What is the true cost of free checking?

Earlier this month I reported that the average checking account costs banks about $350 annually, including company overhead, according to research firm Moebs Services Inc.

But whether banks should use that $350 estimate in determining individual customer profitability remains up for debate, at least according to some feedback I've gotten on the story.

Do you think banks are correctly accounting for the costs of checking? Please comment below.

Many of our readers argued that banks should be looking at the marginal cost of adding a new checking account customer, not at the average cost of that account. Marginal costs are the variable costs that each new customer adds. Those costs exclude certain fixed costs, like overhead.

"If all of the 'unprofitable' customers were eliminated, very little overhead would be eliminated. So overhead doesn't belong in the equation," said one reader of the original story, who identified himself as Jeff P.

According to the estimates I gathered from Moebs and other industry members, overhead accounts for about 20% of each account's average costs. For the hypothetical account costing $350, taking out overhead would bring the cost of the account down to about $280, thereby making a far larger group of customers appear profitable.

"Banks should calculate individual customer profitability on whether or not the customer covers their truly marginal costs," such as processing and sending customers monthly statements, Jeff P. added. "Overhead belongs in the analysis to calculate branch-level or bank-wide profitability — not individual customer profitability. For a customer what matters is if they contribute something towards overhead."

That makes sense to a point, especially if some of the bank's checking customers bring in revenue well above their total costs -- including overhead. Those people can essentially subsidize additional bank customers who bring in less revenue.

But Mike Moebs of Moebs Services stands by his original estimate. While he does not discount the importance of marginal costs, he argues that bankers looking to recoup their checking account expenses should be wary of focusing exclusively on those costs.

"Here's the problem with marginal costs: it's a very short-term focus," says Moebs. "The focus on marginal costs cannot go much beyond a three-month to six-month timeframe."

In the longer term, a business needs to recoup both indirect functional costs, like equipment costs and managers' salaries, and overhead, which includes executive pay and the cost of utilities, he says.

"You've got to adjust [the equation] somehow. Either raise prices or lower direct and indirect functional costs, because we've got to at least contribute to overhead at a minimum," he says.

New regulations, including caps on overdraft and debit swipe fees, have altered key revenue streams for the banks — making it more difficult for high-revenue customers to subsidize the lower-revenue ones.

"In the past, free checking masked a host of issues. I could bring customers in and with debit card revenue and overdraft fees and cross-selling, eventually people would become profitable," says Hank Israel, a partner at New York-based consulting firm Novantas LLC.

Now "banks are going to have to find a new normal," he says, adding that retail bankers may have to try to reduce some fixed costs through methods including layoffs or branch closings.

Israel says that banks do not necessarily need to ditch customers who do not bring in a certain amount of revenue -- but they do need to increase the revenue that those customers bring in, by charging them for using a checking account or by selling them additional, higher-margin bank products.

And Mike Branton, a managing partner with StrategyCorps LLC, who commented on the first story, takes a middle-of-the-road approach in thinking about marginal costs.

"You need to put in that calculation some allocation of overhead, but don't fully [consider] it," he says, arguing that that method provides "a more accurate picture of what it truly costs to acquire and maintain a checking account relationship than just marginal cost."

Banks are more squeezed than ever when it comes to making a profit from their checking customers. Many of those customers buy additional products and services — but even so, Branton estimates that about 40% to 50% of banks' customers are not generating $250 or more in revenue.

"We think $250 is a conservative estimate of what a relationship should be generating in terms of revenue to cover costs," he adds.

In recent months, banks have made several well-chronicled efforts to increase the revenue they make from their checking account customers — some of which have been more successful than others.

Branton says that efforts including Bank of America Corp.'s now-retracted $5 debit card fee jack up prices in a "consumer-unfriendly way," and are not the best options.

He argues that banks need to offer "non-traditional value that a customer is willing to pay a fee for," such as merchant-funded discounts, identification theft protection, and insurance programs.

"The basic tenet of being able to deal with these unprofitable accounts is what economists call a fair exchange of value," he adds. "If there is a fair exchange of value for a fee, customers have shown time and time again a willingness to pay that fee."

"At the end of the day what matters is, every bank needs more customers, on as profitable a basis as you can make them. So you have to design and price your products accordingly to accomplish that and that's how you grow," Branton says.