Chapter 5, Problem 57P

Customers as a Cost Object

Morrisom National Bank has requested an analysis of checking account profitability by customer type. Customers are categorized according to the size of their account: low balances, medium balances, and high balances. The activities associated with the three different customer categories and their associated annual costs are as follows:

Additional data concerning the usage of the activities by the various customers are also provided:

Required:

(Note: Round answers to two decimal places.)

1. 1. Calculate a cost per account per year by dividing the total cost of processing and maintaining checking accounts by the total number of accounts. What is the average fee per month that the bank should charge to cover the costs incurred because of checking accounts?
2. 2. Calculate a cost per account by customer category by using activity rates.
3. 3. Currently, the bank offers free checking to all of its customers. The interest revenues average $90 per account; however, the interest revenues earned per account by category are $80, $100, and $165 for the low-, medium-, and high-balance accounts, respectively. Calculate the average profit per account (average revenue minus average cost from Requirement 1). Then calculate the profit per account by using the revenue per customer type and the unit cost per customer type calculated in Requirement 2.
4. 4. CONCEPTUAL CONNECTION After the analysis in Requirement 3, a vice president recommended eliminating the free checking feature for low-balance customers. The bank president expressed reluctance to do so, arguing that the low-balance customers more than made up for the loss through cross-sales. He presented a survey that showed that 50% of the customers would switch banks if a checking fee were imposed. Explain how you could verify the president’s argument by using ABC.

To determine

Compute the value of costs per account per year. Also, compute the average fee per month that should be charged by the bank to cover their costs incurred in verifying the accounts.

Explanation of Solution

Activity Based Costing (ABC):

Activity based costing is an apportionment of costs that first considers the activity drivers that helps in the allocation of costs to various activities and then allocates costs to different cost objects by using the drivers.

Use the following formula to calculate value of costs per account per year:

$\text{Costs Per Account Per Year}=\frac{\text{Total Costs}}{\text{Number Of Statements Used}}$

Substitute $6,105,000 for total costs and 75,000 for number of statements used in the above formula.

$\begin{array}{c}\text{Costs Per Account Per Year}=\frac{\$6,105,000}{75,000\text{acoounts}}\\ =\$81.40\end{array}$

Therefore, a cost per account per year is $81.40.

Use the following formula to calculate value of average fee per month:

$\text{Average Fee Per Month}=\frac{\text{Costs Per Account Per Year}}{\text{12Months}}$

Substitute $81.40 for costs per account per year in the above formula.

$\begin{array}{c}\text{Average Fee Per Month}=\frac{\$81.40}{\text{12}\text{Months}}\\ =\$6.78\end{array}$

Therefore, average fee per month is $6.78.

To determine

Compute the costs per account by customer category with the help of activity rates.

Explanation of Solution

Computation of costs per account by customer category:

Activity	Rate(R)	Quantity (Q)	Low $\left(R\times Q\right)$ ($)	Medium $\left(R\times Q\right)$ ($)	High $\left(R\times Q\right)$ ($)
(A)Opening and closing	101	22,500	225,000
	101	4,500		45,000
	101	3,000			30,000
(B)Issuing monthly statements	0.502	675,000	337,500
	0.502	150,000		75,000
	0.502	75,000			37,500
(C)Processing transactions	0.103	27,000,000	2,700,000
	0.103	3,000,000		300,000
	0.103	750,000			75,000
(D)Customer inquiries	0.204	1,500,000	300,000
	0.204	900,000		180,000
	0.204	600,000			120,000
(E)Providing ATM services	0.705	2,025,000	1,417,500
	0.705	300,000		210,000
	0.705	75,000			67.500
Total Cost $\left(\text{A}+\text{B+C+D+E}\right)$			4,980,000	810,000	315,000
Number of accounts			57,000	12,000	6,000
Cost per account $\left(\frac{\text{Total Costs}}{\text{Number Of Accounts}}\right)$			87.37	67.50	52.50

Table (1)

Working Note:

1. Calculation of opening and closing rates:

$\begin{array}{c}\text{Opening And Closing Rate}=\frac{\text{Total Opening And Closing Costs}}{\text{Number of Accounts opened}}\\ =\frac{\$300,000}{30,000\text{accounts}}\\ =\$10\text{per account}\end{array}$

2. Calculation of issuing monthly transactions rate:

$\begin{array}{c}\text{Issuing Monthly Transcations Rate}=\frac{\text{Total Issuing Monthly Transactions Costs}}{\text{Number of Statements issued}}\\ =\frac{\$450,000}{900,000\text{statements}}\\ =\$0.5\text{per statement}\end{array}$

3. Calculation of processing transaction rate:

$\begin{array}{c}\text{Processing Transcations Rate}=\frac{\text{Total Processing Transactions Costs}}{\text{Number of Transactions}}\\ =\frac{\$3,075,000}{30,750,000\text{t}\text{ransactions}}\\ =\$0.10\text{per transaction}\end{array}$

4. Calculation of rate of customer inquiries:

$\begin{array}{c}\text{Customer Inquiries Rate}=\frac{\text{Total Customer Inquiries Costs}}{\text{Number of Customer Inquiries}}\\ =\frac{\$600,000}{3,000,000\text{minutes}}\\ =\$0.20\text{per minute}\end{array}$

5. Calculation of rate of providing ATM services:

$\begin{array}{c}\text{Providing ATM }\text{}\text{Services Rate}=\frac{\text{Total Providing ATM }\text{}\text{Services Costs}}{\text{Number of ATM Transactions}}\\ =\frac{\text{\$1,680,000}}{\text{2,400,000}\text{transactions}}\\ =\$0.70\text{per transactions}\end{array}$

To determine

Compute the average profit per account. Also, compute the profit per account with the help of ABC approach.

Explanation of Solution

Use the following formula to calculate average profit per account:

$\text{Average Profit}=\text{Interest Revenue Average}-\text{Costs Per Account Per Year}$

Substitute $90.00 for interest revenue average and $81.40 for costs per account per year in the above formula.

$\begin{array}{c}\text{Average Profit}=\text{\$90}\text{.00}-\text{\$81}\text{.40}\\ \text{=\$8}\text{.60}\end{array}$

Therefore, an average profit per account is $8.60.

Use the following formula to calculate profit per account with the help of ABC approach of low balance customers:

$\text{Profit}=\text{Interest Revenue Average}-\text{Costs Per Account }$

Substitute $80.00 for interest revenue average and $87.37 for costs per account per year in the above formula.

$\begin{array}{c}\text{Profit}=\$80.00-\$87.37\\ =-\$7.37\end{array}$

Therefore, the loss per account of low balance customers is $7.37.

Use the following formula to calculate profit per account with the help of ABC approach of medium balance customers:

$\text{Profit}=\text{Interest Revenue Average}-\text{Costs Per Account }$

Substitute $100.00 for interest revenue average and $67.50 for costs per account per year in the above formula.

$\begin{array}{c}\text{Profit}=\$100.00-\$67.50\\ =\$32.5\end{array}$

Therefore, the profit per account of medium balance customers is $32.5.

Use the following formula to calculate profit per account with the help of ABC approach of high balance customers:

$\text{Profit}=\text{Interest Revenue Average}-\text{Costs Per Account }$

Substitute $165.00 for interest revenue average and $52.50 for costs per account per year in the above formula.

$\begin{array}{c}\text{Profit}=\$165.00-\$52.50\\ =\$112.50\end{array}$

Therefore, the profit per account of high balance customers is $112.50.

To determine

Discuss the steps for verifying the argument of president with the help of ABC approach.

Explanation of Solution

The steps for verifying the argument of president with the help of ABC approach are explained below:

• • Compute the value of profits from various loans provided by the organization to their customers such as credit card with the help of ABC approach.
• • Compare the 50% of the profit of cross sales of the low balance customers with the total loss of low balance customers in verifying the accounts.
• • At the end, if the amount of profit of cross sales are more than the loss of cross sales, argue of president is valid.