The Allocation Game — Managing Cost Before Money is Spent

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Spend Matters welcomes this guest post from Steven Krueger, principal, and Matt Polvara, senior manager, at Ernst & Young LLP.

In the aftermath of the 2008 financial crisis, financial institutions became subject to significant new regulation, and interest rates remained near all-time lows. In an effort to maintain return-on-equity (RoE) goals in the face of stricter capital requirements, banks shed billions in expenses from multiple parts of their businesses. Now, the tides are shifting. The Federal Reserve has begun to increase its benchmark interest rate for the first time since the crisis, and banks appear poised to thrive under an administration that is promising to relieve regulatory burden and foster economic growth.

With more interest rate hikes a likelihood, banks are poised for growth. But that doesn’t mean they should stop their cost reduction programs. By strategically reducing or eliminating costs, and in particular by optimizing infrastructure costs (which account, on average, for about 40% of a bank’s cost base) banks can be leaner and more agile in a changing economic and regulatory environment. They will be better positioned to face off increasing threats from FinTech firms that are aiming to introduce disruptive technology-enabled business models. Ultimately, banks can reallocate funds they saved to invest in products and technologies to defend or grow market shares.

Three challenges stand in the way of market practitioners achieving sustainable cost leadership:

Identifying and removing resistant costs. Despite the industry’s shift toward digitalization, banks still incur sizeable costs related to traditional services and operations. For example, banks are still spending billions of dollars a year moving cash around in armored trucks. Banks also sink money into sending paper statements via post and maintaining a population of plastic credit cards. Once banks identify these resistant costs, they can replace legacy processes via updated technologies, methods and software — and save money in the process.

Fully assessing short-term expense cuts. Banks should think through if their proposed reductions are “penny-wise and pound-foolish.” They could deploy strategies or initiatives that may deliver on short-term cost reduction targets, but fall short in the long term or when economic conditions change. Perhaps there’s no real way to track the estimated reductions back to the bottom line, or the cost savings may not be sustainable over long periods of time, especially upon an increase of business volumes.

A current example? Local branches. U.S. banks have cut their retail branch population since 2009 and further reduced branch personnel across the board. However, those cuts had a negative impact on the customer experience, and, in some cases, banks had to add branch tellers and bankers back to their operations and modify their branch strategy after incurring significant exit costs for the initial personnel reduction. 

Managing persistent costs. Persistent costs are those expenses that continue to rack up, even when the product or function to which they are related ends. For example, if a bank closes a trading desk or a retail branch, there are elements of the cost base — office lease fees, application licensing fees, etc. — that will remain in the profit and loss statement. These are the unintended consequences of poorly planned and executed cost-cutting efforts that don’t take into proper account the management of corporate overhead (i.e., the allocated cost base) and their relationship to changes in business volumes and business mix.

When it comes to managing the allocated cost base, banks can find themselves caught up in the academic exercise of cost accounting and allocation rather than an objective of controlling or reducing the overall cost base of the enterprise. Cost allocation, as a traditional exercise, seeks to fully distribute the overhead costs of an institution on an equitable basis, and by that process, contribute to determining the profitability of the businesses at a granular level. However, while a fully loaded cost base is useful to assess each business’ contribution to enterprise performance on a comparable basis, firms need to maintain the perspective that cost allocation simply moves costs after they are incurred from one side of the organization to another, as it is geared only to inform business units of their share once during the planning season and then again after the money has been spent.

We often see this process creating significant internal frictions due to the lack of cost transparency, in particular around consumption data and billing rules. Most banks spend too much time and too many resources investigating and managing allocation disputes, which runs counterintuitive to the cost-cutting they seek. This also distracts the organization from what really matters: optimizing the bank-wide cost base.

Instead, to achieve cost excellence, banks must comprehensively rethink the way they manage costs —the answer is not as simple as traditional cost reduction levers, such as the elimination of management layers or branches. There are several steps organizations can take:

  1. Create the incentive to act. Review cost accountability models and assign end-to-end cost accountability to the cost recipients. This will increase banks’ incentive to improve their understanding of the infrastructure costs and work collaboratively with the supporting functions to reduce them, through changes in sourcing and consumption behavior.
  2. Speak one bank-wide language. Define common guiding principles internally, and use these to lay the foundation for a bank-wide costing plan. Banks should adopt common allocation principles endorsed by senior management. They should develop one company-wide service catalog and master data architecture to improve consistency and enable a central orchestration of cost management activities based on common standards.
  3. Balance simplicity with ability to act. Simplify cost allocation methodologies to improve cost awareness and allow the bank to focus on forward-looking management of cost instead of backward-looking arguments. This may require investments in granularity through enhanced data sourcing, improved analysis and supporting technology, based on tangible business cases.
  4. Improve integration of processes. Improve integration between cost allocation use cases, such as management and legal entity allocation, living wills (i.e., determine pre-funding requirements for operational continuity of ‘critical services’) and transfer pricing to increase consistency and reduce costly reconciliation and duplicative activities.
  5. Leverage advancements in technology. Adopt the latest technology features, such as in-memory capabilities and data virtualization, allocation lineage, and cloud-based platforms to improve cost allocation and transparency, while minimizing disruption to current processes.
  6. Act at the right time. Improve the ability to manage the allocated cost base during financial planning to minimize unused capacity, as opposed to discussing costs only when they are incurred, or when reduction levers are no longer available.

We see a number of institutions pursuing improvements to cost allocation and cost management through increased technology spending only or through the implementation of just one of the above strategies. As a result, often the outcome have been disappointing, particularly in the dynamics and partnership between the lines of businesses and the corporate center; this partnership is a critical success factor toward durable cost leadership. The greatest success is achieved by pursuing the above strategies jointly, under a bank-wide consensus and orchestration that creates momentum and improves adoption rate. We see that clients that pursue cost management in this fashion also create other opportunities, by building onward from these strategies, driving more effective consumption patterns and breeding better analytics that can be leveraged to lower the overall cost base.

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First Voice

  1. John:

    This is a very good article. I believe that everyone should read this since I find it helpful to those managing costs before spending to stuff. The tips shown in this article can really efficiently change our ways of spending. Good work !

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