Activity-Based Costing in Banking
ACC522: Budgeting and Cost Accounting
April 15, 2013
Activity-based costing (“ABC”) is considered one of the best and most popular tools for allocating costs by identifying individual activities as cost objects. Originally, activity-based costing was mainly used in manufacturing industries but, due to its preciseness, this system has recently grown popular in the service industries as well, including banking. Activity-based costing provides bank mangers with a better and more accurate understanding of costs and true profitability associated with the daily operations of the bank and can be utilized in all aspects of banking. As mentioned previously, activity-based costing has proved to be an effective measure to accurately determine costs associated with products and services of a company. “ABC systems identify activities in all functions of the value chain, calculate costs of individual activities, and assign costs to cost objects such as products and services on the basis of the mix of activities needed to produce each product or service.” ABC is further defined as: “1) a more accurate cost management methodology, 2) mostly focuses on indirect costs (overhead), 3) traces rather than allocates each expense category to the particular cost object, 4) makes ‘indirect’ expenses ‘direct.’” Activity-based costing is best to use in an industry where competition is prevalent. According to Mehmet Kocakulah, “The competitive environment in the banking/financial institution industry has made it very difficult to increase revenues and market share that is sufficient in growth and maximizing shareholder’s wealth. The minimal growth in the area plus the over saturation of banks, financial institutions and other sectors (mortgage companies, insurance agencies, internet companies, etc.) competing for the traditional banking products has forced banks to look at ways to control their costs to reach the profitability levels that are necessary to appease their shareholders.” Thus, activity-based costing is a logical choice for cost allocation in banking. According to a study by Paul Sharman, President of Focused Management, Inc., “Most banks are quite involved with process improvement, for which the ABC provides information on what processes cost.” This comment is further supported by a study performed by Peter Drucker, in which an overview of his studies written by Mitchell Max quotes, “Sophisticated banks – and their stakeholders – realize that improved performance cannot come from cost-cutting alone. Comprehensive performance management approaches, systematic management of central costs, razor-sharp pricing and customer profitability information are emerging by enlightened banks as the keys to their profitable future.” Activity-based costing will allow a bank to ultimately determine how lucrative the products are to the bank. “As ABC is implemented in a bank organization, the activities that contribute to providing the bank’s services are defined, and then costs are assigned to each of these activities. The end result is that a bank can determine how profitable deposit services and loans actually are . . . For example, the bank can determine the costs and profits of interest-bearing checking accounts, home equity loans, car loans and so forth.” Activity-based costing will also allow bank managers to better study the demands of customers, improve their decision-making and ultimately create higher profits. As quoted by Mitchell Max, “The sheer fact that customers have multiple channel and process options for sales and service interaction with banks, means that only by understanding and managing customer demand can cost and profitability be understood and managed. Best practice organizations explicitly measure and manage the true profitability of each customer relationship.” There are generally four steps in the activity-based...
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