Introduction
Gibson Insurance Company is faced with a challenge that is critical to the long-run sustainability of the company: how to use costing systems to operate more efficiently. With the growing size of the company in the recent years, the current cost allocation system is no longer suitable to provide vital information for the management in making pricing decisions, compensating employees, and managing costs. Therefore, it is essential that a new cost allocation system must be implemented to better measure the costs and gain insights to guide managerial decisions which can affect the organization’s efficiency. By evaluating Gibson’s current business practices and product lines, the report will identify issues and provide a rationale to utilize a new cost allocation system in order to increase efficiency and profitability.
Company Background
Gibson Insurance sells two different types of financial products: annuities and life insurance. Annuities are typically financial contracts that offer a re-occurring payment plan. Annuities consist of tax-deferred investments; this means that investors can place their pre-tax dollar income into various financial tools in order to decrease their income. The main goal of tax-deferred investments is to lower an individual’s income for an overall tax savings. Another product is a life insurance in which the policy holders contribute a certain amount of money per year in order to pay a lump sum to any benefactors if the policy holder is deceased. Both of these products are sold by agents who are employed directly by Gibson Insurance.
With the vision and mission to pursue a growth strategy for the next several years, the management implemented an acquisition plan. Acquiring other insurance firms would not only increase Gibson’s holdings, but it would also increase customer base. An increased potential customer base would allow its sales team to push for more sales and increase their assets under management. After defining its organizational goals, Gibson acquired both Compton Insurance Services and Midwest Mutual Insurance Company. Midwest and Compton sells products that are very similar to those of Gibson. The only difference between the three companies is the variance of price and features on each of their life insurance and annuity products. For example, one company aims to sell variable annuities whereas another sell fixed annuities. Each subsidiary operates as a separate legal entity, but Gibson provides the administrative services for all three companies.
SWOT Analysis
Current business practices and the existing cost allocation system at Gibson will be first analyzed through SWOT analysis, identifying Gibson’s strengths, weaknesses, opportunities and threats, considering both internal and external factors.
Strengths
Corporate Acquisition Strategy
Pursuing the corporate acquisition strategy, Gibson is able to grow a large customer base. Acquiring Compton and Midwest Mutual insurance companies shows competitors that Gibson is an industry leader. It also reduces competition as the acquired companies now sell as subsidiaries of Gibson.
Product variety
With the acquisition of Compton and Midwest Mutual, Gibson offers a greater variety of products to customers varying in price as well as features such as term-length of policies as well as their associated tax benefits. Product variety is one differentiating factor among the competitors, as it allows the products to be tailored to the customers’ needs.

Weaknesses
Inadequate Cost Allocation System
Using number of policies as a single allocation base for support service costs for all business units and product types is misleading in terms of the true cost of a product or the use of support services by business units.
Declining Profitability despite Increase in Sales Volume
Gibson has experienced an increase in sales volume partly due to growing number of recent corporate acquisitions, which has expanded the customer base. However, a lack of proper cost information regarding the product lines has led to improper cost management and pricing decisions, resulting in a decline in overall profitability.
Opportunities
Profitability and Growth
The growth strategy of acquiring other companies can quickly increase Gibson’s customer base and increase future profitability. Given that sales volume is increasing, if Gibson is able to identify areas of improvement, whether it is setting the right prices or improving organizational efficiency, then the company may be able to realize high profits in the future.
Threats
Industry Regulations
The requirement of financial information from legal business unit entities such as Midwest, Compton and Gibson makes the strategy of corporate acquisitions more difficult to maintain and poses a challenge to consistent cost allocation across all entities. It also raises costs involved in providing financial disclosure of all related business entities as it is time-consuming and costly. Transparency is also another issue as it is hard to understand where specific information is derived from.
Issue Identification
The main issue is inadequate cost allocation system that allocates support costs to various product lines using volume-based cost driver, the number of policies. Using number of policies as a single base disregards all the variances in product features such as the new and in-force policies as well as the differences in the tasks involved in selling each product. In other words, applying an equal cost of $82.25 per policy for all product lines does not accurately reflect the resource consumption of the policies sold by the business units. For example, one new life insurance sold by each of the three companies would not result in the same financial risk or reward as selling one in-force annuities, because selling new policies in general require more time and effort, and thus the new policies should cost more. Another concern is the decrease in profitability even though the sales are soaring. Possible causes are mismanagement of costs and that the price is set incorrectly. The root cause can only be identified by implementing a proper cost allocation system so that the costs can be better tracked to each product lines and business units.
Rationale to Revise Cost Allocation System
The rationale behind revising the allocation of corporate support costs to the product lines and business units is based on the need for better product line cost information and gain an accurate insight to profitability to identify the root cause of the decline in profitability. The resources used in Gibson range from non-financial resources like human resources to financial resources and a better cost allocation system will accurately track which product lines have consumed what resources to what extent. This way, Gibson will be able to run the entire company with a higher degree of efficiency with an ultimate goal of increasing profitability. Further, an accurate cost allocation will help management at Gibson make proper decisions about product pricing, identify areas of improvement and evaluate sales agents for performance and compensation purposes.
New Cost Allocation System
The new cost allocation system proposed for allocating corporate support costs uses four categories: policy acquisition, customer service, sales and marketing and other corporate support. The four categories are derived from 50 corporate accounts which have been grouped together according to similarities. This gives a more structured framework for allocating costs by providing a system that is manageable and understandable. Here are the chosen allocation bases for each of the four categories and its justification.
1. Policy Acquisition number of steps in taking new policy to in-force policy – life insurance and annuity policies have different number of steps in achieving this task.
2. Customer Service number of incoming calls – the number of customer calls received will depend on the type of policies and the number of policies sold. For instance, those business units that sell more policies usually have more calls needing customer service support.
3. Sales and Marketing number of sales solicitations – the sales efforts can be directly traced to sales agents and to the new businesses. The different type of policy require sales efforts; for example, 20 contacts have to be made to sell one new life insurance policy, compared to 10 contacts for new annuities policy.
4. Other Corporate Costs dollar value of AUM (assets under management) – the overhead costs in this category were determined by the time spent by home office personnel which created greater AUM.

As seen, each category has its own allocation basis chosen with a proper rationale that accurately identifies the activity that drives cost for that particular category. Referring to Table A, a unit cost is calculated based on the consumption of resources for each activity. Therefore, each policy has varying unit cost and the table indicates that new policies have a high cost while in-force policies have a relatively low cost. Most importantly, the new cost allocation system recognizes the true costs associated with each product line in terms of its use of support activities. Also, using new cost allocation bases provide a better assessment and evaluation of management performance as this system will force each business unit to become more efficient in their use of support services. This is because they will be assessed on their use based on each of the four categories rather than on a general basis, like the previously used allocation base, number of policies. Through more accurate information about product line costs, management will have the necessary information to make proper pricing decisions and assign compensation to sales agents. The new cost allocation system also focuses on identifying areas of improvement.
Further, although it is not required by regulators, the unit costs per policy in Table A explain why Gibson should track support costs per policy by product and company. As mentioned, accurately assigning costs to different products by business unit allows management to gain a better understanding of product profitability. Even though Gibson had a higher volume of sales in the past few years, their profitability had declined, meaning that prices were not set correctly, costs were too high and/or resources were not allocated properly. Since tracking costs gives management more information on the individual product costs, they could assign prices to the products more effectively to make a desired profit. This accurate cost information would also allow management to compensate sales agents on a fair basis, which would encourage agents to work harder as their efforts would be tied directly to compensation. This would also help management influence behaviour of the division managers as they saw fit. Management would charge over-users of resources more for services and under-users less, so division expenses would be proportional to use of services. Also, having accurate cost information allows management to assess where they need to improve efficiency. They could use the products with low costs as models to improve the inefficient processes and assign resources accordingly. As well, the knowing how the costs are split amongst product and business units is a useful piece of information in making managerial decisions.
There is one slight drawback to the new cost allocation system however; certain allocation bases may cause unethical behaviour from the sales agents to reduce costs as much as possible. With the newly proposed allocation system, there are loopholes and opportunities for manipulation. For example, staff may try to reduce the number of steps in issuing life insurance to reduce cost since number of steps is the driver behind cost allocation. This phenomenon will be more evident if compensation is tied to cost reduction for the departments or business unit.
Existing Allocation Basis VS New Allocation Bases
The new support cost allocation provides Gibson Insurance with a more accurate reflection of resources used for various annuities and life insurance sold by each legal business unit entity. As shown in the “New Allocation Bases” in the calculation part of Table A, the various products require different resources and processes. For instance, annuities require two major steps in issuing a policy; a review of the application data and the electronic imaging of the application. Life insurance policies on the other hand require additional steps on top of the two steps mentioned; generating files for reinsurance, reviewing medical information and getting supervisor’s approval. Therefore, using a single measure, “number of policies” to allocate the support costs is not a reflective claim on the shared corporate resources. Comparing the current allocation bases with the new allocation bases, the unit cost per policy varies greatly depending on the resources used. Table A shows that in-force policies require less support costs compared to the new policies for both annuities and life insurance. This results in a unit cost of $12 for in-force policies and $214 for new policies for annuity products. As well, life insurance policies appear to be more costly in general than annuities, with significantly higher unit costs. This was not revealed in the old allocation basis. Under the existing cost allocation, the support costs were spread across all products regardless of whether or not certain support activities were required by the policies. For instance, new policies require sales solicitation, whereas in-force policies require none. In this way, a single unit cost of $82.25 per policy was applied to all policies, resulting in inaccurate reflection of the resources consumed.
Table B shows the total support costs to be reported by the product for each business unit. It shows that Compton reports the highest cost among the three business units, which can be explained by sales of relatively high proportion of life insurance policies. Further, referring to Table C, which it compares the total support costs under the old allocation basis and the new allocation bases, the results seemed to have reversed under the two costing systems. The total support costs under the old allocation system showed high costs for Midwest and Gibson and low costs for Compton simply, while the new allocation basis yield high costs for Compton, and low costs for Midwest and Gibson. The reason is because the old allocation basis was purely based on volume – that is the number of policies. Using number of policies as the allocation basis overstates the costs of Midwest and Gibson, which has high volume of sales (61,850 and 61,775 respectively) and understates Compton, which has the lowest volume of sales (45,615). So the annuities, which are high volume products, were overcosted, basically “subsidizing” the low volume product – life insurance, which involved more complex processes. This misled the management to believe that Compton incurs the lowest cost as a business unit when in fact it consumes the most corporate costs.
However, now that the support costs are allocated based on the four categories, it reveals that Compton actually incurs the most cost due to its relatively high sale of life insurances. Life insurance has the highest per unit cost of $550 due to additional steps required for policy acquisitions, greater number of incoming customer calls, and higher number of sales solicitation compared to annuities. This implies that a higher price must be set for the life insurance policy.
Also, it appears that for each policy sold, a significant amount of sales and marketing costs are involved. For instance, for each annuity sold, 10 customer contacts are made through calls or visits. This is not an efficient way to sell insurance. Compulsory training programs for agents must be in place in order to increase the communication skills and selling skills. Putting advertisements such as print ads that targets a specific group is also an effective method. Further, implementing an incentive system (e.g. commissions) for sales agents may also enhance the effectiveness of sale efforts.
To further improve the new approach of allocating support costs, changes in the following areas are recommended. The customer service costs can be allocated based on the average time spent on customer calls rather than the number of incoming calls. The reason is because some customers may require more assistance than others, thus it is more-time consuming. For instance, it may take 15 minutes to serve one customer, while another customer only takes 2 minutes. Another improvement is in allocating other corporate overhead costs; the new allocation base is the dollar value of assets under management. Considering that costs are incurred for various areas of activities such as product management, accounting, actuarial, human resources and investments, it may be more reasonable to use number of employees rather than dollar value of assets under management. The reason for this is that assets under management does not necessarily apply to activities such as human resources, where the efforts are dedicated to implementing hiring policies and strategies to manage human capital, based on the size of the company.
Conclusion
To conclude, the new allocation information gives a more accurate reflection of the resources used for various policies and product lines by taking into account the actual usage of support costs. Previously, the number of policies as a single allocation base, which is volume based. As a result, it significantly distorted the product costs and misled the management to make incorrect pricing decisions. While identifying which areas need to be improved, the new allocation bases provide insight on how to better compensate sales agents, provide better pricing guidelines and improve costs. This will allow Gibson to improve profitability of their product lines and further facilitate company growth in the long-run.

Appendix
**All calculations rounded to whole numbers
Table A: Unit Support Cost per Policy | Annuities | Life-Insurance | | New | In-Force | New | In-Force | Unit Cost Per Policy | $214 | $12 | $550 | $31 |

Calculations:
Support Costs to be allocated Policy Acquisition | $4,375,000 | Customer Service | 2,426,000 | Sales & Marketing | 4,552,000 | Other Corporate Support Cost | 2,567,000 | Total | $13,920,000 |

New Allocation Basis | Annuities | Life Insurance | | Support Costs | New Basis | New | In-Force | New | In-Force | Total | Policy Acquisition | Steps | 2 | 0 | 5 | 0 | 7 | Customer Service | Calls | 0.5 | 0.2 | 0.6 | 0.4 | 1.7 | Sales & Marketing | Contacts | 10 | 0 | 20 | 0 | 30 | Other Corporate Support Cost | AUM | $50,000 | $50,000 | $1,500 | $65,000 | $166,500 |

The above support costs are allocated to each policy using direct method based on percentage of new allocation bases. Sample calculation shown below.
Example:
Support costs for policy acquisition allocated to new annuity policy based on number of steps
Total cost for policy acquisition: $4,375,000
Number of steps required = 2 steps out of 7
Allocated costs = 4,375,000 X (2/7) = $1,250,000

| Allocations to Product Lines | | | Annuities | Life Insurance | | | New | In-Force | New | In-Force | Total | Policy Acquisition | 1,250,000 | - | 3,1250,000 | - | 4,375,000 | Customer Service | 713,529 | 285,411 | 856,235 | 570,824 | 2,426,000 | Sales & Marketing | 1,517,333 | - | 3,034,667 | - | 4,552,000 | Other Corporate Support | 770,871 | 770,871 | 23,126 | 1,002,132 | 2,567,000 | Total | $4,251,734 | $1,056,282 | $7,039,028 | $1,572,956 | $13,920,000 |

Take the total allocated support costs by policy and divide by the total number of policies for each type of policy to get the total unit cost per policy.

Example:
Unit cost per new annuity policy
Allocated cost for new annuity policy = $4,251,734
Total number of new annuity policies = 19,840
Unit cost = $4,251,734 / 19,840 = $214

Table B: Total Support Costs for Each Legal Business Unit Entity

| Midwest | Gibson | Compton | Total | Annuities | | | | | New | $2,143,011 | $1,848,347 | $260,376 | $4,251,734 | In-Force | 553,349 | 445,139 | 57,794 | 1,056,282 | Subtotal | $2,696,360 | $2,293,486 | $318,170 | $5,308,016 | Life Insurance: | | | | | New | $687,405 | $1897,238 | $4,454,385 | $7,039,028 | In-Force | 173,739 | 418,834 | 980,383 | 1,572,956 | Subtotal | $861,144 | $2,316,072 | $5,434,768 | $8,611,984 | Total | $3,577,504 | $4,609,558 | $5,752,938 | $13,920,000 |

Table C: Comparison of Support Cost Allocation

| Old Allocation Basis | New Allocation Bases | Midwest | $5,807,166 | $3,577,504 | Gibson | $5,080,997 | $4,609,558 | Compton | $3,751,837 | $5,752,938 | Total | $13,920,000 | $13,920,000 |