Knowing the cost to produce, deliver and service a product and its relative profitability is critical for every business.
However, many community banks don’t have a consistent approach to knowing their costs and the relative profitability. Understanding costs at a product level is an essential step to developing the relative profitability of a product, line of business, customer or segment. Community banks tend to be less efficient than their larger regional and national competitors based on average efficiency ratios. Therefore the need to understand costs and profitability is critical, especially in an environment with thin margins.

Making business decisions without knowing costs and profitability can lead to unintended consequences and significant problems. For example, many Treasury Services products are very labor intensive and offer only very thin margins. It is not uncommon for a bank to lose money on many of its Treasury Management products while at the same time providing favorable relationship pricing on loans to its commercial clients using the unprofitable Treasury Management products, generating a result that is the exact opposite of what the bank intended. In such a situation, deeper commercial relationships may actually produce a significantly lower return than those clients without Treasury Management products.

Identifying costs is foundational to understanding profitability, and knowing product profitability is the first building block to getting to line of business, customer and segment profitability. Changing technology, demographics and regulations are having an impact on bank delivery costs and profitability. For many products delivery costs are a substantial element of overall costs. “Check 21” and Remote Data Capture are impacting branch transaction volumes as businesses and consumers no longer need to deposit checks in the branch. Many of the costs of operating a branch are fixed or move up or down in a stepped pattern. Moving transactions out of the branch without adding new incremental transactions makes each remaining branch transaction a higher cost transaction. The combination of ACH transactions, ATMs and remote banking are changing the cost structure throughout the bank. Therefore any cost analysis needs to consider the changing nature of delivery.

Implementing cost accounting and profitability modeling typically begins with questions about allocations of revenues and costs, along with capturing volumes. For most organizations it is difficult to trace back costs to a specific product. Revenues may be somewhat easier to assign. Fees are usually assigned to specific products while interest income requires funds transfer pricing. Costs can be direct, indirect, common and fixed and as a result require an approach that identifies expenses by type. Being able to assign clear descriptions and categories to each of the major expense and revenue categories is essential to any use of the data in answering key questions.

The art of the analysis is in understanding the question being asked. In the previously discussed Treasury Management product example, most of the products were unprofitable before adding the allocated corporate expenses such as executives to the expense number. Redesigning, repricing or eliminating a Treasury Management product would not reduce or impact executive expenses (for example) in any way. Being able to discern which expense items would be impacted and included in the analysis is the key to using cost accounting and profitability tools. Care also needs to be taken when analyzing customer profitability. For instance if a customer is marginally unprofitable and then no longer does business with the bank the remaining costs are spread over a smaller number of customers which increases costs per customer. Even marginally unprofitable customers can help to offset expenses that are not highly variable. The point is that the analysis phase needs to be thoughtfully based on the question being asked.

In addition, it is often helpful to have a reference point to know if a product line or line of business is operating as efficiently as in peer organizations. The Nolan Bank Performance Study, conducted annually, provides approximately 800 performance metrics comparing efficiency with peer organizations. While not a replacement for an ongoing cost accounting process, software and tools, the study provides organizations with a snapshot of their current performance compared with other peer organizations at a line of business level. For any organization interested in the financial performance of lines of business compared with their peers the Performance Study is a good starting point. The results of this study can help an organization to prioritize where to begin with next steps to improve performance.

Armed with cost information and relative profitability, organizations can then work through the planning and decision making processes. Lines of business that are not contributing sufficiently to profitability but are determined to be key strategically are obvious candidates for redesign. Redesign should include a thorough evaluation of people, processes and technology.

While revenues and pricing are important, most banks usually price somewhere in the range of their competitors. Knowing costs and being able to act on that knowledge is the key to remaining a vibrant competitive organization.