## 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)
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