Activity-Based Costing Implementation for Insurance Company - Case Study Example

Report: ABC Implementation for a Certain Insurance Company In the words of management consultant and business Peter Drucker, "Activity-based costing records the cost of not doing, such as the cost of machine downtime, the cost of waiting for a needed part or tool, the cost of inventory waiting to be shipped, and the cost of reworking or scrapping a defective part" (Success Profiles, 2003). In particular in the insurance industry, which was at least partially responsible for its genesis, Activity Based Costing (ABC) is highly effective as more than a tool used for accounting for costs and expenditures. ABC can act as a lens into the business process, allowing your resources to be more efficiently allocated while reducing costs. It can also be an allocation mechanism, facilitating the transfer of pricing internal and external to the organization, thereby making "indirect" costs into "direct" costs (Wipro, 2002). If implemented correctly, it becomes a strategic management and even marketing segmentation tool. The creation of OLAN software programs and ABC-compatible IT systems have made ABC systems far easier to implement. Nevertheless, initial setup and implementation of the system are by no means simple. These can take from six to 12 months. The Institute of Management Accountants (IMA) in Montvale, N.J., recommends starting with a pilot study to see on a smaller scale what can happen in the larger scheme of things. For our pilot study, we will want to begin with your worst department, where you'll be sure to see some success and better understand the cost-uncovering nature of ABC implementation. This will bring about quicker acceptance of implementing the new system from your upper levels of executives and management (Chutchian-Ferranti, 2005). The success of ABC in one area is likely to prompt the company to begin wider implementation for the purposes of modeling and analyzing operational processes, in order to identify and make operational improvements throughout your entire organization (Wipro, 2002). Successfully modeling your operational cost drivers in your life insurance processing locations and departments could very well lead to implementation of ABC for more cost savings, increased marketing results, and even expansion of your business in your P&C locations and department and any other areas of your organization that could stand to have its activity more efficiently managed. To prepare for implementation, we begin with your company's or department's assembled team-which will include members from financial operations, IT, human resources, management, and marketing-identifying its key activities. All the activities performed need to be identified. It is imperative to distinguish between "activities" and tasks that people perform. An "activity" is defined as a process having a definite starting and ending point(s); an activity takes an input, adds some or the other value to it, and converts that mixture into outputs (Wipro, 2002). For studying and analyzing your life insurance department, the list of key activities could comprise prospecting calls, customer service calls, group motivation/evaluation meetings, individual motivation/evaluation meetings, travel between appointments, sales presentations, paperwork, data entry, paying claims, paying commissions and salaries, and continuing education and training. Some of these can be further sub-divided. Second, your team needs to estimate resource cost drivers. Each activity, captured in the first stage, consumes some resources to be performed. In this stage, the cost accounting of all the resources that contribute towards an activity is done. This data is readily available in the general ledgers of your company. However, its extraction can be a tedious task, as it is common to find the costing information in granular details running to accounts and sub-ledger levels. This step is often the under-estimated cog in the wheel of the process. The capture of costs of all the resources can be a very time-intensive task. At once, this is a very crucial initiative, as getting the wrong number can have serious repercussions in the later stages. Simultaneous with cost accounting, time tracking for various activities selected in the first stage is very important (Wipro, 2002). Third, your team will perform activity costing. Activity costing yields the critical cost-driver rates. With the data from the department budget and time tracking, each activity can be costed appropriately. The business of the department is now ready to be analyzed from a process perspective. Your managers can now see how time is being spent - whether on value-add items or non-value adding activities. There can also be rational consideration regarding the outsourcing of non value-adding, resource-heavy activities, such as prospective buyers' medical examinations. Coupled with this exercise, the data needs to be captured on a very granular level. This is especially true of volumetric data, such as the number of policies that need to be in force, maintained, or placed at this stage in order to be able to run an ABC model. Typically, the costing information can be captured in process-specific data marts. These data marts necessarily will have a cross-functional reach. They will include the individual transactions at the most atomic level coupled with the cost drivers associated with them. The data model in these marts will be dimensional in nature with Customer, Products, Locations, and Resources acting as the core (or conformed) dimensions. This dimensional nature of the model will lend itself to supporting the multiview approach (Wipro, 2002). As an example of calculating activity costing, let us consider the formula for calculating cost-driver rate, which is: Activity cost Activity volume = Cost Driver Rate. Taking some data from the financial ledgers, we see that last year the life insurance department for this location, which has 27 employees including managers, data processors, customer service help desk members, and salesmen, paid out $10,400,000 in salaries, commissions, and administrative/overhead costs while placing $145,600,000 worth of new life insurance coverage. The cost-driver rate would come to $.07 per dollar of coverage underwritten by this location-a very important piece of data for an insurance company to have (Imants BVBA, 2005). It is important to keep in mind that the addition of a discrete time parameter t into the calculations results in a more detailed cost mapping, which is yielded by the formula: Cost driver value (i, t) * cost driver quantity (i, j, t), where: t is a discrete time variable (e.g. day, period, quarter, etc.), i is an activity, j is the end product (Pesonen, 2005). The fourth stage is that of migrating to the ABC system. Once the data is in place, the next step is to migrate the model to an ABC system. The atomic data that has been "warehoused" can now be analyzed using various On-Line Analytical Processing (OLAP) Tools. These tools can render information in a user friendly and secure format for consumption by the decision makers. The users can fire ad-hoc queries for pivoting the information in various ways. An electronic ABC system can either be stand-alone or a part of a suite of software available to the business. An important point at this stage is to ensure the consistency of the ABC model with other models in the company. Ensuring this consistency is important so that data captured by other models are not lost when merged with the new ABC model (Wipro, 2002). Finally, the fifth stage is the segue into activity based management. The first immediate benefit of ABC is that it allows you to cost transactions. Most current ABC software programs have unit costing functionality; however, for calculating the cost of a particular unit transaction, the help of an OLAP tool is required (Wipro, 2002). Once the segue into implementation for activity based management has taken place, the managers of your location and department will find the cost-data they need laid bare before their very eyes, without any more guessing games. Management can now consider costs from many new perspectives and angles. One is activity analysis. This analysis allows consideration of several different attributes of a given business activity, including turnaround time, value-addition, productivity, and predecessor/successor relationships connecting it or needing to connect it to different activities (Wipro, 2002). A second new perspective comprises benchmarking. The activities so analyzed can be used to benchmark this particular location (cost center), your organization as a whole against other cost centers, or even against similar organizations in the insurance industry for competitive reasons. Key attributes to compare are cycle time and productivity. In the insurance industry, benchmarking has been found to be very common for customer satisfaction. Ironically, very few insurers have sought to benchmark their finance function (Wipro, 2002). A third new angle for management to view is a value-added analysis. Analyses of an activity's value-add can provoke questions with regards to its importance in the entire cycle of activity (Wipro, 2002). Fourth, an "S-Curve" analysis now becomes possible. The "S-Curve" analysis allows you to rank each of your department's or entire organization's services or products by profitability to determine which product and customer segments are the most attractive. For doing the "S-Curve", your different products, such as variable life insurance, term life, and annuities, are ranked according to how ABC costing compares with traditional costing. Where products have been over-costed, ABC reveals hidden profits. Conversely, where ABC costing is above traditional costing, hidden losses are revealed. Given that popular products are usually "comp" products (those that the customers use to compare prices across competitors), overcosting these (which presumably leads to overpricing) can have significant implications for your market share. Losing business to competitors who offer consistently lower premiums for term life policies can be lessened or even reversed if it is discovered that the cost of delivering and maintaining a term life policy is less than presently believed (which presumably would lead to your lowering the premiums on your term life products) (Wipro, 2002). In step with this angle comes the possibility of a client segmentation analysis. Clients can be segmented based on multiple criteria, e.g., average life-time value and cost-to-serve. A high demanding client may not necessarily be the most profitable one. Clients can be incisively segmented so that the profitable segments would receive more personalized interaction at touch-points such as their homes or here in the office, while the high-cost-to serve clients are migrated to less costly touch-points like self-service on the Web (Wipro, 2002). ABC implementation helps with "insource" versus "outsource" decisions. For an insurance company this decision can be especially vital for certain IT activities which might be considered for outsourcing but might actually be less expensive to keep in-house. It is also especially true for making prospecting calls or contacts, which might initially seem like activities that would be too expensive to outsource but in fact often should be (Wipro, 2002). ABC accounting, as stated, is complex to set up and implement; all elements of preparation and implementation have to go right or the system shall fail. Parts of it are time-intensive. It needs to be realized, also, that ABC is not truly an accounting tool, but a management tool. "It brings cost information out of the accounting department and into the hands of people that make decisions for an organization" (Chutchian-Ferranti, 2005). Additionally, "the data is after the fact! Improvements may affect future years, but short duration projects, regardless of payoff, are below the radar It also requires a significant investment in training your staff, and it's not uncommon to experience significant resistance to the ongoing administrative burden the benefits of implementing all this change may be limited to what you learn from the data, a fine-tuning of costs and next year's budget estimates" (NMDA, 2005). All of these factors must be borne in mind when deciding upon whether or not to implement this system. Sources Chutchian-Ferranti, Joyce. "Activity-Based Costing". Business QuickStudy: Computerworld, Inc. Retrieved Nov. 1, 2005. < http://www.computerworld.com/news/1999/story/0,11280,36607,00.html >. Imants BVBA. "Activity Based Costing and Lean Accounting". (PowerPoint presentation). Manufacturing Excellence Series. Retrieved Nov 2, 2005. < http://www.managementsupport.com/leantools.htm >. Mohan, Deepak and Hemantkumar, Patil. "Activity Based Costing for Strategic Decisions Support". Wipro Technologies. 2002. Retrieved Nov 1, 2005. (PDF) . N. Dean Meyer and Associates, Inc. "Activity Based Budgeting". Retrieved Nov. 2, 2005.< http://www.ndma.com/resources/ndm14164.htm#14165 >. Pesonen, Lasse T.T. "Implementation of Design to Profit in a Complex and Dynamic Business Context". Oulu University: 2005. Retrieved Nov. 1, 2005. . Success Profiles. "Activity Based Cost Accounting". Retrieved Oct. 31, 2005. . Read More