Abc Costing in Banking Essay Example

reach the profitability levels that are necessary to appease their shareholders. " Thus, activity-based costing is a logical choice for cost allocation in banking. According to a study by Paul Sherman, President of Focused Management, Inc. "Most banks are quite involved with process improvement, for which the BBC provides information on what processes cost. This comment is further supported by a study performed by Peter Trucker, in which an overview of his studies written by Mitchell Max quotes, "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. Activity-based costing will allow a bank to ultimately determine how lucrative the products are to the bank. As BBC is implemented in a bank organization, the activities that contribute to providing the banks services are defined, and then costs are assigned to each of these activities. The end result is that a bank can determine how profitable deposit services and loans actually are ... For example, the bank can determine the costs and profits of interest-bearing checking accounts, home equity loans, car loans and so forth. Activity-based costing will also allow bank managers to better study the demands of customers, improve their decision-making and ultimately create higher profits. As doted by Mitchell Max, "The sheer fact that customers have multiple channel and process options for sales and service interaction with banks, nears 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. " There are generally four steps in the activity-based costing method, which include identifying the activities, determining the cost of each activity, determining cost drivers, and assigning activity costs to products. It is vital for users to follow all four steps of the system, as activity-based costing can be difficult to implement, especially when starting the process in the middle.

As supported by McGuire, Oklahoma and Wagers, "Activity-Based Costing is a process that cannot be started in the middle; to succeed it needs to follow all steps" The benefits of activity-based costing to a bank "include the proper costing of transactions, the ability to trace specific costs to bank customers and the ability to measure customer and product profitability. The end result of these benefits is the ability to improve decision-making and help organizations meet their strategic objectives. " The first step in activity-based costing is identifying the activities.

This first step identifies all activities in the value chain and as activities are identified, they are classified as one of four categories: unit level, where "resources and activities are resources acquired and activities performed specifically for individual units of product and service;" batch level, where "resources and activities are the resources acquired and the activities performed to make a group, or batch, of similar products;" product level, where "resources and activities are the resources acquired and the activities performed to produce and sell a specific good or service;" or facility level, where "resources and activities are the resources acquired and the activities performed to provide the general capacity to produce goods and services. By classifying activities into

separate categories, it allows users to trace the costs of resources of the goods and services. There are several activities that exist in banking. Fund raising activities are popular amongst banks as many exist to attract and service depositors. Many costs are associated tit fund raising including those generated through administering accounts, providing statements, clearing checks, processing deposits, and several other transactions handled to support the funds provided by depositors. Since deposit funds are generally the largest source of revenue for banks, this activity can become quite detailed and the need to accurately trace the numerous costs related to the deposits is extremely important. A bank that wants to survive into the next century must update its understanding of deposits ... And their respective contributions to profit. BBC can help a bank overhaul its concept of its core business.

According to Hicks, Electronic and Curricle at D. T. Hicks & Co. , "there are a number of processes involved in raising funds and it may be useful for the bank to better understand the cause and cost of these individual processes. Knowing the cost of processing a lobby deposit vs.. An ATM deposit, clearing an electronic check vs.. A paper check, or performing any other transaction' can facilitate process improvements and guide attempts to modify customer behavior in ways that will reduce bank costs. In addition, "there may be some situations in which it would be useful to know the cost f supporting a specific customer who is both a depositor and a borrower ... It should be apparent [which] depositor/borrower is more profitable, but without knowing the transaction costs of deposits and check clearing

it is impossible to measure the difference. " 9 As a result of the intricate details of fund raising expenses, activity-based costing is an advisable method to identify and accurately measure these costs. Another important activity apparent in banking is fund using. "Once a bank has accumulated funds, it can then use those funds in a variety of products designed to earn the bank a profit.

Each product will have an easily measurable net interest margin, but that measure will not provide a complete picture... The ability to match the cost of these activities with the products they support provides a much more complete and accurate picture of product and customer profitability. " Fund using activities may include outside contractor costs such as appraisers, insurers, title searchers and in-house activities such as loan closings, loan advances and check processing. Again, activity-based costing would be a beneficial method for tracing costs of using funds since these expenses can also come rather detailed as they are a major aspect of daily banking operations.

Departmental activities are also a major source of day-to-day banking expenses. In marketing, it is important to know the costs generated by advertising the banks products and services to various markets such as retail customers, large commercial businesses, or small businesses. "Banks must compete with other banks for business - not only for the depositors who provide funds, but for borrowers who 'buy the banks products [and] marketing efforts directed toward attracting borrowers need to be segregated and assigned to the banks products... As a result, activities should be established for each significant market category being actively pursued by the bank. Other departments where

various activities take place include human resources, accounting, information technology, maintenance and legal. "Once activities have been sub-divided into these categories, the process of distributing costs and developing product and customer costing rates can begin. " The last major activity of banking includes product lines and support. "Activities take place that develop and support its various products: commercial real estate loans, working capital loans, detail auto loans, equipment loans, and the like... It is important to assign each product's or product line's development and support costs to the products that fall within the appropriate product category.

As a result, activities should be established for each significant product or product line being sold by the bank. " As discussed, the first step in activity-based costing of identifying activities is important in banking. Banks have numerous daily activities and it is crucial to identify the major activities so that bank managers can later determine the costs associated with each of these activities. "The key to developing an effective activity-based cost model is establishing the appropriate activities and the relationships between them. It's a matter of being able to ask the "right people" the "right questions. " If the "right questions" are asked, it is only the accuracy - not the precision - of their answers that is important. Once the activities have been established, the second step in activity-based costing is determining the cost drivers. First, the cost of activities must be determined and is generally supported by data gathered from the various employees, in this case bank tellers, loan officers, branch managers, etc. In a study by Withered and Kim, "The total cost of each activity

must be calculated using employee data from personnel interviews and financial data from the accounting department. Employees are asked to identify the amount of time they spend on each activity in an average week and then identify the physical resources that were used to support the activity. This information is compiled on an employee activity data sheet. It is important to remain in contact with all bank employees as they are the backbone of information on the various activities in the bank.

"The primary building material for BBC is knowledge-knowledge of the activities performed by the people and resources employed by the bank or organization. The downfall of many aborted BBC programs lies in inadequate documentation of the information that is collected. " After determining the cost of activities, the bank managers can now define a cost driver for each activity representing the third step in an activity-based costing system. "A cost-driver rate is the estimated cost of resource consumption per unit of he cost driver for each activity. This rate should use a base that has some causal link to the cost. The total activity cost is divided by the total activity volume, which is figured from the results of cost of activities gathered from employees, and this establishes the cost driver rate. Cost drivers in banking may include the number of times an activity is performed, which is considered a transaction driver, and may include the number of times checks are deposited, how many times a loan is approved, how many times an electronic payment is made, etc. When determining a cost driver in a bank setting, it is important to keep in

mind that "banks have four conditions that significantly influence their cost characteristics. First, banks have transaction volumes that vary during a given period. The number of transactions on Monday and Friday are greater than the rest of the week.

Second, a large portion of a banks non-interest expenses do not vary with volume. Third, bank costs are somewhat predictable in that payday and holiday patterns influence the volume of transaction activity. Fourth, bank costs are traceable because a significant portion of administrative and clerical expense can be directly identified with lending and other revenue producing functions. " Lastly, the fourth step in activity-based costing is assigning activity costs to the goods and services at the bank by using the cost-driver rates determined in step three. There are three general steps to assigning the activity costs. "First, all the activities related to a given product or service must be identified.

Without an intimate understanding of a company's organizational structure and the relationships between departments, it may be difficult to identify accurately all the activities elated to a product or service. Second, the number of units of each activity that are used per unit of product should be determined. Third, costs should be assigned to products using the cost-driver rates for each activity. " By determining the cost drivers and eventually assigning costs to each banking activity through the activity- based costing system, this allows banks to keep abreast in the competitive industry and deliver the most valuable products to customers at a reasonable cost to the bank. Greater customer-eccentricity will permit a more sophisticated understanding f the drivers of customer value and their cost. In turn,

this will permit banks to deliver 'smart customization'?streamlining and consolidating delivery of customer 'nonnegotiable,' while charging appropriately for extra features that customers actually value. " One way in which banks today are implementing activity-based costing is through activity-based pricing, particularly in business-to-business services. According to Mitchell Max, "Financial services organizations are recognizing that significant value can be derived from pricing which leverages BBC information. "

There are many instances where pricing should be based on the cost to serve the particular product to each customer. "In particular, business-to-business 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. " Studies have also shown that banks may face certain challenges when implementing an activity-based costing system. First, some bank managers believe that the amount of time and resources it takes to apply the activity-based costing method does not outweigh the benefits of the system.

According to the study by Withered and Kim, "A few managers expressed concern that the new cost accounting system was merely going to reshuffle the banks costs and that, unless hard actions were taken to remove costs from the bank, the project would serve no useful purpose. " The time and resource concern relates to the need for regular updating of the BBC system and the ongoing labor that must support the system. The study by Mitchell Max states, "Early adopters of BBC were plagued by the size of the staff groups that

were needed to maintain their systems; without large staff complements, BBC models quickly became outdated. It is not uncommon to find BBC teams with over 20 people, plus a dedicated systems group supporting them. As a result, frustration with the significant maintenance costs associated with BBC has become rampant. Another concern with the activity-based costing system is maintaining compliance with the generally accepted accounting principles (GAP) and Serbians-Solely legislation for external and regular reporting. According to Mitchell Max, "Coffs must demonstrate that the information presented in segmented reporting has the same integrity as that presented under the GAP statements. The same standards apply to the use of BBC information in supporting decisions made by management or the board. " He further states, "BBC 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.

The last concern to be discussed relating to activity-based costing is the most popular apprehension in the study performed by Withered and Kim. This was a concern of the particular bank on which they focused their study; however is likely a common difficulty in other banks. According to the study, "After all the cost center allocations were created and entered into the systems, the most difficult part of the project was gaining approval for the cost information produced by the new allocations. " The study further describes the concern as follows, "This challenge was specially evident for centers whose assigned costs from a support

center increased as a result of the change in cost allocation methodology.

After gaining approval from the operating managers with specific product profitability responsibilities, the approval process then required approval from the project steering committee and executive-level management. " Despite the challenges with implementing activity-based costing in banking, the system has proved to be effective based on studies performed on various banks over the years. With the banking industry being so competitive, it is important to follow he steps of BBC to ensure that costs are accurately traced and calculated allowing banks to maximize profitability.