Chapter 26, Problem 26.3CP

Activity-based costing for a service company

Wells Fargo insurance Services (WFIS) is an insurance brokerage company that classified insurance products as either “easy” or “difficult.” Easy and difficult products were defined as follows:

Easy: Electronic claims, few inquiries, mature product

Difficult: Paper claims, complex claims to process, many inquiries, a new product with complex options

The company originally allocated processing and service expenses on the basis of revenue. Under this traditional allocation approach, the product profitability report revealed the following:

	Easy Product	Difficult Product	Total
Revenue	$600	$400	$1,000
Processing and service expenses	420	280	700
Income from operations	$180	$120	$ 300
Operating income margin	30%	30%	30%

WFIS decided to use activity-based costing to allocate the processing and service expenses. The following activity-based costing analysis of the same data illustrates a much different profit picture for the two types of products:

	Easy Product	Difficult Product	Total
Revenue	$600	$400	$1,000
Processing and service expenses	183	517	700
Income from operations	$417	$(117)	$ 300
Operating income margin	70%	(29%)	30%

Explain why the activity-based profitability report reveals different information from the traditional sales allocation report.

Source: Dan Patras and Kevin Clancy, “ABC in the Service Industry: Product Line Profitability at Acordia, Inc.” As Easy as ABC Newsletter, issue 12. Spring 1993