Cost Accounting Practices in the Service Industry
Most managers associate cost accounting practices with physical products in the manufacturing industry. However, cost accounting techniques also can help service industry companies understand their costs. One difference in cost accounting practices for service companies is the terminology and construction of the cost of goods sold account. A manufacturing company's cost of goods manufactured is the sum of its material, labor and overhead costs. A merchandising company's cost of goods sold consists of the net purchase price it paid for the products. A service company's cost of services provided is primarily labor wages, overhead costs and a small amount of direct materials.
With some tweaks, product and period costs concepts can be applied to the service industry. Standard costing differentiates product costs and period costs. Product costs are associated with product manufacturing, while period costs aren't directly associated with any product. For a service company, the product manufacturing is equivalent to delivering a specific service. For example, professional salaries and office supplies are considered product costs. Advertising, rent and insurance are considered service period costs.
Variance analysis factors in product companies consist of direct materials, direct labor, variable manufacturing overhead and fixed manufacturing overhead. In the case of a service company, direct materials are the computers, office equipment and office supplies necessary to complete the service. Direct labor is the salary of the professional providing the service. For example, a lawyer's salary is considered direct labor in a law firm, while the general secretary's salary is considered an overhead cost.
Although usually framed in terms of production, volume variance analysis is suitable for service companies. Volume variance equals the budgeted production volume minus the actual production volume. For a manufacturing company, this could be the number of chairs built or sofas constructed. In a service industry, this could be the number of lawsuits filed, tax returns processed or audits performed. For example, a law firm that expected to handle 50 cases and instead processed 20 would have a volume variance of 30.
Because the bulk of a service industry's cost tends to be professional wages, labor variance analysis is especially beneficial. Labor variances can be analyzed by rate or efficiency. Labor hourly rate variance is the difference between the standard rate of pay and the actual rate of pay. Service companies could incur rate variances because of unanticipated overtime. For example, a law firm that budgeted to pay its paralegals $15 an hour and instead paid them $17 an hour has an unfavorable hourly variance of $2 per hour. To find the dollar value of the rate variance, multiply the hourly variance by the actual number of hours worked. In this example, if the paralegals worked 5,000 hours, the total rate variance is $10,000.