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Midwest Financial Services (MFS) and Use of Activity Based Costing ... the administrative expenses change on a monthly basis as the amount of the investment .... Senior management has approved this methodology for these purposes.
THE USE OF ACTIVITY BASED COSTING IN CALCULATING MORTGAGE LOAN SERVICING EXPENSES Mehmet C. Kocakulah University of Southern Indiana, College of Business 8600 University Boulevard, Evansville, IN 47712 812-464-1730, Fax: 812-465-1044, Email: [email protected] Marvin Albin University of Southern Indiana, College of Business 8600 University Boulevard, Evansville, IN 47712 812-465-7030, Fax: 812-465-1044, Email: [email protected] Jim Bartlett 2500 Elder Drive Owensboro, KY 42301 270-689-9751, Email: [email protected]

ABSTRACT Rather than aligning costs by departments or cost centers, activity based costing methodology aligns costs based on activities performed and then allocates these activity costs to beneficiaries of the beneficiaries of the activities and ultimately, the products or services that benefit from the performance of the activities. Activity based costing can help assigned all costs accurately and appropriately to help an organization to control their costs. The results include better credit quality, higher revenues, and reduced losses. Keywords: activity-based costing, mortgage loan expenses, mortgage loan servicing, matching costs and loans

THE USE OF ACTIVITY BASED COSTING IN CALCULATING MORTGAGE LOAN SERVICING EXPENSES What is Activity Based Costing (ABC)? Activity Based Costing allocates overhead costs based on how the organization’s resources are consumed through the production of products or provision of services. Rather than aligning costs by departments or cost centers, activity based costing methodology aligns costs based on activities performed and then allocates these activity costs to beneficiaries of the activities and ultimately, the products or services that benefit from the performance of the activities. Once an activity has been identified, an activity cost driver links the activity to the product or service. By using activity based costing, organizations hope to better allocate overhead costs and derive more accurate product costs and make better decision using the information. 881

Additionally, according to an article on the American Institute of Certified Public Accountants website [3], the AICPA notes that the “basic distinction between traditional cost accounting and activity based costing is as follows: traditional cost accounting techniques allocate costs to products based on attributes of a single unit. An activity based costing system can be viewed in two different ways. The cost assignment provides information about resources, activities, and cost objects. The processes provide operational and frequently non-financial information about cost drivers, activities, and performance [7]. Activity based costing is not only appropriate for use in a manufacturing environment but it is also most appropriate for service organizations. Activity based costing in very basic terms may provide very good payback for businesses. Some of the benefits that relate directly to the financial services industry are [1]: identification of the most profitable customers more accurate product and service pricings increased product profitability well-organized process costs. Midwest Financial Services (MFS) and Use of Activity Based Costing Company Profile Midwest Financial Services (MFS) (company name changed for anonymity), a member of an International Group, Inc., is one of the nation's leading financial services companies. MFS currently operates approximately 1,350 branch offices in 44 states including Puerto Rico, and the Virgin Islands [6]. The branch offices offer a wide variety of services to their customers such as secured and unsecured consumer lending , credit insurance, home equity lines of credit, both first and second mortgages, and retail sales financing. Over the past few years, MFS has shed its bankcard portfolio and satellite financing programs and has instead focused on growth through the acquisition of existing loan portfolios especially mortgage loan portfolios. As a result of the risks involved in portfolio acquisitions, MFS created the Department of Business Analysis. A primary function of the department is to price loans and loan portfolios presented to it by the Acquisitions Department. In effect, this provides a system of checks and balances and at the same time gives each department the opportunity to specialize in its own areas and become the resident experts. The Importance of Accurate Pricing As MFS has pursued its strategy of growth through the acquisition of existing loan portfolios, it has become increasingly important that assumptions made regarding portfolio performance are as accurate as possible. Errors in judgment can be very expensive especially when it comes to items such as charge offs and servicing expenses. When the assumptions made for these items turn out to be unrealistic, the impact to the bottom line could be very considerable. For example, a premium is normally paid for most mortgage loan portfolios in light of expected future cash

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flows. An excessive premium or perhaps any premium at all, paid for a portfolio that pays off sooner than expected could result in a tremendous net less. Loans once acquired must stay on the books long enough to recoup any premium paid before generating a profit. The potential losses due to errors in judgment and faulty assumptions are indeed significant. Current Servicing Assumptions Currently, MFS uses a servicing expense of $2.80 per month and a monthly administrative expense equivalent to .0002% of each month’s investment [5]. The servicing expense of $2.80 remains constant throughout the life of the loan. However, the administrative expenses change on a monthly basis as the amount of the investment changes. According to the Director of Business Analysis [4], these expenses were arrived at using 50% of incremental cost and 50% of full cost. Unfortunately, as MFS has grown and business has gotten more complicated every day, this method of calculating expenses is now overly simplistic and no longer appropriate. Initially, it’s a “one size fits all” philosophy. The same servicing and administrative expenses are applied equally to all accounts including fixed rate and adjustable rate mortgages. Secondly, it doesn’t take into consideration each account seasoning. There is no difference in the servicing expenses between a newly originated account and one that has been on the books for five years. Normally, the delinquency and the default rates are higher for new loans than seasoned loans. Homeowners with seasoned mortgages are more mature, have higher incomes, and better job security. Third, it doesn’t take into consideration credit quality. Logically, the servicing expenses should be lower for a customer with better FICO credit scores. According to Bankrate.com [2], a FICO score is a number that tells lenders what kind of borrower you will likely be based on your credit history. FICO scores range between 300 and 850. The higher the FICO score the better the customer and the financial institution has less risk. Proposed Method for Calculating Servicing Assumptions A servicing expense grid that utilizes activity based costing has a few advantages over the current method of calculating servicing and administration expenses for each type of loan servicing. First, creating a servicing expense grid using activity based costing would result in a more precise expense grid. Second, a servicing expense grid would also consider credit quality and as well as seasoning. CREATION OF THE SERVICING EXPENSE GRID USING ACTIVITY BASED COSTING Data Collection The first step in creating a servicing expense grid is the collection of data. The data used in this case came from four different sources. Expense data was provided by the Budget Department, human resources data came from the Human Resources Information Systems Department, bad

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rate data came from the Risk Department, and all other data was obtained directly through various MFS reporting interfaces. Creation of the Servicing Expense Grid The following four steps where completed during the building stage of the servicing expense grid. Per Account Servicing Expense Calculation The activity based costing portion of the process occurred at this stage. The process began by entering the raw data into the spreadsheet (Figure 1—figures available from atuhors). Next, the data was categorized as either origination or one of four types of servicing. The servicing types include maintenance, collection, real estate owned / bankruptcy, and overhead. Once the data had been properly categorized, it was totaled and divided by the appropriate cost driver. The drivers in this case are: (1) Average number of accounts 60+ days delinquent, (2) Average number of accounts outstanding, and (3) Average number of bankrupt accounts plus the average number of real estate owned accounts. National Average Bad Debt Rates The next step in creating the servicing expense grid introduces national average bad rates by FICO score to the process (Figure 2). The three agencies include Experian, Empirica, and Beacon. The bad rate report includes the following information: base number of accounts in each FICO range, 60+ number of accounts 60+ days delinquent in each FICO range, 90+ number of accounts 90+ days delinquent in each FICO range, charge Off / Major Derog. number of accounts charged off in each FICO range, and bankruptcy Number of accounts in bankruptcy in each FICO range. NOTE: Each of the categories also includes a percentage of bases. Although two of the three categories necessary for the creation of the servicing expense grid by FICO range are already present, one must be calculated. 60+ delinquencies less bankruptcy is calculated by subtracting 60+ delinquencies from Charge Off / Major Derog. Preliminary Servicing Expense Grid Next, a rough servicing expense grid (Figure 3) is assembled using the costs per account calculated with the activity based costing method in step 1 and the national bad rate data from the previous step. The maintenance cost per account, $57.17, is the same for all FICO ranges. On the other hand, the collection cost per account does change depending on the FICO range. It is calculated by adding together the products of the next two operations. Collection cost per account times the bad rates for accounts that are 60+ days delinquent excluding bankruptcies.

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Real estate owned and bankruptcy cost per account times the bad rates charge off / major “derog” accounts. The overhead cost per account, $7.06, is the same for all FICO ranges. Final Servicing Expense Grid Lastly, the final servicing expense grid (Figure 4) is created by establishing three times spans. Following are the calculations for each span: Servicing expenses for years 1 through 4 are calculated by summing the servicing, collection, and overhead costs located in the rough servicing expense grid. This is done for each FICO range. Servicing expenses for years 5 through 10 are calculated by summing the servicing and overhead costs located in the rough servicing expense grid. This is also done for each FICO range. Collection cost is not included during this time period because it is thought that most of the delinquency that MFS will incur happens during the first 4 years of the loan. Senior management has approved this methodology for these purposes. Finally, 10 year weighted average servicing expenses are calculated by for each FICO range. Testing Once the servicing expense grid is ready, the next step involves testing the pricing obtained using the new servicing expense grid versus the results obtained using the current methodology of $2.80 servicing and 20 bps administration expense per month. To accomplish this, a fixed rate mortgage account and an adjustable rate mortgage account are each priced twice. The first pricing uses the original $2.80 servicing and 20 bps admin expenses per month. The second pricing uses the new servicing grid that has been constructed using activity based costing. Results Summary The comparison results for the fixed rate account were favorable in the fact that the servicing expense calculated was lower using the servicing expense grid than using $2.80 servicing and 20 bps admin. The comparison results for the adjustable rate account were also favorable in that the use of the servicing expense grid resulted in lower servicing expenses than using $2.80 servicing and 20 bps admin. The outcome was favorable for both the fixed rate and adjustable rate tests in terms of lower servicing costs. Additionally, the difference between the new and old methodologies was also different between the products. The difference for the adjustable rate product was less than that shown in the fixed rate product. However, perhaps most importantly is the fact that both outcomes produced more accurate expense assumptions. Not only have we incorporated credit quality and seasoning into the equation, we’ve introduced a servicing expense grid calculated in part by activity based costing.

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Conclusion As mentioned earlier, as MFS has pursued its strategy of growth through the acquisition of existing loan portfolios, it has become increasingly important that assumptions made regarding portfolio performance are as accurate as possible. Errors in judgment can be very expensive and unprofitable, especially when it comes to items such as servicing expenses. Fortunately, as seen above calculations using activity based costing can help assign all costs accurately and appropriately to help an organization to control their costs. This is especially true for those in the financial services industry to make better business decisions. The end results include better credit quality, higher revenues, and reduced losses. Finally, MFS should realize major benefits from the implementation of activity based costing into its servicing expense grid. However, it will take time to see exactly what the impact will be. Accounts purchased today will have to be loaded onto MFS systems and then be given time to perform before statistics can be gathered and analyzed.

REFERENCES [1] Davis Byerly, Eric Revell, Stan Davis. Benefits of activity-based costing in the financial services industry. Cost Management, Boston: Nov/Dec 2003, Vol. 17, Iss. 6; pg. 25 http://lproxy.usi.edu:2055/pqdweb?index=0&did=000000476926891&SrchMode=1&sid=1&Fm t=4&VInst=PROD&VType=PQD&RQT=309&VName=PQD&TS=1087671082&clientId=4130 [2] FICO Score Estimator. Bankrate.com, 2004, http://www.bankrate.com/brm/fico/calc.asp [3] Implementing Activity-Based Costing. AICPA, (No date included in the article.) http://www.aicpa.org/cefm/cost_management_05.asp [4] Interview - Director of Business Analysis, Midwest Financial Services, June 16, 2004 [5] Interview - Senior Business Analyst, Midwest Financial Services, June 15, 2004 [6] Midwest Financial Services. Hoovers Online, 2004, Hoover’s Inc. 19 June 2004 http://lproxy.usi.edu:2055/pqdweb?index=0&did=000000387447011&SrchMode=1&sid=1&Fm t=3&VInst=PROD&VType=PQD&RQT=309&VName=PQD&TS=1087671414&clientId=4130 [7] Michael Tinkler, Daniel Dube. Strength in Numbers. CMA Management, Hamilton: Sep 2002, Vol. 76, Iss. 6; pg. 14 http://lproxy.usi.edu:2055/pqdweb?index=8&did=000000156378621&SrchMode=1&sid=9&Fm t=4&VInst=PROD&VType=PQD&RQT=309&VName=PQD&TS=1087673946&clientId=4130

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