Royal Financial Services (RFS) provides front end loan origination services for a number of banks who process and maintain loan portfolios. RFS accepts applications from customers and processes them through closing of the loan agreement before turning the loan over to customer banks. RFS is paid regardless of whether the loan closes or not. RFS currently services three types of loans - residential mortgages, auto loans, and personal unsecured loans. RFS has no cost accounting system so total operating expenses are simply allocated to each product line based on revenue.
For the year just ended, RFS reported financial results as follows:
Income Statement Mortgage Auto Personal Total
Annual Volume of Loans 1500 6000 4000 11500
Origination Fee/Unit 350 200 115
Total Revenues $ 525,000 $ 1,200,000 $ 460,000 $ 2,185,000
Operating Expense $ 504,673 $ 1,153,538 $ 442,189 $ 2,100,400
Profit $ 20,327 $ 46,462 $ 17,811 $ 84,600
Profit % Revenue 3.9% 3.9% 3.9% 3.9%
RFS management is concerned about the overall low profitability of the business and has asked you to apply activity based analysis in order to give RFS a better understanding of relative product profitability. After extensive interviewing of staff and analysis of RFS's cost structure, you determine there are four primary activities that RFS performs, with cost drivers and total cost as follows:
Activities Activity Driver Mortgage Auto Personal Total Cost
Accept applications # pages per application 4 3 1 616,000
Obtain credit referrals # credit sources/applic. 2 2 1 332,500
Do loan analysis # hours analysis/applic. 3 2 1 656,000
Close loan # hours to close loan 4 2 1 495,900
You determine that the application processing and loan analysis activities are performed using internal RFS resources while the credit and closing activities are performed primarily by external credit agencies and law offices on a per transaction basis (e.g. $X per credit check, $Y per closing hour). You also learn 65 % of the mortgages end up being closed (the remainder are not approved after loan analysis); 75 % of auto loans close and 85 % of personal loans close.
You also identify a key external measure of how well RFS is performing versus the industry. While RFS does not bear the cost of defaults, their customers do track RFS performance and use it to negotiate future origination fee rates.
Mortgage Auto Personal
Default rate experienced by loan processor 2% 1% 6%
Industry average 2% 3% 4%
Assignment (Template provided on Blackboard)
A. Based on the above information, use activity based costing to assess the total and per unit profitability of RFS's three loan products.