Activity-Based Costing (ABC) in Service Industries

The Freelance Writers Den offers educational and membership services to freelance writers for a monthly subscription price, as well as eBooks, tutorials, and workshops offered to non-subscription members through a traditional e-commerce store. The Freelance Writers Den was started by Carol Tice after she recognized an unmet need in the market for services geared at freelance writers, particularly new writers that wanted to become freelance writers. The business has grown so much in popularity that there is often a waiting list for new customers until more server space can be purchased or another customer leaves the service. The business, which is located on the West Coast of the United States and employs six employees in addition to its founder. It relies on traditional internet marketing strategies, such as paid advertisements, free offers, paid social media campaigns, and email campaigns to acquire new customers to join the members-only service.

Currently, the Freelance Writers Den has two different subscription levels, regardless of the amount of use, service or benefit the customer derives. For $25 a month, customers gain access to a library of training materials, quarterly educational bootcamps, a freelance writing job board, private messages with moderators and other customers, as well as a member profile that’s searchable by companies that hire freelance writers. The second level of service costs $179 a month and includes a monthly small group mastermind with other customers, a one on one call with the company’s founder, access to an online chatroom, quarterly events, an additional course, and five eBooks. Neither service level takes into account the cost of the activities it takes to create and run these services nor the resources that these services require to create and maintain.

Implementing a time driven activity-based costing system could help overcome these costing oversights and make the business more profitable. Currently, the Freelance Writers Den decides a price that it assumes customers are willing to pay likely based on what else is offered on the market. Instead, the Freelance Writers Den could use Activity-Based Costing, which “is a costing model that could assign precise costs to products and services” (Mihut & Tomai, 2010, p. 358). In the case of this company, activity-based costing would account for the cost of employing the staff members that provide services, the cost of server space, and the resources spent creating the training materials. This is different than job order costing, where cost is based per job, and process costing, where cost of a standardized process is divided up by the number of units. Currently, the Freelance Writers Den uses none of these costing systems to determine its pricing for its services.

To implement an activity-based costing system, the Freelance Writers Den would have to determine what the actual costs of offering these services is, including the staffing, infrastructure, and maintenance costs. This would have to be divided by the cost driver, which is “the relation between an output (product or service) and the activities consumed by it” (Mihut & Tomai, 2010, p. 359). In the case of the Freelance Writers Den, this could be the number of subscribers allowed. Because of the nature of the waiting list, there is a finite number of customers the company can accommodate at one time. Having an activity-based costing system would enable the Freelance Writers Den to know it makes enough revenue to sustain its own operations because there will not be any hidden costs that have not been accounted for. Otherwise, an unexpected or overlooked expense could derail the company’s profitability and long term sustainability.

However, there are benefits of having a costing system based on complexity and not historical costs (Ippolito, Boni, Cinque, Greco, & Salis, 2016). One such benefit is accurate accounting that leads to sustainable operations with long-term profitability. If the price customers are charged accurately reflects the costs of the business, it will be much easier to grow when an appropriate amount of profit has been accounted for. Additionally, a “good cost model eases forecasting and control and provides a basis for accountability and transparency” (Palaiologk, Economides, Tjalsma, & Sesink, 2012, p. 196). In the specific case of the Freelance Writers Den, after a certain number of customers join the waiting list, it would be a safe financial decision for the company to invest in more server space. This way, the company is not wasting money by purchasing more server space when it does not have enough customer growth to justify it.

There are a number of companies that currently provide similar business-related educational offerings to freelance writers. Using an activity-based costing system could provide a competitive advantage to the Freelance Writers Den by helping the company understand the actual costs of its operations to it can sustainably operate without fear of not having enough financial resources to continue. It can also help the Freelance Writers identify unprofitable products, whether e-books or portions of its member website that are not worth the cost of maintaining. For example, if through activity-based costing, the company can identify training that it hosts on the website that customers do not use, the company can take it down and open the service up to more customers because of the increased server space created simply by removing training existing customers do not use or value. There are many such possibilities that could come up because the services and their related costs will be thoroughly examined through the true costs associated with running them.

Additionally, implementing an activity-based costing system would make it easier to highlight any unnecessary costs within the operations. Initially, it is possible that prices would need to rise to cover the true costs of services. Company leaders may think that this may force the company to raise prices to a point where the Freelance Writers Den will not be priced competitively enough to acquire new customers.

However, this is not likely the case over the long term. The awareness the company would cultivate regarding associated costs of delivering its services to customers will also bring with it an interest in driving down costs. Research shows that “expenses that with some care, could often be easily prevented or at least reduced, often turn out to link the final cost of products and/or services” (Medianeira Stefano & do Carmo Duarte Freitas, 2014, p. 154). The company could use the information that it finds to streamline its operations and reduce unnecessary costs.

For instance, the Freelance Writers Den could discover that they need less server space than needed to store training information than originally allocated and provide this in terms of a lower price to customers or allow more customers to access the service at once. The company could also realize that it does not need six employees to run its operations. The awareness and subsequent decision making that could occur from the implementation of activity-based costing could help create a leaner business for the Freelance Writers Den over time, which could help make it much more competitive when compared to other service-based companies within the same market serving the same customers. It is well known that companies that have streamlined, lean, and cost-effective operations will perform better and be more competitive over the long term than companies that do not.

The potential impact of time-driven activity-based costing on services provided online is substantial. With traditional channels, such as in industries that manufacture physical products to sell to consumers at retail, business leaders consistently focus on the correct costing measure to utilize that is fair to customers, competitive in the marketplace, and allows them to be profitable and sustainable over the long run. For many service-based e-commerce companies, business leaders do not know the correct costing measures that accurately reflect the cost of doing business. As a result, the closure rate for e-commerce businesses is high. Because many e-commerce businesses, especially within the service industry, have the ability to operate with lower overhead in terms of employees, physical retail locations, and the cost of delivering services, it should be easier to maintain an online e-commerce business than a traditional business with associated overhead.

By using an activity-based costing system, e-commerce businesses can accurately charge for their services. When all service-based e-commerce websites have prices that reflect the true cost of doing business, the overall prices can increase. This can help with profitability in the health of the businesses. More businesses should be able to stay open longer because of an increased understanding of cost.

Additionally, many consumers do not understand the true cost of services provided to them. Globalization has drastically reduced the cost of products and has enabled easier access to lower-cost services. While many American e-commerce service businesses struggle to justify their higher prices, company management teams must thoroughly understand associated costs with doing business. An activity-based costing model can help managers and company leadership teams understand this.

References

Ippolito, A., Boni, S., Cinque, E., Greco, A., & Salis, S. (2016). Using time-driven activity-based costing to establish a tariff system for home health care services. Journal Of Healthcare Management, 61(6), 436-448.

Medianeira Stefano, N., & do Carmo Duarte Freitas, M. (2014). Framework: Activity-based costing in services. Brazilian Journal of Management / Revista De Administração Da UFSM, 7(1), 153-169. doi:10.5902/1983465910079

Mihut, M., & Tomai, N. (2010). A cost model for the it department. Journal Of Applied Quantitative Methods, 5(2), 358-364.

Palaiologk, A., Economides, A., Tjalsma, H., & Sesink, L. (2012). An activity-based costing model for long-term preservation and dissemination of digital research data: the case of DANS. International Journal on Digital Libraries, 12(4), 195-214. doi:10.1007/s00799-012-0092-1