EBanking Services - Assignment Example

Running head: E-BANKING SERVICES BE PROFITABLE BY USING ACTIVITY-BASED COSTING SYSTEM E-Banking Services be Profitable by using Activity-basedcosting system [The name of the writer appears here] [The name of the institution appears here] Chapter 1: Introduction Over the last few years European banks have spent billions of euros on new electronic channels. However, after some years of excitement it was clear that the banks' long-awaited skyrocketing profits from this area would not be netted. Banks have also invested in expanding and improving the IT systems and a number of new e-banking services have been developed. E-banking has a different set of processes and cost objects are significantly different from those of traditional banking system. For the same reason traditional accounting has not been able to provide an appropriate pictures of costs and thus it was based on gut feeling. This article explores the implementation techniques of Activity-Based Costing (ABC) in the banking sector on the example of bank in order to analyze the cost structure for traditional and electronic channel transactions. The article shows how it is possible to implement ABC in banking and proves empirically that electronic channels help reduce the costs of both banks and their clients. The setup and infrastructure to implement e-banking services requires a huge amount of initial outlay. Therefore, European banks have spent billions of euros into building direct channels like the Web, upgrading branches and call centres, and trying to integrate all these channels. Major financial futurists predicted bright prospects to electronic banking. But after some years of excitement it appeared that the banks' long-awaited sky-rocketing profits from this area would not be yielded. Around the world, Internet banks are faltering. This situation requires a profound analysis to be able to understand the real cost of e-banking, and e-bank transactions in particular. All major banks have declared e-business as one of their core strategies for future developments. Until recently, most of the pricing decisions about e-bank services were made instinctively as the current financial management information systems did not support such analysis. This research explores the implementation techniques of Activity-Based Costing in the banking sector on the example of bank in order to analyze the cost structure for traditional and electronic channel transactions. Also conclusions are drawn about the profitability of e-banking transactions. The research addresses the following questions: 1. How can ABC techniques be implemented in a bank How it is possible to allocate IT expenses to products 2. What are the cost elements of e-channel transactions What are the major cost groups 3. Are e-channel transactions cheaper than those made via the traditional channels Chapter 2: Role of E-banking In the past, banks have used a set of integrated distribution channels has provided the basis for them to build strong relationships with their customers. Those banks leading to shape the way in which products are distributed can often gain long lasting competitive advantages. Like ATMs and 'phone banking, the Internet is seen by many banks today as a new, low cost distribution channel (Feng 2001). Unlike traditional corporate networks (which usually have private computer networks in place), the Internet has become a mass infrastructure available to an ever-growing segment of the population. It is based on an open, standard protocol for communications, and it is relatively inexpensive and non-proprietary with global accessibility. Most of all, the Internet is not only cheaper than other distribution channels but also allows banks to reach new customers in new areas more easily (Feng 2001). The advantages both for banks and their customers are obvious, especially in terms of cost and convenience. If we assume that the end users have the basic understanding of internet usage then substantial cost savings can be achieved if banks can persuade their customers to use the Internet for transactions. An added advantage of the Internet is that it enables banks to adapt to changing customer needs and lifestyles more easily (e.g. more flexible time). "The evolutionary trajectory of the Internet, as an increasingly more sophisticated channel of distribution in banking, has been highlighted by many previous studies and reported widely" (KPMG 2000). The most primitive use of the Internet for banks is to merely establish a 'presence' on the web perhaps by having a website with information, services, news, etc. The content is no more than an electronic version of public relations materials. The next step up is to engage in 'interactive sales support', whereby they use electronic communications to enable interaction with customers. Once banks have gained more confidence in the use of electronic channels, they may provide features that are more complex and involve greater interactivity. These include domestic Internet and PC banking, using proprietary networks. The ultimate goal for banks is to achieve global E-banking, whereby transactions can be carried out in multiple currencies in different countries (Feng 2001). Since internet is itself a new technology, E-banking has the potential to open up other new opportunities for banks (Feng 2001). For example, increased interactivity and better customer services by more availability can be achieved by using Internet telephony and video-conferencing, thus enabling the provision of effective personal advising remotely at low cost. Not only does this overcome the alienation caused by traditional electronic channels, which was disabling for banks when transacting complex products such as mortgages and loans, it also provides customers greater flexibility in choosing the particular advisor they want to speak to or in deciding when and where to conduct their banking (Feng 2001). The interactive nature of the Internet also provides marketers with the opportunity to build brand loyalty and collect valuable consumer information, which can then be used in product cross-selling and new-product development (Middleton, 2000). Chapter 3: ABC Costing Overview It is normally thought that activity-based costing (ABC) typically focus on manufacturing applications. However, ABC and customer costing are increasingly getting popular among service organizations such as banks and health care organizations (Bamber & Hughes II 2001). ABC provides more accurate cost information that managers can use in making important business decisions. Activity-based management (ABM) refers to using ABC information to make decisions that increase profits while satisfying customer needs. Managers use ABC information in making pricing and product or customer mix decisions, in identifying opportunities to cut costs, and in routine planning and control. With the advent of E-Banking the focus of Banking activities has shifted and therefore to efficiently allocate cost ABC costing methods seem more appropriate. ABC customer cost data can help Bank managers develop more effective marketing strategies by more appropriately pricing their services and assessing the profitability of different mixes of customers and/or services. For example, after recognizing that attracting and retaining business accounts is the key to profitability (given the existing cost and revenue structure), a bank may want to add special services for business customers (Bamber & Hughes II 2001). Bank managers can also use ABC data to pinpoint opportunities to improve production (or service) processes and trim costs by reducing: (1) the cost per unit of the activities, or (2) customers' consumption of the activities. For example, highlighting the costs of each activity may help a bank find ways to trim the indirect cost per unit of the cost driver. The bank may train customer account inquiry representatives to handle more calls per hour. This can reduce the cost per call if the bank can then handle the call load with fewer customer service representatives (Bamber & Hughes II 2001). To cut the per-check cost of paying checks, a bank might purchase more efficient check-processing systems. ABM can also help the bank reduce customers' consumption of activities that drive costs (while maintaining their business). For example, a teller service, a relatively high-cost activity, provides a promising starting point for managers looking for significant cost savings. Management may be able to develop creative lower-cost alternatives to reduce customers' use of expensive teller services, such as encouraging customers to use Automatic Teller Machines (ATMs) and to switch to Internet banking. The bank may also develop a web-based account information site that allows customers to access their accounts through the Internet, thereby answering many of their own questions, and reducing the number of inquiries to the customer service call centre (Bamber & Hughes II 2001). Chapter 4: ABC Implementation in a Bank As the findings in the pervious section suggest, perhaps a better option for Banks to measure and manage customer profitability incorporates aspects of activity-based costing. Activity-based costs (ABCs) determine the true costs of activities, transactions, delivery channels, service channels, and corporate overhead. ABCs break down all front- and back-office transaction processes into activities and possibly sub-activities. When used in conjunction with actual transaction volumes, ABCs determine the time and resources consumed in performing each activity by product, by customer, and by channel (Prunty 2001). To implement ABCs in a bank, first we need to identify the main activities which are carried out. The three main activities can be identified as (Bamber & Hughes II 2001): 1. Paying checks 2. Providing teller services 3. Responding to customer account inquiries at the customer service call centre Next, the main costs associated with these activities need to be identified. In service industries like banking, labour (personnel) costs dominate (Bamber & Hughes II 2001). This can be found by asking each employee to fill out a short questionnaire to find out how the employee spends his or her time. After that an in-depth personal interview with each employee can be conducted to find detailed information. This combined information can be used to estimate the percentage of time each employee spent on each of the three activities: (1) paying checks, (2) providing teller services, and (3) responding to customer account inquiries. The other (non-labour) resources can be measured about each of the three activities consumed (Bamber & Hughes II 2001). For example, to the "responding to customer account inquiry" activity: (1) the cost of toll-free telephone lines at the customer service call centre, and (2) depreciation on other equipment and facilities the call centre personnel use. Similarly, the percentage of time the bank's information system is used for check processing and providing teller services (vs. other uses such as compiling periodic financial statements) can also be estimated, to determine how much of the equipment's depreciation to assign to the activities "paying checks" and "providing teller services." The estimated activity costs can be based on previous years' actual data, which is usually easily available (Bamber & Hughes II 2001). In future the budgeted indirect cost rates for each activity can also be determined. The advantage of budgeted rates over actual rates based on the prior year's data is that budgeted rates (budgeted cost associated with the activity divided by the budgeted quantity of the activity's cost driver) can incorporate expected changes in costs and operations. Now, the activity cost pools and cost drivers need to be determined. A cost driver is a factor, such as the number of checks processed, that causally affects costs. For example, the costs associated with the activity "paying checks" rise and fall as the quantity of the cost driver (the number of checks processed) rises and falls (Bamber & Hughes II 2001). Activity Cost Pool - Activity Cost Driver Paying checks - Number of checks processed Providing teller services - Number of teller transactions responding to customer Attending account inquiry calls - Account inquiries to customer service call centre To further identify and classify activities in a bank four categories of activities need to be studied which will help to group similar activities in activity cost pools and identify cost drivers. The classification is as follows (Bamber & Hughes II 2001): 1. Unit-level activities are performed for each unit of product or service. "Paying checks" and "providing teller services" can be identified as unit-level activities. 2. Batch-level activities are performed for groups of products or services rather than for individual units. For example, setting up machines to produce a batch of a specific product is a batch-level activity. In a bank the processing of cheques at end of the day can be a batch level activity for the batch of cheques received that day. 3. Product-sustaining activities, service-sustaining activities, and customer-sustaining activities support individual products, services, or customers. "Responding to customer account inquiries at the customer service call centre" can be termed as a customer-sustaining activity. 4. Facility-sustaining activities are general activities that support the organization as a whole, but that cannot be traced to individual products or services, such as the CEO's activities. Because it is not possible to identify cost drivers for facility-sustaining costs, many ABC systems exclude these costs, or allocate them using a general allocation base. Expense allocations have been considered common practice for assigning channel costs to customer relationships by many banks (Prunty 2001). However, they do not reflect behavior or the true cost of service or delivery. Banks' business strategies to open or close a channel or to shift customers to a channel are destined for failure if they are based on the traditional costing approach. This discussion is further carried out in the next chapter in which the last of the three main questions of this research is answered which is about costs involved in traditional and e-banking costs. Chapter 5: Cost Structures for Traditional vs. E-Banking The major downfall to expense allocations is that banks assume all customers are created equal (Prunty 2001). For example, a customer who banks solely through the Internet channel also assumes charges for a bank's other channels. This method of costing does not provide the level of detail required to analyze how channel-specific customer interactions influence total relationship profitability. The movement toward a less-centralized distribution system affects both customer convenience and banking costs (DeYoung 2001). Convenience may increase because customers do not have to travel as far to perform basic banking transactions, and banks could potentially have lower overhead expenses as the number of full service branches declines. However, these distribution channels are not perfect substitutes. Checking an account balance, transferring funds, paying bills, and applying for credit cards do not require personal contact or a large physical space, and hence are well suited for delivery over the Internet channel (DeYoung 2001). But setting up a new account, applying for a business loan, retirement planning, closing a mortgage and other complex transactions often require a secure physical space and/or person-to-person communication. Furthermore, getting cash is impossible over the Internet and requires either branches or ATMs. Because some banking transactions are more conducive to some channels than to others, and because some customers prefer certain delivery channels, most (but not all) banks deploy a combination of delivery channels. The cost of selling and delivering banking products and services can vary significantly from customer to customer (Prunty 2001). Therefore, the success of any multi-channel strategy depends on how well banks manage the true costs of servicing customers through specific channels. Channels should be considered as outlets to improve customer service, communication, and product delivery, but they must also be thought of in terms of the cost to build them, the time and resources consumed by them, and the total revenue derived from them. Banks' costing initiatives must include all of the components that comprise their products and channels (Prunty 2001). This holds especially true for electronic channels. Electronic channels are much more than the visible customer touch-point. The ATM channel is not only the physical device. The Internet channel is not only the Web pages. For both electronic and traditional channels, there are a number of back-office activities that support the front-office touch-point. To determine the total channel cost for customer transactions, banks must consider all front- and back-office costs associated with that channel. Many banks would only consider the front-office cost when pricing the product. However, there are a number of back-office resources and processing systems assigned to it (Prunty 2001). To price the product correctly, banks must consider both the front- and back-office costs. For example, if an institution charges a per-usage fee of .15 for the E-banking product, thinking that the cost is only .10, the bank will lose money on the product. Unless the product is priced to make a minimum of 1.76, the institution will never sustain its margin and will have 1.75 of front- and back-office costs to attribute elsewhere in the organization (Prunty 2001). The medium usage patterns are a direct reflection of customer preferences and behaviour; therefore, banks should quantify all costs and activities specific to those mediums (Prunty 2001). This requires institutions to track and record all customer interactions and transactions, along with the costs of those transactions. This detailed information enables banks to align revenues generated by individual customers with the cost of generating those revenues based on specific medium usage. As an example by DeYoung (2001), the simple financial statements displayed in table (Appendix, pg18) illustrate the potential financial advantages of the E-Banking strategy (DeYoung 2001). The balance sheet shown in panel A leaves out many items normally found on bank balance sheets, but it offers a reasonable representation of the composition of assets, liabilities, and equity at the typical commercial bank with 500 million in assets in 2000. The income statements are derived using the numbers on the balance sheet plus four additional numbers for the hypothetical 500 million bank: the average interest rate paid on deposits, the average interest rate (including loan origination fees) received on loans and securities investments, total non-interest revenues, and total non-interest expenses (DeYoung 2001). Three different versions of the income statement are presented in panel B. The first column presents the income statement for a hypothetical brick and mortar bank that pays on average an interest rate of 3.33 percent on its deposit liabilities, and earns an average interest rate of 7.50 percent on its investments in loans and securities. Given these rates, the brick and mortar bank earns an interest margin of 4.17 percent and has an interest margin-to-assets ratio of about 3.75 percent. The bottom line is that the brick and mortar bank earns a 1.29 percent return on assets and a 14.33 percent return on book equity (DeYoung 2001). The second column (Internet bank 1) illustrates how the bank's profitability might change if it adopted an Internet distribution strategy, and if such a change in strategy allowed the bank to reduce its overhead expenditures by closing its brick and mortar branches (DeYoung 2001). Note that one of the main assumptions changes-non-interest expenses decline by a hypothetical 20 percent, from 15 million a year to 12 million per year. (Even if a bank closed all its branches and successfully shifted its customers to the Internet, non-interest expenditures would not fully disappear. The bank would still have some physical space requirements, it would have to increase its expenditures on computer equipment, and it would still have labour expense--the biggest expense at banks after interest payments.) Assuming no other offsetting effects, the financial impact of this change would go straight to the bank's bottom line. Return on assets (ROA) would increase to 1.65 percent, and return on equity (ROE) would increase to 18.33 percent (DeYoung 2001). As discussed above, these increased profits could be simply paid out to the shareholders, or they could be retained and used to grow the bank. The third column (Internet bank 2) assumes that the bank uses the hypothetical overhead savings to attract additional depositors by paying higher rates on deposits. In this example, the bank increases its deposit rate by a hypothetical 20 percent, from 3.33 percent to 4.00 percent. This change reduces the bank's interest margin from 4.17 percent to 3.67 percent, but its return on assets and return on equity remain the same as the brick and mortar bank's. Over time these relatively high deposit rates might attract a greater number of customers to the bank, allowing it to grow faster than its brick and mortar competitors. (Although not shown in table (Appendix pg18), a similar result could be accomplished by reducing the interest rate charged to borrowers from 7.50 percent to 6.834 percent, while leaving the deposit interest rate unchanged.) (DeYoung 2001). The central financial characteristic of the E-banking model is reduced overhead spending. By eliminating its physical branch locations, the bank can substantially reduce expenses on rent (or mortgage payments), on upkeep and maintenance, and, most importantly, on the labour needed to run branch locations (DeYoung 2001). Banks can use these savings to increase the per-unit profit on their existing business. Or banks can use the savings to increase their market share, attracting customers by paying higher interest rates on deposits or charging lower interest rates on loans. Although this will reduce the bank's interest margin, increasing the bank's size could create beneficial scale effects by spreading administrative costs over a greater volume of business or allowing the bank to market fee-based services (like investment or insurance products) to a greater number of captive customers (DeYoung 2001). Chapter 6: Conclusion & Recommendation The detailed information provided by the ABC technique can help banks to regulate and reduce some cost components. Understanding of the IT cost components of e-banking distribution channels gives an insight about the fixed and floating components of IT expenses and thus can create the preconditions for cost saving and in turn to increase the profit. The findings presented above confirm the benefits of ABC costing for E-Banking with the ease and efficiency in identification and cost allocations to all of the activities. The faster banks can apply accurate customer costs and relationship behaviours to their profitability models, the quicker they can begin to make better-educated management decisions about opening or closing channels or migrating customers to or from them (Prunty 2001). And while benchmark data (for example, Federal Reserve functional costs) may act as a proxy for institutions' cost structures, there is no substitute for developing actual behaviour-based costs and aligning those costs against the revenue of individual customers, accounts, and products. Most banks still do not conduct the level of analysis required to fully evaluate their current channels and certainly not for prospective channels. Successfully integrating channel strategies requires more from banks than simply calculating individual customer relationship and product profitability information (Prunty 2001). To achieve the maximum return on their investments of time and resources, institutions should take their profitability initiatives to the next step: understanding and interpreting the details behind the calculations. Only then can banks begin to fully exhaust all of the practical business uses for the information across their entire enterprises. As the findings show there is a significant decrease in costs incurred in E-banking channels rather than the traditional ones. Increasing customer expectations for product and service delivery are forcing many banks to place an increased emphasis on the effective integration of their electronic and branch-based delivery channels (Prunty 2001). To do so successfully, institutions should first have a complete understanding of the individual product and service-level requirements of their customers, along with the costs associated with those requirements. These efforts will enable banks not only to identify the behaviours and preferences of their customer relationships but also to react to them before they can harm their bottom lines. Only then can banks begin to deliver the best combination of banking products and service channels to ensure long-term profitable and potentially profitable relationships. Appendix TABLE: Potential advantages of Internet model (millions, unless stated otherwise) A. Balance sheet Cash 40 Securities 140 Loans 310 Plant and other 10 Total assets 500 Deposits 450 Other liabilities 5 Equity 45 Liabilities and equity 500 B. Income statements Legend for Chart: A - Brick and mortar bank B - Internet bank 1 C - Internet bank 2 A B C Assumptions Rate on loans, securities (%) 7.50 7.50 7.50 Rate on deposits (%) 3.33 3.33 4.00 Noninterest income 7 7 7 Noninterest expense 15 12 12 Interest revenue 33.75 33.75 33.75 Interest expense 15.00 15.00 18.00 Net interest income 18.75 18.75 15.75 Noninterest income 7.00 7.00 7.00 Noninterest expense 15.00 12.00 12.00 Before tax profit 10.75 13.75 10.75 Tax (40%) 4.30 5.50 4.30 Net income 6.45 8.25 6.45 Return on assets (%) 1.29 1.65 1.29 Return on equity (%) 14.33 18.33 14.33 Source: (DeYoung 2001) References Bamber, Linda Smith, Hughes II, K. E., (2001). Activity-Based Costing in the Service Sector: The Buckeye National Bank. Issues in Accounting Education, 07393172, Aug2001, Vol. 16, Issue 3 DeYoung, Robert, (2001) The Financial Performance of Pure Play Internet Banks. Economic Perspectives, 1048115X, 2001 1st Quarter, Vol. 25, Issue 1 Feng Li, (2001). The Internet and the Deconstruction of the Integrated Banking Model. British Journal of Management, 10453172, Dec2001, Vol. 12, Issue 4 KPMG (2000). Awaking Giants: How Europe's Big Banks Will Win the e-Commerce revolution. KPMG, London Middleton, P. (2000). Customer-Centric Management. In: The Future of Finances Services: Winning in the Age of Technology, pp. 7105-7110. Technology Publishing Ltd/ KPMG, London Prunty, Joseph, (2001). Implementing Behavior-Based Profitability to Achieve E-Commerce Success. Bank Accounting & Finance (Euromoney Publications PLC), Fall2001, Vol. 15, Issue 1 Read More