profitability solutions expense allocations 2 expense... · 2020. 2. 22. · kiss is an acronym for...

Profitability Solutions

Expense Allocations

June 18th, 2014

Series Overview

This is the second in a series of

three webinars designed to help

you measure profit without

headaches:

• Funds Transfer Pricing – May

• Expense Allocations – Today

• Allocating provision and capital –July 16.

Brad Dahlman

Brad has 25 years of experience with financial institutions. He has held senior roles in audit, finance, operations, and technology. Over the past 9 years, he has focused on Profitability topics (Branch, Product, and Relationship).

Brad was a co-founder of the RPM product, which was sold to Jack Henry in 2005. He now manages Profitability (Branch/Product/Member); Pricing and Dashboarding solutions.

5 years experience building ABC costing models for $5B bank holding company…

Agenda

• Overview

• What does it take to… Defining, implementing, and

supporting an expense allocation approach.

• Expense Allocations (What, How and Why)

– Organization / Branch

– Product

– Client

• Summary

Direct Interest Income $24,977

Charge for Funds Used (15,379)

Total Interest Income 9,598

Direct Interest Expense (6,047)

Credit For Funds Provided 15,379

Total Interest Income 9,332

Net Interest Income $18,930

Provision For Loan Losses (700)

Adjusted Net Interest Income $18,230

Non-Interest Income 1,318

Non-Interest Expense (9,346)

Contribution Before Taxes $10,202

Taxes (2,550)

Contribution After Taxes $7,652

Amount of Capital 48,034

Return on Risk-Adjusted Capital 15.93%

Funds Transfer

Pricing

Cost of Credit

Expense Allocations

Amount of Capital

Income Statement and Methodologies

Series Overview

Expense allocations across profit domains

Expense allocations are used when measuring profit at

any level below total institution. A profit domain typically

includes:

• Organizational or Branch profitability

• Product profitability

• Client (customer / member) profitability

Concept of the Day…

Expense Allocations – walk before you run and you may

never run! Of the methodologies used to determine profit,

expense allocations can be the most challenging.

Why are expense allocation so challenging?

Expense Allocations – why so challenging?

• No industry standards.

• Every organization performs functions differently, difficult

to establish standard costs.

• Materiality - is it worth spending 25 hours of staff time to

determine an accurate allocation for $2,000 annually in

subscriptions?

• Need to identify level of accuracy desired early in

process.

• “Everyone feels like they are paying too much!”

Complexity vs. Simplicity…

According to Wikipedia…

KISS is an acronym for "Keep it simple, stupid" as a design

principle noted by the US Navy in 1960.

The KISS principle states that most systems work best if they

are kept simple rather than made overly complicated; therefore

simplicity should be a key goal in design and unnecessary

complexity should be avoided.

The phrase has been associated with aircraft engineer Kelly

Johnson (1910–1990) – fairly complex topic!

Are you adding unnecessary complexity for little or no benefit?

Defining, implementing, and supporting an

expense allocation approach.

What are expense allocations?

• What are they… It is a process to fairly distribute the

operating expenses of a financial institution.

• Operating expenses are all the expense’s other than

interest, provision, and taxes. It includes salary, data

process, occupancy, and supplies.

• Allow us to see both Pre and Post Allocated view of data

Types of Expense Categories

Three types of expenses…

• Direct Costs - are those costs that can be identified

specifically with a particular sponsored product/activity.

(Example: ATM transaction bills, Rent Payments)

• Indirect Centers - are centers that are not directly

accountable to a specific product/activity but rather a

group of products/activities. (Example: Item Processing;

Deposit Ops; Loan Ops)

• Overhead Centers - are centers that are not directly

attributable to a product/activity. (Example: Accounting;

Executive; HR)

Requirements When Implementing Expense Allocations

• Involve key stakeholders and / or user’s of the information.

• Obtain agreement on level of accuracy. Start out simple and build sophistication over time.

• Communicate results.

• Establish a process to review your expense allocation assumptions – Annually during budget process.

• Continue to educate user’s on concepts.

• Use results in management decisions.

• Adjust your assumptions if needed based upon changes in your organization or external changes.

What are you building?

Biggest Requirement: Involve stakeholder and get

agreement on what we are building!

When building a house… The key is having blueprints and

agreement with architect, builder and homeowner.

Far side example…

Suddenly, a heated exchange took place between the

king and the moat contractor.

General Guidelines… What are you building?

• Branch / Organizational Costs

– Direct Costs Attributable to Branch

– Indirect & Overhead Allocations

– Pre & Post Allocated Branch Results

• Product Level Costs

– Origination Cost

– Monthly Servicing Cost

– Transactional Costs – how many buckets?

• Client Costs - Applied

– Product Costs (above)

– Actual Costs Based on Transaction Cost (above) * Usage

Expense allocations - Branch

What are Branch Expense Allocation?

• The process of allocating a branch their fair share of

expenses.

• This includes:

– Direct Expense

– Indirect Expenses

– Overhead Expenses

How do you Allocate Branch Expenses

• Direct expenses

– Allocate personnel, occupancy, supplies and other direct expenses.

• Indirect Expense

– Define indirect cost centers

– Determine fair manner to allocate indirect• Deposit Ops – Number of Deposit Accounts

• Loan Ops – Number of Loan Accounts

• Overhead Expenses

– Define Overhead Cost Centers

– Determine “proxy” for allocation• HR – Based on headcount

• Executive – Based on revenues

Why are Branch Expense Allocated?

• Determine the branch contribution

• Evaluate the branch manager against the P/L

• Setting Budget Levels

• Evaluate the viability of the branch – Closure/downsize?

Expense allocations - Product

What are Product Expense Allocation?

• The process of allocating a product their fair share of

expenses.

• This includes:

– Direct Expense

– Indirect Expenses

– Overhead Expenses

• Combination of Costs – Much more granular than Branch

– Origination Cost by Product

– Servicing Cost by Product

– Transactional Costs

How do you Allocate Product Expenses

• Gather all expenses (Direct/Indirect/Overhead)

• Split expense by product/activity into buckets (Time Studies)

– Product example: Credit Underwriting – supports commercial

lending products.

– Activity examples: Teller – process deposits, withdrawals, loan

payments.

• Determine fixed expenses vs variable expenses

– Fixed = Average Cost by Product (to originate and to services)

– Variance = Transaction

• Variable expenses

– ABA vs ABC – Cost allocation methods (next page)

Expense Allocation Best Practice’s – Product

Activity Based Allocation Approach’s:

• ABA: A costing methodology that allocates expenses to

the institution’s products based on the percentage of effort

to perform the process-related activities and the number of

times the activity occurred for the product. ABA allocations

represent full absorption of expenses.

• ABC: A costing methodology that allocates expenses to

the institution’s products and services based on the cost

and performance of process-related activities. ABC

allocations represent partial absorption of expenses; the

remaining expense represents capacity (over or under).

Must have a “volume” to come up with unit cost!

Example of teller allocations ABALine Item: Teller Salaries:

Total Teller Salaries 63,750

Total Process Deposit Transaction Cost

(43% of transactions)27,412

Total Process Withdrawal Transaction Cost

Total Process Loan Payments Cost

Total allocated cost 63,750

Excess/(Deficient) Capacity 0

Example of teller allocations using ABCActivity: Process Transactions

Total Teller Cost to Allocate for Transactions 63,750

Total Process Deposit Transaction Cost

(28,368 X $.50)14,184

Total Process Withdrawal Transaction Cost

(32,024 X $ 1.25)42,530

Total Process Loan Payments Cost

(2,618 X $1.75)4,582

Total allocated activity cost 61,296

Excess/(Deficient) Capacity 2,454

Note: This excess capacity represents the dollar value of teller idle time.

This amount can be allocated to the products as overhead expense.

ABA VS ABC:

• Desire to measure excess capacity, or fully allocate

expenses?

• ABC will take longer, includes time studies and

gathering volumes by activity.

• Can do combination. For example, on critical volume

based expenses, use ABC, and balance ABA.

• Other Benefit of ABC…

– Operational groups can determine “efficiency” gains.

• “Rebate” example

• Budgeting with increasing volumes example

Why are Product Expense Allocated?

• Determine the products contribution

• Set product parameters

– Rates

– Fees

– Minimum Balance/Service Charges

• Identify inefficient processes based on knowledge of

cost drivers

• Evaluate product combinations

• Feed Marketing Programs

• Determine which products to sunset

Expense allocations - Client

What are Client Expense Allocation?

• This is NOT the determination of costs but rather the

applying of costs.

• Sophisticated costing set up in “costing engine” often

connected to Product

How do you Allocate Expenses to a Client?

• Client profitability is bottom’s up. Profit is calculated at the

instrument level and aggregated to customer / member,

relationship, and officer. The total of client profit will not

equal your institutions net income.

• Account level costs based on actual usage

– Fixed Product Costs

– + Variance Product Costs

– + Transactional Costs

Client Expense Allocations:

• A key differentiator in client profitability are volume based expense

allocations. Below is a typical stratification of clients profitability:

90-100 80-90 70-80 60-70 50-60 40-50 30-40 20-30 10-20 0-10

% of Total Profit 173% 10% 1% 0% -4% -5% -7% -7% -9% -51%

Profit $4,243,68 $234,923 $23,491 -$5,220 -$92,542 -$128,790 -$163,562 -$176,405 -$228,301 -$1,250,7

Annual Profit/Client $6,921 $387 $37 -$9 -$138 -$205 -$275 -$293 -$358 -$1,854

-$2,000,000

-$1,000,000

$1,000,000

$2,000,000

$3,000,000

$4,000,000

$5,000,000

Client Expense Allocations:

• A key differentiator in client profitability are volume based expense

allocations. Below is a typical stratification of clients profitability:

90-100 80-90 70-80 60-70 50-60 40-50 30-40 20-30 10-20 0-10

% of Total Profit 173% 10% 1% 0% -4% -5% -7% -7% -9% -51%

Profit $4,243,68 $234,923 $23,491 -$5,220 -$92,542 -$128,790 -$163,562 -$176,405 -$228,301 -$1,250,7

Annual Profit/Client $6,921 $387 $37 -$9 -$138 -$205 -$275 -$293 -$358 -$1,854

-$2,000,000

-$1,000,000

$1,000,000

$2,000,000

$3,000,000

$4,000,000

$5,000,000

t Differentiator among majority of clients will be how they use their accounts. Channel usage impacts a

financial institutions expense.

Client Expense Allocations:• Example of Channel Expense Impacts:

• Customer A and B have exact same balances and fee’s, but use different channels. Customer B deposits check with teller, and Customer A use’s the ATM. ATM transactions receive a lower expense allocation and customer A is more profitable.

Desc Balance Rate Income/Expense Desc Balance Rate Income/Expense

Net Collected 10,000 1.75% 14.86 Net Collected 10,000 1.75% 14.86

Interest Expense 0.00% 0.00 Interest Expense 0.00% 0.00

Net Margin 14.86 Net Margin 14.86

Service Fee Income 5.00 Service Fee Income 5.00

Gross Profit 19.86 Gross Profit 19.86

Direct Expense Direct Expense

ATM 30 times 18.00 Teller Deposit 30 times 22.50

Profit 1.86 Profit (2.64)

Customer A Customer B

Direct Expense

Detail of Direct Expense

Why are Client Expense Allocated?

• To get an accurate picture of client profit based on

costs/delivery channels

• Important “differentiator” in client profitability

Summary

Expense Allocation Wrap UP

Key Take Away’s on Expense Allocations:

• These are assumptions, ensure you have buy in and

agreement. Involve key stakeholders during installation.

• Prior to beginning, obtain agreement on the level of

accuracy you want to have to begin your expense

allocations.

• Understand you can refine over time.

• Use the information or results from funds transfer

pricing, either branch, product, or client profitability.

• Questions or challenges are good, means information is

being used.

Long Range Outlook

Organizational Profitability

Product Profitability

Loan-Deposit Pricing

Customer Profitability

Budgeting Process

Asset Liability ManagementPROFITstar

PROFITability-Organization

PROFITability-Product

• PROFITability Performance Solutions

For more information on our products contact:

Lesley Karstens

800-356-9099

ljkarstens@profitstars.com

Thank You!

Brad Dahlman – ProfitStars®

1140 Centre Pointe Drive, Suite 800

Mendota Height, MN 55120

952.738.9189

bdahlman@profitstars.com

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