Activity-Based Information for Financial Institutions

Article excerpt

INTRODUCTION

Financial institutions planning for the 1990's are facing an increasingly diverse, complex, and dynamic competitive market environment. At the same time, the cost of making strategic errors continues to soar. These conditions complicate a bank's task of formulating appropriate and effective competitive strategies, as well as operational decisions. In order to cope, financial executives need accurate and relevant information on which to base their planning efforts and decisions. Inadequate or inaccurate information used as a platform for formulating strategies can lead to suboptimal decisions and, ultimately, failed strategies.

While the range of information needs for financial managers is hroad, the need for understanding the underlying cost structure of a banking operation has become particularly important. Activity-based costing' (ABC) is rapidly emerging as the best approach for providing managers with accurate and relevant information about the cost of a company's products, services, and customers. While ABC technology has gained wide acceptance in manufacturing firms over the last two years (see references), it has not yet significantly impacted financial institutions. The purposes of this article on activity-based costing in financial institutions are to introduce the reader to the fundamental concepts of ABC and to explore how the technology can be used in banking.

STRATEGIC INFORMATION

One of the keys to being competitive and profitable is to have an information system that gives an accurate representation of the cost of products, services, customers, and activities. Without these being known and understood, a financial institution is unnecessarily exposing itself to significant strategic and operational risks. A Northwest financial institution recently found that its cost system failed to accurately and reliably capture the true cost of products and services. Some products that were believed to be highly profitable were found to be only marginally profitable, or actually unprofitable, after an activity-based cost system was designed and installed. Similarly, some of the products that seemingly were unprofitable turned out to be the most profitable offered by the institution. A number of marketing efforts, operational decision, service and product designs had been based on this erroneous information. Annual strategic planning efforts used this information as one of a number of key sign posts for charting the institution's growth and direction.

The need for adequate cost data has intensified as a result of several developments:

* Deregulation of financial institutions. Deregulation has intensified competitive pressures on pricing, product mix, delivery, and profitability.

* Increase in the cost of Interest-bearing sources of funds. This has increased the need for cost information in order to price loans profitably in light of shrinking margins.

* Expansion of non-fund services. The introduction of new, non-traditional products and services has complicated the cost structure and has increased the need for accurate cost information in order to design and price these products and services.

* Unbundling of products and services. In days past, banks often relied on a single service charge to cover a bundle of services, and hoped that on average the total cost of providing services cost less than the revenue generated by the service charge. The trend over recent years has been to unbundle services and price each one separately. This has significantly increased the demand for cost information.

* Automation of main truasactions. While technology has lowered the direct cost per transaction, it has increased the indirect costs. The tracing of these indirect costs to products is a major challenge for a cost system.

Strategic cost information is key to making informed decisions regarding a variety of operational and strategic issues. …