Question

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 70% of the mortgages end up being closed (the remainder are not approved after loan analysis); 80% of auto loans close and 90% 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

Based on the above information, use activity-based costing to assess the total and per unit profitability of RFS’s three loan products

Using this template to solve it

Royal Financial Services
Base Income Statement	Income Statement	Mortgage	Auto	Personal	Total
	Annual Volume of Loans	1,500	6,000	4,000	11,500
	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%
Activities	Activity Driver	Mortgage	Auto	Personal	Total Cost	Cost Driver Rate
Accept applications	# pages per application	4	3	1	616,000
Obtain credit referrals	# credit sources/appl.	2	2	1	332,500
Do loan analysis	# hours analysis/appl.	3	2	1	656,000
Close loan	# hours to close loan	4	2	1	495,900
					2,100,400
% of loan applications that get closed
Revised ABC Income Statement		Mortgage	Auto	Personal
Total Revenues		$525,000	$1,200,000	$460,000
Operating Expense	Accept applications
	Obtain credit referrals
	Do loan analysis
	Close loan
	Total Oper Exp
Profit
Profit % Revenue
		Mortgage	Auto	Personal
Default rate experienced by loan processor		2%	1%	6%
Industry average		2%	3%	4%
Per Unit		Mortgage	Auto	Personal
Total Revenues
Operating Expense	Accept applications
	Obtain credit referrals
	Do loan analysis
	Close loan
	Total Oper Exp
	Profit

Answer 1

		Mortgage	Auto	Personal
	Sales Revenue
	1500*350	$525000
	6000*200		$1200000
	4000*115			$460000
	Accept Application
	$616000*4/8	$308000
	$616000*3/8		$231000
	$616000*1/8			$77000
	Obtain Credit Referrals
	$332500*2/5	$133000
	$332500*2/5		$133000
	$332500*1/5			$66500
	Loan Analysis
	$656000*3/6	$328000
	$656000*2/6		$218667
	$656000*1/6			$109333
	Close Loan
	$495900*4/7	$283371
	$495900*2/7		$141686
	$495900*1/7			$70843
	Total Costs	$1052371	$724353	$323676
	Profit	-$527371	$475647	$136324
	PU Profitability
	-$527371/1500	-$351.58
	$475647/6000		$79.27
	$136324/4000			$34.08