Costs for Decision Making: An Instructional Case of Relevant Costs and Differential Analysis of Cost Reduction Alternatives Comment by Author: Authors: Title is rather lengthy. Suggest alternative:Costs for Decision Making: Differential Analysis of Cost Reduction Alternatives Comment by Author: Agreed
Scott McGregor, DPS, CMA, CPA Comment by Author: Author: We need to know and list your advanced degrees (for example, Ph.D.) and any certifications (for example, CMA, CPA, and so forth. Thanks. Comment by Author: Doctor of Professional Studies (DPS), CMA and CPA
Assistant Professor of Accounting
Fairleigh Dickinson University
INTRODUCTION
Thise 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 A.C. Global, Inc. (The real name has been changed.).A.C. Global is a multinational insurance company with its headquarters in France and annual revenue rankingin the top ten 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, A.C. 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 ongoingglobal recession has significantly decreased the profitability of A.C. Global, increasing the importance of reducing costs.
A.C. Global’s operations in the U.S. (AC-US.) sell life and annuity products and represent approximately 20% of the group’slife 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 N.J., Pa., and N.C.
IMPACT ON SHORT-TERM PROFITS
For an insurance company, there are four keyline 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 comprised of interest and dividends on bonds and common stock investments and is not changed through operating actions. Premium revenue is comprised of fees collected for providing insurance coverage and is only modestly impacted by cu
ent 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 productsdecreased by 30% while life insurance sales fell by 15%[endnoteRef:1]. Like the industry, AC Global has been negatively impacted by the economic downturn. AC.-U.S. 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. [1: Annual Report on the Insurance Industry, Federal Insurance Office of the U.S. Treasury, June 2013.]
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-U.S. 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, 145% 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 AC-US increased from 10.1% in 2007 to over 12.5% in 2009, worse than the 12.1% for AC Global.During the two most recent years, 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). Comment by Author: Author: 10.1/11.7 = XXXXXXXXXX, the proportion the first percentage is of the second.When I then subtract that from 100% (= 1.0 in decimal format) I get XXXXXXXXXXwhich translates to 13.6% or rounded to 14%.But you stated that the expense ratio for A.C.-U.S. was 15% better.Wouldn't it actually be 14% better? Or have I made an e
or in my calculations or concept? Thanks. Comment by Author: Please change to 14% Comment by Author: Author: Right now, the two most recent years are 2015 and 2014, yes? Is that what you really meant to say? If so we should state it explicitly. Since the last year you cite in this case so far seems to be 2010, and you next mention 2009, I'm thinking that either this might have been written a while ago, or you are setting the case to have ended around 2010, 2011, or 2012—and that “last two years” would be 2011 or 2012, definitely not 2014 and 2015. Thanks. Comment by Author: The reference is to the recent years in the case, suggest deleting
Figure 2. Operating expense ratio for AC Global vs. AC-US).
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. Heset a goal of a 10% reduction in operating expenses. If theAC-US achieved that goal, he estimated that the companywould 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 reductions—; not just recommending cost reduction actions but also providing examples to show they are effective.Thomasreviewed the accounting function first, and decided he wants it to reduce expenses by 10% overall, in line with the company’s overall target. He also would like to see a pay-back 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 informs George that the company has recently began performing some accounting functions in the service center in India and givesGeorge 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).George further 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, SamanthaCharlestonand 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, while 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.[endnoteRef:2] Comment by Author: Author: since these are synonyms we should settle one just one to use consistently. Since you've mentioned it is also called "offshoring," I've used that one. Comment by Author: That is acceptable [2: Nora Palugod and Paul A. Palugod, “Global Trends in Offshoring and Outsourcing,”Internal Journal of Business and Social Science, September 2011.]
George calls Delphi to discuss the services performed at the servicing center in India.Delphi informs George that the service center cu
ently provides some information technology (IT)support for the insurance operations in the United Kingdom (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) accounting requirements, 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 to 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). George’s 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 oversight—which 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 George’s 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