The document discusses calculating profitability for banks using activity-based costing. It involves determining the net interest income and margin, adjusting for risk, deducting expenses allocated using ABC, and determining the net contribution and value added by each customer. ABC involves tracking costs by resource, activity, and cost object. Resources include bank departments. Activities are customer transactions by product and channel. Cost objects group transactions by customer lifecycle events and determine transaction costs, product and channel costs, and customer profitability.

1. PROFITABILITY SOLUTION FOR BANK
When we talk about the profitability solutions for the banks it is calculated by using information from
various sources. Typical profitability calculation starts with the Net Interest Income. This is the
difference between the Net Interest income and the charge for the funds. Also Interest expenses and
the credit for the funds for the deposit products are used for calculations. This information is available
from the Fund Transfer Pricing (FTP) solution. The difference between these gives the Net Interest
Margin (NIM). This is one part of the revenue. The other part could be from the various fee based
products or commission from the third party products. This makes the total revenue from the
customer.
From this margin the bank can adjust the margin by probability of the losses. This is calculated from
the credit risk calculations. The adjusted figure gives the risk adjusted margin for a customer. From
this margin the expenses are deducted. These expenses can be calculated using activity Based Costing
(ABC) solution. This will give net contribution from the customer. Deduct Tax and then cost of funds
and one can get the Net Vale add by the customer. So what we have seen is the calculation of
profitability includes a) Revenue accounting b) Internal funds accounting c) Risk Adjustments d)
Capital Allocation e) Expense Accounting.
The issue for the banks is that, they have good handle on the revenue accounting but little that they
know about the accuracy of expense accounting to the product and customer level. Today we are
going to see more on how this expense accounting be done using ABC. So it is more about how to
calculate the profitability rather than the why bank should calculate the profitability. Even within that
we would be looking at the 'expense accounting' part using ABC technique.
Find below the schematic diagram of the Profitability model using ABC technique.
Resource Section
Activity based costing has three major sections viz. Resource, Activity and Cost Object. For the
profitability model for Banks, the resource section contains the expenses grouped for various
departments (Functions or Cost Centers) in the Bank. Generally these expenses are taken for a period
(say a quarter). The departments are grouped as at corporate office (sometimes Zonal office also),
Branches, Alternate channels like ATM, Call Center, Direct selling agent (DSA), Internet etc. and

2. finally the shared service departments like IT, HR etc. The services that are provided by the ‘shared
service department’ are defined and their costs are calculated. Then, based on the volume of the
services provided by the department, its costs go to the various other departments. Most of the
commercial software solutions available today can handle the ‘reciprocal assignments’ i.e. IT
providing services to HR and vice-a-versa. The departments can be also grouped by the region.
Another way of grouping the branches and ATMs is by their ‘costs’. This means grouping of the
branches or ATMs that are having similar costs. Simple way of doing this is by grouping them as
Urban, Semi-Urban and Rural. The scope can be expanded, if required, in future by doing at each
branch or ATM.
Activity Section
The activities are defined as per the transactions that are performed by the customer for various
products using different channels.
‘Origination of commercial loan’ is a suitable example. For this the activities could be receiving the
application, interviewing the applicant, understanding the credit history, evaluating the applicant,
taking decision, disbursing the loan amount. Like this once you have defined all the transactions, each
transaction is then broken down into activities and then against each activity, put the name of the
department, time taken by the activity. For the activities that are performed in a batch mode, one has
to consider the batch size also. The activities are generally grouped as per departments.
Cost Object Section
As usual this is the most important section of the model and defined first. In cost object we see the
result that is expected out of the model. Typically this section can be divided into two parts. The first
section calculates the cost of various transactions, performed by the customer for various products
using different channels (distribution channel).
Withdrawal of cash using ATM for a savings account is a fine example. Here we can see that the
withdrawal for a checking account and savings account using an ATM may not differ, but still we
calculate the cost for the same separately, as it is required in the next section of the cost object.
Customer lifecycle event - All these transactions are grouped according to different events in the
lifecycle of the customer. They are Acquisition, Provision, Serve, Retain and Close. All the
transactions related to the acquiring of a customer are grouped here in Acquisition. The ‘up selling’ of
a product is grouped here as if it is a new sale. In Provision all the transactions that the customer can
perform as a part of having the product are grouped. For example for a saving account, the customer
can deposit cash/check, withdraw cash, receive account summary, check balance etc. The serve
sections could be similar to the provision but here the transactions are requested by the customer
specifically. For example, the customer can receive a monthly statement of records, but she may ask
for a statement for a particular period in between. This request may or may not be charged. In the
retain section, all the transactions that are performed (mostly by the bank) are grouped. This may
contain the efforts for cross-selling, campaigns, communications etc. The cost of some free gifts can
also be added here. In the close section, the transactions related to the natural closing or forced closing
is added. In addition to this there are two other groups here viz. Cost to sustain business and Cost
available to use. Cost to sustain business are the costs that are neither related to the product nor to the
customer, but are required to run the business? For example the costs of the departments like
Company secretarial, Account finalization etc. These are separated in the model as the model is used
for internal business decision making. In case of any statutory reporting this can be allocated to the
products. The last is the ‘cost available to use’. By using the bottom-up modeling technique we can
calculate and separate cost available to use (aka idle cost) in the organization and that to department
by department.
Channel - The second way of grouping the transaction is by Channel. The primary channel for banks
is a branch. The model can be designed for grouping branches as per their costs (may be within a
region). As described in the Resource section, the branches can be grouped as Urban, Semi-Urban and
Rural. The model can be taken to individual branch level also. This helps the bank to find the branch

3. or location level profitability. Most of the times customers of one branch (where she has opened the
account), avail the facilities of the other branches. In this case the inter-branch charging can be used to
calculate the branch level profitability. The cost of process can also be compared among various
locations and optimized.
Apart from the primary channel as branch, there are other channels (distribution channels) like ATM,
Call Center, and Internet etc. The cost of transaction performed using these alternate channels are
typically less than that performed at the branches. Banks are using various programs to transfer users
from the branches to these channels. The cost savings can be calculated here. But one also has to look
at the ‘resource capacity’ released at the branch. The bank has to take care of this capacity otherwise
there would not be any positive impact on the bottom line of the bank. Now-a-days one of the
segment of the customer is as per the ‘attitude towards technology’. This can be seen by the use of
these newer channels by the user. The bank can get a report on utilization of various channels by
various customers and can use this information for further investments in technology, locations etc.
The information on the cost of the processes and the utilization of the channels has helped the banks
to use the ‘menu based pricing’ methodology for various types of the customers. Now a day the banks
charge the customers for using the branches or ATMs. This typically depends on the type of the
account that you are holding with the bank.
Product – The transactions are also grouped by product. The product group can start at the group
level as Deposit, Credit, Revolving Credit, Fee Based, Third Party etc. Within these groups then a
hierarchy can be created as per the requirement. The same can also be used to calculate the Line-of-
Business (LOB) profitability by grouping the products. The product manager can get reports like
product profitability by region, customer segment etc. She can use this information for creating new
products, proposing to the appropriate customers/prospects, fee structure, risk factors etc. Typically
when we talk about customer profitability, the product profitability is actually built in the model.
Transactions - These are the processes that a customer can perform. For example, deposit cash,
withdraw cash, receive debit card, receive statement, open account, check balance etc. There are some
transactions performed by the bank on their own. This is typically in the ‘Retain’ event.
Communications, offers sent to customers or closure of a dormant account etc. The level should be
decided as a proper transaction performed by the customer.
The ‘unit cost’ calculated for the transaction is end of first level calculation in the profitability
calculation. Once the cost of each transaction is known to the bank then these costs can be taken to the
customer very easily.
Customer Profitability – The customer profitability for banks now means the profitability at the
account level. One customer can have multiple accounts with a bank. For example, a savings account,
a car loan account, a housing loan account, a locker etc. The profitability can be calculated for each of
these accounts. Let me make clear at this point that, when we say customer profitability, it is the
Customer P&L for the period. Then it can be rolled up for a customer. So a customer may not be
profitable for a particular product but may give more profit from the other. Bank can use this
information (if it has got integration of information done) to cross sell, up-sell or provide some
discounts. The customer level information can also be rolled up to a ‘household’. This helps the bank
to propose various products to the members of the family at their life-stage. This also helps not to
propose same product to different members of the family. For example, proposing same housing loan
to the same family may be a waste of resources. Customer profitability report can be provided by each
product. This information can be analyzed and utilized by the bank for various purposes.
The profitability solution can be also created at the customer segment level as initial phase and then
taken to the customer level. The segments can vary for each bank but some of them are shown in the
figure as life stage, products held, attitude towards technology etc. Generally the segment level
information is used for campaigns, introducing new products, up sell, cross sell etc.
Activity Based Costing can measure the profitability of thousands of retail banking customers by
examining their behavior in detail. It actually concentrates on the various activities that are performed
for the transactions that the customer perform and then it distributed the cost of those transactions
based on the use of those transactions by the customers. This provides the accurate information for
calculation of the customer profitability.