80.2K

Verified Solution

Link Copied!

Activity- Based Costing 1n the Service Sector: The Buckeye National Bank Linda Smith Bamber and K. E. Hughes II INTRODUCTION e Buckeye National Bank began operations in the mid-19805; The bank quickly grew by providing checking account services to many small busi- nesses that preferred to do business with a \"local\" bank. Although Buckeye initially offered checking account services for individual accounts (retail custom ers), the bank primarily focused on serving its business customers. During the economic slowdown of the early 19905 that weakenedthe local economy, growth in business customer accounts began to decline. In response, Buckeye's senior management adoPted a new strategy, focusing on increasing the number of retail customer accounts. By aggressively marketing individual retail accounts, Buck- eye continued to grow Today, the Buckeye National Bank strives to maintain a stable base of business customers, while actively competing for an increased mar- ket share of retail customers. _ Recent income statements (Exhibit A) reveal a decline in the bank's prots. The bank's primary (noninterest) expense consists of salaries and employee ben- ets. Most fulltime employees' rst priority is presiding services to customers; these employees conduct their administrative responsibilities during slack times. The Bank schedules additional part-time employees to work during peak demand times, from 31 AM2 PM and Friday aernoons. Flexibility in scheduling part-time employees means that the bank's staff is \"lean and fully utilized. Buckeye's CEO, Rob Garrison, believes that this stafng arrangement allows the bank to provide speedy customer service, while operating at practical capacity. (That is, the bank's staff is fully utilized in efcient operations, after allowing for bank holidays and other scheduled staff activities such as training.) To counter falling prots, Buckeye's directors took two actions last year, both aimed at increasing the bank's retail customer base. First, Buckeye established a service call center to respond to customer inquiries about account balances, checks cleared, fees charged, and other banking concerns. Second, Buckeye's directors authorized year-end bonuses to branch managers who met their branch's target increase in the number of customers. However, even though 80 percent of the branch managers met the targeted increase in customer accounts, the Bank's prof- its continued to decline. CEO Rob Garrison does not understand why prots are declining, given that the Bank is serving more customers. Buckeye's southeast regional manager, Erik Larsen, has also noticed that while small retail custom- ers ock to the bank, the number of business customers is barely stable. Erik Larsen suspects that Buckeye's costing system may be part of the prob- lem. Buckeye developed its simple costing system when the bank began opera- tions in 1985. The bank does not trace any costs directly to individual customers. It simply treats all (noninterest expense) operating costs identied in the Income Statement in Exhibit A as indirect with reSpect to the customer line. The bank allocates these indirect costs to either the retail customer line or the business . customer line, based on the total dollar value of checks processed (which is readily available because each branch must provide the dollar values of daily transac-' tions for internal control). For the current period, Buckeye processed a total of $95 million in checks, of which $9.5 million was written by retail customers, and $85.5 million was written by business customers. This costing approach was fairly typical of banks and other nancial institutions at the time Buckeye developed its cost system. In college, Erik learned about an alternative costing approach called activity- based costing (ABC). Hovvever, the examples he remembered involved manufac- turing rms. He wondered whether Buckeye could develop an ABC system, with the business account customer line and the retail account customer line as the two primary cost objects. Erik approached Rob Garrison with this suggestion. Bob was skeptical, exclaiming, \"Our prots are going down the tubes and you want me to spend money developing a new accounting system?\" However, Erik persisted, and Rob eventually authorized a pilot ABC study using three'local branches of the bank. ' ' The ABC implementation team included Erik, the managers of each of the three bank branches, a bank teller, and a representative from the customer service call EXHIBIT A Buckeye National Bank Consolidated Income Statement . For the three years ending December 31, 20:5 20x5 20x4 _ - 20x3 . ($000) . ($000) ($000) N et interest income\" $3,436 $3,4 17 $3,349 Provision for credit losses 484 475 ' 465 Net interest income after ' provision for credit losses 3,002 2,942 ' 2,884 Noninterest income 1,207 1,199 1,190 Income prior to noninterest . . expenses and income tax 4,209 4,141 4,074 'Noninterest expenses 3.805 3,539 3,362 Income before income taxes 404 602 712 Income tax expense 130 ' 194 230 Net income - s 274 $ 403 _ ' $ 482 ' Net interest income equals interest income less interest expense. The bank's primary income is from interest-bearing checking accounts. Noninterest income includes fees charged for various services, such I as checking account fees charged if the account balance falls below the required minimum level. Noninterest ' expenses are all of the bank' 5 operating costs, including those associated with paying checks, providing teller services, and responding to customer account inquires. center. The team began by identifying the activities Buckeye National Bank per. formed. To start a simple pilot study, the team identied the three most impor tant activities: _ 1. Paying checks 2. Providing teller services 3. Responding to customer account inquiries at the customer service call center If this pilot study turned out to be successful, then the team planned to rene the system by conducting a more detailed activity analysislthe following year. The ABC team began by determining the costs that are associated with each of the three activities. The team quickly discovered that, as is typical in service indus- ' tries like banking, labor (personnel) costs dominate. The ABC team asked each em ployee to ll out a short questionnaire to nd out how the employee spends his or her time. The team then followed up with an in-depth personal interview with each employee. The ABC team used this combined information to estimate the percent- age oi'time each employee spent on each of the three activities: (1) paying checks, (2) providing teller services, and (3) responding to customer account inquiries. The team then estimated the other (nonlabor) resources that each of the three activities consumed. For example, they traced to the \"responding to customer account inquiry\" activity: (1) the cost of toll-free telephone lines at the customer service call center, and (2) depreciation on other equipment and facilities the call center personnel use. Similarly, the ABC team estimated the percentage of time the bank's information system was used for check processing and providing teller services (vs. other uses such as compiling periodic n ancial statements), to determine how much of the equipment's depreciation to assign to the activities \"paying checks\" and \"providing teller services.\" _ To complete the pilot study in a timely fashion, the ABC team based their estimated activity costs on last year's actual data, which were already available. If the pilot study succeeded, then the ABC team planned to develop budgeted indirect cost rates for each activity the following year. The advantage of budgeted rates over actual rates based on the prior year's data is that budgeted rates (bud geted cost associated with the activity divided by the budgeted quantity of the activity's cost driver) can incorporate expected changes in costs and operations. After examining the three branch banhs' indirect costs (that is, the cost items making up the branch banks'noninterest operating expenses), the ABC team clas sied the annual costs in each activity's cost pool (hereafter, all numbers are in thousands)1 as shown in Exhibit B- 1 An activity's cost pool is simply a grouping, or aggregation, of all the individual costs associated with that activ- ity. The bank's ABC team created separate activity cost pools for the costs associated with each of the three activities: (Dpaying checks, (2) providing teller services, and (3) responding to customer account inquiries. EXHIBIT 13 Assignment oflndirect (Nuninterest Expense) Costs to Activity Cost Pools' . Estimated Annual Activity Cost Pool to which Total-Costs Indirect Cost Indirect Cost is Assigned (in $1,0005) Salaries of check-processing personnel Paying checks _ $ 700 Depreciation of equipment ' and facilities used in _ check processing Paying checks ' 440 Teller salaries Providing teller services 1,000 Depreciation of equipment ' and facilities used in teller operations Providing teller services 200 Salaries of customer representatives'at call Reaponding to customer account center inquiries 450 Toll-free phone lines plus depreciation of equipment and facilities in customer Responding to customer account call center inquiries _ 60 Total indirect costs ' $2,850 ' These indirect costs are part of the $3,805 \"noninterest expenses\" in the bank's 201:5 Income Statement in Exhibit A. The rest of the noninterest expenses in the Income Statement shown in Exhibit A pertain to other operating costs that are excluded from the pilot ABC study, such as the CED's salary. (The costs listed in Exhibit B are indirect with respect to the retail customers and business account customers.) The team identied the following cost drivers2 for each activity cost pool: Activity Cost Pool I Activity Cost Driver Paying checks Number of checks processed Providing teller services ' Number of teller transactions _ Responding to customer account Number of account inquiry calls to inquiries customer service call center The ABC team estimated that for the three pilot-test bank branches, the re- tail and business customer lines experienced the annual activity levels (in thou- sands) as shown in Exhibit C. For example, Exhibit C reveals that retail customers had 160,000 teller transactions and made 95,000 account inquiry calls to the cus~ turner service call center. Buckeye National Bank currently services 150,000 retail customer checking accounts and 50,000 business customer checking accounts. The bank earns net interest revenue on the balances that customers keep in their checking accounts.3 On average, the bank earns the following annual revenue from each type of account: Average annual revenue per retail customer account $10 ' Average annual revenue per business customer account . $40 " A cost driver is a factor, such as the number of checks processed, that causally affects costs. For example, the costs associated with the activity "paying checks" rise and fall as the quantity of the cost driver (the number of checks processed) rises and falls. The bank earns net interest revenue by managing the "interest rate spread." This spread is the difference between the interest rate the bank earns on customer deposits (say 8 percent), less the interest rate the bank pays the customer on the average checking account balance (say 4 percent). EXHIBIT C Activity Cost Drivers by Customer Line Annual Number of Units Annual Number of Units of Activity-Cost Driver of Activity-Cost Driver Activity Cost Used by Retail Customers Used by Business Customers Driver (in 1,000s) (in 1,000s) Total (Checks processed 570 2,280 2,850 Teller transactions 160 40 200 Account inquiry calls to customer service call center 95 5 100

Answer & Explanation Solved by verified expert

See Answer