Activity-Based Costing for a Service Company

Five-Stars Insurance Company carries three major lines of insurance: auto, workers compensation, and homeowners. The company has prepared the following report:

Line Item Description	Auto	Workers' Compensation	Homeowners
Premium revenue	$5,800,000	$6,250,000	$8,200,000
Estimated claims	(4,060,000)	(4,375,000)	(5,740,000)
Underwriting income	$1,740,000	$1,875,000	$2,460,000
Underwriting income as a percent of premium revenue	30%	30%	30%

Management is concerned that the administrative expenses may make some of the insurance lines unprofitable. However, the administrative expenses have not been allocated to the insurance lines. The controller has suggested that the administrative expenses could be assigned to the insurance lines using activity-based costing. The administrative expenses are comprised of five activities. The activities and their rates are as follows:

Activity	Activity Rates
New policy processing	$60 per new policy
Cancellation processing	$100 per cancellation
Claim audits	$250 per claim audit
Claim disbursements processing	$80 per disbursement
Premium collection processing	$20 per premium collected

Activity-base usage data for each line of insurance were retrieved from the corporate records as follows:

Line Item Description	Auto	Workers' Compensation	Homeowners
Number of new policies	2,000	1,400	4,100
Number of canceled policies	490	300	2,200
Number of audited claims	390	110	950
Number of claim disbursements	470	220	850
Number of premiums collected	8,500	1,900	15,200

Question Content Area

a. Complete the product profitability report through the administrative activities. Determine the operating income as a percent of premium revenue. Rounded to the nearest whole percent.

Description	Auto	Workers' Comp.	Homeowners
Premium revenue	$Premium revenue	$Premium revenue	$Premium revenue
Estimated claims	Estimated claims	Estimated claims	Estimated claims
Underwriting income	$Underwriting income	$Underwriting income	$Underwriting income
Administrative activities:
New policy processing	$New policy processing	$New policy processing	$New policy processing
Cancellation processing	Cancellation processing	Cancellation processing	Cancellation processing
Claim audits	Claim audits	Claim audits	Claim audits
Claim disbursements processing	Claim disbursements processing	Claim disbursements processing	Claim disbursements processing
Premium collection processing	Premium collection processing	Premium collection processing	Premium collection processing
Total administrative expenses	$Total administrative expenses	$Total administrative expenses	$Total administrative expenses
Operating income	$Operating income	$Operating income	$Operating income
Operating income as a percent of premium revenue	Operating income as a percent of premium revenue%	Operating income as a percent of premium revenue%	Operating income as a percent of premium revenue%

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a. Calculate Activity Cost for each product:

Activity-Base Usage x Activity Rate = Activity Costs

Subtract each activity cost from underwriting income for each product to obtain income from operations.

Divide income from operations by premium revenue to obtain a percentage.

Question Content Area

b. Interpret the report.

All three insurance lines have fill in the blank 1 of 8

differentthe samethe same

percentage of underwriting income to premium revenue. The differences among the insurance lines are in the way they consume fill in the blank 2 of 8

administrativeclaimsadministrative

activities. The fill in the blank 3 of 8

HomeownersWorkers' CompensationAutoHomeowners

insurance line has the fill in the blank 4 of 8

leasthighestleast

profitability because it has fill in the blank 5 of 8

smallerlargersmaller

and fill in the blank 6 of 8

morelessmore

frequent claims that require more auditing and disbursement processing than do the other two lines. In addition, the Homeowners line has a much higher rate of cancellation relative to the other two lines (over 50% of new policies). Lastly, the Homeowners line has more premium collections compared to the other two lines. Possibly, the Homeowners line is collected in smaller amounts from more customers than the other two lines. In contrast, the fill in the blank 7 of 8

HomeownersWorkers' CompensationAutoWorkers' Compensation

line consumes the fill in the blank 8 of 8

mostfewestfewest

administrative activities, causing it to be very profitable. The Auto line is in between these two.

Activity-Based Costing for a Service Company Five-Stars Insurance Company carries three major lines of insurance: auto, workers' compensation, and homeowners. The company has prepared the following report: Five-Stars Insurance Company Management is concemed that the administrative expenses may make some of the insurance lines unprofitable. However, the administrative expenses have not been allocated to the insurance lines. The controller has suggested that the administrative expenses could be assigned to the insurance lines using activity-based costing. The administrative expenses are comprised of five activities. The activities and their rates are as follows: Activity-base usage data for each line of insurance were retrieved from the corporate records as follows: a. Complete the product profitability report through the administrative activities. Determine the operating income as a percent of premium revenue. Rounded to the nearest whole percent