White Paper Retail Bank Profitability

WHITE PAPER

MEASURING PROFITABILITY

RETAIL FINANCIAL SERVICES

PRESENTED BY

GORDON G. SHAW

©MSG, August 2002

INTRODUCTION

“Profitability” is a simple yet complex concept. Profit, easily definable in some industries and less if not truly impossible to define in others. Profitability will be our major topic to explore, dissect, define and determine its place in the retail financial services industry.

“Measurement” a simple term, which provides an easily understood standard to communicate an assessment of an activity. However, is the measurement a level of performance, a benchmark, or does it truly define a standard?

“Financial Services” are a vast array of intangible products, which provide wealth creating, preservation, and revenue opportunities to the user through the intermediary process of the provider.

Throughout history the pursuit of wealth, financial security, and profit have consumed the World’s commerce. It is well documented that success is measured in ownership of assets; and with the ownership, the passage of revenue generated from assets. However, the determinant of revenue must be based on a price for the product. Is it not true that what will set a price is the cost plus a margin to determine profit. This concept of revenue is universal; first, establish a price of a product or service; and as a result profit will flow to the owner given there is a market for the product. In its most simplistic form measuring profit is easy or is it?

How does the owner establish the price? What are the components of determining price? Is the marketplace a component? Are the needs of and benefits to the user a component? What is the cost of the product? Are there fixed and/or variable costs? What are the marketing costs? These and many more questions can be and often are asked, especially in the complex world of intangible products and services.

The issue of profitability also encompass a host of collateral topics, which if not addressed and factored into this discussion will leave our measurement standards incomplete, along with not providing a solid foundation and process to review our profitability on both a micro and macro basis. The dynamics of profitability are like the world’s oceans, constantly in movement, challenged by external and internal forces, and can quickly change if not constantly monitored and conditions evaluated.

How we define and organize the ingredients and components will be the focus of this paper. Where I will attempt to present some divergent views on profitability and measurement. I will attempt to present some alternative methods and concepts, which will not take on the form of a accounting dissertation but rather a reinventing of what is necessary to measure profit in a rapidly changing financial services industry. We shall start with a review of history, making the assumption that the human need for financial gain and security is universal regardless of the geographic location.

HISTORY

In the past financial services industries were segmented into different and distinct delivery channels. The Insurance, Brokerage, and Banking industries performed specific and unique functions for a marketplace of users who focused on each separate industry product offering as fulfilling a specific service to fit a specific need. Differentiation was easily understood.

Assets at risk could be protected through the purchase of insurance; excess cash could be put to work either through banks or brokerage houses based upon the users willingness and risk tolerance. The user needs of safety, security, convenience, and trust were all meet in different ways with different products designed for specific purposes. Each service however had one compelling universal truism, the creation and protection of user wealth. Wealth is a relative term, and will be used as such for financial fortunes may vary in size and measured value however are being unique to the holder.

The purpose of all financial service providers is to create and preserve wealth for their users and customers. Obviously the more a provider can do to assist the user in this process, the more wealth through profit the provider can also create. This simple truism becomes the basis for the evolutionary progression of the industry over the last 100 years and thus the current significance of industry consolidation, in which provider lines of business are starting to blend together. The marketplace needs are more focused toward value added providers who can, with quality and care offer convenience, ease of use, accessibility and simplification of choices thereby saving the user time, and money in the acquisition of wealth creating financial services. One other significant driver in this paradigm market shift, which should not be overlooked or taken lightly, is the technological advancements in computing and telecommunication across traditional geographic boundaries. No longer does the market accept a geographic location as a constraint to business and wealth creation. Accessible information is availability for choice across the world and will continue to grow with users who seek the best possible return and service at the best possible cost. The marketplace is becoming and will continue to become more sophisticated, along with the development of emerging markets to sell more services to and continue the process of wealth creation across vast sectors of cultures, geographies, and users.

Financial service providers who are prepared and understand their markets, provide value added services, and can manage to profit will be the success stories of the next century. Just as those who understood the industrial age prospered, so will those who focus on and implement change in the information age. The information age will continue to make the world smaller and the delivery of services easier. Twenty years from today will be known as the age where more wealth was created then at any other time in human history. Unfortunately, a majority in the financial services industry has resisted change for reasons, which are still unclear, other than having an unwillingness to take on new challenges and attitudes that remain reactive rather than proactive.

“Profits create Wealth”

And

“Success requires Action”

Profitability of Retail Financial Services

Components

Any discussion of profitability would not be complete if we did not look comprehensively at the “who, what, why, where, when and how”

Of an organization’s existence, along with the answers about the provider and its long-term vision and mission. The strategic vision and mission are the first component of profitability and it is imperative that these questions be addressed and answered by management’s leadership ability. The vision and mission also forces and focuses the provider on the marketplace and a thorough understanding of where profit will be made. All profit is derived from the market, make no mistake, understanding the marketplace is the most important key to profitability.

There also exists within the realm of profitability what I shall refer to as an internal marketplace that relies heavily on leadership and management for its direction. Naturally I am referring to the people who work to fulfill the needs of existing and potential customers. These components of profitability are often overlooked, but are most critical in the delivery of services, which, without them either electronically or in person, would make profitability much more difficult to obtain. In today’s current dialogue, much is being said about whether human beings are necessary in the financial services industry. Let me assure you, in the final analysis “people do business with people”, computers and telecommunication tools promote and assist human efficiency and effectiveness by resulting in greater productivity. It is People and their Productivity, which can either make or break an organization. Although very silent in their approach and in most instances not supported by adequate measurement systems, people still are and will be a major component of profit.

While we have so far discussed many “soft issues on profitability”, there are also the hard facts that we all know from the accounting world to measure profit. The accounting treatment of profit is simple, direct, easy to measure and evaluate in the macro environment of the organization. However, very elusive and indiscernible in the microenvironment of the organization. In the macro world,

“REVENUE MINUS COST MINUS EXPENSE = PROFIT”

In the micro world, the Unit produced has a Cost plus Expense plus desired Margin to determine a Price, which the market will accept as valued or not. Non-valued units are rarely purchased; highly valued units are often purchased giving rise to another component of profit; Volume. The mix of volume, price, cost, margin, contribution, units, revenue, and expense are eight integral components of profitability. However, in the

financial services industry and product offerings, hardly any provider will focus on the understanding and measurement of these components to build the process, which clearly defines the components of profit.

For the industry to advance and remain a viable player, change in the way activities and processes are done is inherent. The proliferation of non-bank competitors and other industries into the financial services sector will continue to grow and prosper. One overriding factor to the advancements and opportunities other industries see is that financial services providers do not integrate quality standards as a philosophy inherent in their core businesses. These philosophies can be and will be easily migrated to the financial services sector with product, services and management. I speak here to Total Quality Management (TQM) and empowerment, to develop standards. In the future, international standard organizations (ISO), in the financial services industry will be developed and become very successful. Why? The marketplace will demand it. Individuals, consumers, entrepreneurs, multilateral commerce will force change. Those providers who fail to grasp the concept and implement change will not be profitable. These ‘dinosaurs” will be assimilated and replaced by the new global “Dragons” of the 21st century, who will be agile, adaptable; reinventing jobs and processes instantaneous to meet consumer needs and demands, and yes, also generating and creating a standard of profitability unparalleled in human history.

What are these TQM philosophies? Simply stated they are:

· Improve quality by removing the causes of variations in the system

· The person doing the job is most knowledgeable about that job

· People want to be involved and do well

· Every person wants to feel like a valued contributor

· More can be accomplished working together rather then around the system

· Structured quality improvement process using graphics produces better solutions

· Graphical techniques let everyone know how change has made impacts

· Adversarial relationships between labor and management are counterproductive

· Every organization has undiscovered wealth in people or product waiting to be developed

What are the requirements to install a TQM process in?

They are:

· Provide Leadership and personal commitment

· Develop quality policy and definition

· Create a quality infrastructure to guide change

· Set unifying goals for improvement

· Respond proactively to customer needs and expectations

· Set up active communication with customers to monitor fulfillment

· Emphasize process improvement

· Use teams to solve problems

· Provide training and retraining at all levels

· Adapt a new attitude about quality in your business

· Recognize, reward and positively feedback to employees

· Focus on continuously improving and reinventing your business

These philosophies and requirements naturally can and should be acted on through the total organization, which in turn become the guidepost to benchmark performance against other industry leaders and best practice performers.

It should also be mentioned in any discussion surrounding quality and value that we should also seek out organizations which have proven to be successful in the improvement processes of their business and products.

In Benchmarking to other industries and organizations, visualization of how your business can adapt will be a road map to success. One additional note to benchmarking is that over the years organizations may have developed best practices and high performance quality programs within their organizations, but, due to the lack of measurement and reporting, did not know of there existence and positive impact. This truly gives one reason for introspection of the organization and implementation of TQM, and all its positive impacts.

To this point I have focused primarily on the soft and hard components of profitability and the need to view change in the way profitability is looked as a measure. Surely the simplistic approach to the accounting formulas seems to satisfy macro organizational requirements and comparative analysis or industry evaluation and shareholder requirements. But how does one determine profit of services provided? How does one know if the continuance of a service is viable?

PROFITABILITY MEASUREMENT AND REPORTING

As we proceed in evaluating profitability, we note where we have been and start to question the specifics and microanalysis of profitability and measurement of financial services. The time has come to focus on the specifics; and at this point, we will focus on profitability measurement and reporting.

Earlier I addressed the traditional ways that the accounting profession builds organizational accountability starting with the chart of accounts and winding through sub ledgers, to ledgers, to trial balances, to operating statements, to balance sheets, to schedules and appendices. A necessary structure when the objective is to accurately reflect and record the financial activities an organization encounters each day. It is easy to see in this methodology why the issues of branch, product, and customer profitability have caused considerable confusion. First, the system of accounting was established to benefit the organization not the marketplace. Indeed cost allocation systems and costing systems were secondary thoughts in organizational accounting development of financial firms. Therefore the traditional reporting and measurement systems of other industries were often employed, adapted and added to financial providers. These systems often were not relevant and useful to the lines of business providers offered, which required market driven premises, and customer fulfilled needs. However, it is not my intent to state that the traditional accounting methods are not valuable for they are within the context that organized information is needed. Certainly the evaluation of accounting components is valued and useful to management as a macro management tool.

However, the method most needed in evaluating financial services and profitability are based more in the marketplace and focused toward the market. Tangible service and product providers are best at determining this because the components of product are much easier defined. In our intangible services offerings, the customer is the basis of revenue generation. The customer is our revenue unit; the reason for our existence is fulfilling the need of the customer. If the consumer requires a safe haven to keep currency, then a financial service need is derived. If a number of consumers all have the same need, then a service could be created to fulfill their need. Lets call this product a “Safe”. How should we price this service to users? What are our costs and expenses? This seems simple to enough to determine: We shall start by determining if we have to manufacture a “Safe” or whether someone else has and all we need do is purchase it. Our cost is easily defined if all we do is purchase it. It becomes more difficult if we have to build it, but it’s still definable. However, many questions still remain such as how many consumers will use the service? Does the size of the “Safe” constrain our revenue potential? How shall we maintain the “Safe”? Must we have personnel involved in opening and closing the “Safe” for our customer accessibility? This scenario then becomes a problem in determining a price to charge to each customer. This example is common in our industry because of the difficulty is determining what price to charge for safety and security.

In the past intangibles services had no set model or method to be used. With the advent of micro processing technology and revelation with “activity-based costing” methods along with the parameters used in the manufacturing sector, we now can at minimum start to focus on changing the way we look at profitability and measure it.

We shall change our ways by first calling the customer or consumer of a “Revenue Unit”. This unit will give us many needs over its lifetime, and the opportunity to sell services. We best do all we can to understand the consumers past, present and future needs, and what financial requirements will be necessary to fulfill the needs. Financial services companies have done a horrible job in retaining data and information from their customers. Information that is extremely valuable has been tossed aside in the past as having no value. Now we seek all information on past and present activity level, knowing the “Revenue Unit” will generate its own value, primarily in the form of earnings. The unit will also have costs and expenses in order to continue a lifestyle or create a new one. It is the earning power of the unit that attracts our utmost interest, along with the activity the unit is involve with. How much of the earnings can we have, hold, and use. How much can the unit leave with us, for how long, and in what service will the need be fulfilled. Will we make profit from the unit? Yes, but only if we price to profit in this way: Customers are sources and users of funds. Those who use our services use specific types at different stages in their lives. Our challenge is to be strategic, predictive, and proactive in watching and monitoring the customer’s activity and trends over time. As signals appear, we can predict potential services needed and respond with offerings in a proactive fashion even before the customer has focused on them. This is all available due to database soft wares and predictive modeling methods.

Thus the first step in measurement is information in databases about the consumer and customer. We shall make a commitment to record all contacts, classify the importance and need expressed and evaluate it monthly as is necessary.

The next step is to build a cost model for your product line. The cost model is built as either a full loaded or one in which variable cost is measured and contribution determined. In the financial services industry, I would strongly recommend the use of the variable cost model because it defers fixed cost and the subjective, not standardized, cost allocation methods, which treat service profitability unscientifically. The point is that to evaluate financial service profitability, first, determine the contribution level to profit it provides and does it meet the expectation of the margin anticipated. Let us use for example a checking account, and determine the Unit Variable Cost (UVC) associated with the service. These would include:

1. Time to process activity either manually or electronically or both;

· Manual cost is 3 minutes@ 14cents per minute;

· Electronic cost is a minimum of 1 minute@ 3cents per;

· The customer used 15 minutes a month in manual process time;

· The customer used 6 minutes a month in electronic process time;

· The UVC for this component service is $2.28

2. Paper cost of the checks and printing;

· Paper cost is 1cent per check and deposit slip;

· Printing cost is 3 cents per check;

· The customer uses 10 checks per month;

· The customer gets 5 receipts per month;

· The UVC for this component service is $0.45

3. Our total unit variable cost for the month is $2.73

Our next step is to determine what gross margin should we charge over and above our unit variable cost.

Let say we want a 100% margin applied or one time our UVC, another $2.73;

Then we shall price the service at $5.46 a month.

We then would expect a contribution level of 50% to profitability based on the service only and customer usage. However, this example can be even more amplified when we take into account the collected balance the customer leaves on account with us each month and is unused. We then have an opportunity to use this retained balance for profit.

The moral question raised is should the earnings generated by our intermediation for profit be prorated and passed along to the customer or retained totally by the bank?

Clearly in either case, profitability is affected.

With the customer having an investable balance of $1000 for the month and intermediating for a 5% annualized return, a $4.17 profit is calculated.

Then our contribution profit for the service is raised considerably to $6.90.

To summarize, profitability measurement must be simplified to a unit basis and that unit is the customer and related revenue generation. In our case the contribution to profit method affords the clearest possible view to measurement and reporting. All we need do is to roll up the volume (number of accounts) by the unit contribution determine the service contribution.

As to the fixed cost allocation, history has proven that the industry has for to long use inadequate methods to allocate fixed cost. This is partly due to political internal issues, subjective non-factual information, and a lack of willingness to do it right and fair. In most fixed cost analysis, it is easily determined that there are too many fixed costs. The best way to avoid dealing with fixed cost is to hide it with obscure percentage allocation formulas having no relevance or meaning but negatively impacting negatively impacting micro unit cost analysis customer or consumer service value. The solution to this problem is simple! Keep it out of the service profitability equation unless it can be truly quantified as a unit variable cost. If it cannot, then options and choices have to be honestly examined to support the fixed cost. One immediate area of evaluation is executive payroll as a fixed, non-contributory cost unless the executive can report and measure direct related revenue unit contributions with related unit variable cost counterparts. If the executive cannot, then the impact to profitability is obvious. Justify, quantify, and qualify profitability.

As for streamlining and eliminating product lines. The methodology and concepts presented above can be effectively used. It would be necessary to establish a discipline, say every 6 months, to review your service offerings and related contribution level. Ranges of contribution can be established as acceptable to continue the service or reinvent as necessary based on market needs. Considerations for older more mature product lines should be measured in volume as it relates to the market being serviced. Naturally if a service/product is no longer continuing a level of contribution, then obviously attrition or upgrading to more valued services is required. Services and products have a life cycle, just as our customers do, and we must all face the inevitable openly and honestly when that cycle has run its course.

In closing this paper, please allow me to summarize the concepts and components I have presented. I cannot reiterate enough on the interchangeable issues of marketplace, customer and profitability. They are interrelated and often hiding in the accounting matrix of our organizations financial presentations. Yet this integration of customer to profit is the most valued event in conducting business regardless of industry. You are profitable and successful only when you have made your customer profitable and successful. Measurement is the easy part with today’s technology, finding the value is more challenging.

Delivered at the Retail Banking Summit, Singapore