PRODUCT/SERVICE COSTING

Prof. Shailesh Gandhi

IIM, Ahmedabad
Introduction

 What is cost?
 COST IS MONETARY MEASUREMENT OF
RESOURCE USED FOR SOME PURPOSE
CALLED COST OBJECT.
 Cost objects – product, service, activity,
department, project, etc.
 Why do we need to know the cost of a
product/service?
Introduction (Contd.)

 1) To provide information for economic

decisions
 2) To motivate managers/individuals
 3) To justify costs and /or compute
reimbursements
 4) To measure income & assets for external
reporting
Cost Classification

 There are about 32 types/categories of cost.

 Criteria - traceability
Costs that can be traced to the cost object
in a cost-effective way are direct costs. Few
examples can be discussed.
 In case of a single product or a single
service, all costs are DIRECT.
 Indirect costs/overheads need to be
ALLOCATED to different products/services.
Cost Classification (Contd.)
 Criteria - Variability
Variable costs – changes in TOTAL in
proportion to related level of total activity or
volume
Fixed Costs – remains unchanged in total
for a given time period despite wide changes
in the related level of total activity or volume
e.g. staff salaries, depreciation, etc.
Semi-Variable costs – different types like
step function, fixed up to certain point and
then increasing, fixed up to certain point and
then decreasing.
Cost Classification (Contd.)

 Full cost of a product/service can be

expressed as:
Variable Costs + Fixed Costs, or
Direct Costs + fair share of Indirect
Costs/overheads
 Costing systems help managers to
determine the cost of a cost object.
• Cost hierarchy/Levels

Level Effect on Example

At Unit level Every unit of Raw material cost
production/service
At Batch Every batch In-process QC
level /setup (cleaning)
At Product/ Every product/service Development
service level line costs/free
samples/specific
advt.
At Customer Specific customer(s) Special packing
level
At Facility or All products using the Insurance, factory
operations common facility administration
level
Step-by-step process of cost
determination

 In order to know the full cost of a cost object,

we assign direct costs and allocate indirect
costs to the quantity of various cost objects.
A conventional system follows the following
steps.
 Step 1: Create a set of production/service
and support function cost centers based on
the processes and facilities.
 Step 2: Assign costs directly to various cost
centers to the extent possible.
Step-by-step process (Contd.)
Step 3: When such direct assignment is not
possible, allocate the overhead costs on
some “fair” or “equitable” bases to various
cost centers benefiting from such costs. This
is called “Primary Allocation”.
Commonly used allocation bases:
1. Space related – rent
2. Activity related – electricity for equipment
operation
3. Labour related – employee welfare expenses
Activity-Based Costing System
 Conventional system uses a single cost pool
and a single indirect-cost rate to allocate
indirect costs to products/services. It assumes
various products or services are relatively
alike thereby demanding about the same
amount of resources.
 In a multi product-service set up, different
products/services would place varying
demand on organisational resources. A
conventional system, in such cases, would
lead to under-estimation or over-estimation of
product/service costs.
ABC System (Contd.)

 High volume and low complexity: over-estimation

 Low volume and high complexity: under-
estimation
 Product/service complexity- small batch sizes,
long set-up times, special inspections and
test, special vendors
 Customer complexity – customised products,
short lead times, unpredictable orders,
extensive tech support, extensive post-sales
support.
ABC System (Contd.)

• ACTIVITY-BASED COSTING SYSTEM links

resource costs/expenses to the variety and
complexity of products produced, not just the
physical volumes produced.
 ABC Modelling addresses four issues:

(1) Why is the orgn performing various

activities ?
(2) Why is the orgn spending money on
indirect and support resources ?
ABC System (Contd.)

(3) How much is the orgn spending on each of

its activities ?

Allocation of expense of resources to the

activities is done using “Resource Cost
Drivers” which drive resource costs.
Through this step, the orgn learns how
much they are spending on various
activities.
Activity Salaries & Indirect Stores &
wages Labour Supplies
Process customer
orders
Purchase materials
Schedule production
Set up machines
Inspect items
Design new products

Total 4,250,000
ABC System (Contd.)

(4) How much of each activity is required for

the organ’s products or services ?

The linkage between activities and

products/services is accomplished using
“ Activity Cost Drivers”. It is the quantitative
measure of the output of an activity. Using
ACD activity costs are allocated to a product
or service.
Activity Activity cost Allocation
driver rate for
resource
“Indirect
Labour”
Process customer No. of Rs/ order
orders customer
orders
Purchase Materials No. of Rs/order
purchase
orders
Setup machines Setup hours Rs/Set-up
Hour
Maintain Machines Maint. Hours Rs./Maint Hr
ABC in Service Industries

 ABC is the most appropriate system for a

variety of service providers – healthcare,
banking, telecom, airlines, etc.
 In fact, ABC was developed in manufacturing
companies to allocate costs of “service”
activities that enable products to be produced
but that are not directly involved in actual
production, for example, design, set up,
inspection, training, ordering, scheduling, etc.
ABC in Service Industries (Contd.)

 Service companies must supply virtually

all their resources in advance. The
resources provide the capacity to perform
work for customers/clients during each
period.
 Fluctuations in the demand by individual
services for the activities performed using
these resources do not influence short-term
spending to supply the resources.
ABC in Service Industries (Contd.)
 In a service company, the marginal cost
(the increase in spending resulting from an
incremental transaction or customer) is
negligible. Consider a transaction at ATM
machine, extra passenger on no-frill airline,
one extra call handling by telecom company,
etc.
 For service companies, there is almost a
complete separation between decisions to
incur costs and the decisions by customers
that generate revenues.
ABC in Service Industries (Contd.)

 Decision to incur, or subtract, costs

involve adding or reducing the supply of
resources to provide service; for
example:
 Adding a new city to an airline’s route,
hiring additional physician or adding an
operation theatre, expand network for a
telecom company, adding retail
outlet/additional branch for a retailer or a
bank, etc.
ABC in Service Industries (Contd.)

 Consumer decision that generate

revenues include:
 The size of monthly account balances,
duration of long distance phone calls,
number of passenger miles flown, number
and type of health care procedures
requested, etc.
ABC in Service Industries (Contd.)
 In a manufacturing set up, the costs
associated with meeting customer demands
and the revenues associated with selling
products to customers are linked by the direct
costs of a product (material, labour, utilities,
etc.).
 Service companies have no such direct
connection. A revenue-generating event
makes demands on and requires the service
output from many different organisational
units of such a company.
ABC in Service Industries (Contd.)

 ABC helps service companies in the

following classes of managerial
decisions:
 Managing products and customers
 Configuring the customer service delivery
chain
 Budgeting the supply of resources
ABC in Service Industries (Contd.)
Managing Products & Customers
 Basic operating costs of a standard product/service
are determined by customer behavior. In turn, each
product/service (with its unique characteristics)
makes different demands on the company’s
resources.
 Consider a standard product like a checking account. One
customer may maintain a high cash balance in her checking
account and make very few deposits/withdrawals. This
customer generates high revenues and imposes few
demands on the bank’s resources. Another customer may
behave in an opposite manner.
ABC in Service Industries (Contd.)
 Service companies must continually assess
the economics of their product/service line
variety, making decisions on pricing, quality,
responsiveness, and introduction and
discontinuance of individual
products/services.
 Service companies need to distinguish the
economics of newly acquired customers from
long-time customers.
 Focus on targeted segments of
product/services and customers.
ABC in Service Industries (Contd.)
Configuring the Customer Service Delivery Chain
 It is possible to tailor product/service offerings and
the method of delivery to satisfy customer
preferences.
 In a health care company, ABC study can compare cost of
performing kidney dialysis at home versus at the hospital.
Such a study can identify the extent to which capacities of
various resources are utilized. There can be surprises about
costs of treating patients in existing facilities (could be much
lower) once the cost of unused capacity is separated from
the cost of the used capacity. This can be explained through
the concept of “Relevant Costs”.
ABC in Service Industries (Contd.)

Budgeting the Supply of Resources

 Service companies need to budget and
manage their costs by responsibility centers.
This helps in linking budgeting decisions that
help in the supply of resources for individual
responsibility centers to the demands of
products/services and customers, for the
activities and services provided by these
centers.
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