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Issues in AcCounting Education Vol. 16, No. 3 August 2001 Activity-Based Costing in the Service Sector: The Buckeye National Bank Linda Smith Bamber and K E. Hughes II INTRODUCTION Tie Buckeye National Bank began operations in the mid-1980s. The bank uickly grew by providing checking account services to many small businesses that preferred to do J:>usiness with a "local" bank. Although Buckeye initially offered checking 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, Buckeye's senior management adopted a new strategy, focusing on increasing the number of retail customer accounts. By aggressively marketing individual retail accounts, Buckeye continued to grow, Today, the Buckeye National Bank strives to maintain a Linda Smith Bamber is a Professor at the University of Georgia and K. E. Hughes II is an Assistant Professor at Louisiana State University. We appreciate the helpful suggestions and comments from Barbara Apostolou, Michael Bamber, Tom Harrison, Charlene Henderson, Sue Ravenscroft (associate editor), David E. Stout (editor), and two anonymous reviewers. 382 Issues in Accounting Education stable base of business customers, while acbvely competing for an increased market share of retail customers. Recent income statements (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 11 AM-2 PM and Friday afternoons. Flexibility in scheduling part-time employees means that the bank's staff is lean and fully utilized. Buckeye's CEO, Rob Garrison, believes that this staffing arrangement allows the bank to provide speedy customer service, while operating at practical capacity. (That is, the bank's staf'fis fully utilized in efficient operations, after allowing for bank holidays and other scheduled staff activities such as training.) To counter falling profits, Buckeye's directors took two actions last year, both aimed at increasing the bank's retail customer base. First, Buckeye established a service call center to respond to customer inquiries about account balances, checks cleared, fees charged, and other banking concerns. Second, Buckeye'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 Rob Garrison does not understand why profits are declining, given that the Bank is serving more customers. Buckeye's southeast regional manager, Erik Larsen, has also noticed that while small retail customers flock to the bank, the number of business customers is barely stable. Erik Larsen suspects that Buckeye's costing system may be part of the problem. Buckeye developed its simple costing system when the bank began operations in l 985. 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 checks processed (which is readily available because each branch must provide the dollar values of daily transac- tions for internal control). For the current period, Buckeye processed a total of $95 million in checks, 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 Buckeye developed its cost system. In college, Erik learned about an alternative costing approach called activitybased costing (ABC). However, the examples he remembered involved manufacturing firms. He wondered whether Buckeye could develop an ABC system, with the business account customer line and the retail account customer line as the two primary cost objects. Erik approached Rob Garrison with this suggestion. Rob was skeptical, exclaiming, "Our profits are going down the tubes and you want me to spend money developing a new accounting system?" However, Erik persisted, and Rob eventually authorized a pilot ABC study using three local branches of the bank. The ABC implementation team included Erik, the managers of each of the three bank branches, a bank teller, and a representative from the customer service call Bamber and Hughes EXHJBITA Buckeye National Bank Consolidated Income Statement For the three years ending December 31, 20x5 20x5 20x4 ($000) ($000) Net interest income' $3,486 $3,417 Provision for credit losses 484 475 Net interest income aft.er provision for credit losses 3,002 2,942 Noninterest income 1,207 1,199 Income prior to noninterest expenses and income tax 4,209 4,141 Noninterest expenses 3,805 3,539 Income before income taxes 404 602 Income tax expense 130 194 Net income $ 274 $ 408 = = 383 20x3 ($000) $3,349 465 2,884 1,190 4,074 3,362 712 230 $ 482 = Net interest income equals interest income less interest expense. The bank's primary income is from interest-bearing checking accounts. Noninterest income includes fees charged for various services, such as checking account fees charged if the account balance falls below the required minimum level. Noninterest expenses are all of the bank's operating costs, including those associated with paying checks, providing teller services, and responding to customer account inquires. ,. center. The team began by identifying the activities Buckeye National Bank performed. To start a simple pilot study, the team identified the three most important activities: 1. Paying checks 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, labor (personnel) costs dominate. The ABC team asked each employee to fill out a short questionnaire to find out how the employee spends 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 checks, (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 estimated the percentage of time the bank's 384 Issues in Accounting Education informatfon system was used for check 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 checks" 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 develop budgeted indirect cost rates for each activity the following year. The advantage of budgeted rates over actual rates based on the prior year's data is that budgeted rates (budgeted cost associated with the activity divided by the budgeted quantity of the activity's cost driver) can incorporate expected changes in costs and operations. After examining the three branch banks' indirect costs (that is, the cost items making up the branch banks' noninterest operating expenses), the ABC team classified the annual costs in each activity's cost pool (hereafter, all numbers are in thousands)1 as shown in Exhibit B. 1 An activity's cost pool is simp]y a grouping, or aggregation, of a11 the individual costs associated with that activity. The bank's ABC team created separate activity cost pools for the costs associated with each of the three activities: (l) paying checks, (2) providing te11er services, and (3) responding to customer account inquiries. EXJilBITB Assignment oflndirect

Suppose that the variable portion of servicing one retail customer is $4 (under the new Activity-Based-Costing system). If the bank responds to the new customer profitability numbers by letting one retail customer go, by how much would its total income for the year change?