Profits through cost accounting.

A bank can pretty well count on missing the road to profitability if it is unwilling to consolidate its management information.

It's astounding and alarming that few banks have realized that only through integrated financial management can an institution's profitability be measured and, more important, improved.

Most institutions that have survived into the 1990s realize (even though most regulators still don't) that good financial management cannot be achieved by simply managing interest rate risk and the net interest margin.

Easy to Implement

Attention must also be paid to noninterest income and expense items.

Analytical approaches to coping with wide swings in interest rates and credit quality are complex. Yet they are relatively easy to implement, as good information is readily available to analyze the effect of changes in interest rates.

The same is not true for noninterest income and operating expenses, although at first glance it might appear so.

Certainly an institution can relate personnel expense (its largest operating expense component) to numbers of employees, branches, and the like.

But it must do much more to determine if it should have the same numbers of employees as another institution of the same size.

A Business' Dynamics

Management needs to understand the dynamics of various product and service offerings. And this information is not always apparent from looking at balance sheets and income statements.

Taking this a step further, the institution must start with a good understanding of the businesses that it operates. This takes more than an MBA and an understanding of financial instruments and markets.

A bank must understand its customer relationships and how the products and services it delivers affect revenues and expenses.

A financial institution must also understand cost accounting to reasonably allocate revenues and expenses to the products and services delivered.

Some argue that cost accounting cannot be applied to financial institutions because of the high degree of shared costs involved in the delivery of products and services.

These same observers also say most financial institution costs are fixed and cannot be varied or controlled in the same way that they can in commercial and industrial companies.

Nothing could be further from the truth.

Yes, it is difficult to identify and allocate shared costs among a wide variety of products and services, but not impossible.

And financial institutions are subject to both fixed and variable costs, as evidenced, for example, by a data processing services contract that charges a base monthly fee plus an amount per item processed.

However, fully exploring cost accounting issues does not result in a complete understanding of integrated financial management. Cost accounting is part of a larger, more comprehensive effort which is best described as "profitability measurement".

It is this profitability measurement, along with prudent management of risks, that leads to integrated financial management and long-term viability for any financial institution.

Profitability measurement is a process wherein a company calculates the cost and revenue dynamics of organizational units, product offerings, and customer relationships.

There are well-defined steps along the way to measuring and understanding the profitability of a financial institution.

A Look at Each Unit

This analysis starts by looking at each organizational unit in order to understand who are the users and providers of internal services.

From this point, an institution can move on to measure the relative profitability of its branches and various other departments as well as begin the process of calculating unit costs related to delivery of products and services.

Product- and service-line profitability measurements require calculation of unit costs as well as an understanding of fixed and variable cost components.

Allocation of direct interest income and expense along with charges and credits for funds used and provided begin to round out the measurement of product- and service-line profitability.

Once good product line cost and revenue information is available, customer profitability can be addressed. It is not possible to calculate meaningful customer profitability without having good unit cost information.

Many systems calculate product and customer profitability, but do so without the ability to build in these all-important unit costs. By feeding good unit-cost data into the equation, the information produced is significantly improved.

Factors Involved

Issues that a financial institution must deal with in implementing a profitability management system include: charges and credits for funds used and provided, allocation of capital used, who is held accountable for organizational profitability, and how to best allocate local and system overhead.

An inability to get organizational consensus on these conceptual issues can keep an institution from even attempting to implement the most rudimentary form of profitability measurement.

It is important to realize that implementation of these systems is an ongoing process, with results coming over time.

This allows everyone in the institution an opportunity to understand the measurements and analyses and grow through the process.

The road to integrated financial management is rough, uphill, and strewn with obstacles But there is no more important passage an institution can take. And the road's end is very sweet: improved profits.

Mr. Weiner is chairman and chief executive officer of Atlanta-based Interactive Planning Systems, a software provider.

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