Service-based costing is used when a service center within a business charges its services to other parts of the business. The service charge associated with this activity should be based on at least the direct costs associated with providing services. The charge can also ramp up to a more rounded concept of cost, where an overhead charge and even a profit is added to the service charge. Examples of service centers that might use service-based costing are information technology (IT), janitorial services, and facilities maintenance.
By using service-based costing, "client" departments can decide upon the volume and quality of services that they want to receive, based on the budgeted price. Alternatively, they can decide to look elsewhere to obtain services for a lower price. This has the effect of putting downward pricing pressure on the service department, which must now compete with the prices offered by outside service providers.
When exposed to outside competition, a service center is more likely to re-evaluate its cost structure. For example, an IT service center may be more inclined to switch away from legacy computer systems and toward off-the-shelf software or a cloud-based solution.
In some cases, the manager of a service center may realize that it is impossible to compete with an outside supplier of the same service and even voluntarily agrees to outsource the department. A more likely circumstance is that the manager will constantly compare internal to external costs to ensure that his or her department remains competitive. Another possible outcome of service-based costing is that a service center provides its services outside of the company, to third parties.
A caution when using service-based costing is that an outside provider might lower its prices sufficiently to cause an internal service department to be disbanded, after which the provider raises its prices when there is no longer any internal competition.
This approach will create more work for the accounting department, which must enter into the accounting system all costs being billed between departments.