forms of professional consulting. Medical services and architects.

Direct costs (mainly labour) can be easily traced to job. Indirect costs (overhead including minor raw materials) allocated, usually based on direct labour.

More of a ‘front office’ situation, where staff interact directly with customers. Service shop

Medium contact time between staff and customers, medium customisation of service and medium discretion in what service is offered.

Hotel chains, banks, insurance offices, cafes and restaurants.

Hybrid costing is appropriate.

Major transport facilities such as trains, planes and bus services.

In many mass services, similarities in service means that process costing can be used.

Postal and telecommunication services.

Modifications needed, depending on the degree of discretion.

Move away from ‘front office’ towards ‘back office’ orientation. Mass service entity

Many customers, with each one requiring limited staff time, little customisation and very little opportunity for staff discretion. Mainly non-professional staff. Back office orientation. Equipment often involved.

Job costing where services are different (e.g. car repairs, printing) moving towards process costing (or more likely operation costing) where some parts of service are standardised.

Electricity and gas providers.

Emphasis on what is delivered rather than how.

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6.9

Examples of public services that may be suited to the following costing approaches: (a)

Job costing is most likely to be appropriate for road building, bridge repairs, building an infant welfare centre and the development of plans for a new skate park.

(b)

Process costing would be appropriate for processing library loans, collecting cash from parking machines, monitoring parking meters and issuing fines.

(c)

Hybrid costing methods may be needed for servicing traffic lights, repairing roads and lopping roadside trees. Each job is performed regularly and will be similar but will often differ in terms of time, distance travelled, materials used or equipment required (but not all of these).

6.10 When billing systems are used to measure employee performance there is a temptation for the managers to overstate the time spent working for each client. This helps the manager to meet billing targets and may lead to promotion due to exceeding targets. Unfortunately, this builds on itself as the next target will be set above the false amount stated, placing even more pressure on the manager next year to overcharge clients by overstating time worked for them.

6.11 Process costing is used where products are homogeneous and tracing direct costs to the cost object is not economically feasible. Total costs for each process are divided by total output, so that the unit cost is essentially an average cost. ‘Mass services’ are produced in large quantities, usually using repetitive processes. On the surface, there would be a prima facie case for using process costing for mass services entities, but it is not always straightforward. While each unit of output requires the same production processes and consumes the same types of resources, each of the ‘experiences’ is not necessarily identical. Over-the-counter banking transactions may appear to be the same, but are not. The same applies to claims made at a Medibank health insurance office. Returning from overseas has often highlighted the ‘luck of the draw’ when choosing a queue to be processed by immigration officials. While similar processes are involved in producing these services different customers may make very different use of them. The greater the degree of discretion in the provision of the service, the less accurate process costing will be in these situations, as each service will consume different amounts of resources, for example staff time.

6.12 Usually manufacturing firms include manufacturing overhead but exclude upstream and downstream costs in the product cost, as per the influence of the Australian accounting standard AASB 102 Inventories, which requires that only manufacturing costs may be included in the product cost for the inventory valuation. As many services are consumed immediately they are produced, there are no inventories. As a consequence, individual service costs are not disclosed separately for financial reporting purposes. Instead service costs are estimated for management purposes, such as pricing their services, and the overhead recovery rate used in service firms usually includes all upstream (and downstream) costs. A software developer would incur relatively large upstream costs in research and development and design. The production and delivery segment of software programs would consist largely of direct labour and support costs. It is highly likely that a software developer would include upstream and downstream costs in the overhead rate as it would wish to recover the upstream costs in particular as soon as possible, given the relatively short life cycle of many software products and services. 6.13 Estimates of service costs can help managers to create value. For example, this information can help them to set fees at a level that reflects value for the customer and recover all, or a satisfactory portion of the costs associated with providing the service. Managers may be prepared to forego a profit on some services in order to make higher profits on other services that may be required by the same customer. Managers cannot do this unless they have an estimated cost of the various services. Managers will also be able to allocate resources to those services where the value created for the firm is greatest—provided that they set the fees at a level that will attract customers. By knowing the estimated cost of each service, they may choose to promote some services, refine services or withdraw some of the services that they offer. In Australia, the banks seem to have done this exercise very well in the past few years and have succeeded in changing the way in which Australians conduct their banking.

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6.14 The three factors that influence the costs and benefits associated with service costing are: 1.

the complexity of the costing system

2.

the accuracy of the service cost information

3.

the relevance of service cost information to managing resources and creating value.

The type of service firm (professional services, service shops or mass services) affects these factors variably, from a high to low range, depending on the degree of variability of the production processes, amount of indirect costs and the competitive environment.

6.15 Since service costing is directly concerned with the accumulated costs relating to the services rendered by the provider, and in the case of MyInteriors, where all of the costs incurred are period costs, there is little benefit in having a service costing system. They are all period costs and there are no other specific costs relating to specific services provided by MyInteriors. It would be difficult to develop and implement a service costing system for MyInteriors. However, service costs are useful to plan and control costs—up to a point. Many service activities (especially professional services) utilise job costing, because each service is essentially unique. Estimated service costs can be used to prepare a budgeted cost for the entire project and actual costs can be compared to this to judge whether costs are being controlled. The problem lies in whether the actual service that is delivered is the same as the one that was used to estimate costs. For many services, the way that the service was originally planned to be delivered may change once the job commences. Hence, some latitude should be introduced when comparing costs with a budgeted figure. Nevertheless, the budget based on the original intention is useful as the basis for originally allocating resources to the project: a function of the planning aspect of budgeting.

6.16 Because manufacturing firms apply overhead to units produced using predetermined recovery rates, there will almost certainly be underapplied or overapplied overhead at the end of the accounting period. It is necessary to adjust the cost of goods sold for the difference between actual and applied overhead. Budgeted overhead rates may be used in service industries but since service costing systems usually are not fully integrated into the accounting systems, there is no need to adjust the service costs for underapplied or overapplied overhead. However, managers need to monitor the amount of underapplied or overapplied overhead, to ensure that service costs contain sufficient amounts of allocated overhead.

6.17 Organisations such as law firms, software development companies, accounting practices, architects and consulting engineers often work on ongoing projects, which overlap the closing date for financial reporting. While this work in process is not inventory in a physical sense, Australian accounting standard AASB 102 Inventories requires that their costs be recorded as assets where fees have not been charged. Costs of work in process must only contain production costs, so upstream and downstream costs must be excluded.

6.18 According to AASB 102, for external reporting purposes inventories of goods purchased for resale should include: 

the purchase price of the merchandise



import duties and other taxes related to the purchase price



the cost of transportation into the business and handling costs



other costs directly attributable to acquiring the inventory less



deductions for trade discounts, rebates and other similar items.

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SOLUTIONS TO EXERCISES EXERCISE 6.19 (10 minutes) Classifying costs; controllable costs: hospital (a)

May be controllable by the director to a certain extent, but could also be considered uncontrollable, as it may depend on the medical needs of the patients.

(b)

Controllable cost.

(c)

Uncontrollable cost.

(d)

Controllable cost.

(e)

Controllable cost.

EXERCISE 6.20 (10 minutes) Classifying costs; direct costs: pizza franchisee (a)

Direct cost—directly related to the operations of the pizza franchisee, it is a cost incurred by the franchisee in the provision of its output.

(b)

Direct cost—directly related to the operations of the pizza franchisee, it is a cost incurred by the franchisee in the provision of its output.

(c)

Indirect cost—cost not under the control of the pizza franchisee and not directly related to its operations.

(d)

Indirect cost—cost not under the control of the pizza franchisee and not directly re...