imperative that banks focus on operational and financial efficiencies to sustain and increase their stakeholder values. Many redundancies in functions, operations, and support staff are the inevitable result of bulking up.
An aggressive cost management approach is, therefore, a must for understanding the cost components of each product and customer relationship
An approach called "target costing" is rapidly emerging as a cost management tool in the United States, Germany, Italy, and Japan. The goal is to proactively plan without compromising quality and functionality.
In target costing, cost becomes not the outcome but an input in the basic profit equation of revenue minus costs. It is an opportunity to develop a rational cost-reduction objective, to strive toward corporate profit goals.
There are five key terms at the heart of understanding the process.
Target cost -- the cost to the most efficient competitor of offering and servicing a given product in order to earn its target profit margin.
Best achievable cost -- the lowest possible cost achievable for a product without sacrificing quality. This is based on the level of sophistication in technology and processing systems.
Allowable cost -- the point at which a bank can earn its desired profit margin, on the basis of historical experience.
Target profit margin. This is based on a bank's profit expectations and history, calculated with a view toward the product's current market and competitive position.
Target selling price. This is based on prices of comparable products of equal quality and functionality in a bank's service area.
Target costing begins by estimating a target selling price on the basis of a bank's current competitive and market standing and then subtracting the desired but realistic profit margin.
The allowable cost of a product equals its target selling price minus the target profit margin. Note, however, that the allowable cost is not a bank's target cost because the allowable cost may not be the best achievable and a bank may not have systematically examined inefficiencies, redundancies, and the like in offering a service.
The goal, therefore, is to make the analysis and changes in service delivery needed to achieve the target cost.
In achieving target cost, a bank should use a systematic, disciplined, and interdisciplinary approach to examine the key components that make up product and-or customer costs -- front- and back-office functions and all related ones -- in order to pinpoint areas where process and operational improvements are feasible.
Through this we can attain a de facto target cost for each product and service. A costing system that includes activity-based costing -- an accurate methodology for assigning costs based on what is required to produce and service a product -- could be the basic tool to initiate this cross-functional analysis.
The ultimate cost reduction potential is the difference between the allowable cost and the target cost. However, the immediate cost-reduction challenge is the degree of cutting that may be required to get to the allowable cost.
How can target costing help a bank?
First, it is a simple tool for identifying product and customer segments in which cost-reduction potentials exist and for gauging that potential. When communicated to the affected cost- and profit-center managers, this information becomes valuable for developing productivity enhancement or cost-reduction objectives.
Second, as a cost leader a bank will have better control over its pricing strategies. Thus it can price products of equal quality lower than those of its competition, or it can sell products of higher quality at similar prices, providing greater value to core customers.
Third, target costing offers a valuable source of reliable data to develop a realistic annual profit or strategic plan and-or budget.
Fourth, it supplies a de facto cost standard as a basis for achieving or strengthening a competitive edge.
Fifth, it is an ideal weapon for new-product development and planning, such as an entry into e-commerce.
Target costing may provide a benchmark for reengineering functions, operations, and processes, with the added benefit of providing a measure of cost savings. It is an aggressive management tool that does not compromise product features and service quality, though fostering long-term profit and revenue-growth objectives.