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Royal Financial Services (RFS) provides front end loan origination services for a number of banks who process and maintain loan portfolios. RFS accepts applications from customers and processes them through closing of the loan agreement before turning the loan over to customer banks. RFS is paid regardless of whether the loan closes or not. RFS currently services three types of loans - residential mortgages, auto loans, and personal unsecured loans. RFS has no cost accounting system so total operating expenses are simply allocated to each product line based on revenue.

For the year just ended, RFS reported financial results as follows:

Income Statement	Mortgage	Auto	Personal	Total
Annual Volume of Loans	1500	6000	4000	11500
Origination Fee/Unit	$350	$200	$115
Total Revenues	$525,000	$1,200,000	$460,000	$ 2,185,000
Operating Expense	$504,673	$1,153,538	$442,189	$ 2,100,400
Profit	$ 20,327	$ 46,462	$ 17,811	$ 84,600
Profit % Revenue	3.9%	3.9%	3.9%	3.9%

RFS management is concerned about the overall low profitability of the business and has asked you to apply activity based analysis in order to give RFS a better understanding of relative product profitability. After extensive interviewing of staff and analysis of RFS%u2019s cost structure, you determine there are four primary activities that RFS performs, with cost drivers and total cost as follows:

Activities	Activity Driver	Mortgage	Auto	Personal	Total Cost
Accept applications	# pages per application	4	3	1	616,000
Obtain credit referrals	# credit sources/applic.	2	2	1	332,500
Do loan analysis	# hours analysis/applic.	3	2	1	656,000
Close loan	# hours to close loan	4	2	1	495,900

You determine that the application processing and loan analysis activities are performed using internal RFS resources while the credit and closing activities are performed primarily by external credit agencies and law offices on a per transaction basis (e.g. $X per credit check, $Y per closing hour). You also learn 70% of the mortgages end up being closed (the remainder are not approved after loan analysis); 80% of auto loans close and 90% of personal loans close.

You also identify a key external measure of how well RFS is performing versus the industry. While RFS does not bear the cost of defaults, their customers do track RFS performance and use it to negotiate future origination fee rates.

		Mortgage	Auto	Personal
Default rate experienced by loan processor		2%	1%	6%
Industry average		2%	3%	4%

Assignment

A. Based on the above information, use activity based costing to assess the total and per unit profitability of RFS%u2019s three loan products

B. RFS is considering adding a new product line, Home Equity Loans, which RFS believes will make the mortgage business more attractive to their customers. RFS research shows they could originate 500 of these loans at $230 each. RFS would have to process a 3 page application, obtain 2 credit referrals from outside credit agencies, do 2.5 hours of loan analysis, and complete a 4 hour closing process, with 85% of applications being closed. RFS believes existing resources in the company can handle the additional application processing and loan analysis work. Using the cost driver rates you developed in part A, compute the estimated incremental and fully loaded profitability of this new line of business for RFS. Note: incremental analysis would only include the incremental costs that result from adding home equity loans.

C. Write a brief memo (maximum 1 page, double spaced, font 12) to RFS management summarizing the results of your analyses. Make specific recommendations to RFS (1) to improve business profitability and (2) to add home equity loan business or not.

Fully Loaded Home Equity? Incremental Home Equity?

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