Costs for Decision Making: Differential Analysis

INTRODUCTION

This 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 AC Global, Inc. (The real name has been

changed.) AC Global is a multinational insurance company with its headquarters in France

and annual revenue ranking in the top 10 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, AC 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 ongoing global

recession has significantly decreased the profitability of AC Global, increasing the importance

of reducing costs.

AC Global's operations in the U.S. (AC-US) sell life and annuity products and represent

approximately 20% of the group's life 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 New Jersey,

Pennsylvania, and North Carolina.

IMPACT ON SHORT-TERM PROFITS

For an insurance company, there are four key line 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 composed of interest and dividends on bonds and

common stock investments and is not changed through operating actions. Premium revenue is

composed of fees collected for providing insurance coverage and is only modestly impacted by

current 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 products decreased by 30%

while life insurance sales fell by 15%.1 Like the industry, AC Global has been negatively

impacted by the economic downturn. AC-US 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.

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-US 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, 14% 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 ACUS

increased from 10.1% in 2007 to over 12.5% in 2009, worse than the 12.1% for AC Global.

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).

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. He set a goal of a 10% reduction

in operating expenses. If AC-US achieved that goal, he estimated that the company would

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 reductionsnot just recommending cost- reduction

actions but also providing examples to show they are effective. Thomas reviewed the accounting

function first and decided he wants it to reduce expenses by 10% overall to be in line with the

company's overall target. He also would like to see a payback 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 informed George that the company

has recently began performing some accounting functions in the service center in India and

gave George 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). He 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, Samantha Charleston and 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, 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. George calls Delphi to discuss the services performed at the servicing center in India.

Delphi informs George that the service center currently provides some IT support for the

insurance operations in the 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) 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 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). His 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 oversightwhich

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 on the 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 informs George that the U.S.-based operations would need to maintain staff

to coordinate the transfer of information. Based on a similar project being undertaken by the

company's U.K. operations, Delphi estimates that one staff member within the Accounting

Department should be sufficient to support both accounts payable and bank reconciliations.

Delphi and George discuss the necessary skills. George believes that retaining the accounts

payable manager, who likely has the necessary skills, would be a good solutionand he uses

that assumption for his analysis.

The accounts payable manager's annual salary is $75,000. The allocated benefits charge

is $18,750, but actual benefits and taxes are $19,488. George estimates that the cost for a

personal computer, supplies, travel, and all other expenses (excluding postage) would total

$15,500. He assumes that the salary, benefits and other expenses associated with the manager

would be allocated 65% to accounts payable and 35% to bank reconciliations based upon the

estimated time requirements to support each function. George does not include the allocation

of rent, corporate expenses, or 50% of IT support in his cost-reduction estimate.

Delphi also gives George the data transfer and connectivity specifications to discuss

with the IT Department. Josephine Young, of the IT Department, analyzes the requirements

and informs George that they would need to improve connectivity and alter the time of the

batch processing for accounts payable. She estimates there would be a one-time cost of

$100,000 plus $2,500 per month for improved connectivity. The change in the batch

processing time will also cause an increase in personnel costs of $2,500 per month. But there

are no additional technology requirements for offshoring bank reconciliations.

AUTOMATING ELECTRONIC PAYMENTS

Charleston performs some background research on electronic payments. She finds that

the use of electronic payments has increased substantially as the number of checks used in

business-to-business transactions rose. The use of paper checks decreased by 5% from 2006 to

2009.3 The estimated savings from using electronic payment instead of paper checks ranged

from 20% to 90%.4

Since the accounts payable function issues all of its payments as checks, Charleston

believes that there may be significant savings if the company made greater use of electronic

payments. Charleston contacts the company's corporate banking representative to inquire about

electronic payments alternatives. She finds that the bank charges an average of $0.125 per

electronic payment. The bank also provides Charleston with a contact at a company that

recently adopted electronic payments (identified as Company XYZ).

As a means to estimate the potential impacts, she contacts Company XYZ's treasurer to

discuss how it impacted their staffing needs and costs and is informed that Company XYZ

averaged 2 minutes in labor per manual check and only 1.5 minutes for each electronic payment.

For recurring payments, Company XYZ experienced an 80% time savings annually. To support

her analysis, Charleston requests and receives a report showing the number of the company's

checks that are recurring to vendors as well as those to employees and business partners, which

are good candidates for electronic payments (see Table 4).

Based on her preliminary analysis, Charleston estimates that the company could process

up to 50% of its current payments electronically. Using the results for Company XYZ as a

proxy, she estimates that electronic payments would reduce processing time by 25% for each

electronic payment. Since recurring payments require minimal work after initial set-up, the

potential estimated time savings is 80%. Since 16% of payments are recurring, labor savings

would be possible.

Charleston estimates that electronic payment processing would reduce staff, with

associated reductions in salaries and benefits as well as other associated costs. To estimate the

impact on staff, she uses 10 employees processing 600,000 checks annually and assumes that

50% of the payments could become electronic. To calculate the potential savings in salaries and

benefits, she assumes that the staff reductions would involve less-experienced staff and represent

15% of total salaries and benefits for accounts payable. She estimates also that there would be

savings in personal computer (PC) costs, IT support, and other costs of $1,775 per employee.

Additionally, there would be a reduction in postage costs in direct proportion to the reduction of

the number of checks. These savings would be partially offset by an additional cost of $0.125 for

each electronic payment that replaces a check. Further, she uses the information from Table 6 to

estimate that severance costs would represent 15% of the maximum eligible severance for

accounts payable.

RELOCATION

Falkirk meets with the head of corporate facilities to discuss the availability of space in

the N.J. service center and the possibility of subleasing any excess space created in the New

York office. The head of facilities states that the company currently has more than 4,000

square feet of excess space in N.J. There also is up to an additional 28,500 square feet of space

available in the building that could be leased for approximately $25 per square foot. But space

must be leased in blocks of 9,500 square feet, which is equivalent to one floor in the building.

Also, the head of facilities states that the company currently has approximately 3,500

square feet of excess space in the New York office and could sublease the space in blocks of

10,000 square feet (equivalent to one floor). But if a block or blocks of 10,000 square feet of

space cannot be created, the available space could not be subleased. Given current real estate

prices, he estimated the sublease rent would be $65 per square foot. Based on past moves, he

estimates the costs to move employees and set up new workstations average $1,000 per position

in the new space plus $50,000 per floor to build out and wire the new space.

Falkirk prepares a grid (see Table 5) highlighting the level of management and

interdepartment interaction as well as the number of N.J. resident employees in each function.

He believes that those functions with the lowest level of interdepartment and management

interaction would be best for possible relocation and selects the departments with low to

medium interdepartment rankings. Additionally, Falkirk prepares a summary list of employees

by function and their residence (see Table 6) to estimate the likely number of employees that

would be retained and the potential severance costs if a portion of the accounting functions are

relocated to N.J.

He assumes that department heads and their assistants would have offices in both the

corporate headquarters and the N.J. location. He estimates that 250 square feet of office space

per position will be needed for each employee relocated from the New York office and a

comparable amount would be available for subleasing. He assumes 100% of all employees who

are N.J. residents would be retained. Of the residents not in New Jersey, he assumes all

department heads and their assistants would remain while all other employees not from New

Jersey would terminate, and severance would be paid to any employee not relocating.

Information regarding the company's severance policy is provided in Table 7, section F, and

summary employee information by department is in Table 6.

INTERACTION OF ALTERNATIVES

If the company only outsources bank reconciliations, the team has assumed that the bank

reconciliation department will need to retain the most experienced employee to support the

process. The most experienced employee in the department has eight years of service, a salary of

$48,000, health insurance costs of $10,000, 401(k) contributions at 5%, and payroll taxes of

7.65%. In addition to the savings in salaries and benefits for the positions eliminated in bank

reconciliations, it is also estimated that there would be a savings of $8,000 in total for expenses

other than salaries and benefits. The one time initial costs would consist of severance costs for

the positions eliminated.

CASE QUESTIONS

Provide responses, displaying all work, to the following questions:

1. What costs are relevant to each of the three alternatives: offshoring, relocating

functions, and automating functions?

2. Based on George's assumptions that all of the remaining supervisor's costs are split

65% to accounts payable and 35% to bank reconciliation, and all incremental

ongoing technology costs and postage costs are charged to accounts payable,

calculate the annual savings per function through offshoring.

3. Using the information that Charleston gathered on electronic payment processing,

determine the potential staff reduction and calculate the potential annual cost

savings from electronic processing of 50% of the accounts payable checks.

Operating Earnings ($ in millions)

9,000

8,000

7,000

6,000

5,000

4,000

3,000

2,000

1,000

-

(1,000)

2004 2005 2006 2007 2008 2009

AC Global

AC-US

Figure 2: Operating Expense Ratio for AC Global vs. AC-US

14.0%

13.0%

12.0%

11.0%

AC Global

AC-US

10.0%

2004 2005 2006 2007 2008 2009

Table 1: Accounting Department Expense Budget Summary

Function

Number of

Employees

Annual Salaries

Annual Benefits Load

All Other

Total Budgeted

Expenses

Federal tax preparation 8 $802,000 $200,500 $176,500 $1,179,000

State tax preparation 12 812,000 203,000 170,000 1,185,000

Tax management 2 250,000 62,500 72,500 385,000

Controller 2 285,000 71,250 68,750 425,000

SEC reporting 7 525,000 131,250 158,750 815,000

U.S. GAAP reporting 7 575,000 143,750 126,250 845,000

Regulatory financial reporting 6 525,000 131,250 118,750 775,000

Management reporting 6 455,000 113,750 106,250 675,000

Cost accounting 6 385,000 96,250 98,750 580,000

General accounting 10 628,000 157,000 100,000 885,000

Accounts payable 10 470,000 117,500 393,750 981,250

Bank reconciliations 5 215,000 53,750 61,750 330,500

Planning and budgeting 4 325,000 81,250 88,750 495,000

Financial analysis 8 685,000 171,250 108,750 965,000

Totals 93 $6,937,000 $1,734,250 $1,849,500 $10,520,750

Table 2: Matrix of Potential Accounting Functions for Outsourcing

Function

Skill Level

Required

Local Knowleged

Required

Mgmt. Support/

Interaction

Technology

Support Required

Compliance Risk

Tax Department

Federal tax preparation Medium High Low Low High

State tax preparation Medium High Low Low High

Tax planning High High High Low Medium

Controller's Department

SEC reporting High High Medium Medium High

U.S. GAAP reporting High High Medium Medium High

Regulatory reporting Medium High Medium Medium High

Management reporting Medium Medium High Medium Low

Cost accounting Medium Low Medium Medium Medium

General accounting Medium Medium Medium Medium Medium

Accounts payable Low Low Low Medium Low

Bank reconciliations

Financial Planning and Analysis

Planning and budgeting

Low

Medium

Low

Medium

Low

High

Low

Medium

Low

Low

Financial analysis Medium Medium High Low Low

Table 3: 2010 Detailed Expense Budget for Accounts Payable

and Bank Reconciliations

Expense

Accounts

Payable

Bank

Reconciliations

Salaries $470,000 $215,000

Benefits load 117,500 53,750

Rent and related 64,000 42,000

Supplies 16,750 1,750

PCs 12,000 6,000

IT support 11,500 6,000

Postage 270,000 -

Travel and entertainment 11,500 3,000

Corporate expenses 8,000 3,000

Total $981,250 $330,500

Table 4: Summary of Checks Processed per Month

Recurring

Business Partners/

Employees

(probably electronic)

All Others

Total

Checks (monthly) 8,000 17,000 25,000 50,000

Percentage 16% 34% 50% 100%

Table 5: Matrix for Evaluating Relocation Prospects

Function

Number of

Employees

Management

Interaction

Interdepartment

Interaction

Employee(s)

in N.J.

Tax Department

Federal tax preparation 8 Low Low 4

State tax preparation 12 Low Low 9

Tax planning and management 2 High Medium 0

Controller's Department

Controller 2 High High 1

SEC reporting 7 Medium Low 5

U.S. GAAP reporting 7 Medium Low 5

Regulatory financial reporting 6 Medium Low 4

Management reporting 6 Medium High 4

Cost accounting 6 Medium Low 5

General accounting 10 Medium Low 9

Accounts payable 10 Low Medium 7

Bank reconciliations

Financial Planning and Analysis

Planning and budgeting

5

4

Low

Medium

Low

High

3

2

Financial analysis 8 High High 6

93 64

Number of

Employees

Weeks of Eligible

Severance

Total Annual

Salaries

Benefits

Load

Health

401(k)

Payroll Taxes

Tax Department:

Department head and assistant

2

32

$250,000

$62,500

$17,200

$12,500

$19,125

Federal Tax

N.J. residents

4

76

445,000

111,250

32,200

22,250

34,043

Non-N.J. residents 4 66 357,000 89,250 27,200 17,850 27,311

Total

State Taxes

N.J. residents

8

9

142

140

802,000

627,000

200,500

156,750

59,400

76,600

40,100

31,350

61,354

47,966

Non-N.J. residents 3 52 185,000 46,250 20,000 9,250 14,153

Total 12 192 812,000 203,000 96,600 40,600 62,119

Department head and assistant

2

28

285,000

71,250

15,000

14,250

21,803

N.J. residents

5

96

379,000

94,750

34,400

18,950

28,994

Non-N.J. residents 2 36 146,000 36,500 17,200 7,300 11,169

Total

U.S. GAAP Reporting

N.J. residents

7

5

132

74

525,000

413,500

131,250

103,375

51,600

37,200

26,250

20,675

40,163

31,633

Non-N.J. residents 2 30 161,500 40,375 12,200 8,075 12,355

Total

Regulatory Reporting

N.J. residents

7

4

104

52

575,000

351,000

143,750

87,750

49,400

27,200

28,750

17,550

43,988

26,852

Non-N.J. residents 2 30 174,000 43,500 17,200 8,700 13,311

Total

Management Reporting

N.J. residents

6

4

82

52

525,000

303,000

131,250

75,750

44,400

27,200

26,250

15,150

40,163

23,180

Non-N.J. residents 2 30 152,000 38,000 17,200 7,600 11,628

Total

Cost Accounting

N.J. residents

6

5

82

70

455,000

322,000

113,750

80,500

44,400

34,400

22,750

16,100

34,808

24,633

Non-N.J. residents 1 12 63,000 15,750 10,000 3,150 4,820

Total

General Accounting

N.J. residents

6

9

82

128

385,000

559,000

96,250

139,750

44,400

69,400

19,250

27,950

29,453

42,764

Non-N.J. residents 1 18 69,000 17,250 7,200 3,450 5,279

Table 6: Summary Employee Information for Severance Calculations

Actual Costs

Controller's Department:

SEC Reporting

Total 10 146 628,000 157,000 76,600 31,400 48,042

Table 6: Summary Employee Information for Severance Calculations (continued)

Actual Costs

Number of

Employees

Weeks of Eligible

Severance

Total Annual

Salaries

Benefits

Load

Health

401(k)

Payroll Taxes

Accounts Payable

N.J. residents 7 106 333,000 83,250 46,600 16,650 25,475

Non-N.J. residents 3 60 137,000 34,250 25,000 6,850 10,481

Totala

10 166 470,000 117,500 71,600 23,500 35,956

Bank Reconciliation

N.J. residents 3 42 137,000 34,250 30,000 6,850 10,481

Non-N.J. residents 2 24 78,000 19,500 12,200 3,900 5,967

Totala 5 66 215,000 53,750 42,200 10,750 16,448

Financial Reporting & Analysis Department:

Budgeting

N.J. residents 2 28 177,000 44,250 12,200 8,850 13,541

Non-N.J. residents 2 26 148,000 37,000 15,000 7,400 11,322

Total

Financial Analysis

N.J. residents

4

6

54

72

325,000

526,000

81,250

131,500

27,200

39,400

16,250

26,300

24,863

40,239

Non-N.J. residents 2 30 159,000 39,750 17,200 7,950 12,164

Total 8 102 685,000 171,250 56,600 34,250 52,403

a The severance and continuing benefits for the accounts payable manager total $29,073, and the severance and continuing benefits for the most experienced staff member in bank reconciliations is $19,714.

Note: When calculating severance using the total salaries, you must first find the average weekly salary (salaries/number of employees/52 weeks) and multiply by the number of weeks of severance. Follow a similar process for

health benefits. For 401(k) and payroll taxes, you may either follow the same process or apply the rate.

Table 7: Supplemental Information on Relevant Expenses

A. The benefits load of 25% of salaries is designed to represent the costs to provide health, dental and vision insurance, the employer contribution to the 401(k)

plan, and employer payroll taxes.

1. The company's share of health benefits (including dental and vision insurance) is $10,000 per year for family (F), $7,200 for parent/children or employee/

spouse (P/C), and $5,000 for single (S) employees.

2. The employer portion of payroll taxes is 7.65% of salaries.

3. The company contribution to the 401(k) plan is 5% of salaries.

B. The company has eight years remaining on its lease and is unlikely to be able to reduce space unless it can create 10,000 square feet (one floor) of available

space for sublease. Based on an average of 250 square feet per employee, staff in the New York office would need to be reduced by 40 or more.

1. The company pays $65 in rent per square foot in New York. The standard workstation is approximately 250 square feet per employee, and office space of a

department head and assistant are 500 square feet in total.

2. The rent per square foot is $25 in the service center in N.J., located just across the Hudson River from the New York headquarters.

C. The corporate expense allocation is for the company cafeteria and an on-site gym; the company's costs are unlikely to fall if staff in the Accounting Department is

reduced.

D. PCs are leased, and the company can return them with no penalty; 50% of the IT support costs are variable and can be saved when the PCs are eliminated.

E. The postage costs in accounts payable would not change by offshoring or relocation as the checks would be printed and mailed from the company's office in

the U.S.

F. The company severance policy calls for two weeks of salary for each year of service with minimum payment of 12 weeks. Health benefits and retirement

plan contributions continue to be provided during the severance period. Payroll taxes would also apply.