Activity-based costing (ABC) was initially developed for the manufacturing industry and has become the standard for 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.

The key is finding the right basis, or cost driver, to use in allocating cost. Using personal interviews and Web based surveys, The Kafafian Group works with departmental managers to determine the best method for distributing costs. Our process values the unique insight of bank staff to enhance data. We also perform "full absorption" costing. Using this technique, all of the bank's operating expenses are allocated somewhere. Nothing is hidden in full absorption costing and it is preferable to standard costing.

Sometimes referred to as "matched maturity" funds transfer pricing, this method is the hallmark of FTP and is probably the one least subject to the variability of assumptions.

The purpose of this type of FTP is to calculate the benefit (or cost) of a loan or deposit over or under a wholesale opportunity, based on an appropriate termed wholesale rate. For example, a two-year CD originated today gets a two year cost of funds. Its benefit to the institution is the amount below a comparable wholesale borrowing rate the account (hopefully) provides.

However, calculating the funding cost for an adjustable rate mortgage (ARM) using the term defined by the origination and maturity dates would not be appropriate. The treasurer typically funds an ARM from the last interest rate change until the next one. The term between these interest rate change dates represents the FTP term. A one-year ARM would get the one year rate from the day that the interest rate changed last, which might be the origination date.

The traditional way of evaluating a lending area is to consider the institution's cost of funds as determined by its average interest expense rate. Lenders like this because they generally view it as a "hard" number. If the branch network grows progressively less efficient, however, the lenders' profitability trend worsens without any action on their part. Also, as we all know, costs of funds can change rapidly. These changes should not affect the profitability of a well-priced loan put on the books in different market conditions.

Another issue is the cumulative difference between the funds charges and funds credits at the institution level. This is generally called the maturity gap or mismatch. By isolating this mismatch in a treasury area rather than where the loans and deposits reside, it becomes easier to evaluate how well the FTP system represents the interest rate risk the bank has assumed. It should generally agree with the output of an Asset/Liability Management application and adds to the credibility of the reporting.

As a demonstration, consider a hypothetical bank with two accounts: a five year loan and a two year certificate of deposit for the same amount, originated on the same day, with the following wholesale rates available for the institution on that day:

While the rates on these accounts are arbitrary, this example shows:

1. The institution could borrow money from the wholesale market more favorably than it could raise money through CDs.
2. The institution is making almost as much money from assuming interest rate risk as it does from the lending function itself. This should be evaluated.

A possible result of the evaluation is that the loan may prepay and therefore the bank may not be taking on as much risk as this analysis suggests. Also, the deposits may be checking accounts and have indeterminate maturity characteristics. Different FTP methods have arisen to accommodate these issues.