The Hindu Business Line : Banking on ABC

WHILE activity-based costing (ABC) renders itself to easier adaptation in manufacturing organisations through more accurate classification, analysis and charging of overheads based on activities that are more easily identifiable, it does not preclude service organisations from using it just as effectively.

There is no essential difference between the analysis of operating expenses in manufacturing support departments and the analysis of the expenses of the operating units of service organisations. The only difference lies in determining the factors that create the demands for the functions performed by the operating departments in the manufacturing and service industries. What are the usefulness of applying ABC to service organisations which, typically, are businesses such as banks, insurance companies, healthcare, freight forwarders, and so on?

Considering banking, gone are the days when commercial banks were compelled to charge for their services at regulated rates without having any regard to what it cost the individual banks to render those services. With the gradual deregulation of the banking sector, both the public and the private sector banks are now hard pressed to maintain profitability when competition is beginning to dictate the pricing of their products.

Banks are now finding ways and means of ensuring profitability of their operations by market-related pricing while making sure that the quality of service is not compromised.

One way of monitoring profitability of all its operations is to establish profit-centres and identify separately costs and revenues of each of these profit-centres, thus ensuring that all costs that relate to a profit-centre have actually been charged to it and recovered through the price of the service provided. These profit-centres are also known as strategic business units (SBU), which generate most of the revenues of the bank and, as such, contribute to the ultimate profit of the bank as a whole.

Strategic business units are "segments of a business enterprise by which both revenues are received and expenditures are caused or controlled, such revenues and expenditure being used to evaluate segmental performance". While the actual SBU could be different from one bank to another, typical examples could be: the corporate division, the commercial division, the retail division, the rural credit division and the treasury operations.

In a bank, many expenses for typical products such as current accounts, savings accounts, cash credits, commercial loans, housing loans and so on, and many expenses for service functions are driven more by the demands of individual customers rather than by product demands. And, there are large variations in the demands that different customers place on the organisation even when they are using the same basic product.

A major qualitative difference between cost systems in a service and a manufacturing organisation is the need to model the customers' behaviour when analysing the source of demands for service functions. The final result of SBUs, in order to be meaningful, must contain reports on customer profitability as well and not just product profitability.

The starting point of adoption of ABC for a bank is to arrive at a satisfactory unit cost for processing transactions arising from products and customers. Firstly, an hourly cost is computed by dividing the total expense of a department within an SBU by the total number of available hours. Where the work is predominantly manual, the total available hours will be the total effective and productive man-hours, exclusive of holidays, lunch and tea breaks during the day, available to perform the work of a department.

Where the work of the bank is in a computer environment, the total processing time of the machines employed in the department to perform the work of that department is used to arrive at the cost per machine-hour. If the department is too large that a great deal of variation arises in the hourly rates for performing different types of work within the department, then the department could be broken into smaller cost centres and separate unit rates arrived at.

What is cumbersome in the process of setting an activity-based costing system is the estimating of the product unit time. The time consumed by each activity in a department that is involved in the processing of a transaction — for example, paying a cheque, crediting a deposit, paying on an overdraft or the making of a demand draft — will have to be estimated. And, for this purpose, the staff could themselves be asked to keep track of the time they spend on the various activities and measuring the output of work achieved during that period. This could be monitored through a logbook maintained specifically for the purpose.

Once the department costs per hour and the time spent for processing each product type in each department have been satisfactorily arrived at by the above process, the cost of processing the transaction for a given product (such as the cost of processing a deposit, paying by cheque, opening a new banking account or processing of a loan/overdraft) can be arrived at by multiplying the cost per hour by the unit hour for each activity to arrive at the cost per activity and then, by summing up the cost of all the activities involved in the processing of a transaction.

There can be a great deal of subjectivity in the calculation of unit cost by this process but this is the only satisfactory basis of doing so.

With the basic unit cost having been calculated, it will now be easy to arrive at the costs and revenues of all the transactions associated with each product (such as current accounts, savings accounts, cash credits, and so on) within an SBU and arrive at the contribution it has made to the profits of the SBU and, in turn, to the overall profits.

The product could itself then be broken down customer-wise to ascertain the profitability of each customer falling within that product. This will help in concentrating on customers who make the maximum contribution to the product and, thus, to the SBU and finally to the overall profits. This latter analysis will further show which customers involve the bank with more transactions for less revenues and vice versa.

The ultimate objective of the use of activity-based costing in service organisations such as banks is to monitor the profitability by product, and, by customer, as well as on a geographical basis. This facilitates retaining the more profitable segments of operations and improving the profitability of the less profitable segments through increased pricing, improvement of product quality, technology improvements and better relationship with the customer.

The use of ABC as a means of product-pricing will be inevitable, sooner than later, as organisations will be hard put to maintain their competitiveness and ensuring, at the same time, that all transaction costs are passed on to the product or the service in respect of which they were incurred.

In this regard, the public sector banks could even become more competitive than at present, having shed a lot of their excess baggage through the countrywide VRS schemes offered by most of them.

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