By John J. Coffey, C.P.A. and Gene Palm, www.profitres.com, originally published July 2004, ABA Bank Marketing

Banks are very good at measuring very big things or very small things, many, however, struggle with measuring the things that fall in between!  For example, your bank most likely could tell you something about the total interest income generated by loans last year.  But, it may not be able to tell you how profitable particular loan products may be.  Your bank most likely could tell you that a particular customer made a deposit on Tuesday.  But, it may not be able to tell you how much it cost the bank for that customer to make this deposit.

For all of the things that are “in between” a bank needs to use a means of assigning items of income and expenses to its branches and departments, its products and transactions as well as to its customers.  This means of assignment is called “Cost Accounting.”

Cost accounting has been used by industries that deal with tangible goods for many years.  For instance, a baby food company knows exactly how much it costs to make a jar of baby food.  And, that it’s biggest expense is “waste,” raw foodstuff purchased, but not used in manufacturing the end product.  However, cost accounting has not been around for as long in the banking industry.  That’s because banks sell intangible services and it is much harder to assign items of income and expense to services.  As such, cost accounting in the banking industry is not only a science, but also an art!

Approaches to Cost Accounting

There are several approaches to cost accounting that a bank can utilize:

§         Organizational Profitability – This involves identifying, classifying and assigning the income and expenses of the bank to each functional unit – typically branches and departments.  While many banks have broken out their non-interest income and expenses by functional unit, to complete this process, a bank also needs to allocate funds transfer pricing as well as provision for loan losses to its branches and departments.

§         Product Profitability – This involves identifying and assigning the income and expenses of each functional unit to the products with which each one works.  Product profitability has four components:

§         Net Interest Income

This is by far the largest driver of profitability.  It is the difference between the interest income that is generated by loans and investments and the interest expense that is paid on deposits and borrowed funds.  There are various means of calculating this at the product level, but the most accurate method is called Historical Funds Transfer Pricing (HFTP).  This method assigns a funds transfer rate to each loan and deposit as of the date the account was opened, except for non-maturing products, like checking and DDA accounts.

§         Non-interest Income

Your bank probably has detailed non-interest income that breaks out fees generated by your products.  However, these fees are not typically organized by product.  For instance, your NSF fees need to be assigned to only the checking accounts that generated those fees, and your loan late fees need to be assigned only to those loans accounts that generated those fees, or some similar approach.  Using transactions that give rise to these fees provides the necessary variable non-interest income that will ultimately be assigned to your products.

§         Non-interest Expense

Your bank may also have a detailed non-interest expense statement that breaks out the costs of the bank.  However, these costs are most likely not organized by product, but by organizational units.  To overcome this, you might assume that the cost of your loan collection personnel is directly related to the accounts that generated delinquency notices and charge-offs.  If most of your marketing efforts are geared toward increasing your bank’s deposits, you might assume that these expenses are directly related to the resulting new deposit accounts.  Using transactions that give rise to these costs provides the necessary variable non-interest expenses that will ultimately be assigned to your products.

§         Provision for Loan Losses

It’s a plain truth that some of your loans will be written off.  And, the bank needs provide for this eventuality.  Some loan products such as unsecured loans and lines will have a higher percentage of bad loans than some real estate-secured loans.  This needs to be taken into consideration when assigning the provision for loans losses to your loan products.

§         Customer Profitability – This involves identifying and assigning the income and expenses of each product to customers.  Customer profitability is a byproduct of product profitability.  It can be generated by combining the profit of all the products used (accounts) by a customer.  Your MCIF, CRM, or in-house CIF-key are means of linking accounts to customers, and many times to households and businesses.

Implementing Cost Accounting

Some banks begin the implementation of cost accounting using a “top down” organizational-product-customer profitability approach.  Other banks begin their implementation of cost accounting using a “bottom up” transactional-product-organizational approach.  Others, however, use a “foundational” approach, which begins by pragmatically moving all assignments to the product-level.  This approach provides the most rapid return on your investment of resources because you can use the results for your marketing efforts in order to generate more income for your bank!

John J. Coffey, C.P.A. and Gene Palm are the principals of Profit Resources, a consulting company that specializes in MCIF technologies.  © Profit Resources, Inc. 2006