Implementing activity-based management in the banking industry

Journal of Bank Cost & Management Accounting, The, 1998 by McGuire, Brian L, Kocakulah, Mehmet C, Wagers, Leonard G

by Brian L. McGuire*, Mehmet C. Kocakulah** and Leonard G. Wagers***

INTRODUCTION

The rapid pace of change that began in the banking industry during the eighties has continued into the nineties. Competition has increased not just between banks but also between banks and insurance companies, finance companies, brokerage houses and other non-bank institutions. Increased competition has brought about an increased awareness of profitability. Banks need to increase profitability not only in order to increase shareholder value but also to stay independent. In these days when a bad year (or even a bad quarter) can lead to a takeover attempt, increased profitability has become a condition for survival. This paper will explore activitybased costing (ABC) and how it might be implemented in order to help a company such as Midwest Banking, Inc. (named changed for confidentiality reasons), to identify ways to reduce waste and increase profitability.

Midwest Banking, Inc. (MBI) is a three-state bank holding company that has grown from $659 million in assets in 1984 to $3.6 billion in assets at the end of 1995. It has six banks with ninety-one offices, along with a finance company, a trust company and an insurance company. In its efforts to grow and compete, MBI could benefit from activity-based costing.

There was little, if any, competition between banks during the period prior to bank deregulation. Federal regulations placed limits on the amount of interest that a bank could pay on deposits. This artificially low cost of funds, coupled with the fact that the banks charged a market-based rate of interest on loans, allowed banks to maintain a healthy interest rate spread and eam an almost monopoly-type profit. The reforms of 1982 changed this by deregulating the banking industry and permitting savings and loans to offer negotiated instruments of withdrawal (NOW) accounts. This brought an end to the monopoly that banks had as providers of checking accounts. Additional changes in laws led to banks expanding beyond their local boundaries and the emergence of the interstate multibank holding company like MBI. All of this has resulted in competition as never before seen in the banking industry.

ACTIVITY-BASED COSTING CONCEPTS

In general, the purpose of cost accounting is to provide management with information that will help to improve profits, control expenses, and identify profitable and unprofitable areas of business.1 Cost accounting allocates direct and indirect costs to the services or products that are provided or produced.

The concepts of Activity-Based Costing (ABC) have grown significantly during the past decade. ABC departs from traditional cost accounting in that it focuses on the costing of activities that are required to produce a product or provide a service.2 The key to ABC is that it identifies the activities that cause (or drive) the associated costs of using a company's resources. These activities are referred to as "cost drivers." ABC then uses these cost drivers to allocate costs to the defined activities.3 ABC's goal is to identify the costs (both direct and indirect) that are associated with a product or service.

Information is gathered in order that indirect costs (administrative, executive, accounting, human resources, etc.) can be assigned to the activities that consume these resources. If a cost cannot be assigned to an activity in a manner that is both easily and economically identifiable, then it is not assigned. Those costs that do not contribute to producing a product or providing a service should be classified as business sustaining activities instead.4 If an activity is not utilized in the production of a service, then its cost should not be allocated because the resulting number would mislead management.5 ABC's benefit lies in providing information that is more accurate in the allocation of overhead (with regard to product or service costs) than traditional cost accounting. Better information in turn will allow management to make more informed and, therefore potentially better, decisions regarding the allocation of assets.

The basic business of a bank is the buying and selling of funds. A bank buys funds in the form of deposits and sells funds by making loans. Although more and more emphasis is being placed on service and fee income, the major source of income for a bank continues to be interest on loans and investments. This has led to a tendency on the part of some managers toward viewing service activities as unimportant (and therefore they do not have a significant impact on profitability). The modest amount of emphasis that has been placed on bank profitability has been on overall bank profitability, rather than to look at each product or line of business individually. Deposit gathering was seen chiefly as a source of inexpensive funds that could be turned into profit through loans and investments. A bank that wants to survive into the next century must update its understanding of deposits and loans and their respective contributions to profit. ABC can help a bank overhaul its concept of its core business.