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Ruhl, J. M. and B. P. Hartman. 1998. Activity-Based Costing in the Service Sector. Advances in Management Accounting (6): 147-161.

Summary by Melissa Hagood
Master of Accountancy Program
University of South Florida, Fall 2001

Activity Based Costing Main Page | Service Industry Accounting Main Page


At its core, activity-based costing (ABC) is about cost management. This is reducing and controlling costs while still creating a quality product. ABC allows managers to identify how various cost objects are using resources differently and to highlight areas for continuous improvement. The literature on ABC focuses mainly on its use in manufacturing settings because it has been so successful in that area. This article discusses the use of ABC in service environments.

The Cost Hierarchy

Cooper (1996) defined cost behavior as falling into four levels:

A unit-level activity is performed each time a unit is produced.
A batch-level activity is performed each time a whole batch is produced.
Product-sustaining activities allow products to be produced.
Facility-sustaining activities allow the production process to occur.

Different services may consume very different amounts of a resource in a service firm. The levels of competition and regulation in a service environment influences the costing system. More competitive markets require more sophisticated systems that better match costs to different cost objects. ABC is such a sophisticated system.

Service firms are becoming more interested in costing accurately in order to make long- term strategic decisions as well as day-to-day operating decisions. Accurate costs are necessary to make product pricing, staffing, and resource allocation decisions. Service customers all require different amounts of resources. Accurate costs, along with the quantity and patterns of resource consumption, let managers know the proper price to charge for services. But ABC is hard to implement in service firms since employees often work on many projects in a day and for different amounts of time. This makes it hard to trace the resources used by cost objects.

Applying ABC to Service Businesses

Service companies have had problems coming up with decent cost accounting systems because they have been modeling them after systems found in manufacturing firms. The problems with this are that manufacturing firms place emphasis on valuing inventory, which service firms do not have, and use standard costs calculated for direct materials and labor. Direct materials and direct labor are not major cost categories in service firms and it is hard to calculate standard costs in a service setting. Nonetheless, service firms do need to know accurate costs for product profitability analysis. They need to find out:

Which products are profitable.
Which products should be emphasized.
Trends in product profitability over time.
Product costs as a basis for setting prices.

This means that costing in the service sector needs to be forward-looking, and ABC is a tool for such analysis. There are several service industries where ABC has started to emerge, and will continue to prove useful.

Financial Services

As the regulation ended in the banking industry, costing became more important as banks competed with one another. Banking costs are not driven by the volume of customers, but rather the number of transactions processed. Traditional volume based costing is obviously inappropriate in this case. Banks are moving to the concept where the user pays for the cost of the services they use, so that all users do not share the bill evenly. To do so they must have an accurate reflection of the cost of services.

Sharma (1992) described step-by-step how banks should implement ABC:

Split the bank into profit centers.

Prepare a list of products associated with each profit center and a list of product related and non-product related activities.

Divide non-product related activities into activities with unit-specific significance and activities with organization-wide significance.

The former activities are spread across all products produced by the unit. The latter category should include as few things as possible.

Many banks have already had success applying such division principles. Refer to the article for specific examples.


Healthcare providers used to be able to increase their prices or service to increase revenues and profitability. Today Medicare or managed care firms essentially set revenues with their prospective payment system (PPS). All healthcare providers can do to improve profitability is make good decisions with accurate cost information. PPS improved the sophistication of cost accounting systems in healthcare.

In a survey of hospital administrators about what information they needed to manage effectively, they said:

The cost of an episode of care.
Accurate allocation of administrative costs to products.
A comparison of costs and their causes over time.
Information regarding the cost of various activities.

All of this information is available from an ABC system. There are examples of hospitals successfully implementing ABC systems in the article.

Young and Pearlman (1993) believed that hospital’s cost accounting systems evolve in a four-step process:

The hospital improves the overall cost accounting systems.
The system separates variable and fixed costs.
The system identifies factors that drive costs, the ways these factors can be controlled, and redefines departments as profit or cost centers.
The accounting system supports the reconfiguration of administrative systems that cut across traditional functional lines.

Another viewpoint on hospital cost accounting systems is provided by Ramsey (1994). He believes that it should serve three purposes:

It should promote cost efficiency without sacrificing product and service quality.
It should allow the organization to maximize its resources through product and service line management.
It should highlight areas for continual improvement.


This industry is also making the move toward better management of costs due to increased competition. Here workers may spend a long time working on one task and the time on each task varies greatly depending on the case. The discussion in this section is mainly about ABC concepts and hospital malpractice insurance. A study found that a variety of factors drove malpractice costs and that the risk of malpractice was also tied to geographical locations. With these facts a malpractice insurance cost per medical procedure was calculated and divided by the number of that type of procedure for accurate costing.


ABC can be applied in service industries other than those described here. It has become increasingly important for companies whose markets are becoming more competitive. Since ABC is really about cost management, using it allows service companies to reduce and control their costs in order to make correct pricing and other decisions, and to increase their profitability. It is likely to continue to become more prevalent in the service industry in the future.


Cooper, R. 1996. Activity-based costing: Theory and practice. In Handbook of Cost Management, edited by B. J. Brinker, B1-1-B1-33. New York: Warren, Gorham, and Lamont.

Ramsey, R. H. 1994. Activity-based costing for hospitals. Hospital & Health Services Administration 39(3): 385-396.

Sharma, V. 1992. Determining product profitability. The Bankers Magazine. (March/April): 67-71.

Young, D. W., and L. K. Pearlman. 1993. Managing the stages of hospital cost accounting. Healthcare Financial Management (April): 58-80.


Related summaries:

Caltrider, J., D. Pattison and P. Richardson. 1995. Can cost control and quality care coexist? Management Accounting (August): 38-42. (Summary).

Carter, T. L., A. M. Sedaghat and T. D. Williams. 1998. How ABC changed the post office. Management Accounting (February): 28-32, 35-36. (Summary).

Cooper, R. and R. S. Kaplan. 1992. Activity-based systems: Measuring the costs of resource usage. Accounting Horizons (September): 1-13. (Summary).

Kaplan, R. S. and M. E. Porter. 2011. How to solve the cost crisis in health care: The biggest problem with health care isn't with insurance or politics. It's that we're measuring the wrong things the wrong way. Harvard Business Review (September): 46-64. (Time-driven ABC applied to health care). (Summary).

Kaplan, R. S. and S. R. Anderson. 2004. Time-driven activity-based costing. Harvard Business Review (November): 131-138. (Summary).

Kaplan, R. S. and S. R. Anderson. 2007. The innovation of time-driven activity-based costing. Cost Management (March/April): 5-15. (Summary).

Kaplan, R. S., M. E. Porter and M. L. Frigo. 2017. Managing healthcare costs and value. Strategic Finance (January): 24-33. (Summary).

MacArthur, J. B. and H. A. Stranahan. 1998. Cost driver analysis in hospitals: A simultaneous equations approach. Journal of Management Accounting Research (10): 279-312. (Summary).

Martin, J. R. Not dated. Chapter 7: Activity Based Product Costing. Management Accounting: Concepts, Techniques & Controversial Issues. Management And Accounting Web. /Chapter7.htm

Thurston, K. L. D. M. Keleman and J. B. MacAarthur. 2000. Providing strategic activity cost information: Cost for pricing at Blue Cross and Blue Shield of Florida. Management Accounting Quarterly (Spring): 4-13. (Summary).

West, T. D. and D. A. West. 1997. Applying ABC to healthcare. Management Accounting (February): 22, 24-26, 28-30, 32-33. (Summary).

Zeller, T. L. 2000. Measuring and managing E-retailing with activity-based costing. Journal of Cost Management (January/February): 17-30. (Summary).