As easy as ABC: using activity based costing in service industries

National Public Accountant, The, Feb, 1993 by Gordon D. Pirrong

The firm then multiplies the total cost by a profit factor to get the desired return for the partners. For this example, if the firm multiples total cost by 1.25 (a mark-up of 25% above total cost), then the average price of an audit engagement would be $46,724.

Using a cost-driver approach, the firm would still allocate all of the direct costs of the engagements as shown in Table 2. The cost driver for the direct costs is the engagement. Instead of collecting all of the unallocated costs into a large pool and allocating that pool using direct labor costs, the firm would look for causes of the additional costs incurred and use these cost drivers to allocate the costs. In this example, the firm used the seven cost pools shown in Table 3. The firm then searched for cost drivers to allocate the costs in each pool to the engagements or activities that caused them.

This firm used the cost pools of Professional Development, Administration, and Client Development and the functions of Audit, Taxes, MAS and Write-up work as separate cost pools. Most of the remaining direct labor costs can be directly assigned to the Professional Development, Administration, or Client Development areas because these are the activities that caused the costs to be incurred. Other costs such as the Library/Tax Service and the Computer can be partially assigned to the Administrative function and some to the Audit, Tax, MAS, or Write-Up areas because these were the activities that "drives" these costs. However, there are some costs that cannot be reliably allocated to any of the costs pools and they are included in the Unassigned Balance.

The totals of each pool are calculated and then the firm searches for cost drivers that will assign the costs to the jobs in the best manner. Firmsusing the ABC approach will spend a great deal of time determining the cost drivers that best reflect cause and effect of activities and costs incurred for their firm. For this example, the cost drivers chosen are listed at the bottom of Table 3.

Substituting the cost allocation using the cost drivers for the Overhead Allocation based on direct labor costs (shown in Table 2), gives significantly different results as shown in Table 4.

Table 4 starts with the Total Direct Cost of each engagement as developed in Table 2. Allocating the Professional Development costs by the number of employees in each area allocates the $130,000 in this pool very differently than the general overhead approach. The number of employees is the cost driver. The $165,000 aggregated in the Audit function cost pool is charged only to the auditing jobs and is a different approach than using a standard overhead rate applied on the basis of direct labor cost and charging the costs to all jobs. The Unassigned Balance, made up primarily of fixed costs, is allocated on the basis of direct labor costs but can be allocated using any common denominator the firm finds useful.

Using cost drivers leads to significantly different total costs for the average engagement in all areas, as shown in Table 5.