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.

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):

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:

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:

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:

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