Virgin Islands National Bank Case

INTRODUCTION The Virgin Islands National Bank began operations in the mid-1980s. The bank quickly grew by providing checking account services to many small businesses that preferred to do business with a local bank. Although Virgin Islands initially offered checking account services for individual account (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, Virgin Islands senior management adopted a new strategy, focusing on increasing the number of retail customer accounts. By aggressively marketing individual retail accounts, Virgin Islands continued to grow. Today, the Virgin Islands National Bank strives to maintain a stable base of business customers, while actively competing for an increased market share of retail customers. Recent income statements (Exhibit A) reveal a decline in the banks profits. The banks 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 11am-2pm and Friday afternoons. Flexibility in scheduling part-time employees means that the banks staff is lean and fully utilized. Virgin Islands CEO, Rob Garrison, believes that this staffing arrangement allows the bank to provide speedy customer service, while operating at practical capacity. (That is, the banks staff is fully utilized in efficient operations, after allowing for bank holidays and other schedules staff activities such as training.) To counter falling profits, Virgin Islands directors took two actions last year, both aimed at increasing the banks retail customer base. First, Virgin Islands established a service call center to respond to customer inquiries about account balances, checks cleared, fees charged, and other banking concerns. Second, Virgin Islands directors authorized year-end bonuses to branch managers who met their branchs target increase in the number of customers. However, even though 80 percent of the branch mangers met the targeted increase in customer accounts, the Banks profits continued to decline. CEO Rob Garrison does not understand why profits are declining, given that the Bank is serving more customers. Virgin Islands southeast regional manger, Erik Larsen, has also noticed that while small retail customers flock to the bank, the number of business customers is barely stable. EXHIBIT A Virgin Islands National Bank Consolidated Income Statement For the three years ending December 31, 20X5 20X5 20X4 20X3 ($000) ($000) ($000) Net interest income* $3,486 $3,417 $3,349 Provision for credit losses 484 475 465 Net interest income after provision for credit losses 3,002 2,942 2,884 Noninterest income 1,207 1,199 1,190 Income prior to noninterest expenses and income tax 4,209 4,141 4,074 Noninterest expenses 3,805 3,539 3,362 Income before income taxes 404 602 712 Income tax expense 130 194 230 Net income $ 274 $ 408 $ 482 *Net interest income equals interest income less interest expense. The banks 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 banks operating costs, including those associated with paying checks, providing teller services, and responding to customer account inquiries. Erik Larson suspects that Virgin Islands costing system may be part of the problem. Virgin Islands developed its simple costing system when the bank began operations in 1985. 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 value of daily transactions for internal control). For the current period, Virgin Islands 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 Virgin Islands developed its cost system. In college, Erik learned about an alternative costing approach called activity-based costing (ABC). However, the examples he remembered involved manufacturing firms. He wondered whether Virgin Islands 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 manager of each of the three bank branches, a bank teller, and a representative from the customer service call center. The team began by identifying the activities Virgin Islands 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 banks information 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 equipments 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 years 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 years data is that budgeted rates (budgeted cost associated with the activity divided by the budgeted quantity of the activitys 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 activitys cost pool (hereafter, all numbers are in thousands) 1 as shown in Exhibit B. EXHIBIT B Assignment of Indirect (Noninterest Expense) Costs to Activity Cost Pools* Estimated Annual Activity Cost Pool to which Total Costs Indirect Cost Indirect Cost is Assigned (in $1,000s) Salaries of check processing personnel Paying checks $700 Depreciation of equipment and facilities used in check processing Paying checks 440 Teller salaries Providing teller services 1000 Depreciation of equipment and facilities used in teller operations Providing teller services 200 Salaries of customer representatives at call Responding to customer account 450 center inquiries Toll-free phone lines plus depreciation of equipment and facilities in customer Responding to customer account center inquiries 60 Total indirect costs $2,850 *These indirect costs are part of the $3,805 noninterest expenses in the banks 20X5 Income Statement in Exhibit A. The rest of the noninterest expenses in the Income Statement shown in Exhibit A pertain to other operating costs that are excluded from the pilot ABC study, such as the CEOs salary. (The costs listed in Exhibit B are indirect with respect to the retail customers and business account customers.) 1 An activitys cost pool is simply a grouping, or aggregation, of all the individual costs associated with that activity. The banks ABC team created separate activity cost pools for the costs associated with each of the three activities: (1) paying checks, (2) providing teller services, and (3) responding to customer account inquiries. The team identified the following cost drivers2 for each activity cost pool: Activity Cost Pool Activity Cost Driver Paying checks Number of checks processed Providing teller services Number of teller transactions Responding to customer account inquiries Number of account inquiry calls to customer service call center The ABC team estimated that for the three pilot-test bank branches, the retail and business customer lines experienced the annual activity levels (in thousands) as shown in Exhibit C. For example, Exhibit C reveals that retail customers had 160,000 teller transactions and made 95,000 account inquiry calls to the customer service call center. Virgin Islands National Bank currently services 150,000 retail customer checking accounts and 50,000 business customer checking accounts. The bank earns net interest revenue on the balances that customers keep in their checking accounts.3 On average, the bank earns the following earns the following annual revenue from each type of account: Average annual revenue per retail customer account $10 Average annual revenue per business customer account $40 EXHIBIT C Activity Cost Drivers by Customer Line Annual Number of Units Annual Number of Units of Activity-Cost Driver of Activity-Cost Driver Activity Cost Used by Retail Customers Used by Business Customers Driver (in 1,000s) (in 1,000s) Total Checks processed 570 2280 2850 Teller transactions 160 40 200 Account inquiry calls to customer service call center 95 5 100 2 A cost driver is a factor, such as the number of checks processed, that causally affects costs. For example, the costs associated with the activity paying checks rise and fall as the quantity of the cost driver (the number of checks processed) rises and falls. 3 The bank earns net interest revenue by managing the interest rate spread This spread is the difference between the interest rate the bank earns on customer deposits (say 8 percent), less the interest rate the bank pays the customer on the average checking account balance (say 4 percent). Required: Part 1 Your task is to assist Erik Larson and his ABC team by providing the following information:

1) Under the original (old) cost system:

A) Compute the single indirect cost allocation rate that the bank would use to allocate the total indirect costs presented in Exhibit B. B) Use your answer to part A to determine the total annual indirect cost assigned to: (i) the retail customer line, and (ii) the business customer line. What drives these allocations?

C) What proportion of the total indirect cost is assigned to: (i) the retail customer line, and (ii) the business customer line? Why? That is, what is the underlying rationale for indirect cost allocation under the old system? What assumption must hold approximately true for the original cost allocation procedure to generate accurate customer cost information?

D) Use your answer to part B and data on the number of retail and business accounts to determine: (i) the indirect cost per retail account, and (ii) the indirect cost per business account.

E) Assuming there are no direct costs or other indirect costs, compute the average contribution to profit per account for retail customers and for business customers. What business strategy would a manger using the original cost allocation system likely adopt? Why?

2) What are the signs that Virgin Islands original cost system is broken, such that it needs refinement or improvement?

3) Under the new activity-based costing (ABC) system, compute the indirect cost allocation rates for each of the three activities: A) Paying checks B) Providing teller services C) Responding to customer account inquiries

4) Use the following schedule to compute the total indirect cost allocated to each customer line (show your computations beside the activity description): Total Indirect Total Indirect Cost Cost Assigned Assigned to To Retail Business Activity Customer Line Costomer Line Paying checks Providing teller services Responding to customer account Inquiries Total Indirect Costs

5) What proportion of each activity is attributable to: (i) the retail customer line, and (ii) the business customer line?

6) Using the ABC data from Requirement 4, computer (i) the indirect cost per retail customer account and (ii) the indirect cost per business customer account.

7) Explain why the results in Requirement 1, Part D, and requirement 6 differ. Be specific.

8) Using the ABC data, compute the average contribution to profit per account for both retail and business customers. What business strategy would a manger using the ABC cost system likely adopt? How does this result compare to your response to Requirement 1, Part E?

9) The ABC team of Virgin Islands National Bank plans to increase the number of major activities (activity pools) with unique cost drivers to six. Please suggest three major activities with unique cost drivers and three cost drivers. Provide detailed reasons for your choices.