on

Issues in Accounting Vol. 16, No.3 August 2001

Education

ABSTRACT: The U.S. Bureau of the Census projects that by 2006, the service sector will employ 74 percent of the workforce. This case illustrates why a major segment of the service sector-banks-needs accurate cost information to make strategic decisions, and how more refined accounting systems help fulfill this need. Buckeye National Bank is a hypothetical bank that has suffered falling profits despite a shift in customer base toward retail customers, which the current information system reports are more profitable than business customers. Following a stepby-step approach, you will develop the Bank's average cost of serving a retail customer account and a business customer account, under (1) the Bank's traditional single allocation base system, and (2) a (pilot test) activity-based costing system. You will analyze these results to determine how and why costs reported by the activity-based system differ from the costs reported by the traditional system, and what this difference means for the Bank's business strategy. Finally, you will consider how the Bank's managers can use the new, more refined activity-based cost data in strategic decision making, including controlling costs and developing more profitable business strategies.

INTRODUCTION IJ;~ Buckeye National Bank began operations in the mid-1980s. The bank quickly grew by providing checking account services to many small businesses that preferred to do business with a "local" bank. Although Buckeye initially offered checking account services for individual accounts (retail customers), the bank primarily focused on serving its business customers. During the economic slowdown of the early 1990s that weakened the 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, Buckeye continued to grow. Today, the Buckeye N ational Bank strives to maintain a
Linda Smith Bamber is a Professor at the University of Georgia and K. E. Hughes II is-an Assistant Profess~~~tLouisiana State U!!!!!-!!-rsity.

-We appreciate the helpful suggestions and comments from Barbara Apostolou, Michael Bamber, Tom Harrison, Charlene Henderson, Sue Ravenscroft (associate editor), David E. Stout (editor), and two anonymous reviewers.

382

Issues in Accounting Education

stable base of business customers, while actively competing for an increased market share of retail customers. Recent income statements (Exhibit A) reveal a decline in the bank's profits. The bank's primary (noninterest) expense consists of salaries and employee benefits. Most full-time employees' first priority is providing 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 11 AM-2 PMand Friday afternoons. 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 staffing arrangement allows the bank to provide speedy customer service, while operating at practical capacity. (That is, the bank's staff is fully utilized in efficient operations, after allowing for bank holidays and other scheduled staff activities such as training.) To counter falling profits, 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 profits continued to decline. CEO Rob Garrison does not understand why profits are declining, given that the Bank is serving more customers. Buckeye's southeast regional manager, Erik Larsen, has also noticed that while small retail customers flock to the bank, the number of business customers is barely stable. Erik Larsen suspects that Buckeye's costing system may be part of the problem. Buckeye developed its simple costing system when the bank began operations in 1985. The bank does not trace any costs directly to individual customers. It simply treats all (noninterest expense) operating costs identified 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 transactions for internal control). For the current period, Buckeye processed a total of $95 million in checks, ofwhich $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 financial institutions at the time Buckeye developed its cost system. In college, Erik learned about an alternative costing approach called activitybased costing (ABC). However, the examples he remembered involved manufacturing firms. 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. Rob was skeptical, exclaiming, "Our profits 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

(
Bamber and Hughes 383

EXInBIT A Buckeye National Bank Consolidated Income Statement For the three years ending December 31, 20x5
20x5 ($000) 2O:x4 ($000)
$3,417 475

20x3 ($000)

Netinterestincomea Provision for credit losses Net interest income after provision for credit losses Noninterest income Income prior to noninterest expensesand income tax Noninterest expenses Income before income taxes Income tax expense Net income

$3,486 484 3,002 1,207

4,209 3,805 404 130 $ 274

$3,349 465
2,884 1,190
4,074 3,362 712 230 $ 482

2,942 1,199
4,141 3,539

602 194 $ 408

a 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 as checkingaccountfeeschargedif the accountbalancefalls belowthe required minimum level. Noninterest expensesare all of the bank's operating costs, including those associatedwith 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 identified the three most important 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 refine the system by conducting a more detailed activity analysis the 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 industries like banking, labor (personnel) costs dominate. The ABC team asked each employee to fill out a short questionnaire to find 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 percentage of 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

384

Issues in Accounting

Education

information system was used for check processing and providing teller services (vs. other uses such as compiling periodic financial 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 (budgeted 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 banks' indirect costs (that is, the cost items making up the branch banks' noninterest operating expenses), the ABC team classified the annual costs in each activity's cost pool (hereafter, all numbers are in thousands)l as shown in Exhibit B.

EXIUBIT B Assignment of Indirect (Noninterest Expense) Costs to Activity Cost poolsa Activity Cost Pool to which Indirect Cost is Assigned
Paying checks

Indirect

Cost

Estimated Annual Total Costs (in $1,000s)

$ 700

Salaries of check-processing personnel Depreciation of equipment and facilities used in check processing Teller salaries Depreciation of equipment and facilities used in teller operations Salaries of customer representatives at call center Toll-free phone lines plus depreciation of equipment and facilities in customer call center

Paying checks Providing teller services

440

1,000

Providing teller services

200

Responding to customer account inquiries

450

Responding to customer account inquiries

f
Bamber and Hughes 385 The team identified
Activity Cost Pool

the following

cost drivers2 for each activity Activity

cost pool:

Cost Driver

Paying checks Providing teller services Responding to customer account inquiries

Number of checks processed N umber of teller transactions Number of account inquiry calls to customer service call center

The ABC team estimated that for the three pilot-test bank branches, the retail and business customer lines experienced the annual activity levels (in thousands) 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 customer service call center . Buckeye N ational 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 Average annual revenue per business customer account $10 $40

Required: Your task is to assist Erik Larsen and his ABC team by providing the following information: 1) Under the original (old) cost system: A) Compute the single indirect cost allocation rate that the bank would use to allocate the total indirect costs presented in Exhibit B.
2 A cost driver is a factor, such as the number of checksprocessed, that causally affects costs.For example, the costs associatedwith the activity "paying checks"rise and fall as the quantity of the cost driver (the number of checksprocessed) rises and falls. 3 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 accountbalance (say 4 percent).

EXIllBIT C Activity Cost Drivers by Customer Line

Annual Number of Units of Activity-Cost Driver Used by Retail Customers (in I,OOOs) 570 160 Annual Number of Units of Activity-Cost Driver Used by Business Customers (in I,OOOs) 2,280 40 200

Activity Driver

Cost

Total

Checks processed

Teller transactions

Account inquiry calls to customer service call center

95

100

386 B) Use your answer to part A to determine

Issues in Accounting Education

the total annual indirect

cost

assigned to: (i) the retail customer line, and (ii) the business customer line. What drives these allocations? C) What proportion of the total indirect cost is assigned to: (i) the retail customer line, and (ii) the business customer line? Why? That is, what is the underlying rationale for indirect cost allocation under the old system? What assumption must hold approximately true for the original cost allocation procedure to generate "accurate" customer cost information? D) Use your answer to part B and data on the number of retail and business accounts to determine: (i) the indirect cost per retail account, and (ii) the indirect cost per business account. E) Assuming there are no direct costs or other indirect costs, compute the average contribution to profit per account for retail customers and for business customers. What business strategy would a manager using the original cost allocation system likely adopt? Why? 2) What are the signs that Buckeye's original cost system is "broken," such that it needs refinement or improvement? 3) Under the new activity-based costing (ABC) system, compute the indirect cost allocation rates for each of the three activities: A) Paying checks B) Providing teller services C) Responding to customer account inquiries 4) Use the following schedule to compute the total indirect cost allocated to each customer line (show your computations beside the activity description):
Total Indirect Cost Assigned to Retail Customer Line Total Indirect Cost Assigned to Business Customer Line

Activity Paying checks Providing teller services Responding to customer account inquiries Total Indirect Costs

5) What proportion of each activity is attributable to: (i) the retail customer line, and (ii) the business customer line? Using the ABC data from Requirement 4, compute (i) the indirect cost per 6) retail customer account and (ii) the indirect cost per business customer account. 7) Explain why the results in Requirement 1, Part D, and Requirement 6

differ. Be specific. 8) Using the ABC data, compute the average contribution to profit per account for both retail and business customers. What business strategy would a manager using the ABC cost system likely adopt? How does this result compare to your response to Requirement 1, Part E?

In

Bamber and Hughes

387

;t

it

il it .d 1~t

ild

9) Recall Buckeye National Bank's bonus-based incentive plan to increase the number of customers. Do you believe this strategy is wise? Would you suggest any change in strategy based on the ABC analysis? 10) Activity-based management (ABM) refers to managers' use of ABC data in making business decisions. How can Buckeye's managers use the ABC data to plan more profitable marketing strategies? How can Buckeye's managers use ABC information to identify opportunities to trim costs while still satisfying customers' needs? 11) Why might Erik Larsen have suspected that the benefits of ABC would likely outweigh the costs of implementation at Buckeye N ational Bank? 12) Why do you think it is important for a CEO or a bank branch manager to understand ABC?

le )r 19

:b
ct

to

l):

~t

~r ~r ~r 6
cld It