What does an audit really cost? An exploratory study of auditor pricing of initial engagements in a fixed cost model

Abstract

Despite decades of research on audit fees, we know very little about the cost to produce an audit. In this paper, we discuss the nature of fixed and variable costs in the audit process. We then use this cost perspective to examine the debate about the pricing of initial audit engagements, an event where marginal costs and marginal revenues are likely to diverge. This is often referred to as ‘lowballing’ which, technically, means delivering a service below cost. However, a fee discount does not necessarily indicate that revenue is below cost for an engagement. Using a sample of engagements from regional audit firms, we analyse audit fees, actual costs, and contribution margins. We find that actual contribution margins are generally positive in new engagements, suggesting that fee discounts do not result in lowballing. We attribute this to a firm pricing audits conditional on an understanding of their fixed cost structure.