An Experiment Using ABC-Based Value Indexing for Bank Services

By Quarles, Ross; Ashorn, Leroy et al. | Academy of Banking Studies Journal, Annual 2003 | Go to article overview

An Experiment Using ABC-Based Value Indexing for Bank Services


Quarles, Ross, Ashorn, Leroy, Bexley, James, Academy of Banking Studies Journal


CHANGES IN BANKING THAT CREATE A NEED FOR BETTER COST DATA

Significant changes in the banking industry in the last fifteen years have created a situation in which banks are now faced with many of the same cost analysis problems traditionally faced by manufacturing firms. The reduction in spreads and the increased competition, both among banks and between banking and other financial services organizations, have produced an environment where bankers must now face the perils and pitfalls of management of the income statement in addition to management of a balance sheet. Banks are deriving more and more of their income from fees for services offered to ever growing customer bases. Bank managers in a previous day may have faced asset management as their primary management activity. Today, however, these individuals increasingly face management of the relationship between service fee revenue and the cost of producing that revenue and may be forced to apply somewhat unfamiliar cost management models to bank operations. However, there is at least one major shortcoming of the traditional models that bankers should avoid in this new endeavor.

OVERHEAD: THE CRITICAL SHORTCOMING OF TRADITIONAL COST MANAGEMENT MODELS

Over the past twenty-five years accountants have recognized a major problem in traditional cost management models. These models generally fall short in accurately addressing overhead costs associated with the production of specific products or services. Traditional models involving allocation of overhead to products inadequately, or sometimes improperly, address the relationships between those costs and the products/services to which they are indirectly but undoubtedly linked. As suggested by Cokins, Stratton, and Helbling (1993), traditional cost models do not mirror the true economics of physical production and resource cost consumption. This shortcoming has become materially acute as overhead costs in total and as a percentage of total cost have dramatically increased in the last twenty years. As long as overhead costs were comparatively small in relation to total cost, allocation-driven inaccuracies in traditional cost management models were not necessarily a significant issue. Given the significance of overhead cost in today's typical cost structure, these inaccuracies are no longer tolerable. In response to this realization, accountants have developed activity based costing (ABC) to correct this problem and overcome the shortcoming of traditional models regarding overhead.

ACTIVITY BASED COSTING

Activity based costing (ABC) is a method of measuring the cost of products and services that allows those costs to be apportioned to the products and services based on the actual activities and the resources consumed in producing those products or services (Turney, 1993). The overall ABC process assigns the cost of resources consumed through the use of resource drivers to the actual activities being carried on in an operation. Resource drivers are the factors that measure the consumption of resources by activities on a causal basis. This linkage establishes a causal-based measure of the physical consumption of resources by activities and permits the quantification of the cost of that consumption by each activity.

ABC recognizes that activities are the sources of products and services. It is consumption of these activities which create products or services. The ABC model, therefore, links activity consumption through activity drivers to products or services (cost objects in the formal ABC terminology). These activity drivers are the measures of the quantitative output of the activities occurring in a process. The concept of activity drivers recognizes that not all activities are consumed by products or services in identical patterns. Consumption may be due to hours or time, transactions, events of differing natures, degree of complexity, or any of a wide variety of patterns. …

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