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Calculating the Cost of Profit

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Editor's Note: This article originally appeared in the January edition of Bank Technology News Magazine.

It's a truism among financial institutions that not all revenue is created equal: some revenue costs a lot more to produce. Yet among many organizations, the exact costs related to specific revenue remain a mystery.

Capco recently worked with the retail brokerage division of a major bank that believed that the right way to profits was to incentivize top investment advisors - an approach that on the surface makes perfect sense. The incentive program rewarded investment advisors based on the fee income and other revenue their book of business generated, with top producers earning a trip to Hawaii. However, an in-depth analysis conducted afterward showed that many of the top agents required a disproportionate share of client service and support expenses, making 25 percent of the top investment advisors unprofitable - with these "top producers" ultimately losing more than $2 million for the company.

How do these types of problems develop? To start with, institutions are looking to generate more revenue by restructuring products and services in order to meet new customer demands. Such initiatives are essential to maintaining revenue and securing a company's customer base, but how profitable will these efforts actually turn out to be? Many institutions simply don't have clear visibility into the economics of each transaction as it flows through the business. What, for example, is the actual profit on a product being sold through a given channel to a customer in a given region?

Capco's clients, including banks and other institutions, are increasingly looking for a way to unravel the question of profits, yet certain institutional roadblocks often stand in the way of the best approach. One innovation, called strategic cost management, can help firms better understand these roadblocks and kick-start a fresh new approach to developing information on profitability.

In our experience, the first major roadblock is the belief that profitability measurement systems are too expensive and complex to undertake. Previous methods of measurement, such as activity-based-costing (ABC), were developed over a decade ago and are not only difficult to maintain but are no longer useful. But so-called strategic cost management can deliver encouragingly quick results; progress can be made in a reasonable time frame and with ROI generated along the way.

Another factor creating problems in profitability analysis is the tendency to view profit drivers as separate, single dimensions rather than as interconnected, end-to-end elements contributing to the profit equation. One crucial aspect of the picture often left out of the analysis is the customer view. Strategic cost management, on the other hand, provides organizations with a multidimensional view of cost information, spread across various products, channels, regions and customers. By extending cost modeling to include the customer view, firms can gain valuable insight into the full economics of the transaction. Factoring customer behaviors, patterns and interactions into the equation along with product, channel and market views can bring new levels of insight and precision to profitability analysis.

Our experience indicates that typically 20 percent of the customers generate 80 percent or more of a company's profits. The challenge is to identify which ones: what are the characteristics of profitable, marginally profitable and unprofitable customers? Is it customer life cycle, product mix, volume or pricing? All of the above?

A third factor is that firms believe that they have to engage in a lengthy process to start gaining benefits. We have found that this is unequivocally untrue. In fact, we worked with a large, global institution recently in which we helped the firm move from a general ledger view of performance to an enterprise-wide view of profitability by product, channel and geography in just six months.

How is this possible? Rather than committing to a large program, we have found that rapid prototyping, which accelerates business results prior to investing in systems and data stores, works far better. In rapid prototyping, banks can try out various approaches for measuring profitability before settling on a specific method. While somewhat counter-intuitive for many organizations, rapid prototyping allows for the evaluation of the information and insights gained from each method before implementing the necessary enterprise-wide systems and underlying data stores. Additionally, rapid prototyping can potentially create a funding mechanism for the full implementation, by executing expense reductions and efficiency gains to offset implementation costs.

In one recent project, we were enlisted to implement a rapid prototype in the technology division of a major financial institution. The purpose of the project was to develop transparency into the technology division to help the CIO deliver on his expense reduction target. Because budget dollars were unavailable, the project had to be completely self-funding. In seven months' time, we built a prototype cost model for the technology division and helped the institution meet its cost reduction targets and achieve a four-to-one savings for every dollar invested in the project.

In today's environment, precise and timely profitability data is no longer a "nice to have" capability but rather is a necessity for corporate and business unit leaders to make critical business decisions.

Frank Mackris is a partner at Capco and the leader of its North American Banking, Wealth & Investment Management practices.

 

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