The Hindu Business Line : Activity-based costing of a banking service

ABC Bank is examining the profitability of its premier account, a combined savings and cheque account. Depositors receive 7 per cent annual interest on their average deposit. ABC Bank earns an interest rate spread of 3 per cent (the difference between the rate at which it lends money and rate it pays to depositors) by lending money for home loan purpose at 10 per cent.

The Premier Account allows depositors unlimited use of services such as deposits, withdrawals, cheque facility, and foreign currency drafts. Depositors with Premier Account balances of Rs 50,000 or more receive unlimited free use of services. Depositors with minimum balance of less than Rs 50,000 pay Rs 1,000 a month as service fee for their Premier Account.

ABC Bank recently conducted an activity-based costing (ABC) study of its services. The use of these services in 2005-06 by three customers is as shown in Table 1.

Assume Customers X and Z always maintain a balance above Rs 50,000, whereas Customer Y always has a balance below Rs 50,000.

Required: Compute the 2005-06 profitability of the Premier Accounts of Customers X, Y and Z at ABC Bank. What evidence is there of cross-subsidisation among the three Premier Accounts? Why might ABC Bank worry about this cross-subsidisation, if the Premier Account product offering is profitable as a whole?

What changes would you recommend for ABC Bank's Premier Account?

Solution: The statement of profitability during 2005-06 is presented in Table 2.

The total profit on Premier Account product:

Customer X — Rs (10500)

Customer Y — Rs 2,700

Customer Z — Rs 29,660

Net profit — Rs 21,860

Even though it is profitable as a whole, the Bank's worry is justified because cross-subsidisation results in loss in the case of Customer X, which uses more services free of cost; it is highest at Rs 12,150. Even when compared to Customer Z, the cost of services by Customer X is much higher.

Changes recommended: Restrictions may be imposed on the number of transactions/services. Service fee may be collected from Customer X also. Else, minimum balance may be increased to Rs 5,00,000 for availing services free of cost.

Profitability statement

PQR Ltd produces a product which has a monthly demand of 52,000 units. The product requires a component X which is purchased at Rs 15 per unit. For every finished product, two units of Component X are required. The ordering cost is Rs 350 per order and the carrying cost is 12 per cent per annum.

Required: Calculate the economic order quantity for Component X.

If the minimum lot size to be supplied is 52,000 units, what is the extra cost the company has to incur?

What is the minimum carrying cost the company has to incur?

Solution: For Component X, annual consumption = 2 x 52,000 x 12 months = 1,24,8000 units

Carrying cost: 12 per cent of 15 = Rs 1.80 per unit per annum.

i) EOQ = square root of 2AO / C = square root 2 x 1248000 x 350 / 1.80 = 22,030 units

ii) Minimum lot size: 52,000 units

Ordering cost = 12,48,000/52,000 = 24 orders at Rs 350 = Rs 8,400

Carrying cost (52,000 + 0 / 2) x 1.80 = Rs 46,800

Total cost = Rs 55,200

Cost in case of EOQ:

Ordering cost = 12,48,000 / 22,030 = 57 orders at Rs 350 = Rs 19,950

Carrying cost (22,030 + 0 / 2) x 1.80 = Rs 19,827

Total cost = Rs 39,777

Extra cost the company has to incur (55,200 - 3,97,77) = Rs 15,423

iii) Minimum carrying cost = Rs 19,827