the use of activity based costing in calculating mortgage loan

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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.

mailto:[email protected]



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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



[7] Michael Tinkler, Daniel Dube. Strength in Numbers. CMA Management, Hamilton: Sep

2002, Vol. 76, Iss. 6; pg. 14



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