Activity based costing for financial institutions

Journal of Bank Cost & Management Accounting, The, 1995 by Weiner, Jerry

HISTORY OF ACTIVITY BASED COSTING

Activity based costing (ABC) as a defined subject matter was first introduced in 1987 by Robert Kaplan and Robin Cooper as a chapter in their book Accounting and Management: A Field Study Perspective. Their focus was on manufacturing environments where increasing technology and productivity improvements have decreased the percentage of costs represented by direct labor and materials. What had historically been relatively low percentages of overhead costs (e.g., depreciation from robotics and other automated manufacturing systems) had grown in significance but was not easy to measure since the same systems were used by multiple products.

Whereas direct labor and materials are relatively easy to trace directly to products, it is more difficult to directly allocate costs to products that use common resources. In addition, products may use common resources differently and require some sort of weighting in the cost allocation process. Any time that multiple products share common costs, the danger of crossproduct subsidies exists, wherein one product gets too little cost, overburdening other products with too much cost.

The first extension of ABC into financial institutions was in 1990 in an article appearing in the Journal of Bank Cost and Management Accounting (Volume 3, Number 2) by Richard Sapp, David Crawford and Steven Rebishcke. The authors identified that financial institutions also have diverse product sets which creates opportunities for cross-product subsidies. In this and a subsequent article in 1991 in the same Journal (Volume 4, Number 1), the authors concluded that ABC techniques could be used to more accurately allocate costs in this environment.

In the past five years, the banking industry has undergone significant changes in terms of its sensitivity to staffing levels and related productivity. And, since personnel expenses represent the largest single component of non-interest expense in financial institutions, it logically follows that the industry would be looking for ways to more accurately allocate such costs to products and customers. Activity based costing, as developed for manufacturing, can be a useful tool for doing so.

OBJECTIVES OF COST MEASUREMENT

Before jumping head first into the nitty gritty of ABC, it is worthwhile to review why it is that we worry about such issues in the first place. The overall objectives of cost measurement, which ABC is an integral part of, include:

Understand sources of profitability by organizational unit, product, customer and line of business. The more pertinent measurements for most banks are product, customer and line of business profitability, since organizational unit measurements tend to be based more on the way a particular institution is organized and less on the way customers view the institution and use products. Line of business analysis can only be performed once good product profitability is established and represents groupings of products based on customer buying behavior. Line of business profitability measurements provide the linkage to the bank's overall strategic direction.

Provide a mechanism for pricing by developing accurate product and activity unit costs. Customers use products one unit at a time. It is difficult at best to develop good approaches to pricing without first understanding the underlying costs of delivering one unit of product to a particular customer. In an industry where underlying cost structures have rarely been a significant factor in determining pricing, the development of accurate product and activity unit costs can result in competitive advantage.

Create an increased awareness of productivity issues and how they relate to an Institution's overall strategic plans. Ultimately, all financial institutions must understand their position in various defined lines of business and how they can become (or stay) a market dominator or specialty provider. Progress toward long-term strategic objectives can be made by better understanding productivity and capacity utilization issues.

DEFINITION OF ABC AND PERTINENT TERMINOLOGY

The Computer Aided Manufacturing-International (CAM-I) defines Activity Based Costing as "...the collection of financial and operation performance information tracing the significant activities of the firm to product costs ...". The key thought here is that activities are traced to costs, not vice versa. It is not assumed that just because a cost was incurred it was necessary. It follows then that products and customers consume resources which must be measured, as opposed to simply allocating incurred costs against actual activity levels.

Figure 1 shows the ABC Model which starts with resources consumed based on statistical measures of functions performed as part of completing product oriented activities. (figure 1 omitted) Functions (tasks) are generic operations that can be used by more than one product activity (e.g., open the mail, encode n item, enter a payment). Activities (AKA cost pools) are uniquely related to a specific product (e.g., take a mortgage loan application, open a retail DDA account). Resources are either general ledger accounts (in a full absorption system) or engineered costs per unit of measure (in a standard cost system).