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Costs for Decision Making: Differential Analysis INTRODUCTION This case is based on a real-life project and takes place in 2010 at the New York City headquarters for the United States operations of AC Global, Inc. (The real name has been changed.) AC Global is a multinational insurance company with its headquarters in France and annual revenue ranking in the top 10 companies globally. The company has significant operations in the United States, Europe, Japan, and Australia, and the operations in each country are separate insurance companies and operate with a large degree of autonomy. Recently, AC Global established insurance operations and a servicing center in India. The servicing center in India primarily provides some information technology (IT) support for the insurance operations in the United Kingdom (U.K.), Belgium, and France. The ongoing global recession has significantly decreased the profitability of AC Global, increasing the importance of reducing costs. AC Global's operations in the U.S. (AC-US) sell life and annuity products and represent approximately 20% of the group's life and annuity revenues. AC-US has approximately 3,000 employees, with about 1,000 employees based in the New York City headquarters. The remaining employees are located at the company's service centers in New Jersey, Pennsylvania, and North Carolina. IMPACT ON SHORT-TERM PROFITS For an insurance company, there are four key line items on the income statement: premium revenue, investment income, benefits/claims expense, and operating expenses. Operating expenses provide the greatest opportunity for short-term improvement in earnings since the other line items are less controllable or the impacts of changes emerge over a long period of time. Investment income is primarily composed of interest and dividends on bonds and common stock investments and is not changed through operating actions. Premium revenue is composed of fees collected for providing insurance coverage and is only modestly impacted by current sales. Benefits and claims are paid to policyholders and their beneficiaries and are also difficult to impact in the short-term. The global economic downturn that began in late 2008 put intense pressure on the financial services industry. During 2009, U.S. sales of annuity products decreased by 30% while life insurance sales fell by 15%.1 Like the industry, AC Global has been negatively impacted by the economic downturn. AC-US premium revenue fell 8% cumulatively between 2007 and 2009. In 2010, the company's operations remained stable, but revenue was expected to be similar to 2009. AC Global's operating earnings decreased over 80% from 2007 to 2008, and AC-US suffered an operating loss in 2008. Although operating earnings recovered somewhat in 2009 (shown in Figure 1), the earnings for AC Global consolidated and AC-US are still 36% and 40%, respectively, below those in 2007. As a result, the company's stock price is down nearly 50% since the beginning of the crisis in 2008. AC-US measures operating efficiency based on the expense ratio, which is operating expenses divided by premium revenue. In 2004, AC-US went through a restructuring that reduced personnel overlap and inefficiency. Through the restructuring, AC-US reduced the workforce by 4%, reduced operating expenses by 5%, and improved the expense ratio from 12.7% in 2004 to 10.1% by 2007, 14% better than the expense ratio of 11.7% for AC Global. While operating expenses have grown modestly at 2% since 2007, the expense ratio for ACUS increased from 10.1% in 2007 to over 12.5% in 2009, worse than the 12.1% for AC Global. AC-US has underperformed AC Global in earnings and cost efficiency during 2009, which is concerning for the management of AC-US (see Figure 2). COST REDUCTION ANALYSIS PROJECT Peter George is a vice president responsible for financial planning and analysis (FP&A) at AC-US in New York. In his role, George and his team evaluate all significant projects with financial implications. George led the team that analyzed and recommended the restructuring six years ago that significantly improved the expense ratio. George met with Brian Thomas, the chief financial officer (CFO). Thomas had reviewed the first quarter preliminary revenue and earnings and told George that it is imperative for the company to find ways to reduce expenses to improve earnings. He set a goal of a 10% reduction in operating expenses. If AC-US achieved that goal, he estimated that the company would return the expense ratio to a value below 11% and operating earnings would return to 2007 levels. Before engaging the rest of the organization, the CFO would like the functions he manages to take a leadership position in the cost reductionsnot just recommending cost- reduction actions but also providing examples to show they are effective. Thomas reviewed the accounting function first and decided he wants it to reduce expenses by 10% overall to be in line with the company's overall target. He also would like to see a payback period of two years or less for any one- time costs. Thomas asked George to evaluate potential cost-saving alternatives and provide him with a preliminary analysis within one week. Thomas then informed George that the company has recently began performing some accounting functions in the service center in India and gave George the contact information for Sanjay Delphi, the project manager for the company's India facility. George believes that in addition to outsourcing (offshoring), increasing the use of electronic payments in accounts payable and relocating some of accounting functions to the service center in N.J. are two other viable ways to reduce costs. George made notes on information regarding expenses relevant for the analysis, including the severance policy (see Table 7, section F). George also pulled up the organization chart to list all of the various accounting functions as well as their annual expense budgets (Table 1). He assembled information on the staff in each of the accounting functions, including their salaries, benefits, residence, and possible severance based on the years of service and prepared a summary by function (see Table 6). George meets with two of his team members, Samantha Charleston and Ryan Falkirk, to explain the project. Given the one-week turnaround time for the analysis, George suggests that each of them select one option to analyze over the next four days and then meet to develop their recommendations. George selects offshoring, Charleston decides to analyze electronic check processing, and Falkirk will analyze relocating accounting functions. OFFSHORING George reviews some general information on offshoring and finds that global offshoring has grown rapidly. He finds that accounting processes such as accounts payable, accounts receivable, sales ledger, general ledger, financial reporting, and bank processing are increasingly offshored. George calls Delphi to discuss the services performed at the servicing center in India. Delphi informs George that the service center currently provides some IT support for the insurance operations in the U.K., Belgium, and France; performs some customer service functions; and also recently added a few accounting functions. Delphi emphasized that the service center is just beginning to add staff with accounting expertise and has minimal knowledge of U.S. generally accepted accounting principles (GAAP) state regulatory accounting requirements, and U.S. tax law (the U.S. Internal Revenue Code). George determines that the first step in his analysis is to identify which accounting functions would be the best candidates for offshoring and then analyze the financial and logistical feasibility of doing that. George prepares a matrix to assist him in analyzing which functions would be the most appropriate to offshore (see Table 2). His matrix takes into account required skill levels, local knowledge (of the U.S. Internal Revenue Code, for example), compliance risk, technological support, and the need for direct management oversightwhich may be difficult due to distance and differences in time zones. He rates the functions on each of the criteria as high, medium, and low. George concludes that the functions that score low or medium on all of the criteria would be the best candidates for outsourcing. Based on the matrix, he believes that the accounts payable and bank reconciliation functions are the best candidates for initial consideration. The accounts payable function has a separate manager while the bank reconciliation function reports to the manager of general accounting. The Bank Reconciliation Department prepares 50 reconciliations per month (600 per year), and the Accounts Payable Department processes 50,000 checks per month (600,000 per year). George reviews the annual expense budgets (provided in Table 3). George sends Delphi an email and requests information on the accounts payable and bank reconciliation service functions. Delphi responds that the charges for outsourced services for accounts payable and bank reconciliation are a base monthly fee of $1,250 for each function ($15,000 per year) plus $0.65 per payment for processing accounts payable and $200 per bank reconciliation. Delphi also informs George that the U.S.-based operations would need to maintain staff to coordinate the transfer of information. Based on a similar project being undertaken by the company's U.K. operations, Delphi estimates that one staff member within the Accounting Department should be sufficient to support both accounts payable and bank reconciliations. Delphi and George discuss the necessary skills. George believes that retaining the accounts payable manager, who likely has the necessary skills, would be a good solutionand he uses that assumption for his analysis. The accounts payable manager's annual salary is $75,000. The allocated benefits charge is $18,750, but actual benefits and taxes are $19,488. George estimates that the cost for a personal computer, supplies, travel, and all other expenses (excluding postage) would total $15,500. He assumes that the salary, benefits and other expenses associated with the manager would be allocated 65% to accounts payable and 35% to bank reconciliations based upon the estimated time requirements to support each function. George does not include the allocation of rent, corporate expenses, or 50% of IT support in his cost-reduction estimate. Delphi also gives George the data transfer and connectivity specifications to discuss with the IT Department. Josephine Young, of the IT Department, analyzes the requirements and informs George that they would need to improve connectivity and alter the time of the batch processing for accounts payable. She estimates there would be a one-time cost of $100,000 plus $2,500 per month for improved connectivity. The change in the batch processing time will also cause an increase in personnel costs of $2,500 per month. But there are no additional technology requirements for offshoring bank reconciliations. AUTOMATING ELECTRONIC PAYMENTS Charleston performs some background research on electronic payments. She finds that the use of electronic payments has increased substantially as the number of checks used in business-to-business transactions rose. The use of paper checks decreased by 5% from 2006 to 2009.3 The estimated savings from using electronic payment instead of paper checks ranged from 20% to 90%.4 Since the accounts payable function issues all of its payments as checks, Charleston believes that there may be significant savings if the company made greater use of electronic payments. Charleston contacts the company's corporate banking representative to inquire about electronic payments alternatives. She finds that the bank charges an average of $0.125 per electronic payment. The bank also provides Charleston with a contact at a company that recently adopted electronic payments (identified as Company XYZ). As a means to estimate the potential impacts, she contacts Company XYZ's treasurer to discuss how it impacted their staffing needs and costs and is informed that Company XYZ averaged 2 minutes in labor per manual check and only 1.5 minutes for each electronic payment. For recurring payments, Company XYZ experienced an 80% time savings annually. To support her analysis, Charleston requests and receives a report showing the number of the company's checks that are recurring to vendors as well as those to employees and business partners, which are good candidates for electronic payments (see Table 4). Based on her preliminary analysis, Charleston estimates that the company could process up to 50% of its current payments electronically. Using the results for Company XYZ as a proxy, she estimates that electronic payments would reduce processing time by 25% for each electronic payment. Since recurring payments require minimal work after initial set-up, the potential estimated time savings is 80%. Since 16% of payments are recurring, labor savings would be possible. Charleston estimates that electronic payment processing would reduce staff, with associated reductions in salaries and benefits as well as other associated costs. To estimate the impact on staff, she uses 10 employees processing 600,000 checks annually and assumes that 50% of the payments could become electronic. To calculate the potential savings in salaries and benefits, she assumes that the staff reductions would involve less-experienced staff and represent 15% of total salaries and benefits for accounts payable. She estimates also that there would be savings in personal computer (PC) costs, IT support, and other costs of $1,775 per employee. Additionally, there would be a reduction in postage costs in direct proportion to the reduction of the number of checks. These savings would be partially offset by an additional cost of $0.125 for each electronic payment that replaces a check. Further, she uses the information from Table 6 to estimate that severance costs would represent 15% of the maximum eligible severance for accounts payable. RELOCATION Falkirk meets with the head of corporate facilities to discuss the availability of space in the N.J. service center and the possibility of subleasing any excess space created in the New York office. The head of facilities states that the company currently has more than 4,000 square feet of excess space in N.J. There also is up to an additional 28,500 square feet of space available in the building that could be leased for approximately $25 per square foot. But space must be leased in blocks of 9,500 square feet, which is equivalent to one floor in the building. Also, the head of facilities states that the company currently has approximately 3,500 square feet of excess space in the New York office and could sublease the space in blocks of 10,000 square feet (equivalent to one floor). But if a block or blocks of 10,000 square feet of space cannot be created, the available space could not be subleased. Given current real estate prices, he estimated the sublease rent would be $65 per square foot. Based on past moves, he estimates the costs to move employees and set up new workstations average $1,000 per position in the new space plus $50,000 per floor to build out and wire the new space. Falkirk prepares a grid (see Table 5) highlighting the level of management and interdepartment interaction as well as the number of N.J. resident employees in each function. He believes that those functions with the lowest level of interdepartment and management interaction would be best for possible relocation and selects the departments with low to medium interdepartment rankings. Additionally, Falkirk prepares a summary list of employees by function and their residence (see Table 6) to estimate the likely number of employees that would be retained and the potential severance costs if a portion of the accounting functions are relocated to N.J. He assumes that department heads and their assistants would have offices in both the corporate headquarters and the N.J. location. He estimates that 250 square feet of office space per position will be needed for each employee relocated from the New York office and a comparable amount would be available for subleasing. He assumes 100% of all employees who are N.J. residents would be retained. Of the residents not in New Jersey, he assumes all department heads and their assistants would remain while all other employees not from New Jersey would terminate, and severance would be paid to any employee not relocating. Information regarding the company's severance policy is provided in Table 7, section F, and summary employee information by department is in Table 6. INTERACTION OF ALTERNATIVES If the company only outsources bank reconciliations, the team has assumed that the bank reconciliation department will need to retain the most experienced employee to support the process. The most experienced employee in the department has eight years of service, a salary of $48,000, health insurance costs of $10,000, 401(k) contributions at 5%, and payroll taxes of 7.65%. In addition to the savings in salaries and benefits for the positions eliminated in bank reconciliations, it is also estimated that there would be a savings of $8,000 in total for expenses other than salaries and benefits. The one time initial costs would consist of severance costs for the positions eliminated.

CASE QUESTIONS Provide responses, displaying all work, to the following questions: 1. What costs are relevant to each of the three alternatives: offshoring, relocating functions, and automating functions? 2. Based on George's assumptions that all of the remaining supervisor's costs are split 65% to accounts payable and 35% to bank reconciliation, and all incremental ongoing technology costs and postage costs are charged to accounts payable, calculate the annual savings per function through offshoring. 3. Using the information that Charleston gathered on electronic payment processing, determine the potential staff reduction and calculate the potential annual cost savings from electronic processing of 50% of the accounts payable checks