In recent years cost allocation has become something of an industry in its own right. Contemporary information technology has given banks the ability to allocate virtually any cost at any level of organization down to any line on the income statement.

Professional journals and well-intentioned consultants advise on proper methodologies for every type of cost and allocation, and financial analysts and systems experts regularly attend symposia dedicated to improving their skills in this highly visible activity.

Despite the remarkable technical advances in our ability to apportion costs, cost allocations persistently rank among the most controversial, contentious, and time-consuming issues in any financial services enterprise.

For line business managers, allocations are never just a technical issue. Allocations directly influence their financial results, their performance ratings, their budgets, and their incomes. Consequently, cost allocations influence their decisions about future business strategies, product development, pricing, and relationship management, significantly affecting their institution's bottom line for years to come.

Too often banks and banking consultants concentrate on developing technically perfect cost-allocation schemes but ignore these more profound behavioral and economic impacts of their efforts. This lack of perspective can have serious consequences. It does a bank little good to precisely apportion the costs of the company cafeteria or the executive jet if in the process it forces managers to price products above the rates the marketplace will bear.

We must always remember that, by themselves, cost allocations neither reduce costs nor improve profits. In some institutions they may do quite the opposite.

Elaborate cost allocation schemes can eat up enormous quantities of human and system resources while assigning obscure or notional costs, generating far more expense than we could ever hope them to save.

Inefficient service or administrative departments may mask their own excesses by laying off most or all of their budgets to line users. In the process, they may transfer accountability from the managers who could actually control the costs to those who can do nothing at all about them.

The first and most important principle in cost allocation is to understand and respect the business purposes of the cost and to structure the allocation method accordingly. The fundamental purpose of any allocation scheme is to assign the accountability for each material cost to the manager who controls it or the activity that generates it.

An allocation is useful only when it causes managers to change their behavior or activity in ways that are beneficial to the bank.

As an example, it does little good to assign the costs of marble columns at world headquarters to branch managers in farming communities hundreds of miles away. These managers do not control these costs, and they probably derive no benefits from them. In fact, the branch system probably generates low-cost funds which help to subsidize these costs for the combined bank.

Yet many bankers strive to "accurately" and "precisely" apportion corporate overhead costs throughout their organizations.

It might make a little more sense to assign our marble column costs to the commercial lending or trust departments located in the headquarters, since they conceivably derive some indirect benefit from corporate or trust clients impressed by the surroundings at issue. But even this strategy is of questionable merit, because the managers of these departments can do nothing to influence these costs.

Corporate costs like these are best left where they originate, with the executive officers that initiated the expenditures in the first place. Allocating them out to individual line units will only create resentment and distrust, adding no value to the profitability picture and impairing the credibility of the system as a whole.

A far better strategy is to establish a mechanism for assigning individual line business units a target contribution to corporate overhead and profits. (For an in-depth treatment of this approach, focusing on the concept of shareholder value added, readers may consult van Deventer and Uyemura's "Financial Risk Management in Banking," 1992.)

Of course this method of target-setting will probably still cause line managers to mutter about the waste at corporate headquarters - but they will usually accept an earnings or contribution margin target more easily, especially if they are assured that their colleagues at other operating units bear an equal burden.

This example illustrates a second principle of effective cost allocations: Allocations achieve their best effects when they are simple, readily understood, and universally applied.

The more complex and elaborate the allocation scheme, the more contention and dispute it will create. In addition to creating confusion and resentment among the affected managers, such schemes can destroy the integrity and decision support value of an otherwise excellent management reporting system. They contribute to the state of "data chaos" common in too many banks, where multiple and unbalanced data systems destroy all confidence in the managerial reporting process, in effect reverting the organization to its former reliance on unsophisticated but familiar bellwethers such as "number of new loans," "total asset footings," and the like.

The fact remains that choices about cost allocation, whether conscious or unconscious, will reinforce or alter the behavior of managers whose business units are affected. Successfully designed allocations will encourage beneficial decisions and desirable change. Others can in fact encourage less desirable change.

The acid test of any cost allocation is whether it benefits the bank as a whole over the long run.

Thus, to be effective, allocations must be structured so that the natural reaction of the affected manager will be congruent with the bank's goals and objectives. Only then will the cost allocation method fully serve the fundamental and ultimate objective of the enterprise, which is to increase shareholder value.

Mr. White is director of European marketing for Treasury Services Corp., Santa Monica, Calif.

Subscribe Now

Access to authoritative analysis and perspective and our data-driven report series.

14-Day Free Trial

No credit card required. Complete access to articles, breaking news and industry data.