When we talk about the profitability solutions for the banks it is calculated by using information from various sources. Typical profitability calculation starts with the Net Interest Income. This is the difference between the Net Interest income and the charge for the funds. Also Interest expenses and the credit for the funds for the deposit products are used for calculations. This information is available from the Fund Transfer Pricing (FTP) solution. The difference between these gives the Net Interest Margin (NIM). This is one part of the revenue. The other part could be from the various fee based products or commission from the third party products. This makes the total revenue from the customer.
From this margin the bank can adjust the margin by probability of the losses. This is calculated from the credit risk calculations. The adjusted figure gives the risk adjusted margin for a customer. From this margin the expenses are deducted. These expenses can be calculated using activity Based Costing (ABC) solution. This will give net contribution from the customer. Deduct Tax and then cost of funds and one can get the Net Vale add by the customer. So what we have seen is the calculation of profitability includes a) Revenue accounting b) Internal funds accounting c) Risk Adjustments d) Capital Allocation e) Expense Accounting.
The issue for the banks is that, they have good handle on the revenue accounting but little that they know about the accuracy of expense accounting to the product and customer level. Today we are going to see more on how this expense accounting be done using ABC. So it is more about how to calculate the profitability rather than the why bank should calculate the profitability. Even within that we would be looking at the 'expense accounting' part using ABC technique.
Find below the schematic diagram of the Profitability model using ABC technique.
Resource Section
Activity based costing has three major sections viz. Resource, Activity and Cost Object. For the profitability model for Banks, the resource section contains the expenses grouped for various departments (Functions or Cost Centers) in the Bank. Generally these expenses are taken for a period (say a quarter). The departments are grouped as at corporate office (sometimes Zonal office also), Branches, Alternate channels like ATM, Call Center, Direct selling agent (DSA), Internet etc. and finally the shared service departments like IT, HR etc. The services that are provided by the ‘shared service department’ are defined and their costs are calculated. Then, based on the volume of the services provided by the department, its costs go to the various other departments. Most of the commercial software solutions available today can handle the ‘reciprocal assignments’ i.e. IT providing services to HR and vice-a-versa. The departments can be also grouped by the region. Another way of grouping the branches and ATMs is by their ‘costs’. This means grouping of the branches or ATMs that are having similar costs. Simple way of doing this is by grouping them as Urban, Semi-Urban and Rural. The scope can be expanded, if required, in future by doing at each branch or ATM.
Activity Section
The activities are defined as per the transactions that are performed by the customer for various products using different channels. For example ‘origination of commercial loan’. For this the activities could be receiving the application, interviewing the applicant, understanding the credit history, evaluating the applicant, taking decision, disbursing the loan amount. Like this once you have defined all the transactions, each transaction is then broken down into activities and then against each activity, put the name of the department, time taken by the activity. For the activities that are performed in a batch mode, one has to consider the batch size also. The activities are generally grouped as per departments.
Cost Object Section
As usual this is the most important section of the model and defined first. In cost object we see the result that is expected out of the model. Typically this section can be divided into two parts. The first section calculates the cost of various transactions, performed by the customer for various products using different channels (distribution channel). For example, withdrawal of cash using ATM for a savings account. Here we can see that the withdrawal for a checking account and savings account using an ATM may not differ, but still we calculate the cost for the same separately, as it is required in the next section of the cost object.
Customer lifecycle event - All these transactions are grouped according to different events in the lifecycle of the customer. They are Acquisition, Provision, Serve, Retain and Close. All the transactions related to the acquiring of a customer are grouped here in Acquisition. The ‘up selling’ of a product is grouped here as if it is a new sale. In Provision all the transactions that the customer can perform as a part of having the product are grouped. For example for a saving account, the customer can deposit cash/check, withdraw cash, receive account summary, check balance etc. The serve sections could be similar to the provision but here the transactions are requested by the customer specifically. For example, the customer can receive a monthly statement of records, but she may ask for a statement for a particular period in between. This request may or may not be charged. In the retain section, all the transactions that are performed (mostly by the bank) are grouped. This may contain the efforts for cross-selling, campaigns, communications etc. The cost of some free gifts can also be added here. In the close section, the transactions related to the natural closing or forced closing is added. In addition to this there are two other groups here viz. Cost to sustain business and Cost available to use. Cost to sustain business are the costs that are neither related to the product nor to the customer, but are required to run the business. For example the costs of the departments like Company secretarial, Account finalization etc. These are separated in the model as the model is used for internal business decision making. In case of any statutory reporting this can be allocated to the products. The last is the ‘cost available to use’. By using the bottom-up modeling technique we can calculate and separate cost available to use (aka idle cost) in the organization and that to department by department. You can read more about the ‘bottom up’ modeling in my earlier post at http://activitybasedmgmt.blogspot.com/2010/06/push-and-pull-in-abc.html
Channel - The second way of grouping the transaction is by Channel. The primary channel for banks is a branch. The model can be designed for grouping branches as per their costs (may be within a region). As described in the Resource section, the branches can be grouped as Urban, Semi-Urban and Rural. The model can be taken to individual branch level also. This helps the bank to find the branch or location level profitability. Most of the times customers of one branch (where she has opened the account), avail the facilities of the other branches. In this case the inter-branch charging can be used to calculate the branch level profitability. The cost of process can also be compared among various locations and optimized.
Apart from the primary channel as branch, there are other channels (distribution channels) like ATM, Call Center, Internet etc. The cost of transaction performed using these alternate channels are typically less than that performed at the branches. Banks are using various programs to transfer users from the branches to these channels. The cost savings can be calculated here. But one also has to look at the ‘resource capacity’ released at the branch. The bank has to take care of this capacity otherwise there would not be any positive impact on the bottom line of the bank. Now-a-days one of the segment of the customer is as per the ‘attitude towards technology’. This can be seen by the use of these newer channels by the user. The bank can get a report on utilization of various channels by various customers and can use this information for further investments in technology, locations etc.
The information on the cost of the processes and the utilization of the channels has helped the banks to use the ‘menu based pricing’ methodology for various types of the customers. Now a day the banks charge the customers for using the branches or ATMs. This typically depends on the type of the account that you are holding with the bank.
Product – The transactions are also grouped by product. The product group can start at the group level as Deposit, Credit, Revolving Credit, Fee Based, Third Party etc. Within these groups then a hierarchy can be created as per the requirement. The same can also be used to calculate the Line-of-Business (LOB) profitability by grouping the products. The product manager can get reports like product profitability by region, customer segment etc. She can use this information for creating new products, proposing to the appropriate customers/prospects, fee structure, risk factors etc. Typically when we talk about customer profitability, the product profitability is actually built in the model.
Transactions - These are the processes that a customer can perform. For example, deposit cash, withdraw cash, receive debit card, receive statement, open account, check balance etc. There are some transactions performed by the bank on their own. This is typically in the ‘Retain’ event. Communications, offers sent to customers or closure of a dormant account etc. The level should be decided as a proper transaction performed by the customer.
The ‘unit cost’ calculated for the transaction is end of first level calculation in the profitability calculation. Once the cost of each transaction is known to the bank then these costs can be taken to the customer very easily.
Customer Profitability – The customer profitability for banks now means the profitability at the account level. One customer can have multiple accounts with a bank. For example, a savings account, a car loan account, a housing loan account, a locker etc. The profitability can be calculated for each of these accounts. Let me make clear at this point that, when we say customer profitability, it is the Customer P&L for the period. Then it can be rolled up for a customer. So a customer may not be profitable for a particular product but may give more profit from the other. Bank can use this information (if it has got integration of information done) to cross sell, up-sell or provide some discounts. The customer level information can also be rolled up to a ‘household’. This helps the bank to propose various products to the members of the family at their life-stage. This also helps not to propose same product to different members of the family. For example, proposing same housing loan to the same family may be a waste of resources. Customer profitability report can be provided by each product. This information can be analyzed and utilized by the bank for various purposes. You can find more details in the post http://activitybasedmgmt.blogspot.com/2009/12/customer-analytics-with-profitability.html
The profitability solution can be also created at the customer segment level as initial phase and then taken to the customer level. The segments can vary for each bank but some of them are shown in the figure as life stage, products held, attitude towards technology etc. Generally the segment level information is used for campaigns, introducing new products, up sell, cross sell etc.
Activity Based Costing can measure the profitability of thousands of retail banking customers by examining their behavior in detail. It actually concentrates on the various activities that are performed for the transactions that the customer perform and then it distributed the cost of those transactions based on the use of those transactions by the customers. This provides the accurate information for calculation of the customer profitability.
