What is the Cost of Service? And How to Account for It?

The financial statements prepared by a company use a specific format. Usually, this format comes from the accounting standards that dictate the accounting process. While this format stays fixed most of the time, some changes may exist for different companies. On top of that, accounting standards also provide some room for companies to adjust their reports accordingly. However, the underlying statement must follow some rules.

One area where the financial statements may differ is for service-based firms. The most common form of financial statements involves selling a physical product. Usually, accounting for those companies is straightforward. They can follow similar formats as other companies, with minor or no adjustments. However, the same does not apply to companies that render services as their primary activity.

For those companies, some items may change in the financial statements. Usually, these changes reflect the underlying operations carried out by the company. The primary difference, however, relates to the exclusion of stock. For those, this change will be a part of the balance sheet. However, the income statement may also vary based on underlying operations. This variance causes service-based companies to calculate and record their cost of services.

What is a Cost of Service?

The cost of service is a term that extends the idea of the cost of sales for service companies. Most production companies use the cost of goods sold in the income statement. However, for firms that render services, this term will differ. These firms use the cost of service to present their direct expenses better. Essentially, the cost of service is an extension of the cost of sales for service firms.

Cost of service, like the cost of sales, includes the direct expenses incurred by firms. For companies, these include direct material, direct labor, and factory overheads. Apart from these, companies also consist of any costs that contribute to the production or selling process. However, the same does not apply to service firms, as their structure differs. For these firms, the cost of service includes fewer items.

See also  What is Seasonal Unemployment? Definition, Example, and More

The most critical item in the cost of service is direct labor. It includes any salaries and wages paid to the staff directly involved in rendering services. Usually, service firms do not have direct material expenses. However, some may incur expenses in that area as well. For those firms, direct materials will include a negligible amount. However, they will contain it as a part of the formula for cost of service.

Essentially, the cost of services includes all direct costs involved in rendering services. Usually, these include the costs of direct labor as the primary expense. If firms can link other costs to the rendering process, they can consist of it as a part of the cost of services. Any expenses that do not contribute to those services are not a part of the cost of services.

Overall, the cost of service includes any costs directly attributable to service. For most firms, it only consists of direct labor. However, it may also consist of direct material and other direct expenses. Factory overheads do not become a part of the cost of service. Once firms calculate this amount, they can include it in the income statement. This treatment is similar to the cost of sales.

How to calculate the Cost of Service?

As mentioned above, the cost of service includes all expenses directly attributable to the rendered service. However, the elements of the formula for cost of service may differ from one firm to another. On top of that, firms can adjust this formula to include or exclude items accordingly. However, some common elements constitute the cost of service.

Based on the above definition, the simplest cost of service formula is as follows.

Cost of services = Sum of all direct costs

However, direct costs may include various elements. Once expanded, the above formula for cost of service may look as follows.

Cost of services = Direct labor + Raw material + Shipping costs + Other direct costs

The above formula for cost of services includes the most common elements for the figure. Direct labor is usually the most prominent figure in this formula. Usually, it contains the salaries and wages for employees involved in rendering a service. For some firms, it also consists of payments to employees directly contributing to the process.

See also  What is an Accounting Estimate? – Example and Definitions

Raw material includes any items used to render the service. These items are crucial in helping firms provide a service. For example, markers or chalks are direct materials for schools. Similarly, shipping costs are a part of the formula for the cost of services. However, these are the least common elements. On top of these, firms may also include other direct costs in the formula for the cost of services.

How to account for the Cost of Service?

The accounting for the cost of service is straightforward. It follows a similar treatment as the cost of sales for other companies. Usually, this process involves recording an expense for the amount of the underlying element. On the other side, firms can record the compensation paid in exchange for that service. Usually, it includes cash or bank accounts. However, it may also consist of liabilities in the case of credit purchases.

Firms use the following journal entries for the cost of services to record any expenses in this area.

DateParticularsDrCr
 Cost of servicesXXXX 
 Cash or bank or payables XXXX

Practically, firms may use various accounts to separate the elements within the cost of service. These accounts are a part of the cost of services category. Once firms record all amounts within those accounts, they can accumulate them. Usually, they use the above formula for the cost of services to sum all direct costs. However, they may use separate accounts for each element.

For example, firms can record direct labor, direct materials, etc., in a separate account. For that process, the journal entries will differ from the above. This treatment requires firms to segregate expenses based on their origin. Depending on that process, they can record each item separately. In that case, the journal entries for direct labor will be as follows.

See also  Sold Merchandise Account Journal Entry: What is the Cost of Merchandise Sold? And How to Record It
DateParticularsDrCr
 Direct laborXXXX 
 Cash or bank or payables XXXX

Similarly, firms can record direct material separately as below.

DateParticularsDrCr
 Direct materialXXXX 
 Cash or bank or payables XXXX

At each year-end, firms can calculate the closing balance on each account. Once they do so, they can put it in the formula for cost of services. This accounting treatment for the cost of service is more practical as it allows for better control and analysis. However, the decision will depend on the firm accounting for the underlying expenses.

Example

A firm, ABC Co., provides accounting services to many clients. The firm takes up a new project that requires it to take over the accounting function for a client. During this process, ABC Co. pays its employees $10,000 in cash to keep the books for that client. This expense constitutes direct labor for the firm. ABC Co. records it as follows.

DateParticularsDrCr
 Direct labor$10,000 
 Cash $10,000

ABC Co. also incurs a direct material expense for the project. These materials are worth $500, which the firm pays in cash. Similarly, these expenses relate to office supplies essential to the bookkeeping process. Therefore, they constitute direct materials. ABC Co. records these expenses using the following journal entries.

DateParticularsDrCr
 Direct material$500 
 Cash $500

At the end of the project, the cost of service for it will be as follows.

Cost of service = Direct labor + Direct material

Cost of service = $10,000 + $500

Cost of service = $10,500

Conclusion

Cost of service is an extension of the cost of sales for service firms. This amount is crucial in calculating gross profits for those firms. Usually, it includes direct labor as a prominent amount. However, it may also consist of direct materials, shipping costs, and other direct expenses. The accounting for the cost of services is straightforward, as discussed above.