Wag the Dog

I experienced one of my greatest epiphanies during the work with my final thesis at the University. Like many other students, we wanted to challenge what we had been taught during the last 3.5 years and decided to challenge the traditional product pricing principles by applying the brand new concept of Activity Based Costing (yes, I am that old) to develop a better calculation model for a real company. The company that we selected is an electronics subcontractor that assembles circuit boards and you can imagine our enthusiasm when the CFO confirmed that their cost-plus calculations were arbitrary when they assigned the indirect costs to the products. But it didn’t take long for as to share the CFO’s frustration when we tried to come up with better ways to allocate the indirect costs that was the lion share of the total costs for the products. That is when I had the epiphany and came up with the “cost driver pyramid”. It was not that hard for us to explain what drove the indirect costs when we put the product in a context and looked at the different levels all the way from client, product group, product type, batch, individual product down to the components that each product consists of.

I will argue in his blog post that banks should take the opportunity to put their products in a larger context when they apply the new risk weights implied by Basel III to get a complete view on the performance of their products. You may call me cynical but I am certain that it will not take long after the top executives have seen the revised risk-adjusted performance numbers on the products until they will ask how to restore them to the old levels. And IT, that constitutes 15-20% of the total costs to a bank, is probably one of the largest indirect costs that are allocated to the products. Who knows? Increased insights into how the products actually drive IT costs may very well trigger an epiphany on how to actually reduce the IT costs, not merely re-allocating them.

We have seen a fury with new regulations lately to reduce the risks that governments have to bail out financial institutions that are considered too big to be allowed to fail. The risk weights in the Basel III directive are not finalized yet but everyone knows that the legislation will hurt the Return on Equity when the banks are forced to inflate their balance sheet. The graph below is based on the calculations that Capgemini has done on the effects on the RoE of different business lines.

I have seen similar estimates from other management consultants so I think is fair to assume that the banking executives will not like what they see when they get the performance per product and they will say that action is required. One popular approach is to terminate unprofitable products. To some extent, we have seen that happen already when all major players in the Nordics have made an exit on proprietary trading. The electronics company that I referred to initially applied the same strategy and cancelled several contracts that were classified as unprofitable according to their traditional calculation model. So, you can imagine the face of the CFO when we presented the differences in profitability on their product groups using our vs their model.

I have firsthand experience on what may be the best possible example that products drive IT costs. Years ago, I was engaged to help a Nordic bank decide on how to redesign their system architecture to align with their strategy to grow on the equity market. I still take pride in how we mapped their business strategy using a simple model into a crisp recommendation on a target architecture with standard software that would help them slash their transaction costs. Though, we experienced a deep valley of despair when one of the project team members exclaimed that we cannot pursue a standard system since it probably wouldn’t support one of their legacy products. As she explained, they had been forced to implement so many patches over years to handle this product that certain modules were restricted and had to be maintained by designated experts that had the history on the patchwork. The client quickly realized that they had to cancel the product but imagine the alternative cost if some decision maker had dismissed the system that has improved their competitiveness with an ironic “the devil is in the details”. It would really have been the perfect illustration of the joke “wag the dog” if he long tail of legacy products would dictate the future of the bank.

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