Production Efficiency and the Pricing of Audit Services*

Abstract

In this paper, we examine the relative efficiency of audit production by one of the then Big 6 public accounting firms for a sample of 247 geographically dispersed audits of U.S. companies performed in 1989. To test the relative efficiency of audit production, we use both stochastic frontier estimation (SFE) and data envelopment analysis (DEA). A feature of our research is that we also test whether any apparent inefficiencies in production, identified using SFE and DEA, are correlated with audit pricing. That is, do apparent inefficiencies cause the public accounting firm to reduce its unit price (billing rate) per hour of labor utilized on an engagement? With respect to results, we do not find any evidence of relative (within‐sample) inefficiencies in the use of partner, manager, senior, or staff labor hours using SFE. This suggests that the SFE model may not be sufficiently powerful to detect inefficiencies, even with our reasonably large sample size. However, we do find apparent inefficiencies using the DEA model. Audits range from about 74 percent to 100 percent relative efficiency in production, while the average audit is produced at about an 88 percent efficiency level, relative to the most efficient audits in the sample. Moreover, the inefficiencies identified using DEA are correlated with the firm's realization rate. That is, average billing rates per hour fall as the amount of inefficiency increases. Our results suggest that there are moderate inefficiencies in the production of many of the subject public accounting firm's audits, and that such inefficiencies are economically costly to the firm.

Characteristics of statutory internal auditors and operating efficiency

“…In determining the effect of operating efficiency, prior studies (Dopuch et al, 2003;Leverty and Grace, 2012;Demerjian et al, 2012Demerjian et al, , 2013 utilized two primary statistical methods: stochastic frontier estimation (SFE hereafter) and data envelopment analysis (DEA hereafter). SFE is a parametric approach in which measurement noise is considered separately from the effects of inefficiency depending on the distribution type -normally distributed, exponential or truncated (Anderson et al, 1999;Kalirajan and Shand, 1999).…”

Do Auditing Standards Matter?

“…Further, auditors often are confronted with situations in which they feel forced to undercharge for services because of competitive pressures. This is often reflected in reduced realization rates (Dopuch et al 2003). Nevertheless, certain audit-quality threatening behaviors documented in the research literature, such as premature signoff of audit procedures (Margheim and Pany 1986) or failure to perform required audit procedures (Otley and Pierce 1996), may be manifestations of overcharging if the audit fee is conditioned on the completion of such work.…”

IPO underpricing and flotation methods in Taiwan – a stochastic frontier approach

“…Wadud and White (2000) examine the farm household efficiency in Bangladesh with both stochastic frontier and DEA models. Cullinane and Song (2003) The stochastic frontier approach is applied not only in the agricultural or manufacturing industry but also in the service industry like banking (Bhallachayye et al, 1997;Rezvanian and Mehdian, 2002;Peng and Wang, 2004), life insurance companies (Green and Segal, 2004), hotel industry (Anderson et al, 1999), museums (Bishop and Brand, 2003) and audit service (Dopuch et al, 2003). Recently, this methodology has also been adopted in pricing IPOs.…”