An Effective Cost Allocation System Accounting Essay

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Banco National Bank is a bank that largely focuses on its business customers, but in recent years due to economic downturn has put more of an emphasis on increasing its retail customer accounts to increase revenue. They attracted new retail customers by adding a service call centre for the convenience of its customers. Furthermore, they gave branch managers a quota to fulfill in terms of adding new retail customers, which if successful would lead to their year-end bonus. However, even after increasing retail customer accounts to the expected margin for 80% of the branches, the profit has not necessarily increased.

Exhibit A shows that "Net Interest Income" has been growing gradually from fiscal 2010 to fiscal 2012. It has grown from $3,349,000 [2010] to $3,486,000 [2012], which is a growth of $137,000. However, "Noninterest Expenses" has gone up since the bank's operating costs have gone up due to the increase implementing a service call centre. It has gone up from $3,362,000 [2010] to $3,805,000 [2012], which is an increase of $443,000 in expenses. Expenses during these years have increased in a larger margin than revenue. Therefore as management accountants, we have done an analysis to dissect the root cause of the direful condition presently experienced by your bank, which is why is "Net Income" declining even though revenue and customer base has increased over these years? BNB's senior management has been making decisions primarily on a flawed costing system that shows retail customers as more profitable than business customers [which is wrong as proven in the subsequent sections], which has led them to engage in ill-advised strategic and tactical plans. Below is a re-evaluation of BNB's current cost allocation system method, followed by relevant recommendations for further steps.

Criteria

The main criteria we have decided upon is financial performance, which is ultimately to maximize profit both short and long term.

Issue: An Effective Cost Allocation System [Financial Analysis]

Alternative 1: Current System

BNB currently has a costing system in place to allocate costs to its respective customer lines (retail and business). Under this method of assigning costs, BNB does not trace any costs directly to its individual customers. It treats all "Noninterest Expense" as indirect costs, which are then allocated to either the retail customer line or the business customer line, based on the total dollar value of checks processed. Table 2 below will explain further how they allocate costs in this current costing system.

Average Revenue Per Account

Number of Accounts

Total

(in 1000s)

Retail

$10

150,000

$1,500

Business

$40

50,000

$2,000

Total

$3,500

Table : Revenue

Retail Customer

(in 1000s)

Business Customer (in 1000s)

Total

(in 1000s)

Total Dollar Value of Checks Processed

$9,500

$85,500

$95,000

Percentage of Total Dollar Value of Checks Processed

10%

(9500/95000 x 100%)

90%

(85500/95000 x100%)

100%

Cost

Allocation

$380.50

(3805 x 10%)

$3,424.50

(3805 x 90%)

$3,805

(from Exhibit A)

Table : Allocation of Costs

Retail

(in 1000s)

Business

(in 1000s)

Total

(in 1000s)

Revenue

$1,500

$2,000

$3,500

Expenses

$380.50

$3,424.50

$3,805

Operating Income (Loss)

$1,119.5

($1,424.50)

($305)

Table : Operating Income (Loss)

Evaluating Alternative 1

With this current costing system in place, BNB essentially uses a system that is very simple to use and implement as the method of allocating costs only requires one element, which is the total dollar value of checks processed for each customer line. This information is readily available because each branch must provide the dollar values of daily transactions for internal control purposes. Although this method may seem feasible in terms of simplicity, it is the root cause for the problems that are withholding the senior management of BNB from being able to truly find a solution that is effective and efficient. Our preliminary analysis of this costing system shows that retail customer line ($1,119,500), has been really profitable for BNB, whereas the business customer line ([$1,424,500])have resulted in a loss for them. The main problem created with this easy-to-use costing method is that it does not reflect the actual cost for each of the customer line (retail and business). This is due to the fact that they use an outdated cost driver ("Total dollar value of checks processed") that severely undermines the cost of the retail line and significantly exaggerates the cost of the business line, which will be further proven in the subsequent parts of our analysis.

Alternative 2: Activity-Based Costing System

BNB has the option to switch their costing system to an Activity-Based Costing system as proposed by one of your own, Brian Larsen. In this costing model, the activities of BNB will be identified separately and assigned their controllable costs of capacity resources for each activity, according to the actual consumption by each activity. The ABC method is a much more accurate illustration of the costs of for each product essentially.

Under the ABC method, the different costs pools must be first identified based on the business activities in the process of creating each product. For BNB, the cost pools include: paying checks, providing teller services and responding to customer account inquiries. Once the costs pools are set up, the costs assigned to each pool and what cost driver to use for each pool must be determined. Tables below will show how ABC will give a better understanding and a more accurate picture in terms of cost allocation, which in turn will help make better strategic and tactical decisions for the senior management of BNB.

Activity Cost Pools

Paying Checks

(in 1000s)

Providing teller services

(in 1000s)

Responding to customer account inquiries

(in 1000s)

Salaries Expense

Salaries of check-processing personnel

$700

Teller salaries

$1,000

Salaries of customer representatives at call center

$450

Equipment Expense

Depreciation of equipment and facilities used in check processing

$440

Depreciation of equipment and facilities used in teller operations

$200

Toll-free phone lines plus depreciation of equipment and facilities in customer call center

$60

Total (in 1000s)

$1,140

$1,200

$510

Table : First-Stage Allocations to Activity Cost Pools

Activity Cost Pools

Total Cost (in 1000s)

Total Activity (in 1000s)

Activity Rate

Paying checks

$1,140

2,850 checks processed

$0.40/check

Providing teller services

$1,200

200 teller transactions

$6/teller transaction

Responding to customer account inquiries

$510

100 inquiry about account

$5.10/per inquiry

Table : Activity Rate Calculation

Activity Cost Pools

Activity Rate

Activity (in 1000s)

ABC Cost (in 1000s)

Paying checks

$0.40/check

570 checks

$228

Providing teller services

$6/teller transaction

160 teller transactions

$960

Responding to customer account inquiries

$5.10/per inquiry

95 inquiries

$484.50

Total

$1,672.50

Table : Overhead Costs for Retail Customer Line

Activity Cost Pools

Activity Rate

Activity (in 1000s)

ABC Cost (in 1000s)

Paying checks

$0.40/check

2,280 checks

$912

Providing teller services

$6/teller transaction

40 teller transactions

$240

Responding to customer account inquiries

$5.10/per inquiry

5 inquiries

$25.50

Total

$1,177.50

Table : Overhead Costs for Business Customer Line

Retail Customers (in 1000s)

Business Customers (in 1000s)

Total (in 1000s)

Net Interest Income

$1,500

$2,000

$3,500

Less: Expenses

-

-

-

Paying Checks

$228

$912

$1,140

Providing teller services

$960

$240

$1,200

Responding to customer account inquiries

$484.50

$25.50

$510

Product Margin

($172.50)

$822.50

$650

Less: Other Operating Costs

-

$955

Operating Income

($305)

Table : Operating Income (Loss)

Evaluating Alternative 2

Under the Activity Based Costing system, BNB is ensured a much higher amount of accuracy and reliability in each cost that is incurred for different products. This can be accounted to the fact that ABC method considers the activity rate (in association with its usage) for each different cost activity contributing to a more accurate total costs associated with each individual product essentially. However, the one downside of implementing an ABC system is that it may be more costly and time-consuming than the current Product-Costing system.

ABC gives the senior management a more exhaustive breakdown of costs, which will help your team come up with efficient and effective strategic and tactical plans. From the ABC report, the costs of providing teller services and the costs of responding to customer account inquiries for retail customers' line are considerably higher than those same costs for business customers' line. There is only three times more retail customers compared to business customers [150,000/50,000=3], however the cost of teller services is four times higher [960/240=4] and responding to customer account inquiries is nineteen times higher [484.5/25.5=19].

ISSUE 1: Recommendation

Now that we have gone through the procedures of the current costing system and the ABC system, we recommend that it would be best for BNB to implement the Activity-Based Costing system. Currently, the conventional costing system in place is resulting in vague cost information regarding the two different customer lines. This is causing them to implement new strategies that are not resulting in significant increase in "Net Income" due to the cost allocation system reflecting an inaccurate misunderstanding of the different customer lines. With the ABC in place, we are able to understand the actual reflection of the impact of the different customer lines, resulting in a better understanding of each customer lines' (retail and business) profitability.

The ABC Costing system allows BNB to compete with their competitors and gain new customers as BNB understands where the real profit lies. With ABC in place, BNB can see that business customer line is more profitable and helps them in the long run. Therefore, implementing the ABC Costing System will allow for profits to rise in BNB, as costs will be allocated effectively and your team of senior management will get a better understand of the detailed breakdown of the costs.

Alternatives

After switching to the ABC system, BNB has several alternatives to consider in order to increase "Net Income" in subsequent years. BNB has the option of doing nothing essentially standing pat and hope that the economy turns around and the business customers come back stronger than ever. Next, BNB also has the option of just focusing on the business customer line and eliminating their retail section as the bank originally did when they first started off and focus on a niche customer base. Lastly, BNB can have a hybrid of the two alternatives aforementioned and focus on improving their existing services for its retail and business customers, and spend more on recruiting more retail and business customers. All these alternatives are given with the assumption that BNB implements ABC system in its operations.

Alternative 1 [Stand Pat]

The option of standing pat essentially means that BNB is going to hope that the economy turns around and the business customers come back stronger than ever. It also means that BNB continues to build its quantity in terms of the number of retail customers it wants to acquire each year. Just like the current cost system is the simplest and easiest one to use, this alternative has similar characteristics in terms of its simplicity and easy-to-implement ability. This would result in retail customers constantly increasing as branch managers have the incentive to do so, because their year-end bonus depends on meeting the target for increase in retail customer accounts. As a result, revenue would increase steadily as it has throughout the last three years because of following this plan. As proven by the ABC system analysis, BNB's most profitable line is its business customer line. Thus, if BNB stands pat and does nothing, it will lose out on maximizing its profit by missing out on the opportunity to take advantage of the business line that provides a greater profit margin that retail customer line.

Alternative 2 [Eliminate Retail Customer Line]

The other option BNB has is to completely eliminate its retail customer line and follow the bank's inception philosophy, which is to only focus on its business customer line. This way they are going to be focused on a niche customer base, and they will be able to maximize their profit as the business customer line section provides the most profitability for this bank as proven by the ABC analysis. It might sound like an attractive idea, but in reality they have gained almost 150K retail customer accounts since they started the retail customer line. This has brought average annual revenue of $1.5M in the fiscal year 2012. If they just eliminate retail customer line, BNB loses 150K customers and essentially revenue of $1.5M. BNB has invested so much in recruiting new retail customers and the last three years has focused mostly on the retail section. It would be demoralizing for its employees to go through so many drastic changes that shake up BNB's philosophy within a range of 3+ years. Lots of jobs will be lost as the people that got hired to serve the retail customer line would no longer be needed, which would not sit well with the media and ultimately with the consumers. Due to economic downturn, it is hard to capture growth in the business customer line currently, but if they pursue same marketing tactics as implemented for retail then BNB might be able to attract more business customers' thus increasing profitability.

Alternative 3 [Hybrid]

The final alternative is that BNB can have a hybrid of the two alternatives aforementioned and focus on improving their existing services for its retail and business customers, and spend more on recruiting more business customers. This would essentially stop BNB from continuing to pursue more retail customers as their profitability is way lower than business customers. BNB should focus more on continuing to further enhance their existing services provided by improving customer service, customer retention, customer satisfaction etc. If they are able to do this, they should be able to attract new business customers as well as retail customers from their competitors, which will increase their profitability. This ultimately puts BNB in a good situation when the economy starts booming again as they will have a bigger business customer line, which will increase their profitability as businesses will start doing well again. The ways to improve their existing client services are either by increasing service charges for different services provided and/or cut expenses by coming up with more effective and efficient way of providing service. Since BNB has put so much emphasis on enhancing its services, it has the utmost right to increase its service charges. However, BNB has to be careful as they do not want to overcharge and lose its customers to its competitors. BNB can also cut its expenses. One of its highest expenditure as found by the ABC analysis is the teller services expenditure. Since it is the digital era, BNB should focus on putting its clients online via website or mobile app designed to see their personal/business accounts. This will result in more people relying on the internet and their smart phones to do their own teller services such as checking balance, making a payment etc. However, BNB has to be careful in order to still keep the customers satisfied but provide them excellent service as before, because BNB does not want to lose them to its competitors. If BNB is able to do this, then the profit margin will increase significantly.

Recommendation

This is only a preliminary analysis but with further research and data, we will be able to provide BNB with a more comprehensive action plan. Our final recommendation is to advise BNB to implement the new Activity-Based Costing system in order to get a more accurate breakdown of costs, which will help the senior management of BNB to make efficient and effective decisions. We also recommend that after implementing ABC system that BNB goes ahead with the third alternative to focus on improving their existing services for its retail and business customers, and spend more on recruiting more business customers. This way the higher profit margin as proved by the ABC analysis of business customer line will be taken advantage of and still have the annual revenue of 150,000 retail customers with less expenditure. Additionally, BNB will not have its egg in one basket, because if the economy takes longer than expected to recover than BNB is still able to capitalize on its existing business customers as well as growing retail customers. Thus, we recommend BNB to continue to improve its existing services and focus slightly more on recruiting business line customers as they provide a better profit margin.

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