OzBank[1]
Introduction
OzBank began operations in the mid-1980’s. The bank quickly grew by providing cheque account services to many small businesses that preferred to do business with a “local” bank. Although OzBank initially offered cheque 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, OzBank’s senior management adopted a new strategy, focusing on increasing the number of retail customer accounts. By aggressively marketing individual retail accounts, OzBank continued to grow. Today, OzBank strives to maintain a stable base of business customers, while actively competing for an increased market share of retail customers.
Recent statements of financial performance (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 11am-2pm and Friday afternoons. Flexibility in scheduling part-time employees means that the bank’s staff is lean and fully utilized. OzBank’s CEO, Ima Doubtful, 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, OzBank’s directors took two actions last year, both aimed at increasing the bank’s retail customer base. First, OzBank established a service call centre to respond to customer inquiries about account balances, Cheques cleared, fees charged, and other banking concerns. Second, OzBank’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 Ima Doubtful does not understand why profits are declining, given that the Bank is serving more customers. OzBank’s southeast regional manager, Anna Lyst, has also noticed that while small retail customers flock to the bank, the number of business customers is barely stable.
Anna Lyst suspects that OzBank’s costing system may be part of the problem. OzBank 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 cheques processed (which is readily available because each branch must provide the dollar values of daily transactions for internal control). For the current period, OzBank processed a total of $95 million in cheques, 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 financial institutions at the time OzBank developed its cost system.
In college, Anna learned about an alternative costing approach called activity-based costing (ABC). However, the examples she remembered involved manufacturing firms. She wondered whether OzBank could develop an ABC system, with the business account customer line and the retail account customer line as the two primary cost objects. Anna approached Ima Doubtful with this suggestion. Ima was sceptical, exclaiming, “Our profits are going down the tubes and you want me to spend money developing a new accounting system?” However, Anna persisted, and Ima eventually authorised a pilot ABC study using three local branches of the bank.
Exhibit AOzBank
Statement of Financial Performance
For the three years ending June 30th, 2003
2001 / 2002 / 2003
($000) / ($000) / ($000)
Net interest income / 3,349 / 3,417 / 3,486
Provision for credit losses / 465 / 475 / 484
Net interest income after provision for credit losses / 2,884 / 2,942 / 3,002
Noninterest income / 1,190 / 1,199 / 1,207
Income prior to noninterest expenses and income tax / 4,074 / 4,141 / 4,209
Noninterest expenses / 3,362 / 3,539 / 3,805
Income before income taxes / 712 / 602 / 404
Income tax expense / 230 / 194 / 130
Net income / 482 / 408 / 274
The ABC implementation team included Anna, the managers of each of the three bank branches, a bank teller, and a representative from the customer service call center. The team began by identifying the activities OzBank performed. To start a simple pilot study, the team identified the three most important activities:
1. Paying cheques
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, labour (personnel) costs dominate. The ABC team asked each employee to fill out a short questionnaire to find out how the employees spend 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 cheques, (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 estimate the percentage of time the bank’s information system was used for cheque 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 cheques” 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 Implement an ongoing ABC system.
Exhibit BNon-interest Expense categories
(in 1,000s)
Salaries / 2,150
Depreciation of equipment & facilities / 640
Toll-free phone lines / 60
Other / 955
TOTAL / 3,805
After examining the three branch banks’ indirect costs (that is, the cost items making up the branch bank’s noninterest operating expenses), the ABC team identified the following:
§ Approximately 35% of the salary cost is associated with paying cheques, 45% associated with providing teller services and 20% associated with responding to customer account enquiries;
§ Around 70% of the depreciation of equipment and facilities is associated with paying cheques, while the remaining 30% is associated with providing teller services;
§ All of the costs associated with the tool-free phone lines were associated with responding to customer account enquiries;
§ All other non-interest expense categories were classified as other and were associated with facility-level activities.
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.
OzBank currently services 150,000 retail customer cheque accounts and 50,000 business customer cheque accounts. The bank earns net interest revenue on the balances that customer keep in their cheque accounts. 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
Exhibit CPossible Activity Cost Drivers For Year Ended June 30th 2003
Retail customers
(in 1,000s) / Business customers (in 1,000s) / Total
Cheques processed / 570 / 2,280 / 2,850
Value of cheques processed / 9,500 / 85,500 / 95,000
Teller transactions / 160 / 40 / 200
Account enquiry calls to customer service call center / 95 / 5 / 100
Number of accounts / 150 / 50 / 200
Required:
You are Anna Lyst. After attending the professional seminar on Activity-Based Costing (ABC) and conducting a preliminary analysis of the product costing system currently used by OzBank, you are convinced that the company would benefit from implementing an ABC system. However, in order to do so, you must convince the company's managing director, Ms. Ima Doubtful, of the benefits of such a move. In order to assist her in her decision, Ms. Ima Doubtful has authorised you to conduct a pilot ABC study. As part of this pilot study, you are required to report to Ima Doubtful on the following issues:
1. Under the original (old) costing system:
1.1. 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?
1.2. Determine the total annual indirect cost assigned to the retail customer line and the business customer line. Assuming there are no direct costs or other indirect costs, compute average contribution to profit per account for retail customers and for business customers. What business strategy would a manager likely adopt when using the original cost allocation system? Why?
1.3. What are the signs that OzBank’s original costing system is ‘broken’, such that it needs refinement or improvement?
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2. Under the proposed ABC system:
2.1. Determine the total annual indirect cost assigned to the retail customer line and the business customer line. Assuming there are no direct costs or other indirect costs, compute average contribution to profit per account for retail customers and for business customers.
2.2. Explain why these results are different to the figures calculated under the exiting costing system. Be specific. What business strategy would a manager using the ABC cost system likely adopt? How does this result compare to your response under 1.3?
2.3. In your opinion why is it likely that the benefits of the proposed ABC system outweigh the costs?
3. Future strategy - Recall OzBank’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? How can OzBank’s managers use the ABC data to plan more profitable marketing strategies? How can OzBank’s managers use ABC information to identify opportunities to trim costs while still satisfying customer’s needs?
4. Limitations – Outline the limitations of the ABC model proposed by Anna Lyst, and the limitations of ABC systems in general that the CEO should be made aware of. Do you think that the benefits of ABC will outweigh its costs at OzBank? Give specific reasons.
Presentation marks (5 marks)
Total marks: 50 marks (25% of total assessment)
Length
Maximum of 1,500 words
Format/expectations
Please provide refrences while solving the problem.
NOTE: In answering questions one and two of this assignment, you are required to include two diagrams in the appendix of your report: a diagram of OzBanks existing costing system and a diagram of the proposed ABC system. The diagram below is provided only for guidance. Students may find that the number of resources categories, activities, activity rates, and direct costs in their diagram differ from that shown in the diagram below.
[1] This case study has been adapted from Bamber & Hughes (2001), Activity-Based Costing in the Service Sector: The Byckeye National Bank, Issues in Accounting Education, Vol. 16(3), pp. 381-408.