Chapter 10, Problem 10.25E

Activity-based costing in an insurance company
Umbrella Insurance Company carries three major lines of insurance: auto, workers' compensation, and homeowners. The company has prepared the following report for 20Y2:

Management is concerned that the administrative expenses may make some of the insurance lines unprofitable. However, the administrative expenses have not been allocated to the insurance lines. The controller has suggested that the administrative expenses could be assigned to the insurance lines using activity-based costing. The administrative expenses are comprised of five activities. The activities and their rates are as follows:

Activity-base usage data for each line of insurance were retrieved from the corporate records and are shown below.

a.Complete the product profitability report through the administrative activities.
b.Determine the underwriting income as a percent of premium revenue.
C.Determine the Operating income as a percent of premium revenue, rounded to one decimal place.
d.Interpret the report.

To determine

(a)

Concept Introduction:

Activity based costing is one of the costing method that identify the important activities in the organisation and accordingly identify their cost drivers. Then cost is allocated on the basis of activities used by each product.

Through administrative activities complete the product profitability report.

Answer to Problem 10.25E

The product profitability report through the administrative activities is given in table below.

Explanation of Solution

The product profitability report through the administrative activities is below:

Particulars	Auto (in $)	Worker compensation (in $)	Homeowner (in $)
New policy processing   $@\text{ \$}160$ per new policy	$\begin{array}{l}240,000\\ (1,500\times 160)\end{array}$	$\begin{array}{l}232,000\\ (1,450\times 160)\end{array}$	$\begin{array}{l}656,000\\ (4100\times 160)\end{array}$
Cancellation processing   $@\text{ \$240}$ per cancellation	$\begin{array}{l}84,000\\ (350\times 240)\end{array}$	$\begin{array}{l}60,000\\ (250\times 240)\end{array}$	$\begin{array}{l}480,000\\ (2,000\times 240)\end{array}$
Claim audit   $@\text{ \$500}$ per claim audit	13y13   $\begin{array}{l}160,000\\ (320\times 500)\end{array}$	Y13y3   $\begin{array}{l}50,000\\ (100\times 500)\end{array}$	$\begin{array}{l}350,000\\ (700\times 500)\end{array}$
Claim disbursement   $@\text{ \$120}$ per claim disbursement	$\begin{array}{l}48,000\\ (400\times 120)\end{array}$	$\begin{array}{l}21,600\\ (180\times 120)\end{array}$	$\begin{array}{l}90,000\\ (750\times 120)\end{array}$
Premium collection processing   $@\text{ \$25}$ per premium	$\begin{array}{l}187,500\\ (7,500\times 25)\end{array}$	$\begin{array}{l}37,500\\ (1,500\times 25)\end{array}$	$\begin{array}{l}300,000\\ (12,000\times 25)\end{array}$
Total administrative cost	$\$719,500$	$\$401,100$	$\$1,876,000$

Preparation of Income statement is as follows:

Particulars	Auto (in $)	Worker compensation (in $)	Homeowner (in $)
Underwriting income before administrative expenses	$\$2,160,000$	$\$1,950,000$	$\$2,760,000$
Less: Administrative expenses	$\left(\$719,500\right)$	$\left(\$401,100\right)$	$\left(\$1,876,000\right)$
Underwriting net Income	$\$1,440,500$	$\$1,548,900$	$\$884,000$

To determine

(b)

Concept Introduction:

Activity based costing is one of the costing method that identify the important activities in the organisation and accordingly identify their cost drivers. Then cost is allocated on the basis of activities used by each product.

To compute:

The underwriting income as a percent of premium revenue.

Answer to Problem 10.25E

The underwriting income as a percent of premium revenue is $16.91\%$

Explanation of Solution

Calcultion of underwriting income as a percent of premium revenue are as follows:

  $\begin{array}{c}\text{Total underwriting income}=\text{\$1,440,500}+\text{\$1,548,900}+\text{\$884,000}\\ =\text{\$3,873,400}\end{array}$

  $\begin{array}{c}\text{Total premium}=\text{\$7,200,000}+\text{\$6,500,000}+\text{\$9,200,000}\\ =\text{\$22,900,000}\end{array}$

Underwriting income as a percent of premium revenue is:

  $\begin{array}{c}\text{Premium percentage}=\frac{\$3,873,400}{\$22,900,000}\times 100\\ =16.91\%\end{array}$

So, the answer is $16.91\%$

To determine

(c)

Concept Introduction:

Activity based costing is one of the costing method that identify the important activities in the organisation and accordingly identify their cost drivers. Then cost is allocated on the basis of activities used by each product.

The operating income as a percent of premium revenue.

Answer to Problem 10.25E

Operating income as a percent of premium revenue is $17\%$

Explanation of Solution

Calculation of operating income as a percent of premium revenue is as follows:

  $\begin{array}{c}\text{Income from operation}=\text{Underwriting Income}-\text{Administrative cost}\\ =\text{\$6,870,000}-\text{\$2,966,600}\\ =\text{\$3,903,400}\end{array}$

  $\begin{array}{c}\text{Total premium = \$7,200,000}+\text{\$6,500,000}+\text{\$9,200,000}\\ \text{= \$22,900,000}\end{array}$

Operating income as a percent of premium revenue

  $\begin{array}{c}\text{Premium percentage}=\frac{\$3,903,400}{\$22,900,000}\times 100\\ =17\%\end{array}$

So, the answer is $17\%$

To determine

(d)

Concept Introduction:

Activity based costing is one of the costing method that identify the important activities in the organisation and accordingly identify their cost drivers. Then cost is allocated on the basis of activities used by each product.

The interpretation of report.

Answer to Problem 10.25E

The premium revenue's significant part is used in the administrative expenses.

Explanation of Solution

Underwriting income as a percent of premium revenue after reducing administrative expenses is $16.91\%$.

So, this clearly shows that important part of premium revenue is used in administrative expenses, which helps company in profitability.