Question

Royal Financial Services (RFS) provides front end loan origination services for a number of banks who...

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

Homework Answers

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
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