On the other hand, service companies do not have any stock of tangible products at the end of an accounting period. P. Kotler defines a service as: “any activity or benefit that one party can offer to another that is essentially intangible and does not result in the ownership of anything. Its production may or may not be tied to a physical product” (Marketing Management, p.681. Prentice Hall, 1986). Examples of service companies include; accounting firms, architecture firms, law firms and advertising agencies. On average, within service companies labour costs are the most significant cost category, often reaching as high as 70% of the company’s total costs.
In the case of a service organisation providing telecommunications, the identification of direct costs in a similar vein to manufacturing is extremely difficult. There are no material costs, there is some labour and, in fact, most significant costs relate to capital equipment.
Although a manufacturing company can earn revenue in the future from products that are on hand today, a service company cannot do so. It must try to minimise its unused capacity. For instance, a hotel with rooms unoccupied or an airline with seats unsold cannot recoup the costs after the event.
Furthermore, the costs of many service organisations are essentially fixed in the short run. In the short run, a hotel cannot reduce its costs substantially by closing off some of its rooms. Accounting firms, law firms, and other professional organisations are reluctant to lay off professional personnel in times of low sales volume because of the effect on morale and the costs of rehiring and training new employees.
An important factor in many service organisations, therefore, is the extent to which current capacity is matched with demand. Service organisations attempt this matching in two ways: First, they try to stimulate demand in off-peak periods by marketing efforts and price concessions and secondly, if feasible, service organisations adjust the size of the workforce to the anticipated demand by such measures as scheduling training activities in slack periods and compensating for long hours in busy periods with time off later.
Another characteristic which distinguishes manufacturing organisations from service organisations is difficulty in controlling quality. A manufacturing company can inspect its products before they are shipped to the consumer, whereas a service company cannot judge product quality until the service is rendered, and then the judgements are often subjective.
Most service companies are a lot more labour intensive than many manufacturing companies. They cannot add equipment or machinery and automate production lines, thereby replacing labour and reducing costs. For instance, a law firm expands by adding partners and new support personnel.
Managers or directors of management companies etc will very rarely be seen directly contributing to the products been produced, for example, assembling a T.V or table etc. hence the charging of a managers salaries via overheads.
On the other hand, within service companies, managers are usually ‘professionals’ and are well trained and skilled at providing the service the company offers. For instance, a manager in an accounting firm will still have clients and do accounts and so therefore are directly and indirectly involved in the day to day business of providing the service.
Due to the fact that a service industry’s main asset is knowledge it is very difficult to identify exactly what or how much of an asset is used, how you quantify knowledge, what one unit is and does one hour of one person’s time or knowledge equal another’s?
An unfortunate feature of service organisations in relation to cost analysis and cost allocation is the fact that they are not at all easy to define and they include such a wide range of activities from hairdresser to doctor to tax collector. Although services cannot be stored, it is possible for firms engaged in service production to have work in progress inventories. However as we already mentioned many services are provided in such a way that there are no work in progress inventories. Teeth cleaning, hair dressing and carpet cleaning are just a few examples where work in progress inventories would be virtually non- existent. Consider the hairdressing service. This is a single process usually carried out in a room dedicated to the purpose, with a hairdresser (direct labour), materials, and equipment. In this case, the service is labour and overhead intensive. The direct materials used to provide this service are a small percentage of the total service cost. Unit costs can be calculated by dividing the costs of the period by the output of the period.
One approach which is often used by service companies to improve the costing system is activity-based-costing. Activity Based Costing (ABC) is an “approach to costing that focuses on activities as the fundamental cost objects. It uses the cost of these activities as the basis for assigning costs to other costs objects such as products, services or customers” (Management and Cost Accounting p. 934). In essence, this approach focuses on cost drivers, looking at complexity-related costs, rather than the traditional distinction between fixed and variable cost, transaction-based cost drivers can be identified and use as a more appropriate means of overhead cost allocation.
Looking at the structure of a company provides us with a second dimension based on where the company’s costs are focused. Does the company have significant costs in production or is the focus of the company in other areas such as research and development or marketing and service provision? Putting these two dimensions together we can group companies according to the percentage of their cost base that is outside of production and the percentage of revenues for the company that is derived from products or services. Four types of company emerge for what has, to this point, been referred to as ‘manufacturing’ reflecting the complexity of modern manufacturing. The first are product manufacturers who have the majority of their costs in production and generate the majority of their revenues from selling products direct to customers. These companies are what most commentators have in mind when they refer to manufacturing and a good example of a leading UK company in this category is Cadbury Schweppes. Moving upwards we have companies that are still strongly based around production, but now have begun to derive their revenues from services. Rolls-Royce is a clear example of such a service led producer.
Tom Sheridan once acclaimed “costing in the service industry is no different from costing in any other industry” (Management Accounting, 1996). He pointed out that information on costing relies on strong basic input systems. The database must be properly set up, the information has to be collected in the right way, management must have agreed on why it wants the information and what it will do with the results.
Bibliography
Don R. Hansen, Maryanne M. Mowen, Cost Management: Accounting and Control, 2005. (Thomas South-Western).
Horngren, C.T., Bhimani, A., Datar, S.M. and Foster G. (2008). Management and Cost Accounting, 4th Edition, (Financial Times – Prentice Hall, London).
http://www.investopedia.com.
The cost incurred by a company to produce, store and sell one unit of a particular product. Unit costs include all fixed costs (i.e. plant and equipment) and all variable costs (labor, materials, etc.) involved in production.
Investopedia Says:
Unit cost is an important metric to look at when evaluating a "unit grower" stock, or a stock that chiefly produces items that have a low fixed cost. Generally, the larger a company grows, the lower the unit cost it can achieve through economies of scale.
