Activity-based costing identifies the actual cost of activities by determining what resources were consumed by each activity and how much they cost. Then, it applies those costs to products, services, customers, and channels.

Management Accounting

Activity-Based Costing Provides Insights into the Economics of Banking

Activity-based costing (ABC) offers a way to analyze costs that is different from traditional methods. People often say that ABC is a better way to do product costing. But, in fact, it is a huge mistake to think that ABC is either better or worse than traditional costing. Traditional costing is premised on accounting concepts that were designed to satisfy the needs of external and regulatory financial reporting, based on an ancient set of assumptions. By contrast, ABC is a practical method designed to provide management with meaningful information with which to make better decisions. This article will describe the difference between the two approaches and benefits of ABC to banking organizations.

Different Perspectives

Four years ago, a research consortium of banks produced a report that clearly described how management accounting information in banking needed to be reevaluated. [1]The most substantial finding was that customers who maintain low balances consume more of the bank’s resources and cost than they create revenue for the bank. The consortium noted that most retail banks have a very high proportion of customers who maintain low balances and generate minimal fee income. It discovered that the inverse is also true; a relatively small proportion of customers maintain high balances and pay large amounts of fees. These findings are consistent with our own experiences in completing studies to determine profitability by customer or segment. The outcome is that high balance/fee customers in essence subsidize those with low balances/fees. Often the gap can be significant, for example, high balance/fee customers produce earnings contribution that is three to five times final total bank profits. These profits are then diluted by losses made on low balance/fee customers. In one recent study in which I participated, 10% of a bank’s clients produced 90% of the revenue and 60% of the bank’s resources were tied up in serving the other 70% of the clients (10% of the revenue).

The report legitimized a view that was, and remains, highly contentious among bankers. Various individual banks had performed ABC before the release of the report; however, many banking personnel are used to the traditional profitability information. Furthermore any suggestion that low-revenue customers are a bad business proposition for banks challenges a prevailing view in banking that low-value customers are in training to become future profit generators. People in many banks become alarmed that the identification of low-profit or loss-producing clients might lead to them being abandoned, which to many is unacceptable. The whole idea of profitability by customer or segment struck many managers I spoke to over the years as unnecessary, impractical, and possibly threatening. Recently, it seems that more bank personnel are coming around to a more modern view of customer/segment profitability.

Manufacturing View Is Contradictory for Banking

Traditionally, bank profitability information has been developed using cost allocation logic from generally accepted accounting principals (GAAP), that is, fair allocation of overhead to products. For most people, because accounting logic was indeed generally accepted it was also assumed to be correct and useful for decision-making purposes. Most people, however, are not aware that cost allocation for financial reporting purposes under GAAP was developed in order to match cost with revenue in some reasonable way. The “reasonable way” was to assume that expenses are all incurred to produce products that customers will value and be willing to pay for. Accountants employed by banks are obliged to follow GAAP in order to produce financial statements and calculate earnings. Most accountants would agree that earnings numbers so calculated are premised on a variety of opinions. Few accountants would suggest that numbers produced for financial reporting are appropriate to support detailed operational decisions. It is not that financial results are wrong; rather, it is that they may be misunderstood and the numbers can be misapplied.

Under traditional cost accounting methods, accountants identify a denominator to allocate all of the operating expenses of each cost center to an object that represents products of the business. The denominator most commonly used is something that could be perceived to contribute to the preparation of the products. The usual denominator used for cost allocation is one that varies with revenue level and usually is a measurement that is only applicable to one activity. For example, it is interesting to note that in many branches, where cost is allocated on the basis of number of transactions processed, that the actual proportion of resources consumed in processing transactions is often in the order 40% of the total resources consumed by the branch. Therefore, 60% of the resources of the branch are allocated based on a denominator to which they are unrelated and the data produced is not representative of the facts. In all probability, accountants know that the cost distribution occurs in this manner, but most believe that their objective is to create some fair distribution of cost. In the accounting model, it actually doesn’t matter that there is this misrepresentation of cost, because it is assumed that these other costs are required to facilitate the processing of transactions, and that is good enough.

“Sixty percent of the resources of the branch are allocated based on a denominator to which they are unrelated.”

The concept of the “product” imbedded in the GAAP mental model was developed for manufacturing organizations earlier in the century. Until the last 10 years, this model was perceived by most people to be a viable method of satisfying all cost accounting needs, these being for decision-support purposes as well as accounting profit/balance sheet valuation. Now that many organizations produce results using ABC that are quite different from traditional cost accounting, the validity of GAAP cost allocation for purposes other than preparation of financial reports has been proved inadequate. A critical aspect of the inappropriateness of traditional costing is the use of the idea of products as the central object for cost allocation. This is because the term product refers to a discreet and tangible output; in contrast, banks perform services in which processing of transactions is the central theme. Because each transaction has unique characteristics, it is important to view the services provided by banks as distinctly different from products produced by manufacturing. Each transaction in a financial service organization is created by activities. A transaction is the closest entity that a bank actually has to the idea of a product. When bank personnel refer to a product, what they are actually describing is account types or individual billable services, which in turn are composed of many and varied transactions. Indeed, the application of GAAP cost allocation to banking cost accounting for decision support purposes provides numbers that could be highly misleading.

Interestingly, non accountants in banks accept information based on GAAP to influence decisions. But what choice do they have? GAAP caries the weight of law, and its methods are institutionalized and assumed to be correct by managers. Whether or not GAAP solutions represent the best way to analyze financial and management information is not broadly understood. Central to the question of the adequacy of GAAP cost allocation is the definition of products and services, which are very different things. A product is a discreet and tangible object that can be physically stored and moved. In banking, each transaction is intangible and has a unique characteristic such as the name of the account holder, account type (product), the payee, the value, and the channel by which the transaction is processed. So, the notion of a product in banking is very different from that which was used to develop cost accounting in manufacturing.

Bear in mind that ABC is widely accepted as the most appropriate replacement for traditional cost allocation in manufacturing companies. To many in banking, use of the term product as opposed to service may seem like a semantics issue; however, that simply underscores the problem. Actually, use of the term product causes banks to ignore the customer profitability aspect of their business, because it is not required for financial reporting. Hence, bank operating managers assume that accountants are providing meaningful information, which they are generally. But, in today’s highly competitive and fast moving business environment, operating managers need different and specific information to help them make better decisions.

Many people feel challenged by this argument, usually because the data challenges some very basic assumptions about banking economics. Sometimes, people prefer older models, because they take comfort in GAAP accounting, they have been working with GAAP-based numbers for a long time, or they wonder if the new data could have other flaws. People worry that new, more accurate profitability information could be dangerous because someone may decide to abandon all low-value, loss-producing customers without recognizing their potential future value. Or they think that without the less profitable clients, the bank would to reduce its number of employees. While there is an element of truth in these concerns, banking activities and processes are changing in response to the incredible opportunities offered by new computing and communications capabilities. As banks change the way in which they operate, they must also adjust their cost accounting and measurement systems work.

ABC Links Expenditures to Revenue-Generating Products, Services, Customers, or Channels

ABC produces quite different results because, when implemented properly it simulates the way in which actual activities actually consume resources. ABC then applies the output of activities to the objects of those activities, for example, the cost of a sales call is assigned as a cost of serving the specific client or segment according to the level of detail required in the analysis. Note that if there is no product orientation to an activity, then no allocation is attempted. There are many different assignment paths in ABC, but the principles of assignment are very straightforward. If a resource or activity is actually used by an object, then the cost will be assigned to that object. If the object does not use certain resources or activities, even though they exist, then none of their cost is allocated to the objects.

“If there is no product orientation to an activity, then no allocation is attempted.”

Using this approach, ABC identifies the actual cost of activities by determining what resources were consumed by each activity and how much they cost (Exhibit 1). To be effective, activities should be defined correctly, that is, the activity is real and all material activities are identified, whether they contribute to the processing of transactions or not. For example, when staff members are involved in a special project, they are performing a legitimate activity, but it is not involved with transaction processing. If working on special projects is material, that is, consumes more than 5% of the time of the people involved, it should be identified. Cost of resources assigned to an activity will include both controllable expenses and the cost of those resources and activities that are provided by other departments that facilitate the performance of activity in the recipient department. Activity drivers are the denominators of the activity cost pools that are used to calculate a unit cost of each activity in order to assign the cost to objects. A driver is generally a measure related to the output of the activity and is absolutely specific. For example, a driver might be the number of phone calls for the an outbound customer satisfaction assessment activity; for a call center activity, the driver could be the number of calls received. In a branch, the number of accounts reconciled may influence how much effort is expended on reconciling accounts.

Activity cost information can be used in many different ways. For example, the cost of activities can be compared across cost centers and branches that perform similar activities so that best and lowest cost practices can be identified and targets established. Also, ABC information can be used to identify “non-value adding” activities, so that people can work on eliminating them. In addition, most banks are quite involved with process improvement, for which the ABC provides information on what processes cost. Process cost information can be used to identify high cost processes in order to rank improvement efforts as well to conduct cost/benefit analysis of alternative improvement choices. And cost information can be used to plan and manage activity and process performance.

After calculating the cost of activities, their output is assigned to the objects of those activities. Generally the objects in banking are transaction types. There is another category of activity assignment for activities that are performed to sustain the business, which means that the activity is not used to produce a product or service a client or support a channel. For example, a business sustaining activity would be developing new computer software or preparing a budget. The costs of sustaining activities are isolated from other objects; they are paid for out of profits.

Transactions in banking usually have multiple attributes. For example, clearing a check will relate to a check for a specific customer and type of account that was processed through a specific channel. These dimensions relate to other characteristics, such as customers or channel (phone banking or banking machine). This implies that transaction-type cost objects need to have all attributes identified and loaded into a database for sorting. Revenue can then be determined by account, and ABC cost used to determine profitability.

Getting Started with Activity-based Costing

The place to start is to understand the competitive business issues of your bank and to determine how valuable ABC will be for your organization. Typically, financial institutions must have two compelling reasons to implement ABC:

· ABC is to facilitate data mining and simulation modeling to support marketing initiatives focusing sales efforts to acquire customers with who will provide new sources of revenue and profits.

We suggest that you begin by obtaining training on what ABC is and how to implement it. When you understand the basics you should assess the business issues faced by your organization. It is important to sell the benefits of ABC to senior managers in your bank, because ABC requires the involvement of people from all functions.

Once you have established the business case for implementing ABC, you can develop an approach and a plan for implementation. Different consulting and software firms will compete for your attention and the opportunity to sell their goods and services. Each has different strengths and weaknesses. So, do your homework.

ABC Defined

ABC works within the context of GAAP rules of accrual accounting but handles cost quite differently by tracing costs of resources, or indirect costs, consumed in conducting business to activities and from there to the object of those activities based on their use. Under ABC, “resource drivers” are used to assign the cost of resources to activities and “activity drivers” are used to assign the cost of activities to cost objects. The terms[i] used here mean the following:

· A resource is the physical element that is actually used by the business to perform activities that are used convert to inputs into outputs. Examples of resources include people, machines, buildings and supplies.

· A resource driver is a measurement of the physical quantity of resources consumed in performing an activity.

· An activity is a group of tasks that have a common purpose and a common activity driver and are performed in a department.

· An activity driver is a measure of the frequency and intensity of the demands placed on activities by cost objects. It is used to assign costs to cost objects.

· A cost object is the receiving entity that receives the outputs of activities. Examples of cost objects are products, services, customers, and channels. Cost objects are defined by the outputs of the activities that actually contribute to their creation or existence.

· A fundamental principal of ABC is that of causality, whereby it is recognized that the level of activity is caused by the quantity of driver units demanded by products and services relative to the demand from customers.

[1] Traveling by Daylight. The Advisory Board Company. Washington

[i] Adapted from the CAM-I Glossary of Activity-Based Management, Edited by

Norm Raffish and Peter B. B. Turney, (Arlington: CAM-I, 1991.)