Implementing activity-based costing (ABC) to measure commercial loan profitability

Journal of Bank Cost & Management Accounting, The, 2001 by Kocakulah, Mehmet C, Diekmann, Douglas

INTRODUCTION

The banking industry is one that has experienced a great amount of change in the last 20 years. In attempts to appease shareholders and stock analysts with continued record growth in earnings, and improvements in efficiency, and returns on assets and equity, banks and bank management have moved aggressively and often blindly into new market areas such as insurance, brokerage, and financial and estate planning. The bank's motive is to find other products that impact earnings but require fewer resources. Often, new products are enormously expensive to set up, and they may be either unprofitable or may not yield to senior management's long run earnings goals.

In light of the wide changes in bank product mix and corporate strategies, research was conducted on a sample of commercial loans held at Indiana Bank (name changed for confidentiality purposes) to compare the reported profit from the traditional income model to the calculated profit from an activity-based costing model. The thought process behind this comparison centered on the Bank's better understanding of the true costs of its core operations; thus returning to core profitable activities and departing from becoming caught up in the industry trend of expand or perish.

ACTIVITY-BASED COSTING

Activity-Based Costing (ABC) concepts were formed in the last two decades and are used as a management tool to assess the costs of various repeated activities for a client and passing those costs on to the client accordingly. Though it is a fairly new concept, ABC has been implemented by such companies as Allied Signal and Coca-Cola and has made a dramatic impact on the ability to track and control expenses for these companies.1

The basic distinction between traditional cost accounting and ABC is that traditional cost-accounting techniques allocate costs to products based on the attributes of a single service rendered. Traditional cost allocations often depict a limited and unrealistic view of profitability that may be significantly distorted. In contrast, ABC, in most cases, is designed to provide profitability information for each individual segment of a product or service. The ABC approach centers on all of the activities required in providing a service; then, it allocates costs based on the usage of those activities. "Using ABC, overhead costs are traced to services by identifying the resources, activities, and their costs and quantities to render the service. A unit of output (a driver) is used to calculate the cost of each activity. Cost is traced to the product or service by determining how many units of output each activity consumed during any given period of time."2

ABC is a natural fit for the banking industry because there are easily identifiable cost drivers that can be measured and priced per event. As an example, most demand deposit accounts are priced and measured based on monthly activity and usage. A business is charged a certain cost for each check that is written and for each item that is deposited into the business checking account. Similarly, the concept can be applied to commercial lending transaction activities from the initial loan review and setup to the myriad of advance requests, account maintenance requests, and payment applications.

Some key benefits of the ABC approach are to change the way an organization thinks about its costing system and to revitalize the bank's penetration strategies and processes.3 ABC also forces a company to consider its activities, to seek efficiencies, and to consolidate tasks in providing services and conducting business. Considering this action for the banking industry immediately shows that this is a win-win scenario in all circumstances. The customer benefits from a higher level of customer service, and the bank benefits from a streamlined, more cost-effective approach to providing services. In various articles on the topic of ABC, there exists a consistent set of guidelines that are needed for the successful implementation of ABC. This list of characteristics as applied to the banking industry is as follows:

1. The full support and direction of senior management.

2. The direct connection with bank earnings, ROA, and ROE goals.

3. The commitment of individuals from various departments in the bank who are committed to the implementation of ABC.

4. A smaller-scale pilot project, which would serve as the basis for bank-wide implementation.

5. A standardized process to track costs and to report other important information,

6. A standardized process to manage the changes from the ABC process.4

One of the key problems with ABC is that some employees and even senior management consider it to be an industry fad and short on usefulness. This could not be further from the truth.

BUILDING AN ABC MODEL

In order to analyze the issue at hand, it is imperative to construct an ABC model, which will provide accurate and useful information. The first step in building an ABC model is to derive a Cost Flow Diagram (CFD), which aids in the documentation of the results and information that will be used in establishing the model.5 The CFD provides a clearer and more effective way to utilize raw data, which is gathered by various teams in an ABC project. The purpose of the CFP is to identify and measure the cost drivers that determine the level of work required and the cause of costs, which result in work and other activities or services. In essence, the CFP diagram helps to define what items drive costs and how those items can be impacted by the ABC analysis.