Mabberley (1992) lists four uses of ABC within Financial Service institutions. ABC can be used for Strategic Cost Management, Product Costing, Customer Profitability and Operational Cost Management. The first three will be discussed briefly and the fourth at length because ABC was implemented in an operational area of the bank.
3.6.1 ABC for Strategic Cost Management
Strategic cost management is an activity that has only recently (around 1992) become popular in the financial sector. It focuses on determining the strategic value of activities and optimising use of resources and it will often include some sort of "what if' analysis. Strategic value is achieved by understanding the factors that affect the profitability of the
various aspects of the business and the impact of changes on the market's perception of the value of the organisation. Sephton and Ward (1990) support the view that financial institutions can gain considerable benefit from using ABC as part of the strategic management process, understanding cost behaviour and analysing profitability: They argue that in the highly competitive financial services market it is crucial to be able to analyse profitability and understand cost behaviour as part of the strategic management process.
Of the four uses of ABC within financial service institutions, strategic cost management is argued to be the most forward looking, (depending on one's perception of what strategic cost management is), and is likely to be performed less frequently than other types of Activity Based Costing. ABC for strategic cost management may be undertaken because there is a need to review the overall direction of the company as the result of a merger, acquisition or take-over and often seems to be a competitor driven exercise. It may be part of a strategic planning exercise or may simply be necessary as a major investment or divestment decision is to be made, and it is unlikely to be performed more than once each year. Through strategic cost management, the identification of high cost activities and the analysis of costs into their main categories such as staff, systems, premises, enables senior managers to identify areas for investment. For example, high cost activities with a high staff content will be identified as a possible area for IT investment, (for example, the Clearing department in this research). Additionally, comparisons could be carried out between the cost of an in-house activity against the cost of external service providers.
The uses of activity based costing in strategic cost management for Financial Institutions can be separated into two types: strategic planning and resource management.
Strategic Planning:
ABC can be use to aid strategic planning by focusing attention on the factors that determine the expenditure on business activities such as types of products or markets. It can help in prioritising business activities, because it can provide information relating to the cost/ benefit to be derived from particular businesses, geographic markets, products or customer groups and the potential benefit to be derived from future investment in particular strategic direction. The main strategic focus of ABC is that of influencing business strategy by providing information that identifies the flexibility within the cost base. The flexibility relates to the ability to utilise costs already incurred to gain competitive advantage and knowing what expenditure would be necessary to pursue a change in direction. As stated earlier, ABC can also be used in banks in the development of value chain analysis as a means of breaking down the strategically relevant activities in order to understand the behaviour of costs (Shank 1989; Shank and Govindarajan 1989).
Resource Management:
With respect to the resource element of strategic cost management, resources within a financial institution include capital, costs and people. Management of costs depends, to a large extent, bn the management of staff costs (in 1992 it was more than half of the costs incurred by any financial institution, Mabberley 1992). Management of people depends on motivation, which in turn, depends on communication. Communication is assisted by knowledge of the underlying activities and focus of the business. Once again value chain analysis can be used to focus attention on those factors that determine the expenditure on
key projects or activities and it can help in the cost/ benefit analysis of individual
initiatives. It can therefore assist the prioritisation of alternatives to maximise the return on investment in line with the strategic direction of the company. Furthermore, because resource management as part of strategic cost management identifies why costs are incurred and relates these to the activities that take place, it can be used to determine when costs should be incurred, such as whether/ when to move to new premises. This enables management to manage costs on the basis of spending (the decision to buy/ lease a new building), as opposed to consumption (the occupation of it). The second use of ABC in Financial institutions is ABC for product costing which is discussed below.
3.6.2 ABC for Product Costing
Activity Based Costing for Product Costing is the most common use of ABC and often forms the basis of product pricing and product profitability. This is largely because activity cost analysis is similar to the standard costing technique, and therefore
encourages organisations to extend existing cost analysis to review the underlying cost drivers in relation to the basic business processes. This is of particular importance in the financial sector, where the increasingly competitive environment and the degree of product differentiation necessary to maintain or improve market share requires effective information relating to the costs of developing and providing such products and services.
By analysing the activities performed and attributing them to individual products and services, efficiency and effectiveness can be improved: Efficiency can be improved by eliminating duplication and unnecessary activities, improving work flows and training staff. Effectiveness is dependent on undertaking the right activities efficiently. By
focused, in order to enable working practices to be made both more efficient and effective, and where costs could be reduced, or performance improved.
3.6.3 ABC for Customer Profitability
This can be used as the basis for customer profitability analysis. The cost of providing the mix of products or services to a customer or type of customer is usually based on
product cost information, but may be enhanced to reflect those costs that can be
attributed directly to individual customers or customer groups. Connolly and Ashworth (1994) argue that a company's initial interest in customer account profitability is typically triggered by a sudden and pressing concern about the profitability of its major customers. They define a meaningful profit contribution as:
"the difference between the revenue earned from a customer and all the costs that can be associated with the customer" (p 36).
Using ABC for customer profitability analysis is argued by Connolly and Ashworth to give a company;
"an improved understanding of, or new insights into, its sources of profitable business" (p37).
Lastly, we turn to ABC for operational cost management.
3.6.4 ABC for Operational Cost Management
In operational cost management ABC can either be used as the basis of regular cost analysis through activity based management, activity based budgeting or performance management or be used as the basis of a one-off cost reduction exercise and many organisations use Activity Based costing as a basis for managing operational costs. Section 3.7 to 3.10 looks at these four ways of managing operational costs.