Profitability in banking is determined not just by capital employed and capital cost, but significantly by operational cost.
Activity-based costing is a widely used method to calculate operational cost, tracing cost from the general ledger to products or transactions.
Departments in banks can be categorized as overhead or direct, influencing how costs are allocated.
Calculating cost down to a transactional level provides a more accurate picture of operational costs and ultimately, bank profits.
Banks, like any other business, thrive on profits. However, the path to profitability in banking isn’t as straightforward as it might seem. It isn’t just about the capital employed or the capital cost. A significant part of it is tied to the operational cost. In this blog post, we delve into how transaction details shape bank profits and the role of activity-based costing in banking.
The Basics of Profit Calculation in Banking
To understand how transaction details shape bank profits, it’s important to understand how banks calculate profitability. While capital employed and capital cost play a significant role, a large part of it is also determined by the operational cost.
Activity-Based Costing in Banking
Activity-based costing is one of the most widely used methods to calculate operational cost within a bank. It might sound old-fashioned, but it’s still very relevant and sophisticated.
The basic premise of activity-based costing is to trace the cost from the general ledger all the way down to the products or transactions. This process involves several layers:
Resources: Costs in the general ledger are there because of resources such as personnel, IT capacity, and infrastructure.
Activities: These resources are used to perform activities that service clients or products.
Products and Clients: The activities lead to services or products for clients.
Transactions: The end result of all these activities are transactions.
The goal of activity-based costing is to layer down all these elements on a cause-and-effect basis.
Classifying Departments: Overhead vs Direct
In a banking situation, departments can be categorized as overhead or direct. Overhead departments include IT, Finance, and HR while direct departments include the front and back office. However, some departments like treasury or risk management can be tricky to allocate as they service both overhead and direct departments.
The Importance of Transactional Level Costing
While product-level costing is common, it often neglects the other elements captured in a transaction. For example, a mortgage transaction doesn’t only have the type of mortgage but also the customer type, the channel, the region, and a timestamp.
Therefore, it’s crucial to calculate cost down to a transactional level as these transactions contain information that differs in operational cost. By knowing the operational costs for different products, banks can set them against the revenue for these products, helping calculate the bottom line of a bank more accurately.