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H EADQUARTERS’ OVERHEAD COST ALLOCATION AT KOREA AUTO INSURANCE CO. INC.
Sangil Kim, Professor Ho-Young Lee and Professor Won-Wook Choi wrote this ca solely to provide material for class discussion. The authors do not intend to illustrate either effective or ineffective handling of a managerial situation. The authors may have disguid certain names and other identifying information to protect confidentiality.
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Copyright © 2009, Ivey Management Services Version: (A) 2009-10-22
In January 2009, Jin Kim, manager of the Taejon City branch of Korea Auto Insurance in South Korea, was frustrated. Taejon City had grown rapidly since the Korean government started moving key central government offices to the city in 2005 and developing large industrial and residential areas around the city. Many private and public rearch institutions had built laboratories in a suburb of Taejon City. Auto insurance companies had opened numerous branches to capture new customers. As a result, the Taejon City branch of Korea Auto Insurance Co. Inc. had experienced vere competition and made efforts to capture greater market share in the region.
After preparing the operations report for the previous year, Kim realized that his branch’s performance was not as good as expected, primarily due to the way cost accounting systems operated within the company. The current cost accounting systems penalized branches that generated more revenue during the fiscal year.
Korea Auto Insurance Co. Inc. was one of the three largest liability insurance companies in Korea. Selling auto insurance policies was its primary rvice. The company had allocated overhead costs incurred at the headquarters across operating branches under a traditional volume-bad allocation process. Overhead costs included resources spent by the headquarters for information technology rvices, general administration and marketing activities. The problem was that the headquarters’ overhead costs had been allocated to branches according to the amount of revenue each branch generated. Differences in the cost structure of each branch were not considered in the process. As a result, some branches were allocated a large portion of overhead, but felt they had not benefitted much from headquarters’ resources. Some branch managers had complained about the current allocation process of overhead. They argued that their earnings targets were unlikely to be reached, solely becau of the inappropriate cost allocation process the company had applied.
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CONCERNS AS A NEW BRANCH MANAGER
韩语翻译在线翻译Kim was transferred to the Taejon branch in 2008. He was considered a key player in the Strategic Planning Department at the headquarters before being transferred to the branch. He had been involved in major business projects and gained a reputation for his ability to plan and budget. In 2007, he successfully directed a three million dollar project establishing an enterpri resource planning (ERP) system for the entire company. He was expected to be promoted to an executive officer position eventually. Transferring Kim to the Taejon branch was a favor from the top management intended to give him an opportunity to gain field experiences at the branch level, as was commonly expected of future key executive officers. Taejon was a rapidly growing city and a strategically important place for Korea Auto Insurance Co. Inc. to expand its market share. Kim willingly accepted the position.
After he took the branch manager position, Kim worked hard to improve the operating results of the branch. Headquarters also provided the Taejon branch with more marketing staff and more office space. As a result of the efforts, the Taejon branch raid insurance revenues from $23.6 million in 2007 to $33.2 million in 2008. However, Kim was frustrated after closing his books while preparing the branch operation report for the fiscal year 2008. He realized that the 2008 net income of the Taejon branch was much lower than for the prior year. The increas in operating costs, including overhead costs allocated from the headquarters, were much higher than the revenues.
BACKGROUND: KOREAN INSURANCE MARKET
The insurance market of Korea had two characteristics that made it distinct from the markets of other OECD countries. First, automobile insurance was by far the best lling policy in the Korean insurance market. Other property insurance policies against casualties, such as real estate insurance against fire, were sold much less, proportionally, in the Korean market than in the United States. The government mandated auto owners to purcha liability insurance. Government-driven economic growth had pushed gross national income per capita to $20,000 in the 2000s. Korean auto makers, such as Hyundai and Kia, had made progress, technologically and financially, and had been able to meet all the increasing demands from Korean auto buyers. Having more cars on the street meant more revenue for auto insurance companies. Second, the Korean financial industry was heavily regulated by the government. The Financial Supervisory Service, a government organization that ruled all the financial institutions, provided very specific operating guidelines to the market participants. It also monitored whether the financial market was dominated by any chaebols, business conglomerates owned by families. Heavy regulation and over-protection of the industry had weakened the competitive edge of many financial companies. Korea Auto Insurance Co. Inc. was a typical ca. An auto insurance company could afford to keep using a potentially unreasonable meth
od of overhead allocation becau its management lacked operating autonomy since the auto insurance industry had been tightly regulated by the government. Although the government had not dictated overhead cost allocation methods, the management of insurance companies tended to looly adopt the simplest or least controversial methods without paying attention to the managerial conquences in detail.
CHANGES IN REVENUE/COST STRUCTURE IN THE TAEJON BRANCH
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Taejon City had, in recent years, dramatically improved its infrastructure by building new freeways and introducing electric railways and a train à grande vites (TGV) or high-speed train. The changes attracted more people to the city and thus expanded the market for auto insurance.
The headquarters of Korea Auto Insurance Co. Inc. tried to capture the Taejon market ahead of potential competitors by providing various supports to the branch. The supports included increasing the branch’s marketing staff from 27 to 35. Sending Kim to the Taejon branch was a top-level management decision to make the branch more competitive. Kim, however, realized that expansion of the branch might penalize him and branch employees by not only incurring direct costs at the branch level but also by the branch being allocated a large amount of the headquarters’ overhead costs, resulting in lower net income. HEADQUARTERS’ OVERHEAD COSTS
Exhibit 1 illustrates the cost structure of Korea Auto Insurance Co. Inc. Direct costs accounted for about 60 per cent of total costs while indirect costs accounted for about 40 per cent of total costs. Direct costs consisted of both operating costs (48 per cent) and administrative costs (12 per cent).
Exhibit 2 reports headquarters’ overhead costs and their allocation bas. There were five teams in the headquarters: information technology (IT), operating support (OS), investment, marketing and general administrative (GA). Costs of the IT team dramatically incread from $18.4 million in 2007 to $24.3 million in 2008. The primary reason for such an increa was the depreciation expen of investment in the ERP system introduced in late 2007. Depreciation was computed bad on the straight-line method over a uful life of five years. Ironically, the successful launching of a new IT system in late 2007 by Kim at the headquarters was a major factor in improving the operating performance of the Taejon branch in 2008. The five teams at the headquarters were the cost centers for overhead. They supported the operating activities of the branches and their support was esntial in maintaining the business infrastructure of the company. Exhibit 3 lists various costs incurred by the teams during the last two years. Primary activities of the IT team included branch PC maintenance, headquarters IT system support and employee computer training. The OS team provided sales training, operating performance evaluation, evaluation reporting, and traffic accident c
a handling. Activities and respective costs of the investment, marketing and GA teams, along with tho of the IT and OS teams, are provided in Exhibit 3.
INDIRECT COSTS DISTRIBUTED TO SALES BRANCHES联系人的英文
Kim was frustrated that the current overhead allocation practices of Korea Auto Insurance Co. Inc. did not take into account the importance of overhead costs. Until 2006, the differences in overhead amounts allocated across branches were not significant. However, the differences became significant as the amount of overhead incread and activities became more diversified.
早上好英文Exhibit 4 provides two-year data for potential cost drivers that could be ud as a basis to allocate overhead costs to operating branches including Taejon. Exhibit 5 outlines the Taejon branch’s revenues and direct costs for the last two years. Exhibit 5 indicates that the proportion of direct costs over total revenues decread from 72 per cent in 2007 to 67.5 per cent in 2008, reflecting Kim’s efforts. Primary overhead costs incurred by each team at the headquarters are discusd below.
IT Team
The costs of IT were associated with activities such as branch PC maintenance, headquarters IT sys泔脚
tem support, branch IT system support and employee computer training. The company currently ud branch insurance revenue as the allocation ba of costs incurred by the IT team. However, overheads that were actually proportional to revenue included the costs of supporting the IT systems of headquarters and branches. Branch PC maintenance costs were approximately proportional to the number of PCs. Attending a computer training program was mandatory for all employees and an appropriate cost driver for the computer training costs would be the number of employees.
Kim had analyzed and reorganized branch activities the previous year and significantly reduced non-value added activities. As a result of this reorganization, he reduced the number of employees from 82 in 2007 to 45 in 2008. This reorganization was a painful process; however, it grabbed management’s and major shareholders’ attention as an example of the firm’s value creation and Kim’s reputation was bolstered. However, Taejon’s cost reduction effort was not rewarded with lower overhead allocation under the current allocation method bad on the branch’s revenue.
Operating Support Team
Primary functions of the OS team included running training programs for insurance sales personnel, handling traffic accident cas, and preparing operating performance reports across branches. Traini
教育观ng costs were directly related to the number of sales people in each branch. Costs of preparing operating performance reports should have been treated the same way across branches. Costs of handling traffic accidents were proportional to the number of accidents. However, Korea Auto Insurance Co. Inc. allocated the overhead costs of the OS team bad on revenue amounts generated by the branches.
The cost of handling traffic accident cas was $16.4 million in 2008. This accounted for the largest proportion of total overhead costs at headquarters. Kim regarded the minimization of the costs as critical to his cost-saving efforts. He therefore ud public relations and campaigns throughout 2008 to prevent customers from being involved in accidents. He also tried to minimize the number of high-risk customers handled by his branch through de-marketing. As a result of his efforts, the number of accidents in the Taejon branch decread from 54 cas in 2007 to 31 in 2008. Regardless, the amount of overhead costs allocated from the headquarters incread in 2008.
Investment Team
The investment team was in charge of the investment of cash generated from insurance premiums. Costs of investment in equity or debt curities were associated with the amount of investment. This install是什么意思
amount was generally proportional to the amount of insurance revenue generated. Costs of investment performance evaluation and reporting did not vary much across branches. The activities of the investment team were not directly related to activities conducted in the branches. By focusing on generating investment gains, the activities of the investment team were independent of branch operating activities.
Marketing Team洗脸后护肤步骤
The marketing team advertid and developed new products and channels. Advertising costs included money spent for TV commercials, Internet banners and other public relations activities to introduce
insurance products to potential customers. The allocation ba of advertiment costs was currently branch revenue. Kim believed, however, that there was little causal relationship between nationwide advertiment and branch performance in terms of revenues. Kim reasoned that advertiments could result in branch-specific revenue increas, but did not benefit Taejon more than other branches. New product and channel development costs were necessary to provide operating infrastructure for branches. Kim believed that the costs might not be related to the incremental revenues of branches.
General Administrative Team
The GA team was in charge of maintaining the company’s asts and human resources. Costs incurred by the GA team were specifically related to payroll, personnel evaluation and employee training. Maintenance costs of the headquarters building were allocated to the Taejon branch on the basis of revenue, although the costs were not related to the operating activities of the branches.
Kim believed that the number of employees would be a more appropriate allocation ba for costs incurred by the GA team. He felt that the current allocation method was not fair since he tried to save GA costs by reducing the number of employees in 2008 and was not rewarded under the current method.
DECISION
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Kim believed that the current cost allocation method was not appropriate. The current overhead allocation system resulted in inefficient resource allocation and provided branch employees with inappropriate incentives that might lower firm value in the long run. Kim, therefore, prepared a more relevant and accurate operating report bad on an alternative overhead allocation method that ud more appropriate cost drivers than current revenue amounts.
Kim put a letter-size notepad on his desk and thought about the best way to persuade management to u more appropriate cost allocation systems. He believed that one way to persuade management was to provide a numerical example that demonstrated how it was possible to reach misleading conclusions bad on information generated by the current cost allocation systems.
Kim realized that, while most overhead costs should be allocated to operating branches, certain headquarters costs did not have to be allocated at all to branches unless there was a direct proportional relationship between the resources and branch activities. He gathered relevant information for developing a better cost allocation system.
