Capacity-based Costing in Banking

INTRODUCTION

In today's competitive business environment, there is increasing pressure to squeeze every bit of profit out of existing infrastructures and resources. To do this effectively, an institution must understand the nature of these resources, how they are deployed and whether they are

Unlike manufacturing organizations, many financial institutions have been slow to realize the financial implications associated with capacity-based metrics in their production environments. Understanding capacity, and its relationship to financial operating results, is becoming increasingly more important in an era of shrinking corporate profits, consolidations, mergers and acquisitions. An appropriately implemented capacity-based costing methodology can assist institutions in understanding the impact of capacity on profitability measurement as well as providing the basis for comprehensive resource management performance metrics.

Capacity-based costing in banking was introduced as a costing technique within the Advanced Cost Management (ACM) methodology in a previous article in the AMIfs Journal, titled "Communication and Costing in Financial Services." In this treatise, the focus is more on the specific business value of capacity-based metrics and capacity based costing. It covers the advantages of two costing methodologies (capacity-based and full-absorption) and in addition provides a detailed overview of the key components and benefits of capacity based costing. It also includes practical (real-life) applications of results across the organization to support pricing and profitability analyses and integrated resource management. The article concludes with a reemphasis of capacity-based costing as the means for critical dialog between the service user and service provider.

CAPACITY-BASED COSTING VS. FULL-ABSORPTION COSTING

There has been a long running debate concerning the choice of developing unit costs using a capacity-based methodology or a full-absorption methodology. While both methodologies have their advantages and disadvantages, the significant benefits that can be derived by both service providers and service users from capacity-based costing make it the best value proposition, and therefore the right choice, for the majority of financial institutions. Yet, for many financial institutions, the choice between implementing capacity-based costing versus full-absorption costing is not an easy one. Both methodologies have been in place at numerous organizations and for many years, and both have their proponents.

Proponents of full-absorption costing will often point to the following advantages as reasons why they choose that option for their organizations:

* Ease of implementation and maintenance - Since full-absorption costing only requires expense pools at the center or functional level as a numerator and volumes (cost drivers) as the denominator(s), an organization-wide costing implementation with this methodology can be put in place quite rapidly. In addition, many organizations have downsized their accounting/finance support staffs, and this methodology requires a relatively small staff for development and ongoing maintenance. Cost analysts do not have to visit the production sites in person, since a detailed understanding of these sites and the functions they perform is not required to create the expense pools and perform the necessary calculations.

* Treats all expenses as relevant - Full-absorption costing directly recognizes that, in the long run, prices established for products and services must cover the institution's full expense structure and therefore, should be included in unit costs.

* Provides results that are "directionally correct" - Since all expenses incurred in the production areas are included in the expense per unit calculation, they are indeed reflective of the expense structure of the financial institution. As such, the bottom line profitability measures are directionally correct.

* Supports Organization, Product and Customer profitability measures - The cost drivers selected to create the expense per unit rates are generally aligned to organizational units, products and customers. As the actual volumes for these cost drivers, with their organizational unit, product and customer identities, are brought into a profitability process monthly and extended by their fully-absorbed unit rates, the resultant total cost can be matched with the revenues to create fully absorbed profitability measures.

Advocates of capacity-based costing, on the other hand, list the following as the reasons for their preference of capacity-based costing:

* Provides unit of time as well as unit cost information - Capacity-based costing introduces the added dimension of time to the fully absorbed calculations, which are simply expense pools divided by a volume statistic, as mentioned above. Capacity measurement, capacity utilization and available unused capacity are examples of the time dimension. Capacity-based costing is a means to quantify the capacity-based performance metrics with a structured process that builds a unit cost rather than backing into the calculation. This build approach analyzes how long a process or transaction takes, expressed as a unit of time (or throughput rate), and associates it with the cost of that time, or an hourly rate for the defined resource group. The hourly rate is calculated as total expenses for the study period divided by the number of hours available for work, or practical capacity (see theoretical vs. practical capacity below). The product of extending the unit time by the hourly rate is a capacity-based unit cost rather than an expense per unit calculation.

* Supports Resource Management throughout the organization - This is where capacity-based costing is most vividly differentiated from full-absorption costing (see more on Resource Management below). Capacity-based metrics provide baseline information that can be used in a variety of ways to support the performance management of resources in production. Examples include: capacity utilization, productivity analyses, rate/volume analyses and benchmarking (both internal and external). Full-absorption costing provides little ongoing information value to this critical part of the organization.

* Supports Organizational, Product and Customer profitability measures - Like the fully absorbed methodology, capacity-based costing also supports integrated profitability calculations. But, the methodology aligns a unit cost rather than an expense per unit rate with product revenues (see practical applications - pricing and profitability below), which does not burden the product contribution margin with the cost of available unused capacity. This effectively reduces some of the pricing pressure for fee sensitive products and customers.

* Supports Bid Pricing for Cash Management and other services - As anyone who has competed against another financial institution to get additional business knows, the winner of such a competition often wins by cents, or sometimes even a fraction of a cent, per item. By utilizing a capacity-based approach to costing, a financial institution has an advantage in such bidding processes since they not only have a clearer understanding of their unit costs, but they also understand if they currently have the capacity and resources for the additional business. This will be discussed more fully in a later section.

* Better identification of variable, semi-variable and fixed portions of unit costs - The identification of expenses as variable, semi-variable or fixed is generally done by G/L account (e.g. all salary expense may be considered semi-variable) regardless of the costing methodology used. But as unit costs are developed from these expenses, the capacity-based methodology treats the "available but unused" portion of many semi-variable expenses as fixed, since the associated unit cost decreases as volume increases within a relevant volume tolerance range (see Fixed, Semi-variable and Variable Classifications below for a more detailed explanation of this concept). This yields a more accurate reflection of the cost components as opposed to the simple G/L account classification approach.

* Facilitates active communication between service providers and service users - Capacity-based costing provides a critical communication linkage between the service user (Product Manager, Customer Relationship Manager, Profit Center Manager) and the service provider (Resource Center Manager, such as Operations or IT). This is because the same base of information is used to create unit costs that support integrated profitability measurement and integrated resource measurements. The management information value of capacity-based costing applies to both the user and the provider, in addition to fostering the ongoing dialogue.

KEY COMPONENTS OF CAPACITY-BASED COSTING

To ensure a clear understanding of capacity-based costing, certain "building blocks" need to be defined and identified. To create meaningful capacity-based unit costs, two elements are required: 1) the cost of the resources to process transaction volumes and 2) the amount of time required for processing that volume.

Resource Groups

What is a resource group? A resource group is a logical grouping of resources (personnel, non-personnel or both) positioned to perform like activities associated with processing products and services for internal and external bank customers. A bank branch, as an example, might have three resource groups: Tellers, Platform and Management. If that branch has a Trust section, a fourth resource group would probably be required. An operations example would be an ACH center where the expenses associated with the ACH software and hardware would be a resource group, and the personnel related expense would be another. Because all items pass through the software but only a subset requires human intervention, separate resource groups are required. Typical criteria for determining the need for a unique resource group are: 1) markedly different compensation rates for the resources positioned for work, and/or 2) unique activities performed, and therefore unique cost drivers supported by a set of resources.

Capacity-based costing is not suited to all resource groups. Capacity-based metrics apply to production oriented resource groups, where relatively high volume and repetitive tasks or activities are performed.

This would include areas like Branch Tellers, Lockbox, Check Processing and certain IT functions like CPU. There are also many areas where capacity-based metrics really don't apply, such as Bank Branch Platform resources, Product managers, Customer

Relationship managers, Legal, HR and certain IT functions like application development. As part of the ACM methodology discussed previously, all resource groups have a Management Accounting treatment based on the center classification type (e.g. profit center, processing center, corporate overhead center, etc.), production orientation and cost transfer method (e.g. rate "X" volume, dynamic %, etc.).

Practical Capacity

Capacity is simply defined as production hours available for a resource group or processing center, whether FTE or equipment resources, for a defined period, such as a day, a week or a month. For performance measurement, capacity is further defined as theoretical capacity and practical capacity. Theoretical capacity is the maximum number of hours available, such as paid hours - 40 hours * 52 weeks for FTEs or 24 * 7 hours for certain equipment devices. Theoretical capacity is adjusted for vacations, holidays, sick time, down time, preventive maintenance, etc. to arrive at practical capacity; a more realistic and sustainable level of hours available for production. Practical capacity serves as the denominator in both the hourly rate and the capacity utilization calculations.

Resource Group Hourly Rates

Resource group hourly rates are calculated by dividing resource group fixed, semi-variable and variable G/L account balances for the study period by the practical capacity hours available for work. If the study group has multiple resource groups, fixed and semi-variable general ledger balances must be distributed to these resource groups to calculate the respective resource group hourly rates.

Unit Time Determination

The amount of time required to process a certain item volume is expressed as a unit time or throughput rate. Sustainable unit times are created through on-site observations, sample measurements, surveys or by using existing throughput standards that have been developed. Unit times can be tested with a capacity utilization calculation. Extending study period volumes by the unit times and then dividing the answer by practical capacity for the same period will yield a capacity utilization calculation. The capacity utilization and unused capacity are important metrics and must be validated. Another option to derive unit times, but not nearly as desirable, is to use industry standard throughputs. However, industry standards are typically generic and may not be reflective of an institution's specific processing environment.

Fixed, Semi-variable and Variable Expense Classification

The classification of expenses (and resources) as fixed, semi-variable and variable works in supporting the definition of capacity available over relevant volume tolerance ranges. Fixed expenses typically have the largest relevant volume tolerance range, which means that it takes a significant volume increase or decrease before these expenses are impacted. Examples of fixed expenses or resources include occupancy or large equipment devices, such as reader-sorters in Check Processing or CPUs in IT. While fixed expenses stay the same or flat as volume is increased within the relevant volume tolerance range, fixed unit costs go down within the same tolerance range. The opposite is true when volume decreases within the relevant tolerance range then that of fixed expenses.

Semi-variable expenses fit logically into a relevant volume tolerance range between the fixed classification and the variable classification. While these expenses don't vary with volume increases or decreases directly, they do change on a smaller scale and within a smaller defined relevant tolerance range than fixed expenses. A good example of semi-variable expenses would be salaries and benefits for personnel, where increases or decreases can be one or very few FTEs at a time within a tighter relevant volume tolerance range than that of fixed expenses. Variable expenses have a direct relationship with volume increases (or decreases) and therefore have no volume tolerance ranges. When expressed as a unit cost, the variable cost component remains constant, regardless of the relevant volume. Examples of variable costs include postage, Federal Reserve Bank ACH, Wire and Check Processing presentment fees, and usage-based outsourcing charges.

PRACTICAL APPLICATIONS

As noted above, three arguments that favor capacity-based costing are that it supports: 1) comprehensive pricing and profitability analyses, 2) integrated resource measurement and management and 3) communication between service providers and service users.

Pricing Analyses

When analyzing pricing for new business, there are several questions that need to be addressed: What financial resources (quantification) will the new volume consume? What is the true impact on profitability?

Can the new volume be effectively processed in the current production environment or will additional resources be required? If an institution has successfully implemented a capacity-based costing methodology and included the results of this methodology in their pricing models, these questions can be readily answered.

What financial resources will the volume consume? A combination of two of the "key components" from above provides the answer to this question: a unit time and an hourly rate. The unit time provides the amount of resources that are required to process one unit of volume. The hourly rate provides the cost of those resources. The multiplication of the unit time by the hourly rate generates an analytically derived "unit cost" that directly reflects the financial resources consumed by one unit of volume. By extending the unit cost by the total volume for a given bid, the user has a solid understanding of the total financial resources that will be consumed should that volume be added to the current environment.

What is the true impact on profitability? Given that the revenue portion of the profitability equation is easy to calculate, the successful determination of profitability for a given bid is completely dependent upon the accuracy of the unit cost information contained in the pricing model(s). (Since this discussion is focused on costing, pricing concepts such as Value of Excess Balances and Credit Relationships are ignored.) Unit costs that have been burdened with the cost of available unused capacity in the production areas - as would be case with a full-absorption methodology - can present a distorted view of profitability. And since the inclusion of available unused capacity will always overstate true unit costs, the true profitability of a given bid opportunity will be distorted. In addition, management may be reluctant to price a bid at a loss so the chances of winning a bid, and therefore adding volume to achieve better operational efficiencies, will be diminished.

In the following simple example a full-absorption methodology indicates an item would need to have a price greater than $.28 to cover the variable and semi-variable cost components. A capacity-based methodology demonstrates the variable and semi-variable costs are actually only $.2175, allowing much more flexibility in pricing.

Can the new volume be effectively processed in the current production environment or will additional resources be required? By definition, a successful implementation of capacity-based costing requires the determination of theoretical and practical capacity, and the identification of that portion of practical capacity that is currently utilized versus the portion available for new volumes. This provides a clear indication of the amount of additional volume that can be successfully handled by the current resources, when new resources need to be added and what level of resources need to be added to handle the new customer volume. This being said, there is no substitute for open, honest discussion between service users and service providers concerning capacity, but having a quantitative tool to use as the core of those discussions can make them much more productive.

Resource Management

As mentioned previously, capacity-based metrics for the resource manager in a production environment include total capacity measurement, capacity utilization and available unused capacity. This is critical information for the resource manager in banking, who unlike their manufacturing counterpart, has to continually anticipate resource requirements. Because bank customers don't announce their transaction intentions or their delivery channel preferences each day, the bank has to be ready with resources positioned in anticipation of customer interactions with the bank. Informed with capacity-based metrics, the resource manager knows where there are potential capacity bottlenecks, as well as where there is room to grow or remove capacity. When capacity-based performance metrics are linked to financial operating results via an ACM capacity-based costing technique, there are some new and unique measures of performance introduced, including the following:

* Capacity Utilization Analyses

* Capacity-based Cost Recovery Analyses

* Equivalent Production Units (EPU) Analyses

* Comprehensive Fixed, Variable and Semi-Variable Analyses

These capacity-based performance metrics are also linked to the following more traditional measures:

* Processing Group Expense Analyses

* Full Time Equivalent (FTE) Analyses

* Volume Statistical Analyses

* Hourly Rate Analyses

* Volume and Ratio Analyses

* Productivity Analyses

* Full Absorption Expense per Unit Analyses

* Limited Fixed, Variable and Semi-Variable Analyses

The introduction of performance targets and measuring actual results against those targets is accomplished with balance type identities, such as actual, budget, multiple forecasts, etc., to facilitate comparisons and comprehensive variance analyses between balance types. More informed results, trends and correlations support more informed planning. With an understanding of current volumes, new deals in the works and volume projections, the resource center manager can optimize capacity utilization and the impact on resources and expenses each period.

Resulting Integration

As mentioned above, the management information value of capacitybased costing applies to both the service user and the service provider. Integrated profitability (integrated views by customer, product and location/organization) and integrated resource management (views by resource group, delivery channel and business process) can be a reality. The resulting integration enables all constituents to focus on

the customer and how the customer is interacting with the bank, rather than on internal billings. The integrated roles of service providers and service users should promote the dialogue between each other to optimize performance. The service provider uses capacity-based metrics to understand and articulate resource requirements and the impact on costs. The service user sees "unit costs" aligned with product revenues to calculate a contribution margin, rather than "expense per unit" rates, which include all of the available unused capacity. With a mutual understanding of how much room is available to grow before having to add resources, incremental revenues can be targeted directly to Net Income (beyond the variable cost component). This capacity-based approach reduces the pressure on pricing and promotes a partnership between the service user and the service provider in new customer deals, strategic business planning and volume-based planning and budgeting initiatives.

Planning and Budgeting

An informed planning or budgeting initiative is the result of credible integrated management information and a commitment to set and achieve new and improved integrated performance targets. Targets are established to challenge management and to continually improve performance, whether expressed as revenue targets, profitability targets or as resource management performance targets. In banking, the communication and coordination between service user and service provider in planning also has a logical sequence of events. It is the job of the product managers, customer relationship and profit center managers to understand the market and to project areas of growth as it relates to products and customers, areas to sustain and areas to de-emphasize. With that understanding, together with the resource management performance targets, such as capacity utilization improvement commitments by site, the resource center managers can establish informed expense and resource plans accordingly. Gone are the days when the resource center prepares the budgetary/ and then profit centers determine how much revenue is required to cover the internal charges. That sequence is backwards and contributes to conflicting strategies; such as a significant revenue growth strategy forced against an expense strategy to stay flat or reduce.

The sequence of a properly coordinated planning initiative should be as follows:

* Key product and non-product growth projections by market and customer segment are provided by each LOB.

* Projected growth and product mix factors are transformed and applied to projected product cost driver and functional resource cost driver volumes, which are aligned by area or site providing the services.

* Resource and expense budgets are established, based upon functional resource cost driver volume projections by site, together with productivity and capacity utilization performance targets.

* Projected product cost driver volumes (and costs or charges) by product and LOB are published along with functional resource cost driver projections by site or area providing the services.

* With published budget (or forecast) volume projections and key performance indicator (KPI) targets, secure "management commitment" to achieving the budget (or forecast) results and KPI targets.

Accountability is the ownership for actual results as measured against informed forecast or targeted results. The coordinated planning by the service user and service provider also provides for ajoint accountability for the actual results against that coordinated plan.

Conclusion

There will always be institutions for which implementing a capacitybased costing methodology will not be appropriate. However, for many institutions, the business value created from such a methodology will far outweigh the additional expense of getting there. Financial institutions must balance their need to allocate costs for segment and management reporting with their need to understand the true cost of providing services to customers. Full-absorption costing has historically been utilized to support management and segment reporting, due to its ease of implementation. But this has come with consequences: inaccurate unit costs for pricing decisions that have been the source of endless internal debates over the charge of services. Capacity-based costing can provide a more accurate picture of the cost and profitability of bank products and services, support production capacity and resource management and in so doing, provide the foundation for integrating volume-based budgeting and KPI targets at an enterprise level.

The combination of better product costs and improved planning capabilities should result in better decisions regarding product pricing and resource management, both of which will continually improve performance and financial operating results of the institution.