Implementing Activity-Based Costing in the Banking Industry By Jeffrey Witherite and Il-woon Kim Benefits include the proper costing of transactions, the ability to trace specific costs to bank customers and the ability to measure customer and product profitability. Activity-based costing ( ABC ) is widely recognized as a superior method for allocating overhead costs. Much emphasis has been placed on the implementation of ABC in the manufacturing industry. However, the service industry benefits from this system of cost allocation as well, due to the fact that service firms usually have high overhead costs and are labor intensive. These characteristics make ABC a logical choice for cost allocation. ABC will help services companies identify and allocate overhead costs and quantify labor costs associated with each activity. For commercial banks, in particular, the potential benefits of ABC implementation can be numerous. These include the proper costing of transactions, the ability to trace specific costs to bank customers and the ability to measure customer and product profitability. The end result of these benefits is the ability to improve decision-making and help organizations meet their strategic objectives. A large commercial bank in the United States recently implemented ABC in four phases over a two-year period: preparation and planning; assessing appropriateness of ABC; designing an ABC system and collecting necessary data; and implementing the system. This article will discuss the process and analyze the benefits of and the obstacles to implementing ABC in a financial services environment. Preparation and Planning for ABC The bank s cost accounting manager introduced the concept of ABC to senior management because the cost accounting manager thought that an ABC system would be a viable solution for the bank s product profitability concerns. Although the bank was able to determine how much revenue each of its various products and services generated, it was not able to determine with any level of certainty how much it cost to provide these products and services. At best, senior management was confident that the commercial side of the bank s business was profitable, while the retail side was not as profitable. In addition, bank management was intrigued by the possibility of gaining a better understanding of the cost associated with the activities performed in the bank and the resources dedicated to performing these activities. Senior management thought that there may be some duplication of activities within the organization and that an ABC system would help identify these areas of duplication. Six specific benefits were to be realized with the implementation of ABC (Exhibit 1). Each would interact with others to create synergies. The first administrative step of the project was to create a steering committee that would define the planning, design and implementation of the system and make important decisions at all stages. During the design phase of the project, a cost accounting software system was identified through an RFP ( request for proposal ) process. After reviewing several ABC applications, software was chosen, primarily because the bank was already using this software in its human resources area, and Jeffrey Witherite is Director of Budgeting at L Oreal USA, Streetsboro, Ohio. Contact him at jwitherite@us.loreal.com. Il-woon Kim is a Professor of Accounting and International Business at the University of Akron, Akron, Ohio. Contact him at ikim@uakron.edu. APRIL MAY 2006 BANK ACCOUNTING & FINANCE 29
the two systems could interface. Recognizing that the bank lacked the requisite skills to implement the ABC system, the steering committee identified a consulting firm that could assist in the implementation of the system, especially with the more technical matters. After interviewing representatives from several consulting firms, one firm was chosen, primarily because of its extensive implementation experience. The firm was given a wide-reaching role within the project, assisting the steering committee with the design of the system to best match the software s functionality, designing and preparing the software and processes, modifying and loading cost-driver information into the new system and assisting in the gathering and loading of cost allocations into the system. For cost accounting support, the bank decided to use mostly existing internal resources, while hiring some new finance employees to assist with the project. While some of the consulting firm s resources were used in a cost accounting capacity, this was intentionally kept to a minimum in an attempt to control costs and avoid potential conflicts of interest. The new team of analysts was given the responsibility of introducing the principles of the ABC project to cost center managers, conducting cost center interviews and creating and recording the new cost allocations. It took approximately a year and a half to conduct all of the Exhibit 1 Expected Benefi ts of ABC Implementation Compare product profitability of wholesale lockbox vs. retail lockbox Assess Competitiveness Evaluate where competitive cost advantages may be Identify the driver of certain costs Compare Product Performance Determine Accountability Evaluate Organizational Performance Recover Cost of Internal Services Provided cost center interviews, create cost allocations and gain approval for the allocations. Full implementation in supporting centers and cleanup took another six months. Assessment of Appropriateness of ABC Before engaging in a major ABC system implementation project, an organization should consider the appropriateness of an ABC system. While the benefits of ABC system implementation are evident to most companies, it is important to keep in mind that many companies have failed to realize all the benefits an ABC system provides. Any company, especially a financial services company, considering an ABC system implementation should carefully assess the following points, which are identified by many ABC experts in determining the appropriateness of ABC for a particular organization: Significant indirect costs Complex goods and services Losses on high-volume products and profits on low-volume products Disagreement by managers over cost allocations Bid results Age of costing system In the case of the bank, more than half of the bank s expenses were incurred by support and administrative Assess the cost difference between item processing in different locations Estimate and Track Costs Identify who used services and how much they were charged Estimate the resources by Resource Center to meet the projected demand of ACH transactions functions and classified as indirect costs. These functions were broken into three major groups: information technology (IT providing hardware and software support and application development services); service company (providing general support services such as check processing, wire transfer processing and ATM servicing); and the corporate center (providing services such as finance, human resources and legal). Another consideration in implementing an ABC sys- 30 BANK ACCOUNTING & FINANCE APRIL MAY 2006
tem is the complexity of the services and the number of processes involved. Many of the bank s products were interrelated and specialized based on the specific portfolio of products used by a customer. A related concern was the similarity of products that financial service organizations provided. Some products were so close in description that it would be difficult to determine what should be defined as a unique product and what should be grouped together with other similar products. For example, the bank offered dozens of similar investment vehicles that varied minimally based on the type of customer, level of investment and bank subsidiary. A common mistake in traditional cost accounting systems is that high-volume services produce losses and low-volume services produce significant profits. This is due to the fact that, generally, low-volume products are undercosted and high-volume products are overcosted, based on the traditional system using volume-related measures for overhead allocation. This was the case at the bank. The expenses that were required to support low-volume goods and services were often not accurately assigned to these products but instead spread to high-volume products. These low-volume, unique products and services were generally provided to fulfill the requests of wealthy customers. While this extra level of support was often successful in attracting wealthy customers, the bank was not able to determine accurately the fiscal impact of offering these products and services. Difficulty in implementing ABC systems is often encountered when departments within the company disagree with the costs allocated to their cost centers. This concern was evident during the ABC project; many client cost center managers initially refused to accept the results produced by the new cost allocations. This was more often the case with center managers who were assigned more cost under the new allocation system, but some managers did voice a concern regarding not being assigned enough cost. Multiple review sessions to explain the method and calculations behind the new cost allocations were required to convince skeptical operating managers about the new system. A sample redesigned expense statement is depicted in Exhibit 2. Some products were so close in description that it would be difficult to determine what should be defined as a unique product and what should be grouped together with other similar products. In general, a company should consider implementing ABC if the company loses low-priced bids and wins high-priced bids. This is an indication that the company s current costing system is not accurately assigning costs to the products and services it is offering. More than any other reason, the bank pursued ABC because it had no way of determining which products were unprofitable and uncompetitive and which products were profitable and underdeveloped. While the bank was able to prosper in the middle-market commercial banking sector without this knowledge, the bank was not able to compete successfully against larger rivals in the retail banking sector. A final consideration when introducing ABC is the age of the company s current costing system. The bank had acquired two of its major U.S. banking subsidiaries, bought a trading company and developed an online trading system since the last cost accounting system review. For this institution, the ABC project was a necessary undertaking. Designing an ABC System and Collecting Necessary Data After completing an assessment of the appropriateness of an ABC system implementation, an organization should give careful consideration to designing an ABC system that will meet the needs of the organization and then to collecting data required to implement the system. The bank followed four steps to design the system and collect data. Step 1: Identify and Classify the Activities Related to the Company s Products The first step is to identify activities in all areas of the value chain. Employees identify all activities that are performed to produce the products or services and then prepare a list called an activity dictionary. As activities are identified, they are classified as unit APRIL MAY 2006 BANK ACCOUNTING & FINANCE 31
level, batch level, product level or facility level. Unitlevel resources and activities are resources acquired and activities performed specifically for individual units of product and service. Batch-level resources and activities are the resources acquired and the activities performed to make a group, or batch, of similar products. Product-level resources and activities are the resources acquired and the activities performed to produce and sell a specific good or service. Facility-level resources and activities are the resources acquired and the activities performed to provide the general capacity to produce goods and services. The objective of classifying resources and activities into categories is to create accurate descriptions of how the organization achieves its work and to have the ability to trace the cost of resources acquired and activities performed to produce goods and services. There are three common approaches for identifying and classifying activities for the activity dictionary: Top-down approach Recycling approach Interview or participative approach The top-down approach uses middle-management or higher-level employees to create the activity dictionary. The interview or participative approach creates a team of employees Difficulty in implementing ABC systems is often encountered when departments within the company disagree with the costs allocated to their cost centers. who interview all employees to compile the activity dictionary. The recycling approach uses documentation of processes that have already been developed for other purposes. For the ABC project, the bank used all three of these approaches to identify and classify activities. Recycling was the first step undertaken, as analysts scoured department mission statements and general ledger account names and definitions for easily translated activities. When activities were defined using this methodology, the corresponding cost centers that budgeted expenses in these general ledger accounts were identified and the information was referenced in the later interview stage. All activities identified through the recycling approach were reviewed by the project steering committee. The bank also used the top-down approach as senior management in each of the major areas of the bank identified the major activities performed in their respective areas. This list of activities was then cross-referenced against the list of activities identified in the recycling process. The consolidated list of activities served as the initial master list of activities that would be used for conducting cost center interviews. During cost center interviews, operational managers were asked to identify ac- Exhibit 2 Redesigned Expense Statement, Resource Center (RC) Employees Occupancy Equipment Supplies End-User Support HR Training Audit Human Resources Total Expenses Provider RC Costs Current $ 44,000 16,000 3,200 4,800 8,400 3,600 100,000 Provider RC Costs Redesigned Direct Costs $ Variable Employees Occupancy Equipment Supplies Total Direct Costs Indirect Costs Business Unit Controllable 44,000 16,000 80,000 Provide End-User Support 3,200 Administer HR Training 4,800 Total Centrally Controllable Audit 8,400 Human Resources 3,600 Total Total Indirect Costs 20,000 Total Expenses 100,000 24,000 32,000 3,200 4,800 0 Fixed 20,000 16,000 4 0 8,400 3,600 40,000 60,000 32 BANK ACCOUNTING & FINANCE APRIL MAY 2006
tivities performed in their centers that were not on the master activity list. The newly identified activities were reviewed by the steering committee and, if approved, added to the master activity list. The main activity distinction used in the project was to define activities as those that assigned costs directly to bank products and services or those that assigned costs to other cost centers. Step 2: Estimate the Cost of Activities Identified in Step 1 Once activities have been identified, it is necessary to estimate the costs associated with specific activities. These costs include both human resources, such as employee labor for maintenance and production, and physical resources, such as the cost of equipment and buildings. The total cost of each activity must be calculated using employee data from personnel interviews and financial data from the accounting department. Employees are asked to identify the amount of time they spend on each activity in an average week and then identify the physical resources that were used to support the activity. This information is compiled on an employee activity data sheet. As part of the project, analysts conducted activity interviews with cost center managers using detailed budget and actual expense information. This information was used as a reference for assigning costs to activities. Once the relationship between specific expenses and related activities was defined, aggregate costs were assigned to each activity. Step 3: Calculate a Cost-Driver Rate for Each Activity As soon as the activity cost data from step two is identified, it can be used to calculate cost-driver rates the company should use for assigning activity costs to goods and services. A cost-driver rate is the estimated cost of resource consumption per unit of the cost driver for each activity. This rate should use a base that has some causal link to the cost. In order to calculate an accurate cost-driver rate, it is necessary to know the total activity cost and the activity volume. The information from step two can provide the total activity cost. The activity volume is the total volume of the cost drivers defined in step one for this particular activity. Once the activity cost and activity volume figures are determined, the cost-driver rates are calculated by dividing the total activity cost by the total activity volume. The calculation of cost-driver rates was made much easier by the extensive amount of historical budget, head count, occupancy and transactional cost information maintained by the company. This information was easily loaded into the database and referenced in the creation of cost allocations. Step 4: Assign Activity Costs to Products In the final step, the cost-driver rates prepared in step three were used to assign activity costs to goods and services at the bank. There are three key points for assigning activity costs to products and services. First, all the activities related to a given product or service must be identified. Without an intimate understanding of a company s organizational structure and the relationships between departments, it may be difficult to identify accurately all the activities related to a product or service. Second, the number of units of each activity that are used per unit of product should be determined. It is easier to define the units of consumption for activities that easily relate to products on a unitary level. For activities that are more unclear or uncertain, defining consumption may not be as easy. Third, costs should be assigned to products using the cost-driver rates for each activity. ABC Implementation and Challenges The biggest challenge to implementing ABC at the bank was generating sufficient buy-in from operational managers. The major concern expressed by bank managers was whether the benefits of the new costing system would justify the time and resources dedicated to implementing the system. A few managers expressed concern that the new cost accounting system was merely going to reshuffle the bank s costs and that, unless hard actions were taken to remove costs from the bank, the project would serve no useful purpose. APRIL MAY 2006 BANK ACCOUNTING & FINANCE 33
Another concern encountered was that the project was initially viewed as another program in a long line of special initiatives and cost-savings programs that resulted in uncertain benefits. The bank had recently completed a major restructuring initiative. While this initiative redefined the support areas of the organization and resulted in workforce reductions, it was uncertain whether this program actually resulted in cost savings. During the cost center interview process, another concern encountered was duplication of effort in collecting information. Duplication of effort was most evident when project analysts asked operating managers for cost accounting information that was collected recently as part of prior cost collection activities. In addition, duplication of effort was evident between the project and the recently completed organizational restructuring. If the steering committee had known earlier that much of the same information was collected as part of the restructuring, time could have been saved and aggravation avoided. A further concern was the occasional lack of creativity on the part of the center managers. Managers were often inclined to estimates instead of taking time to identify an appropriate cost driver to charge dollars based on actual usage. Further, when a suitable cost driver was defined, it was often difficult to collect the driver information necessary to support the cost driver. If it became evident that the driver information was not available, a new driver would be selected or possibly a new activity or set of activities would be used as a replacement. To support the entry and coordination of cost-driver information into the system, three analysts focused their attention on data management, with no cost center interview responsibilities. After all the cost center allocations were created and entered into the systems, the most difficult part of the project was gaining approval for the cost information produced by the new allocations. From a service provider standpoint, many managers were dissatisfied with the result of the allocations and requested that the cost center interview process for their respective center be The most difficult part of the project was gaining approval for the cost information produced by the new allocations. performed again. While it was difficult to gain approval for cost center allocations from the service providers, it proved even more difficult to get approval for the allocations from the client center managers. This challenge was especially evident for centers whose assigned costs from a support center increased as a result of the change in cost allocation methodology. After gaining approval from the operating managers with specific product profitability responsibilities, the approval process then required approval from the project steering committee and executive-level management. The Key to ABC Success The key to successful implementation of ABC is an organization s employees. It starts with the ABC champion. For this commercial bank, the ABC champion was the cost accounting manager. As for all project champions, this role was to convince management of the viability and necessity of the project and to create enthusiasm that extended to employees throughout the organization. For several reasons, the major factor in the success of an ABC implementation is gaining the support and cooperation of the organization s employees. First, the more employees understand and support the ABC initiative, the greater the chance the ABC system will be successful. In this regard, honest and open communication was effectively carried out not only by the steering committee but also by top management. Second, the employees should be allowed to participate fully in the ABC development process to facilitate their commitment to the new system. As mentioned above, the process for acquiring activity and cost information included the participation of the employees. Through the use of the interview approach, employee involvement became imperative to the process. Third, any major changes in the organizational structure will generate employee resistance. Clearly, this was the case for the project. Communication was integral to the process as the committees charged with implementing the ABC system made the effort to fully explain the process and the benefits to the employees. 34 BANK ACCOUNTING & FINANCE APRIL MAY 2006