max, m. (2004) ‘abc trends in the banking sector – a practitioner’s perspective’

JOURNAL OF PERFORMANCE MANAGEMENT32

ABC Trends in the Banking SectorA Practitioners Perspective

Mitchell MaxManaging Partner, [email protected]

Over ten years ago, in The Information Executives Truly Need, Peter Drucker observed that service industries including banks have practically no cost information at all1 . Today, not only has Activity-Based Costing (ABC) become common in the financial services arena, but it is in the midst of an unprecedented resurgence as organizations move quickly to replace, revise or extend their ABC systems and processes. Organizations that have avoided ABC due to perceptions of it being too complex or not producing enough value relative to initial and ongoing effort are now embracing ABC as a new weapon in their arsenals. Individuals with skills in this area are in high demand. Technology developments and investments are stronger than ever, as the tools have caught up with the aspirations of leaders in the field, enabling them to operate in new ways. What is driving this change? Is this truly an evolution or merely a fad which will pass?

From a practioners perspective, this change is being driven by a number of critical business needs which are outlined in this paper. Todays implementers are leveraging advanced technologies and approaches in new ways to deliver sustained value for their organizations through Activity-Based Costing information. This paper seeks to present the reader with a compelling justification for advancing their ABC initiatives, and an understanding of how the new technologies and approaches can be effectively leveraged. It draws on direct experience and interaction with organizations that are raising the bar for value from their ABC investments and looks to measure the progress we have made over the past decade, along with some thoughts for the future.

ABC TRENDS IN THE BANKING SECTOR 33

The Need for ABC Information

Drucker noted that Enterprises are paid to create wealth, not control costs. They have to be managed for wealth creation. To do that requires information that enables executives to make informed judgments. 2 Todays CFOs are responding to an unprecedented need for improved, sustained bank performance to meet growing stakeholder expectations. Sophisticated banks and their stakeholders realize that improved performance cannot come from cost-cutting alone. Comprehensive performance management approaches, systematic management of central costs, razor-sharp pricing and customer profitability information are emerging by enlightened banks as the keys to their profitable future.

The demand for actionable, accurate and transparent cost and profitability information is growing. Bank mergers have promised significant savings, but obvious resource duplication is only one source of cost reduction, and scale efficiencies have not materialized to the extent promised. Technology innovation has also been slow to dramatically drive down operating costs. As a result, banks are looking for more comprehensive and deep understanding of cost information as they strive to meet stakeholder expectations.

Banks have traditionally used average costs as part of their profitability analysis. For those banks that do use ABC, it often takes the form of standard unit costs, with some transactional differentiation for example, using different costs for assisted vs. self-service transactions applied to channel-specific transaction volumes. While providing directionally correct information at a high level, accurate costing often remains elusive to these banks, particularly when viewed at the detailed level.

As differentiation of service increases in financial institutions, it drives multiple levels of complexity. In turn, complexity drives highly different levels of cost consumption, for example:


Product customization, which often requires special back-office processingSpecial compliance functions/proceduresManual reporting/government filingsSignificant effort to explain product features to clientsHigh error rates triggering significant levels of manual adjustmentsDegree of online self-service capabilityProduct complexity driving level of sales/advisory effortElectronic versus manual transactionsStraight-through vs. manual processing

Studies have shown unit cost factors, due to differing demand intensity impacting consumption, to be in some cases 5 or 10 times higher or lower than the average. As a result, average costs have never been more inappropriate! In fact, the level of cost differentiation has become so significant that even business unit executives are rejecting the use of average costs as a basis for decision-making. Only when costs are based on actual consumption, and demonstrated in a transparent fashion, will they be truly accepted by all parts of the business. In fact, when presented in a transparent way, cost information forms a powerful tool in dialog with customers.

New Applications for ABC

Todays banks are identifying new and unique ways to leverage cost and profitability information, including:Activity-Based Pricing, particularly for Business-to-Business services;Linking ABC information into Performance Management scorecards and processes;Providing information on a process view of costs, both to support cost improvement needs and to enable ongoing accountability for management by business process; andInformation on the profitability of discrete customer relationships.


Activity-Based Pricing

Financial services organizations are recognizing that significant value can be derived from pricing which leverages ABC information. In situations where pricing is determined solely by reference to the market, organizations can do little but select and nurture customer relationships with high yields and lower cost to serve. There are many situations however, where pricing can and must be based on an understanding of the cost to serve for each product and customer. In particular, businesstobusiness services have significant potential for profit optimization when the cost to serve can be transparently calculated, and in many cases discussed with clients during price negotiation. As a result, there is great demand for accurate, transparent and reliable cost information by the customer facing sides of the business.

In one case, a transaction processing outsourcer has been highly successful in using this information to target specific clients and, through training of its sales force has begun to improve the profitability of client relationships. Previously, discussions could only refer subjectively to the level of complexity of their interactions. With new information, specific measures of transaction intensity can be described with clients, and additional opportunities to capture pricing for special value-added services become more evident.

Integrating ABC and Performance Management

In their initial work with ABC, most banks focused their implementations narrowly, developing isolated unit costs, product cost data and departmental cost studies, with a focus on understanding specific unit costs generally focused on product and organizational profitability. Many of these studies were static, and quickly became outdated.

Increasingly, we are witnessing a need to develop more comprehensive cost and profitability information, looking for example at the cost of an entire business process which now encompasses multiple channels and organizational units. Further, organizations recognize the significant


value that can be derived from weaving cost and profitability information into more comprehensive and integrated performance management applications across the organization. Cost data now forms an integral part of Balanced Scorecard applications, and internal performance benchmarks are used to identify opportunities for performance improvement. The need for external benchmarking is growing rapidly. Cost and profitability are now critical elements in assessing and managing the ongoing performance of branches, channels and customers.

As a result, banks are experiencing the need to develop linkages between ABC tools, data warehouses and Corporate Performance Management (CPM) platforms. IT groups are becoming more directly involved in ABC applications, as they begin to treat cost information as a corporate asset, and identify the way it is foundational to other information such as CRM data or CPM applications. This technical data integration is expected to continue at an increasing pace as CPM rises in prominence due to a heightened focus by many of the technology analysts. New approaches to Performance Management, such as Beyond Budgeting3 , are reinforcing the need for the integration of these components by demonstrating the need for open and transparent information as the basis for relative performance management and interactive control processes.

The New Goalpost: True Customer Profitability

Studies continue to show that banks that manage the profitability of customer relationships outperform banks managing without this data. Experience has demonstrated that non-profitability-based segmentation (e.g., based on revenue, balances or number of products) can produce behaviors that reward retention of high touch - and generally less profitable - customers. (One retail broker found that over 20% of their high target customers were in the lowest two profitability deciles.)


The sheer fact that customers have multiple channel and process options for sales and service interaction with banks, means that only by understanding and managing customer demand can cost and profitability be understood and managed. Best practice organizations explicitly measure and manage the true profitability of each customer relationship.

All banks recognize the criticality of customer profitability information. The information is increasingly used in developing and executing customer acquisition and retention strategies, with leading organizations incorporating this information into their customer relationship management (CRM) systems. As the more sophisticated banks divest themselves of low-profitability customers, other banks must be wary of accepting their hand-me-down accounts. Banks that market free checking models run the risk of being selected by the very low-profitability customers that have terminated relationships with other banks. Consequently, profitability analysis at the customer level is no longer optional.

Accurate analysis across multiple dimensions requires cost assignment down to the lowest cost object levelthe account. The best way to understand costs across dimensionsincluding customer, product and channel dimensionsis to actually cost them out at the account level. Understanding that lowest level and then developing rollups of the information across all cost object dimensions results in truly accurate information that can be used across the organization. Traditional applications which cascade costs from one profitability dimension to another (organizational, product, channel, and customer) do not meet the test of accuracy.

Based on these observations, it is anticipated that:

Large banks will continue to refine and extend their customer profitability platforms. Many of the largest banks calculate standard unit costs for each channel specific transaction type, and multiply those costs by transaction volumes to determine and store customer


profitability information in massive data warehouses. While these solutions continue to meet many of the profitability analysis needs within those large banks, such as supporting CRM solutions, they do not address the operational cost management needs, or the cross functional process costing analysis requirements for these complex organizations. With new, more scalable costing technology offerings becoming available, larger organizations, with tens or hundreds of millions of customers, are looking towards newer solutions in meeting their costing needs. One major brokerage company, for example, recently converted their in-house ABC application to a commercial software product, enabling them to efficiently and effectively prepare and analyze the profitability of each of its 8 million customers on a monthly basis. By integrating their previously separate unit cost and profitability models, they are able to better use more discrete (and hence, more accurate) cost information and provide more transparent profitability measures to their business segments.

Mid-size banks and non-retail lines of business in large banks also require scalable customer profitability platforms. Mid-size banks and non-retail lines of business need access to comparable customer profitability tools scaled to support customer levels in the ten-million range. Newer ABC tools are making this possible.

Need for effective integration of transactional information across the organization. Pulling data into large data warehouses and understanding how to use and leverage it effectively will ultimately determine the success of the financial institutions customer profitability initiative. As organizations begin to collect and manage a variety of information at the customer level, there is an increasing need to optimize not only the physical storage of this but also the leveraging of this related data amongst all information consumers within the bank.

An end to the separation of cost and profitability information at the customer level. Increasingly, banks now look to solutions which combine unit cost and customer profitability, along with other


profitability measures, in a single product or model. While this was previously not possible, advances in technology have begun to open this solution up to all but the largest banks. One regional bank has retained the use of its A/LM package for Funds Transfer Pricing at a customer level, and is linking it to customer-level cost data from a new ABC system.

Managing the Bank as an Economic Unit

Financial services organizations are clearly becoming more sophisticated about how they manage costs. As banks expand and enhance their costing capabilities, we are witnessing a return to the use of Activity-Based Management as a key weapon in the war on costs. Over their history, banks have inadvertently made ABM more difficult to implement, by breaking up their operations into discrete organizational units in the drive for consolidation and efficiency. This has made it difficult to manage activities as an entire process. For example, customer transactions are handled in one area, branch back-offices are often consolidated in a geographic area, major processing is handled in a central unit or outsourced. Understanding and managing total economic costs through process swim lanes has become a major undertaking.

Banks are beginning to apply process management techniques. More recently, as they seek innovative ways to reduce costs, banks have begun to organize around processes and look at costs from a customer perspective, including recognition that costs will cross multiple sales and delivery channels. Early analysis here often focuses on the total cost of a process (i.e. mortgage origination cost). Since most banks continue to organize and operate in functional silos, ABM information is increasingly in demand, and ABC software is being utilized increasingly to tag activities by business process regardless of where it resides for organizational convenience.

At the same time, process improvement techniques are becoming more sophisticated, with an increasing prevalence of Six Sigma and other


detailed process techniques. The Six Sigma approaches popularized by such companies as Motorola and GE are now being embraced by the financial services sector; back-office processing facilities are starting to introduce Lean Manufacturing techniques. At one large transaction processor, multi-disciplinary ABC project teams include Black Belts, who drive their teams towards more discrete and detailed measures of process performance. This forces a greater level of interest in true qualitative cost drivers (e.g., the level of training) and on process performance measures (e.g., error rates) which in some cases can force additional detail into ABC models. While this is not news to our manufacturing colleagues, this is a clear shift in emphasis as banks realize the degree to which some parts of their organizations resemble factory operations.

This trend creates a number of demands on costing systems and professionals:

Greater need for process costing information and management. Organizations need more detailed process costing information for management reporting. ABC models need to be able to report on costs both by department and process. As banks begin to appoint process owners, information on the cost of business processes is being increasingly demanded in addition to traditional departmental cost data.

Need for better, ongoing measures of performance. When it comes to measuring performance, financial institutions need more granular, rigorous, accurate and timely information. A shift is on to better understand the factors of cost causation, including qualitative cost drivers and the management of demand intensity.

Linkages from ABC foundations to other initiatives. Scorecards, performance measurements, and other components of the CPM tool sets are linked to ABC and changes in costingand are thus becoming more critical. Software vendors are becoming increasingly aware of the need to demonstrate integration amongst the various performance management tools.

Strain between detail required for ABC and causal factors needed for reengineering and Six Sigma programs. As financial institutions take more strategic approaches to building costing systems, they need to develop ABC information at a level of detail that will support the causal factor requirements of reengineering and Six Sigma programs. This granularity is much lower than that required for strategic (product, channel) cost analysis. Greater care and the use of professional judgment are needed in the development of cost models to meet these often-conflicting scenarios.

New Challenges for ABC Implementations

The new needs presented above are matched with a new set of challenges facing ABC implementers.

While the need for this information is rising, the appetite for spending on ABC systems and supporting infrastructure is clearly waning as finance continually looks to optimize the value it provides to the bank. ABC groups are being constantly challenged to do more with less:

Need for regular updates and ongoing reporting is driving the need for lower total cost of ownership (TCO). Early adopters of ABC were plagued by the size of the staff groups that were needed to maintain their systems; without large staff complements, ABC models quickly became outdated. It is not uncommon to find ABC teams with over 20 people, plus a dedicated systems group supporting them. As a result, frustration with the significant maintenance costs associated with ABC has become rampant. As ABC becomes more critical to success and corporations are increasingly in flux, organizations are focusing on how they can develop and maintain accurate costing systems while keeping down costsparticularly ongoing labor costs. Time-based cost models and strong data automation, discussed later in this paper, are supporting a renewed ABC approach with a lower ongoing cost of ownership.


Survey tools falling out of favor. Surveys have traditionally been used to capture the assignment of resources to activities in ABC models. With variable staffing models on the rise, and the frequency of organizational change, survey information has become increasingly inaccurate and requires significant maintenance resources. Different approaches are needed.

Focus on data integrity for external and regular management reporting. As line-of-business profitability and costing information increasingly finds its way into externally published reports, organizations will need to ensure that the information meets generally accepted accounting principles (GAAP) and regulatory requirements and complies with Sarbanes-Oxley legislation. Tying ABC information to authoritative and certified back-office systems is becoming a new theme in advanced applications. CFOs must demonstrate that the information presented in segmented reporting has the same integrity as that presented under the GAAP statements. The same standards apply to the use of ABC information in supporting decisions made by management or the board. ABC practitioners are now coming to realize that cost systems must be as complete and accurate as the information produced for external and other internal reporting, and that compliance will be fully required. Approximates or estimates are coming under greater scrutiny when used as the basis for cost allocation.

At the same time, changes in the structure of bank operations are presenting new challenges to ABC implementers, both for initial design and also for ongoing application maintenance:

Use of non-banking concepts in cost modeling. Banks combine both product manufacturing (marketing, operations) and distribution (sales and service channels). As they reorganize, banks have increasingly been working to separate these functions, and separate cost information is required to support the accountabilities that management is introducing. The traditional non-banking approach of separating product manufacturing from service fulfillment/delivery


allows greater flexibility in costing than the single model approach which has been historically employed. With separate accountabilities, the organization can discretely flow costs between different parts of the organization. For example, mortgage applications and mortgage processing on the product side would be kept separate from loan distribution. Standard costs at the transfer point can be used to measure the efficiency of each group separately. This is a new approach to cost modeling which is being addressed. Trace-back of costs through these separate models is a requirement of many new systems.

Shared Services are here to stay. Banks are unique in the high levels of common cost base and infrastructure which is used to support its products and customers. When costs are fully allocated to branches, many banks find that the level of indirect costs is over 50% of total non-interest costs. To better measure and manage this high level of common costs, Shared Service approaches are becoming commonplace in banks. IT, HR, financial and customer service applications are being centralized and shared. Accountabilities are created for cost and profitability information at discrete levels in the organization. Best practice execution of shared services methodologies require cost allocation models tuned to the organizations culture taking it out of the technical implementation approach and relying to a much greater extent on the use of Change Management specialists.

The need to reflect a systemic view of costs. A financial institution cannot manage technology without considering operations, and vice versa. When examining the cost of processing a mortgage application, for example, a bank needs to consider both the technology and labor costs of the activity or process. If a bank wants to know how much it will cost to process an ATM deposit, it needs to look at the technology costs of running the machines, the costs of servicing the machines, and the costs of the courier systems and item processing areas that handle deposit slips.


Interestingly, many banks have begun a move to combine organizational responsibility for technology and back-office operations. These new Chief Technology and Operations Officers need new information on the total cost of transaction or service handling if they are to make effective decisions. Costs must therefore flow together to support this ongoing analysis for example, by helping to analyze the business case for a technology investment in terms of its ability to reduce manual effort and to track the achievement of benefits post-implementation. This requires a more integrated approach to modeling than is done when the items are treated in distinct models silos.

Banks change fasttraditional costing systems cant keep up! To a greater degree than ever before, change is the only constant.

As a result, banks are seeking ABC platforms that can meet a wide variety of needs concurrently and over time. No one ABC approach or model design will fit all parts of an organization. The organization must find tools flexible enough to meet a variety of needs and evolve as those needs change. Limitations in software design are tolerated less than ever before, simply because the future is so unknown.

Change Management Impacts

In addition to the systems changes that these needs and challenges drive, a number of organizational and people impacts are becoming prevalent:

More widespread use and greater access to ABC models and information. ABC no longer lives predominantly in the realm of finance. Learning that usage and sponsorship are critical to driving value from ABC, Operations, Marketing, HR and IT departmentsas well as various lines of businessare increasingly driving the application of ABC with Finance in a supporting role.


Need for broad change management and links to regular decision-making. Bringing ABC information more broadly into the organization shifts the focus from costing as an accounting science to costing as a management and behavioral science. ABC departments are beginning to re-tool, building competencies in training and change management to augment the purely technical modeling and analysis skills.

Centers of excellence approach to ABC support. Centralized costing groups actively encourage the use of ABC information across the organization, changing the way that information is used and deployed. This reinforces the need for improved training, and also for leveraging technologies which support distributed cost modeling and analysis.

Closing the Gap: New Approaches and Technologies

ABC approaches and technologies are responding to the challenges presented above. While history doesnt always exactly repeat itself, some concepts do re-emerge when the time is right. Advances in ABC technologies have facilitated a return to original principles in costing in financial services.

Resurfacing of time-based approach. Over the past 10 years, ABC implementation approaches have shifted from the use of time-based standards to the use of periodic (or often continuous) survey tools. The high level of effort associated with maintaining survey information on resource consumption which frequently changes is often cited as a reason for abandonment of ABC initiatives. The tide has now turned: in recent implementations, we have begun to see engineering-style estimates for time standardsonce the basis for leading banking applications - returning into vogue as part of the ABC lexicon. This approach is consistent with a more rigorous and scientific approach to the use of metrics in operations. In fact, a natural linkage exists between time-based analysis and productivity standards in back-office operations (e.g., daily applications processed per FTE), which have become stronger as a result of centralization. This approach is only


now feasible with the technological innovations that allow for time to be dynamically assigned based on transactional activity in operational areas.

Awareness and management of key capacity efficiency drivers. The use of time-based costing is also facilitating a renewed interest in the cost of capacity. More sophisticated than a simple fixed/variable cost analysis, our clients are increasingly looking to better measure and manage capacity, both in order to support more refined pricing, and to find ways to focus the organization on developing more flexible platforms. One major organization, for example, has begun to look at alternatives to internal technology capacity as a result of this newly focused attention, with the potential savings of millions of dollars annually. Similarly, significant capacity exists in fixed staffing models; organizations that are able to create flexible work environments can better respond to dynamically changing business volumes and price more aggressively in the market.

Flexible, less specialized business models require adaptive ABC approaches. In the recent past, organizations focused on fixed, specialized business models. As organizations look to better leverage their investment in human capital in a rapidly changing environment, there is a movement back towards flexibilityparticularly with staffing models that must incorporate such trends as job sharing, flexible hours, cross training and seasonality. As staffing needs change daily or even hourly, fixed percentages are increasingly irrelevant in allocating resource costs.

Weights and estimates are arbitrary. ABC practitioners have long used weights and estimates as proxies for average complexity. However, each customer drives distinct consumption levels based on product/channel/service mix. Only systems and approaches based on actual behavior and costs derived from real transactions - using the actual sales or delivery usage by the customer - will give the most accurate, reliable and supportable cost and profitability information.


Conclusions

Clearly, ABC is becoming the sophisticated foundation for enterprise performance management in the financial services sector. The movement of ABC into the mainstream, the renewal of earlier costing ideas, the emergence of process management and new business models, the intensification of differentiation, and attainable customer profitabilityall highlight a renewed need for accurate costing implementations.

We have come a long way from Druckers original challenge. While it is difficult to predict the future, ABC software vendors and consultants report an increasing level of interest from banks in dramatically advancing their cost and performance management capabilities. As bank mergers continue, and stakeholders performance expectations continue to rise, the demand for and investment in costing resources, processes and technologies will also be sustained.

Improved technologies and new financial leadership are critical in supporting this new evolution. Technology is delivering on the promise of ABC that practitioners have looked forward to for many years. However, technology alone cant completely fulfill ABCs potential. ABC thought leaders and practitioners must continue to use ABC-generated information to capture value that supports more investments in the technology.

The true value of ABC is limited only by the creativity of practitioners and the support of corporate leadership. Thankfully, more CFOs, COOs and CIOs now understand the value of this information. With their support, financial institutions can continue to invest in the technology and human resources that will lead to even more successful ABC initiatives, and ultimately, sustained performance improvement of their organizations.

1 Drucker, Peter F., The Information Executives Truly Need, Harvard Business Review, January-February 19952 Ibid.3 For more information, see Max, Mitchell, Budgeting Revisited: Cracks in the Foundation of Bank Performance Management, Journal of Bank Cost and Management Accounting, Vol. 15 No. 3; and also www.bbrt.org


Reprinted from Journal of Performance Management, Volume 17, No. 3. At the time of the original article Mitch Max was the Managing Partner of the Performax Group.

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max, m. (2004) ‘abc trends in the banking sector – a practitioner’s perspective’

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