Activity-based management (ABM)

4. ABC and customer profitability-analyses in service businesses

Service businesses, similar to manufacturing companies, have to determine the cost of services offered and the profits generated by different clients. Many service companies find that volume-based costing results in service price distortions, and as the result, they often use ABC. To illustrate activity-based costing for a service company, let's look at the following example.

Assume BetterHealth Hospital uses activity-based costing to allocate factory overhead costs to its patients. The hospital has determined the following cost centers (or cost pools): admitting patients, blood testing, food and laundry, operating room, and MRI scanning. The hospital has budgeted the following amount of overhead cost and activity rate for each cost center.

Cost Center

Budgeted Activity
Cost Pool

Budgeted Activity
Drivers

Activity Rate

Admitting

$ 2,400,000

12,000 admissions

$200 per admission

Blood testing

$ 1,260,000

9,000 tests

$140 per blood test

Food and laundry

$ 54,750

365 days

$150 per day

Operating rooms

$ 1,056,000

4,800 hours

$220 per hour

MRI scanning

$ 3,648,000

4,560 images

$800 per scan

Total

$ 8,418,750

   

The activity rates shown in the table above can be used to perform patient cost and patient profit analyses. The following data pertains to five patients serviced by BetterHealth Hospital (all names fictitious):

 

John
Adams

Sara
Brown

Tom
Jones

Lisa
Smith

Pat
Woods

Medication

$150

$340

$1,100

$180

$760

Admitting (admissions)

1

1

2

1

1

Blood testing (tests)

2

3

4

1

2

Food and laundry (days)

2

7

12

1

4

Operating rooms (hours)

0

3

7

0

2

MRI scanning (scans)

1

0

3

1

1

Note that medication costs are direct costs, and thus, they are directly traced to each patient. Factory overhead costs are allocated among patients based on their activity-consumption rates. For example, John Adams stayed in the hospital for two days, and thus, he was allocated $300 (i.e. 2 days x $150 per day) for food and laundry costs. The table below summarizes the cost of each patient:

 

John
Adams

Sara
Brown

Tom
Jones

Lisa
Smith

Pat
Woods

Medication

$ 150

$ 340

$ 1,100

$ 180

$ 760

Admitting

200

200

400

200

200

Blood testing

280

420

560

140

280

Food and laundry

300

1,050

1,800

150

600

Operating rooms

0

660

1,540

0

440

MRI scanning

800

0

2,400

800

800

Total

1,730

2,670

7,800

1,470

3,080

Assume that BetterHealth Hospital generated the following revenues for each patient: $2,400 (John Adams), $4,825 (Sara Brown), $13,240 (Tom Jones), $1,260 Lisa Smith, and $4,530 (Pat Woods). Let's perform the patient profitability analysis:

BetterHealth Hospital
Patient Profitability Report
For the Period Ending December 31, 2009

 

John Adams

Sara Brown

Tom Jones

Lisa Smith

Pat Woods

Revenues

$ 2,400

$ 4,825

$ 13,240

$ 1,260

$ 4,530

Less: Patient costs

         

Medication

150

340

1,100

180

760

Admitting

200

200

400

200

200

Blood testing

280

420

560

140

280

Food and laundry

300

1,050

1,800

150

600

Operating rooms

0

660

1,540

0

440

MRI scanning

800

0

2,400

800

800

Total costs

1,730

2,670

7,800

1,470

3,080

Net patient profit

670

2,155

5,440

(210)

1,450

Profit / Revenues

28%

45%

41%

(17%)

32%

As we can see, Sara and Tom provided the highest return on sales while Lisa resulted in the lowest (actually, negative) return. Based on this analysis, BetterHealth Hospital may conclude that it is more profitable to service patients providing high revenues compared to patients providing low revenues as return on sales appears to be directly correlated with revenue amounts.

In service industries, customer profitability analysis helps to determine the most profitable customer niches and thus to focus business activities (e.g. selling, marketing, service pricing) in those market segments. Once a company identifies market segments, it can develop product design, pricing, marketing, and selling strategies tailored for each market segment. Popular forms of market segmentation and their characteristics are listed in the table below:

Market
Segmentation

Segment
Characteristics

Examples

Geographic

Country, region, city

Barcelona FC (Barcelona, Spain)

Demographic

Age, gender, race, education, income

Buick (older people), Happy Meal (kids)

Psychographic

Lifestyle, attitude, values

Whole Foods Market (healthy lifestyle)

Benefit

Benefits provided

YoLite yogurt (tasty and fat free)

Volume

Light use, heavy use

Star Alliance (for frequent fliers)

Related accounting material
Not a member?
See why people join our
online accounting course:
Lecture Contents:
Free Study Notes
Download free accounting study notes by signing up for our free newsletter (example):
First Name:
E-mail:
We never share or sell your e-mail to third parties.
Ask a Question
Suggest a Topic
Do you have an interesting question or topic?
Suggest it to be answered on Simplestudies.com: