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1
Profitability Solutions
Expense Allocations
June 18th, 2014
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2 | © 2012 Jack Henry & Associates, Inc. All Rights Reserved
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.
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3 | © 2012 Jack Henry & Associates, Inc. All Rights Reserved
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…
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4 | © 2012 Jack Henry & Associates, Inc. All Rights Reserved
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
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5 | © 2012 Jack Henry & Associates, Inc. All Rights Reserved
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
Taxes
Amount of Capital
Income Statement and Methodologies
Series Overview
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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
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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.
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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!”
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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?
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Defining, implementing, and supporting an
expense allocation approach.
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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
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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)
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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.
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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.
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Far side example…
Suddenly, a heated exchange took place between the
king and the moat contractor.
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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
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Expense allocations - Branch
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What are Branch Expense Allocation?
• The process of allocating a branch their fair share of
expenses.
• This includes:
– Direct Expense
– Indirect Expenses
– Overhead Expenses
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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
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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?
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Expense allocations - Product
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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
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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)
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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!
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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
(52% of transactions)43,150
Total Process Loan Payments Cost
(5% of transactions)3,188
Total allocated cost 63,750
Excess/(Deficient) Capacity 0
Expense Allocation Best Practice’s – Product
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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.
Expense Allocation Best Practice’s – Product
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Expense Allocation Best Practice’s – Product
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
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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
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Expense allocations - Client
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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
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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
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Expense allocations across profit domains
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
$0
$1,000,000
$2,000,000
$3,000,000
$4,000,000
$5,000,000
Mo
nth
ly P
rofi
t
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33 | © 2012 Jack Henry & Associates, Inc. All Rights Reserved
Expense allocations across profit domains
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
$0
$1,000,000
$2,000,000
$3,000,000
$4,000,000
$5,000,000
Mo
nth
ly P
rofi
t Differentiator among majority of clients will be how they use their accounts. Channel usage impacts a
financial institutions expense.
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Expense allocations across profit domains
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
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Direct Expense
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Detail of Direct Expense
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Why are Client Expense Allocated?
• To get an accurate picture of client profit based on
costs/delivery channels
• Important “differentiator” in client profitability
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Summary
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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.
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40 | © 2012 Jack Henry & Associates, Inc. All Rights Reserved
Long Range Outlook
Organizational Profitability
Product Profitability
Loan-Deposit Pricing
Customer Profitability
Budgeting Process
Asset Liability ManagementPROFITstar
PROFITability-Organization
PROFITability-Product
RPM
• PROFITability Performance Solutions
For more information on our products contact:
Lesley Karstens
800-356-9099
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41 | © 2012 Jack Henry & Associates, Inc. All Rights Reserved
Q & A
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42 | © 2012 Jack Henry & Associates, Inc. All Rights Reserved
Thank You!
Brad Dahlman – ProfitStars®
1140 Centre Pointe Drive, Suite 800
Mendota Height, MN 55120
952.738.9189