CHAPTER 9 Cost Accounting
for Service Businesses

Review Summary
  1.   A service is an intangible benefit, such as consulting, designing, grooming, transporting, and entertaining. It does not have physical properties, and it is consumed at the time that it is provided. It cannot be saved or stored and therefore is not inventoried. Service businesses are important because roughly 85% of U.S. non-farm workers are employed by service businesses, and that percentage is expected to grow.  Knowing the cost of providing services is important to managers for such purposes as contract bidding and deciding what services to emphasize or de-emphasize in their line of offerings.
  2.   The amount and complexity of services provided can vary substantially from customer to customer. When this is the case, a service firm should use job order costing, just as the manufacturer of differentiated products uses such a system. The basic document used to accumulate costs for a service business using job order costing is the job order cost sheet, which also is used in our manufacturing examples. Because direct labor cost usually is the single largest cost to a service firm, and the need for these direct laborers results in all the other costs the firm incurs, the amount of direct labor cost incurred on a job determines how much overhead will be charged to it. There are costs other than direct labor, such as travel and meal charges, that can be traced to a job. These expenses, specifically identified with the job, do not have to be allocated to the job using an overhead rate. Once a job is completed and all of the costs have been charged to it, management can use the information in a number of ways. It can compare the costs charged to a job with the bid price accepted by the client to determine the profitability of the job. It can use the information for bidding on the same or similar jobs in the future and for comparing budgeted to actual costs via a cost performance report for the purpose of controlling future costs.
  3.   The revenue budget is the starting point for the annual budget because the amount of client business must be projected before the amount of labor hours needed and overhead incurred can be estimated. The billing rates reflect the firm’s best estimate of what it will charge clients for the various categories of professional labor in the coming year. Once the amount of professional labor hours required to meet client services is budgeted, a professional labor budget may be prepared. The budgeted hours required in each client service area are multiplied by the budgeted rate to obtain the wages expense for each category of professional labor. The firm must next prepare an overhead budget that includes all of the expense items that cannot be traced directly to jobs but must be allocated to them by using an overhead rate. The last of the individual budgets for a firm would be the other direct expenses budget, which consists of the direct expenses other than professional labor, such as meals and travel, that can be traced to specific jobs. Once all of the individual budgets have been prepared, the information they contain can be used to prepare the budgeted income statement.

  4.   Firms that use activity-based costing (ABC) attempt to shift as many costs as possible out of the indirect cost pool, which has to be allocated to jobs, and into direct cost pools, which can be specifically traced to the individual jobs that caused the costs to occur. The remaining costs that cannot be traced to individual jobs are separated into homogeneous cost pools and then allocated to individual jobs by using separate allocation bases for each cost pool. The increased sophistication and affordability of information processing technology enables costs such as telephone, fax, and photocopying, which previously were classified as indirect and included in the overhead rate, to be traced directly to specific jobs at minimal cost. These items, which had previously been “spread like peanut butter” over all the jobs, can now be specifically identified with the jobs that caused these costs to occur. Peanut-butter costing refers to the practice of assigning costs evenly to jobs using a single overhead rate when different jobs consume resources in different proportions. The other main ingredient of activity-based costing is to take overhead costs that were previously in a single indirect cost pool and to separate them into a number of homogeneous cost pools with a separate cost driver, or cost allocation base, for each pool.  Activity-based costing is worthwhile to implement when different jobs use resources in different proportions. It should be a cost/benefit decision in determining whether to implement a more sophisticated costing system. Namely, does the benefit received from the more refined information exceed the cost of implementing and maintaining the more sophisticated system?  If this is not deemed to be the case, a simplified costing system may be used.

5.     The balanced scorecard approach to measuring a business’s success considers both financial and nonfinancial performance measures.  A balanced scorecard translates a company’s strategy into performance measures that are used to implement the strategy and that employees can understand.  These performance measures are typically divided into the following four categories: Financial; Customer; Internal Business Processes; and Learning and Growth.  Examples of a few balanced scorecard performance measures in each category include: return on investment and operating income (Financial); number of new customers and market share (Customer); percentage of on-time deliveries and percentage of defect-free units (Internal Business Processes); employee turnover ratio and number of employee suggestions (Learning and Growth).  To be effective, the performance measures must be consistent with the company strategy and they should not be too numerous.  Also, employees should be able to understand and have control over the measures by which they are evaluated.

        

Part I

Instructions: Indicate your answer in the Answers column by writing a “T” for True or an “F” for False.

Answers

  1.   A main feature of service businesses is that they have large amounts of inventory.               .......................................................................................... _________
  2.   When developing a balanced scorecard, the performance measures must be consistent with the company strategy.................................................................................        _________
  3.   Historically, cost accountants have spent most of their time developing costs for service businesses.  _________
  4.   The basic document used to accumulate costs for a service business is the job order cost sheet.         _________
  5.   Direct labor cost is usually a relatively small cost to a service firm............        _________
  6.   If all categories of direct labor worked on a job consume the same amount of overhead per hour worked, direct labor hours would be a more appropriate basis to use for charging overhead than direct labor dollars.........................................................................................        _________
  7.   A cost performance report compares the actual costs incurred on a job to the budgeted costs and indicates the variance, or difference, for each item...................................        _________
  8.   The revenue budget is the starting point for the annual budget because the amount of client business must be known before any other budget items can be projected.................        _________
  9.   The term “overhead” for a professional services firm is the same concept as “overhead” for a manufacturer........................................................................................        _________
10.   Once all of the individual budgets for a service firm have been prepared, the information they contain can be used to prepare a budgeted income statement............... _________
11.   Firms that use ABC attempt to shift as many costs as possible out of the direct cost pool, which has to be allocated to jobs, and into indirect cost pools, which can be traced to individual jobs.       _________
12.   The increased sophistication and affordability of information processing technology enables more costs to be classified as direct and traced to individual jobs.......................        _________
13.   “Peanut-butter costing” refers to the practice of assigning costs evenly to jobs using a single overhead rate, even when different jobs consume resources in different proportions.                        _________
14.   In evaluating a business’s success, the balanced scorecard approach considers both financial and nonfinancial performance measures........................................................        _________
15.   The internal business processes balanced scorecard category would include “employee turnover ratio” and “number of employee suggestions” as performance measures.............        _________

Part II

Instructions: In the Answers column, place the letter from the list below that identifies the term that best matches the statement. No letter should be used more than once.
a.  Job cost sheet                                   g.  Service
b.  Balanced scorecard                           h.  Performance measures      
c.  Activity-based costing                        i.  Revenue budget
d.  Cost performance report                     j.  Direct costs
e.  Indirect costs                                    k.  Overhead budget
f.  Peanut-butter costing                          l.  Professional labor budget

Answers

_____    1.   It does not have physical properties, and it is consumed at the time that it is provided.
_____    2.   It is the basic document used to accumulate costs for a service business.
_____    3.   These represent costs that can be specifically traced to an individual job.
_____    4.   It compares the budgeted costs for a job to the actual costs and indicates a variance for each line item.
_____    5.   It is the starting point for the annual budget.
_____    6.   It translates a company’s strategy into performance measures that are used to implement the strategy.
_____    7.   To be effective, these must be consistent with the company’s strategy and there should not be too many of them.
_____    8.   It attempts to shift as many costs as possible out of indirect cost pools, which have to be allocated to jobs, and into direct costs pools, which can be specifically traced to individual jobs.
_____    9.   It refers to the practice of assigning costs to jobs evenly using an overhead rate, even though different jobs consume resources in different proportions.
_____  10.   These represent costs that must be allocated to individual jobs via an overhead rate.
_____  11.   This includes the budgeted hours required in each client service area multiplied by the budgeted rate in each wage category.
_____  12.   This includes all of the expense items that can not be traced directly to jobs.

Part III

Instructions: In the Answers column, place the letter of the choice that most correctly completes each item.

Answers

_______1.  Of the following performance measures, which one would most appropriately fit in                                                                                                                                                                the  Learning and Growth balanced scorecard category:

1. Time taken to replace defective products
2. Customer satisfaction surveys
3. Employee turnover
4. Revenue from new products

_____    2.   All of the following are examples of service businesses except:
a.  Bottlers
b.  Plumbers
c.  Consultants
d.  Professional sports franchises

_____    3.   Which of the following is not a characteristic of a good balanced scorecard?

1. Measures should be consistent with the company strategy.
2. Employees should be able to understand the measures.
3. There should not be too many performance measures.
4. Employee compensation should never be linked to the balanced scorecard.

_____    4.   The basic document used to accumulate costs for a service business using job order costing is the:
a.  Cost performance report
b.  Activity-based costing sheet
c.  Job order cost sheet
d.  Cost/benefit report sheet
_____    5.   In a professional services firm where partners have preferential access to the secretarial support staff, the costs in the secretarial support pool would best be allocated to jobs using:
a.  Professional labor dollars
b.  Professional labor hours
c.  Copy machine hours
d.  Professional and nonprofessional labor hours
_____    6.   The individual budget in a professional services firm that is the ending point in the preparation of the annual budget is the:
a.  Budgeted income statement
b.  Revenue budget
c.  Professional labor budget
d.  Overhead budget

_____    7.   Examples of expenses in a professional services firm that could readily be traced to individual jobs instead of needing to be allocated to those jobs include:
a.  Secretarial support
b.  Lease expense
c.  Utilities
d.  Meals and travel
_____    8.   Of the following balanced scorecard categories, which one would have “Employee Turnover Ratio” as a performance measure?
a.  Financial
b.  Customer
c.  Internal business processes
d.  Learning and growth
_____    9.   Firms that use activity-based costing attempt to:
a.  Shift as many costs as possible out of indirect cost pools and treat them as direct costs
b.  Practice a peanut-butter costing approach to jobs
c.  Use a single overhead cost pool whenever possible
d.  Create as many cost pools as possible
_____  10.   Peanut-butter costing refers to the practice of:
a.  Applying activity-based costing principles to job cost allocations
b.  Assigning indirect costs evenly to jobs even when different jobs consume resources in different proportions
c.  Having numerous indirect cost pools rather than a single pool
d.  Adhering to a cost/benefit approach in determining the number of indirect cost pools

Part IV

Preparing the revenue budget, professional labor budget, overhead budget, other expenses budget, and budgeted income statement.

Henry and Jones, partners in a sports management consulting firm, budgeted the following professional labor hours for the year ended December 31, 20--:
Partners...................................................            4,000
Associates................................................            7,000
Staff........................................................           11,000

Partners have a billing rate of $200 per hour and actually earn $100 per hour. Associates bill out at $120 per hour and earn $60 per hour. Staff have a billing rate of $80 an hour and earn $40 per hour.
Budgeted overhead and other expenses are as follows:
Overhead:
Depreciation—Equipment...................       $ 40,000
Depreciation—Building......................          90,000
Fringe Benefits...................................         190,000
Photocopying.....................................          22,000
Secretarial Support..............................         230,000
Telephone/Fax....................................          31,000
Utilities..............................................          43,000
Other Direct Expenses:
Travel................................................       $ 54,000
Meals................................................          18,000

Instructions:
  1.   Using the schedule below, prepare a revenue budget for the year ended December 31, 20--.
Henry and Jones
Revenue Budget
For the Year Ended December 31, 20--

Item	Professional Hours	Billing Rate	Total Revenues
Partners.......................		$	$
Associates....................
Staff............................
Total........................			$

    

2. Using the schedule below, prepare a professional labor budget for the year ended December 31, 20--.
Henry and Jones
Professional Labor Budget
For the Year Ended December 31, 20--

Item	Professional Hours	Wage Rate	Total Labor Dollars
Partners.......................		$	$
Associates....................
Staff............................
Total........................			$

  3.   Using the schedule below, prepare an overhead budget for the year ended December 31, 20--.
Henry and Jones
Overhead Budget
For the Year Ended December 31, 20--

Item	Amount
Secretarial Support..........................................................	$
Fringe Benefits...............................................................
Depreciation—Building..................................................
Utilities..........................................................................
Depreciation—Equipment...............................................
Telephone/Fax................................................................
Photocopying.................................................................
Total..........................................................................	$

  4.   Using the schedule below, prepare an other direct expenses budget for the year ended December 31, 20--.
Henry and Jones
Other Direct Expenses Budget
For the Year Ended December 31, 20--

Item	Amount
Travel............................................................................	$
Meals............................................................................
Total..........................................................................	$

  5.   Using the schedule below, prepare a budgeted income statement for the year ended December 31, 20--.
Henry and Jones
Budgeted Income Statement
For the Year Ended December 31, 20--

Revenues.......................................................................	$
Operating Costs:
Professional Labor........................       $
Overhead Support.........................
Other Direct Expenses...................
Operating Income...........................................................	$

 

Part V

Comparing the results of cost allocations, using simplified costing versus activity-based costing.

Tracey and Reese, attorneys, have been using a simplified costing system in which all professional labor costs are included in a single direct cost category—professional labor. All overhead costs are included in a single indirect cost pool—professional support—and are allocated to jobs using professional labor hours as the allocation base. Consider two clients: Hartwell Industries, which required 50 hours of tax work; and James Kimmel, who required 45 hours of litigation work. The firm has two partners who each earn a salary of $125,000 per year and five associates who each earn $70,000 per year. Each professional has 1,500 billable hours per year. The professional support costs of $410,000 consist of $280,000 of litigation support and $130,000 of secretarial support. Hartwell’s job required 10 hours of partner time and 40 hours of associate time. Kimmel’s job required 30 hours of partner time and 15 hours of associate time.

Instructions:
  1.   Complete the cost of the Hartwell and Kimmel jobs using a simplified costing system with one direct and one indirect cost pool. (Round wage rates and overhead rates to the nearest whole cent and labor and support costs to the nearest whole dollar.)

	Hartwell Industries	James Kimmel
Professional Labor Cost:
.........................	$
.........................		$
Professional Support:
.........................
.........................
Total....................................................	$	$
Computations:

  2.   Compute the cost of the Hartwell and Kimmel jobs using an activity-based costing system with two direct cost categories—partner labor and associate labor—and two indirect cost categories—litigation support and secretarial support. Use partner labor dollars as the cost allocation base for litigation support and professional labor hours as the base for secretarial support. (Round wage rates and overhead rates to the nearest whole cent and labor and support costs to the nearest whole dollar.)

	Hartwell Industries	James Kimmel
Partner Labor Cost:
.........................	$
.........................		$
Associate Labor Cost:
.........................
.........................
Litigation Support:
.........................
.........................
Secretarial Support:
.........................
.........................
Total....................................................	$	$
Computations:

                                               Part VI
Categorizing balanced scorecard performance measures.

Instructions: Identify each of the following performance measures with the appropriate balanced scorecard category.