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Porter Insurance Company has three lines of insurance: automobile, property, and life. The life insurance segment has been losing money for the past five quarters, and Leah Harper, Porter’s controller, has done an analysis of that segment. She has discovered that the commission paid to the agent for the first year the policy is in place is 55 percent of the first-year premium. The second-year commission is 20 percent, and all succeeding years a commission equal to 5 percent of premiums is paid. No salaries are paid to agents; however, Porter does advertise on television and in magazines. Last year, the advertising expense was $500,000. The loss rate (payout on claims) averages 50 percent. Administrative expenses equal $450,000 per year. Revenue last year was $10,000,000 (premiums). The percentage of policies of various lengths is as follows: Experience has shown that if a policy remains in effect for more than two years, it is rarely cancelled. Leah is considering two alternative plans to turn this segment around. Plan 1 requires spending $250,000 on improved customer claim service in hopes that the percentage of policies in effect will take on the following distribution: Total premiums would remain constant at $10,000,000, and there are no other changes in fixed or variable cost behavior. Plan 2 involves dropping the independent agent and commission system and having potential policyholders phone in requests for coverage. Leah estimates that revenue would drop to $7,000,000. Commissions would be zero, but administrative expenses would rise by $1,200,000, and advertising (including direct mail solicitation) would increase by $1,000,000. Required: 1. Prepare a variable-costing income statement for last year for the life insurance segment of Porter Insurance Company. 2. What impact would Plan 1 have on income? 3. What impact would Plan 2 have on income?

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Cornerstones of Cost Management (C...

4th Edition
Don R. Hansen + 1 other
Publisher: Cengage Learning
ISBN: 9781305970663

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Chapter
Section
BuyFindarrow_forward

Cornerstones of Cost Management (C...

4th Edition
Don R. Hansen + 1 other
Publisher: Cengage Learning
ISBN: 9781305970663
Chapter 18, Problem 38P
Textbook Problem
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Porter Insurance Company has three lines of insurance: automobile, property, and life. The life insurance segment has been losing money for the past five quarters, and Leah Harper, Porter’s controller, has done an analysis of that segment. She has discovered that the commission paid to the agent for the first year the policy is in place is 55 percent of the first-year premium. The second-year commission is 20 percent, and all succeeding years a commission equal to 5 percent of premiums is paid. No salaries are paid to agents; however, Porter does advertise on television and in magazines. Last year, the advertising expense was $500,000. The loss rate (payout on claims) averages 50 percent. Administrative expenses equal $450,000 per year. Revenue last year was $10,000,000 (premiums). The percentage of policies of various lengths is as follows:

Chapter 18, Problem 38P, Porter Insurance Company has three lines of insurance: automobile, property, and life. The life , example  1

Experience has shown that if a policy remains in effect for more than two years, it is rarely cancelled.

Leah is considering two alternative plans to turn this segment around. Plan 1 requires spending $250,000 on improved customer claim service in hopes that the percentage of policies in effect will take on the following distribution:

Chapter 18, Problem 38P, Porter Insurance Company has three lines of insurance: automobile, property, and life. The life , example  2

Total premiums would remain constant at $10,000,000, and there are no other changes in fixed or variable cost behavior.

Plan 2 involves dropping the independent agent and commission system and having potential policyholders phone in requests for coverage. Leah estimates that revenue would drop to $7,000,000. Commissions would be zero, but administrative expenses would rise by $1,200,000, and advertising (including direct mail solicitation) would increase by $1,000,000.

Required:

  1. 1. Prepare a variable-costing income statement for last year for the life insurance segment of Porter Insurance Company.
  2. 2. What impact would Plan 1 have on income?
  3. 3. What impact would Plan 2 have on income?

1.

To determine

Prepare the variable costing income statement for the last year for the Life insurance Segment of Company PI.

Explanation of Solution

Variable costing income statement: A variable costing income statement is a statement where all variable expenses are deducted from revenue to ascertain a separate contribution margin, from which all fixed expenses are then subtracted to arrive at the net profit or loss for the period.

Prepare the variable costing income statement for the last year for the Life insurance Segment of Company PI:

Company PI
Income statement (Life insurance segment)
For the last year
ParticularsAmount ($)
Sales$10,000,000
Less: Variable expenses (1)$9,125,000
Contribution margin$875,000
Less: Fixed expenses$950,000
Operating income($75,000)

Table (1)

Therefore, the operating loss for the Life insurance segment is $75,000.

Working note 1: Compute the Variable expenses:

ParticularsCalculationAmount ($)
Commission on first year policies($0.55×0

2.

To determine

Explain the impact of plan 1 on the income.

3.

To determine

Explain the impact of plan 2 on the income.

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Chapter 18 Solutions

Cornerstones of Cost Management (Cornerstones Series)
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