1. Reproduced with permission from
Management Accounting, March 1997, pp. 20-26.
Copyright by Institute of Management Accountants, Montvale, NJ
ABM Lifts Bank's Bottom Line
by Robert B. Sweeney and James W. Mays
Activity-based management (ABM) was implemented at First Tennessee National Corporation, a
regional bank holding company, eight years ago. The initial profit improvement was $750,000; by
the end of 1994, the total profit improvement had risen to almost $11 million and could reach twice
that amount annually by the year 2000. (For a look at some of the contributing factors and solutions,
see Figure 1 on p. 22.)
For the cost management department at First Tennessee, activity-based management is but one step
to increased profitability through cost management. The steps toward increased profitability start
with financial accounting, then management reporting, then activity-based cost management,
internal and external benchmarking, and, finally, process reengineering. (See Figure 2.)
Step three, activity-based costing (ABC), replaced a sophisticated product costing system at First
Tennessee. That system did not provide operating management with the information needed to
control costs and increase profitability. Activity-based costing, on the other hand, supports process
analysis, design, and, to some extent, reengineering. It focuses attention on productivity by
examining product performance and resource consumption. The answer sought by First Tennessee's
management accountants was, "Are we receiving adequate revenue for the value-added services we
provide our customers?"
Banking is a time-based industry, and its mission is to provide the most value at the lowest cost in
the least elapsed time. To achieve this mission, efficiency and effectiveness are paramount.
Efficiency (doing things right) controls the pattern of resources consumption; effectiveness (doing
the right things) generates profit.
There are two prime inhibitors of efficiency and effectiveness in banking. They are cross-
subsidization among customers and cross-functional internal processes. An example of cross-
subsidization can be seen when profitable customers pay for unprofitable customers, as in the use of
pricing schedules that are unrelated to the cost of services. Fee revenue traditionally has been a
secondary source of income, but that is no longer true. The key to increasing return on equity is to
make fee income grow without increasing equity.
Internal benchmarking is the next step after implementing activity-based costing as shown in Figure
2. It is actually an interactive process. After applying ABC concepts to one operation or process, the
results are applied to the same or similar processes at another location. Each location learns from
the other, and both processes, the benchmark process and the process to which the benchmark is
applied, are improved, further increasing efficiency and profitability.

2. External benchmarking moves one step closer to increased profitability by extending the process
outside the company. While process reengineering may take place at any time, it is the next logical
step after external benchmarking. Reengineering processes involving automation, replacing people,
and, to some extent, replacing paper with virtual electronic systems represent the final steps toward
increased profitability. What were viewed before as temporary changes are more likely to be seen as
changes in culture today.
ABC: MANUFACTURING VS. BANKING
As a time-based industry, banking is significantly different from manufacturing, which was one of
the first groups to apply activity-based costing concepts. In manufacturing, production generally
precedes the sale, modified only slightly by just-in-time (JIT) operations. The cost of
manufacturing, therefore, is incurred prior to making a sale, and profit is determined at the point of
sale. In banking, the sale precedes the processing. For example, a sale occurs when a potential
customer opens a checking account. The major portion of the processing occurs after that. This
issue is exacerbated by the fact that profit is determined by customers' activity over time. While the
unit cost of maintaining a checking account is basically fixed, the customer's volume of activity
determines the total cost and, thus, the profitability. The balance maintained by the customer in a
checking account also materially affects profitability. If we have set levels at which monthly service
charges are discontinued using traditional costing, we may learn after applying activity-based
costing that we are serving some of our customers at a loss. This outcome occurs because the
customers did what we told them to do – keep their account balance slightly above a minimum
balance level. There is a risk that this minimum balance may produce insufficient revenue.
Figure 1
Profit Improvement Through Activity-Based Management

3. Another difference between banking and manufacturing is that once products or services are sold,
they stay in production for years. Unfortunately, processing is difficult to schedule because the
customer determines the usage of various services.
Figure 3
CD Profitability Distribution
Changes in regulatory policies a decade ago have revolutionized banking. The authorization for
savings and loan associations to provide checking accounts is one such change. The removal of
limits on the interest customers could receive on deposits is another. Profitability suddenly has

4. become paramount, and the rules for attaining profitability have changed drastically. Competition
among banks has escalated.
Two other realities also are significant. First, banking operates in an overcapacity environment.
That is, there are too many banks. Only half of the top 10 most profitable banks in 1984 and 1985
are still in existence. The second reality is that bank revenues are derived in two ways – by charging
service fees and by the spread on interest rates, and neither is tied directly to customer usage. For
example, people who maintain higher balances may write the same number as or, in many cases,
fewer checks than those with smaller balances. The same phenomenon is observed with Automated
Teller Machines (ATMs). Those with smaller balances tend to make more numerous, smaller
withdrawals; those with larger balances have fewer but larger withdrawals.
MODIFYING ABC FOR BANKING
Figure 4
Commercial Loans  3-Year Amortization
ABC requires the identification and classification of activities. In banking, activities are classified
first as customer order-driven activities and ongoing-concern activities. The customer order-driven
activities include such things as sales, services, processing, and administration. The ongoing-
concern activities include areas considered as overhead such as accounting and finance, personnel,
general counsel, and purchasing among others. A major effort is made to minimize the cost of these
activities using the value-added, nonvalue-added activities analysis. These analyses have been
renamed mission-related activities and nonmission-related activities analysis. Mission-related
activities are defined as the things we do to satisfy the needs of constituents, while nonmission-
related activities are those things we do that increase the elapsed time of various processes, such as
inspection, movement, storage, and error correction. The objective is to eliminate or at least reduce
the amount of nonmission activities. A major reason for using the word mission instead of value in
classifying activities is psychological. We do not want to imply that an activity, such as correcting

5. errors, has no value. Rather, we want to convey the idea that by avoiding errors we can achieve our
mission and avoid the correction activity.
Activity-based Costing
Adopting a new cost system can be a traumatic process. While senior management endorsed the
effort to apply activity-based costing to various services and processes within the bank, a degree of
skepticism prevailed among operating management. The first product to which activity-based
costing was applied was certificates of deposit (CDs). The cost of processing a CD is fixed
regardless of the magnitude of the certificate, but the revenue is a function of the dollar amount of
the certificate. Thus, a 90-day $500 CD that is reopened four times a year generates only $5 a year
on a 1% interest spread, providing considerably less revenue than the processing cost of
transactions.
Figure 5
Internal Benchmarking of Proof Operations – Location B
Technology
Old check filming
machines
No optical code
reader
People
High staff turnover
Low pay rates
Inexperienced staff
Too much training
time
Methods
Diverse operations
Small volumes
Filming for security
Environment
Widely scattered
collection points
Poor workspace layout
“High-risk” downtown
location
Net result:
Location B processing
efficiency was lower
than location A.
By applying ABC concepts, CDs were put into 10 categories. (See Figure 3.) The graph shows that
30% of our customers were providing 88% of our profit, while another 30% of our customers
actually are serviced at a loss of 7%. This situation was corrected through a combination of higher
minimum balances, new products, and process redesign.
After the initial success with the CD project, interest among operating management began to build.
A subsequent project focused on commercial loans normally handled by bank loan officers. The
project involved analyzing loans by amount and amortization period. An analysis of the typical
profitability of three-year term loans of $50,000, $20,000, and $3,000 is shown in Figure 4. The
sloping lines reflect the revenue generated by each loan over the threeyear period. The total cost per
loan line is constant over the three years and is the same for all three loans.
Note that the $50,000 loan is profitable for the first 19 months and, therefore, is profitable over the
entire life of the loan. Surprisingly, neither the $20,000 nor the $3,000 loan is profitable in any
month.

6. The situation has been addressed by a combination of pricing, product redesign, and processing
changes. A profit improvement of at least $1.5 million per year has been the result.
Internal Benchmarking
This procedure begins by applying the basic concepts of activity-based costing to a process or
operation similar to one reviewed previously. Next, the unit costs of the product components and
the cost drivers in the processes are cataloged. Then a root cause analysis is performed, comparing
the two operations on the bases of technology, people, methods, and environment. Identifying and
sharing best practices at each location results in lower unit costs at both locations.
Table 1
Root Cause Analysis
Location BLocation A
Current With Location A
Benchmark
Total paid proof operator hours 38,000 24,000 15,770
Less vacation, holidays, sick/personal hours (4,340) (2,160) (1,419)
Total proof operator work hours 33,660 21,840 14,351
Less: Nonproductive proof work hours
(breaks, meetings, training, etc.) (8,580) (7,450) (3,658)
Total productive proof operator work hours 25,080 14,390 10,693
Percent of total proof operator work hours 75% 66% 75%
Processing hours per total fields encoded 1,870 1,870 1,870
Total proof operator fields encoded 18 12 8
Fields encoded 63,753,360 27,182,170 27,182,170
Fields encoded per productive hour 2,542 1,889 2,542
Total personnel expense (fringe loaded) $474,240 $271,920 $196,810
Personnel expense savings $75,110
Total personnel dollars per total fields encoded per hour $12.48 $11.33 $12.48
The internal benchmarking of proof operations illustrates this process. Cost management personnel
who previously had applied ABC to one operation at Location A studied the second proof function
at Location B, interviewing the appropriate personnel to gain insight into the operation. This
process ferreted out the unit costs of product components and the applicable cost drivers.
The root cause analysis reflects differences between the benchmark operation in Location A and
Location B proof operations. (See Figure 5.) In terms of technology, Location B had older check
filing machines and no optical code reader. Concerning the methods employed, Location B had
more diverse operations and smaller processing volumes. Additionally, filming was required for
security. The environment differed in that there were more widely scattered collection points and
poor workspace layout. The operation was in a high-risk downtown location, which impacted
employee tenure negatively.
The most significant aspect of the root cause analysis related to people. All of the findings were
interrelated. The low pay rates created a high turnover, and the high turnover resulted in an
inexperienced staff and the need for more training time. The net result was lower processing
efficiency in Location B compared to Location A. Some problems could be remedied easily, such as

7. replacing old check filming machines and changing the workspace. The major problem was staff
turnover. Employees were leaving for higher pay after being trained in Location B.
In the root cause analysis in Table 1 the first two columns of numbers represent data collected from
operations in both locations. Note that the fields encoded per productive hour in Location B are
considerably less than in Location A. While they are offset by lower personnel cost per hour, the
inefficiency still results in a much higher cost per field encoded. The Location A cost per 1,000
fields coded is $5.76 compared with the Location B cost of $8.23.
Using the benchmark approach, the management accounting staff adjusted data for Location B to
the Location A standards using $12.48 as the cost per hour and 2,542 as the fields encoded per
production hour to reflect the anticipated rate from lower turnover. The result is that only eight
people were required to perform the proof operation in Location B, which had been using 12
people. The total personnel expense was reduced from $271,920 to $196,810, generating profit
improvement of approximately $75,000. Total profit improvement in 1994 resulting from such
internal benchmarking was $500,000.
THE FUTURE
As noted earlier, the implementation of ABC concepts has provided First Tennessee with a profit
improvement of approximately $11 million. The next major steps are external benchmarking and
more extensive reengineering, as all levels of management continue to recognize the positive impact
that activity-based management has had on corporate performance. Management now has the tools
to increase its productivity, and the result has been increased profitability. Activity-based costing is
firmly set as a cornerstone of continuous productivity improvement at First Tennessee.
Robert B. Sweeney, CPA, Ph.D., now deceased, held the Thompson-Hill Chair of Excellency in Accountancy at the
University of Memphis, Memphis, Tenn. He was a member of the Memphis Chapter of the IMA, through which this
article was submitted.
James W. Mays is vice president and manager of cost management at First Tennessee National Corporation. He is a
member of the Memphis Chapter of the IMA, and he can be reached at (901) 523-5606.