Cost Attribution Methodology
10 June 2014
Costs on the firing line: why qualified decisions require a radical shift in front-office thinking.
Observing the current state of the banking industry, it seems a return to the easy conditions of the pre-2007 era – the entire period between 1987 and 2007 – is unlikely to happen any time soon. Despite financial implosions and plenty of crises, this era was largely characterised by easy spending, readiness of credit and loose regulation.
Balance sheets are now being rebuilt1 and retail businesses recovering – as are core IB products and high-volume trading lines.
There is a growing realisation that these businesses are only sustainable through fundamental restructuring and a far tighter appreciation of cost. The old days of largesse and free spending across the front office are a thing of the past.
THE PARTY’S OVER
While a decade ago the relationship between a typical trading desk and its internal support services could be summarised as ‘cash is no object, just make sure my revenue growth is never constrained’, the new reality is cost-driven and asks: ‘how does revenue compare to the real cost of business – both for me and my competitors – and where can we be leaner?’.
This mirrors changes in other sectors over past decades, most recently in the pharmaceutical sector – where a changing competitive and regulatory environment, along with increasing pressures on margins, forced a sudden step change in organisational maturity. The good news is that industries can and do adapt to such pressures; banking will adapt and thrive in due course.
To survive and accommodate change on this level requires organisations to understand and embrace the need to mature their operational capabilities; banks will be less about intellectual innovation and more about operational execution.
There needs to be a fundamental shift in front-office understanding of cost, acknowledgement of the need to be transparent, removal of political barriers, and the provision of a framework for measuring the true cost of the resources consumed by each business.
Only once these are in place can truly qualified decisions be made as to which business lines, products and people are most worth investing in.
WHAT IS A COST FRAMEWORK FOR?
As a minimum, any cost framework seeks to answer:
• What are my current and planned capacity needs and where does capacity in shared services exceed these?
• Which product lines are consuming which resources and at what cost?
• Are these costs accepted by the business lines they relate to?
• Are costs correctly attributed to product lines over time and am I using realistic drivers?
• Where capacity is deliberately planned for future growth, is the cost of this investment attributed to and correctly charged to the same granularity as P&L?
• What is my ‘real’ net profitability per product line after considering all these costs, i.e. net trading profitability after cost of funding, capital and shared services?
• How can I better price my expected returns for larger investments and how can I measure objectively whether they have delivered value?
If the above information is not available, there is a danger – as has been the case in the past – that capital and investment are misdirected, and that this misdirection is invisible.
There are numerous ways in which the lack of a robust framework for allocating cost can impact profitability and transparency. In particular, where information is opaque, personal agendas take the place of planning and indirect costs may be deliberately misallocated.
It is time to attach the same importance and discipline to the pricing of shared costs as that applied to financing costs such as liquidity, funding and risk. Only then will the true costs of doing business be apparent.
"Banks previously had been able to ignore cost pressures in their businesses by holding minimal equity capital, using ‘alchemy’ to create lucrative financial products and entering new markets. The banking industry will now have to manage its costs in the way other industries have had to do for a long time."
HSBC CHIEF EXECUTIVE
WALL STREET JOURNAL, MAY 2013
To view the full article, please click the link below.