Precise profitability measurement: a dynamic approach is to use analytics and to fine-tune the overly broad distinction between 'fixed' and 'variable' costs.

• Author: Weissman, Rich

THE BANKING INDUSTRY SHOULD BE PROUD OF ITS INNOVATIONS in providing state-of-the-art customer transaction and delivery systems. Both commercial and retail customers can now access data through a variety of channels including online, mobile, POS and ATM networks. The industry stands out in what it has delivered in the area of customer access to money and information.

Yet, while global transactions can move at the speed of light, the industry has not been able to get its arms around an area critical to its success: profitability. The industry still struggles with understanding what a transaction costs, what an account is worth, and what are the break-even points.

One would think that these fundamental issues would have long been addressed, but that is simply not the case. Most banks haven't a clue about which products, customers and markets are truly profitable--and what are all the dynamics relative to the cost structures behind these profitability numbers.

The industry has been sorely lacking in analytics, and that's what must become the next phase in industry growth. Banks can no longer accept the guessing game behind profitability, and the industry has to address how to pinpoint costs in a serious and detailed way.

[ILLUSTRATION OMITTED]

Costs: Fixed versus variable

Today, most banks think of noninterest expenses in terms of either fixed or variable costs. Fixed costs refer to overhead and variable costs refer to activities that are product or customer specific. As a broad concept, that's fine, but most often a fixed cost is defined as "x" amount of dollars per customer or per account, and a variable cost is defined as a "y" amount of dollars per transaction or activity. More often than not, fixed costs represent the majority of noninterest expenses; and for both fixed and variable costs, the values remain constant over time.

Right? Unfortunately not. This simplistic approach misinforms the bank about its true cost structure.

Although costs can be thought of in terms of fixed vs. variable, each type is dynamic and constantly changing as the bank's cost structure and customer base (and its transactions and behaviors) change month-to-month. Costs are not static, but highly fluid. The traditional way of thinking about costs is through a static framework, which causes the industry to miss the mark--and to miss it big time.

Here are three of the key issues that must be overcome in order for the industry to begin to get its arms around costs...