22 JunThe Cannons of Cost Allocations. Effort Based.

Last week, the Blog introduced the idea of there being four cannons of taxation. Four rules, or rather guidelines you should observe when sharing out costs. This week we take a closer look at the first of them; Effort based.

People & systems. Those are the two big cost blocks. Rent matters too, however invariably that is charged on some combination of headcount and the actual space occupied. Systems and IT in general we will deal with later. That leaves us with People.

Shared and Dedicated Services: this is a game of two halves, but very uneven ones. Dedicated services are ones you provide for a specific business, shared are those that serve multiple businesses. They are the more common type in the modern banking world where the continuous striving for synergies and efficiencies has meant we have a number of pooled resources.

Dedicated services: are pretty straightforward. You can pass on 100% of those charges to the business that you support. There are still some potential pitfalls though:

Regional & entity level allocations. If you have a service centre, be that local, nearshore or offshore, the transactions you process will come from a variety of sources. You almost certainly need to be able to differentiate at both the region and the entity level. Without that you will have a large blob of costs in one region or entity.

Single product with many users. My favourite example is Foreign Exchange. FX is like Wimbledon Common; everybody can use it and many do. It has to a very large extent replaced money markets as a daily funding vehicle. So, although you may may have a single FX business, lots of business lines will use that product. At the very least, you will have the Treasury funding the securities businesses of the bank.

So, in practice. large amounts of costs are for practical purposes shared.

Shared Services: I would suggest dividing up your headcount, or FTE’s as they are sometimes known into two pools.

The first are “Control & Oversight Resources”; this is the work you do every day one way or the other. Checking for breaks, informing the cash management team of your positions. These are tasks that will take the same amount of time eery day of the week. It should not include the effort to resolve the issues though. Those costs should simply be divided by trade count to arrive at a cost per trade.

“Trade Count”. Beware what you consider to be “trade count”. Here’s an example from a payments business. with one bank I was looking at some changes that would reduce external banking charges by some 40%. Reduced cost of about $1.5 million a year for a $500k first year cost and $100k thereafter. By the established laws of economics any firm should be round to the bank manager asap to borrow the money and get the work done. In fact that return is so good, you could borrow on your credit card and still make money. Then came the issue of who pays? Which, correctly, was turned around into “who is going to benefit, or qui bono?” This is a perfect way to phrase it; if you are going to benefit, you ought to bear the charges of the improvement. What happened next is far from perfect. Looking at how the costs for using external banks were collected up, we discovered a very interesting set-up. Every time there was a debit charge at a bank for costs, however small or large, those costs were immediately passed down to the trading books based on the number of trades booked.

Like crime in multi-story car parks, this is wrong on so many levels. The first order of wrong is “visibility”; some trading books were seeing a charge for amounts less than $20. All that does is annoy people. It is not clear what it is for and it is too small to chase. The second order of wrong is “wrong measurement”. Trades are not the same as payments. In an investment bank, the FX trades will likely have the biggest nominal number of outright trades booked. But, lots are settled via CLS, lots are netted. The third order of wrong is “no responsibility”. By failing to collect the costs up and simply passing through the small lumps to trading books, nobody was really on the hook for managing these things. A so called Network Management team negotiated the fees, but was not in the middle of the charging.

The other pool of costs should be the “Exception Processing Resources” These deal with specific follow-ups, for example manually re-booking trades for a certain desk because due to a bug, they cannot be booked the right way the first time. As a rule of thumb, you would expect in today’s banking environment that if this is a 20:80 game, with 80% of the effort going to exception processing. The 80% spent on the exceptions should be charged out on time spent. If you were a law farm, this would be by billable hours. Now depending on the area of the bank you are in this concept might work, but not everywhere. It will work in IT where resources work on particular projects. Using some form of time sheet reporting generally does a large chunk of what is needed. Quite often though, this has its limits; in the ideal world there is a project code to which all areas of the bank can bill time.

My experience has been that any project billing is departmental and it is not possible to collect up and report on costs across departments. In Operations areas, this is much harder, because you are servicing trades and not projects. In this case, a daily time allocation is not practical. The next best proxy is a periodic assessment of what the exception processing tasks are coupled with an analysis of how many trades that covers and whose trades they are.

Percentage or Ticket Cost? Important question. If you know that say 40% of your resources are spent on processing exception tickets for a particular desk, you could just allocate that percentage of your costs. Alternatively, you could work out a ticket charge and charge that way. That works as long as you are not on a fixed price deal, like say your builder offering to do an extension for a fixed fee. Back-office areas are cost centres. A ticket fee approach or what is more formally known as Activity Based Costing has some really useful benefits. Let’s assume you budget that an Interest Rate Swap trade costs $50 to book and $2 to process a coupon. If you charge that to a trader’s book and offset that against your costs, chances are they will never exactly match. You will either over or under recover. Pain, I hear you say. But, like killing yourself in Boot Camp at the gym, from pain comes gain. That process of monitoring the recovery will of course require a few hours of pouring over a spreadsheet, but it forces a whole load of accountability and quite frequently. If you over recover, then chances are volumes were up. Happy days, give your clients in the front office a refund. If you under recover, that might be because volumes are down, but you are covered on that one and can charge. Or your input costs might be too high and then begins the painful, but therapeutic defense against the internal cost allocations. Generally, Napoleonic Law is applied. Somebody allocates internally, you get the charge and you are guilty until proven innocent. I have only ever heard of one shop, the now defunct Bankers Trust, where you had to accept incoming allocations. But, from bad will come good. You will challenge the costs. In the alternative model, where you allocate by %‘age, you might get challenged once per year about what you hand out and you are unlikely to challenge what is coming in to you.

Lessons Learned: Work out what is shared and what is dedicated. Where things are shared, activity based costing or ticket charges can be therapeutic, or perhaps cathartic, but from the bad pain will come good. Make sure that the key you use to allocate has some basis in reality. In the dark moments of dealing with this stuff, take some solace that your pain is shared. Loads of your fellow professionals are in the same boat, but you need to do this to encourage good behaviour.

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