Activity-Based Costing

INTRODUCTION

For at least some people, the first thing that comes to mind when the subject of performing cost allocation comes up is a flock of expensive, intrusive and frequently uninformed consultants tramping around the bank.  At the Kafafian Group, we have developed a number of techniques to collect the information we need to do sophisticated cost allocations without causing this kind of disruption.  Not only that, we have found that our interactions with bank staff frequently add to the success of the project because people will frequently sympathize and offer information that might not otherwise have a forum.

Activity-based costing (ABC) was initially developed for the manufacturing industry by academics like Robert Kaplan of the Harvard Business School. It has since become the standard way of performing cost allocations. The techniques it describes are also useful in allocating non-interest income. Essentially, it involves allocating costs on some basis defined by resource consumption.

It may seem like common sense, but prior to the 1980’s it was just not done. Mostly this is due to the fact that managing an extremely complex network of allocations is impossible without a powerful computer. Usually cost accountants used a system of service rates that were more arbitrary than not. Non-interest expense was allocated like peanut butter, spread evenly over the institution.

The trick is finding the right basis, or cost driver, to use in allocating cost. Kafafian Group staff will actually speak to departmental managers in order to determine the best method for distributing costs. Information-gathering techniques we use include interviews and web-based surveys.

We also perform what is called “full absorption” costing. Using this technique, all of the bank’s operating expenses are allocated somewhere. An alternative method, called standard costing, will establish some baseline for what costs “should” be and report on how the unit in question performed in relation to that. It attempts to measure capacity utilization.  The drawback to standard costing is that the standard costs may be poorly measured and become obsolete quickly. It is possible for all the units of a bank to be performing well while the institution itself performs poorly. Nothing is hidden in full absorption costing.

Something many people associate with ABC is unit costing.  Frequently this is used in customer profitability systems.  Each customer would be billed for the resources they consume based on a number of different unit costs.  For example, you might determine the cost per teller transaction, ATM withdrawal, etc.  Most of our customers choose systems that allocate costs directly to products and organizational units using resource consumption guidelines, but some customers do elect to develop unit costs for use in MCIF or other systems.

EXAMPLE CENTER

Take a hypothetical loan operations center. An interview with a departmental manager in a loan operation area reveals that staff spends their time on the following activities:

This is a brief and overly simplistic example, but nonetheless representative of how activity information can lead to useful allocation guidelines in determining the cost of products, branches, even customers.

Salary and benefit expense is the largest type of non-interest expense for a bank, so determining how staff spends their time frequently yields the most useful information in terms of allocating costs, but there are other methods of allocating cost as well. Transaction volumes, if available, can provide a basis for allocating costs. Choosing the most appropriate measures yields very defensible (and actionable) cost information.