The development of standard costs not only provides a basis for establishing the relative profitability of services but more importantly enables the development of strategic options for individual market segments.
8.4.1 The Pareto law Effect
In the banking industry, as in other industrial sectors, the Pareto law effect is normally found. In retail banking it is relatively common that 85 per cent of cost structure on staff, premises, central computer processors and even marketing expenses can be attributed to the bottom 15 per cent of the account base in terms of deposits. This is because the majority of accounts tend to be low on deposits and relatively high on transaction volume.
The traditional bundling of branch operations, where ‘free’ current account balances were used to cover losses on transaction business, is now giving way to a recognition of the cost of branch operations as interest rate spreads diminish.
Banks now increasingly accept that they must recover transaction costs from those customers which incur them, while rewarding with market related interest payments the accounts of low transaction volume and high relative balance customers. As a consequence, many banks are introducing prices related to costs for transaction business, charging differently for machine versus human teller transactions and offering different interest rates for different levels of account balance. A few are going further and actually attempting to shake out unprofitable accounts by discriminatory pricing or deliberate account closures, while introducing superior service at higher prices to preferred accounts.
In the New York retail market Citibank subdivided its retail account base into seven segments. Those with $15,000 or more on deposit were given service by a personal financial advisor in a pleasantly equipped part of the bank. Customers with lower balances were allowed to use the human teller system but were also encouraged to use teller machines. Customers with less than $1000 in deposits were encouraged to bank elsewhere.
This system of segmentation created significant consumer resentment and eventually segregation against low value accounts was technically withdrawn.
However, by this time Citibank had largely purified its customer base. This purification even included those corporate accounts for whom Citibank undertook payroll processing and where the bulk of employees instantly withdrew their funds after pay day. As a consequence, because the bank was able to offer a superior service to its better customers by partially eliminating worse customers over a period of five years, it actually doubled its share of the New York retail market. At the same time, the bank reduced its branch network from 260 to 220 branches and its staff from 7000 to 5000, while achieving 70 per cent of cash withdrawals on ATMs, thus substantially reducing its overall cost base.
As a generalization, therefore, you should carefully examine the cost and revenue structures of both customers and services. As shown in Figure 8.1, the probability is that 20 per cent of customers and 20 per cent of services will contribute 80 per cent of revenue. Therefore, rather than continuously adding customers and services indiscriminately and thereby increasing costs but not necessarily profits, look carefully also at rationalizing those accounts and
1
Customer revenue
80%
i
20%
t
Service revenue
80% -20%!
20%
No. of services
No. of customers 20%
- 80 %-
80%
_L_ /
Customer account candidates for
-T
purification
Service range Candidates for rationalization
Clear customer/
service candidates for elimination
Figure 8.1 Customer service revenue matrix
services which may be making losses. The 80 per cent of customers and services which only contribute 20 per cent of revenue are candidates for service rationalization or account purification, and that group of customers and services which intersect in the bottom right-hand corner will almost certainly be running at a loss. Such services or customer accounts should clearly be eliminated unless they can be justified for specific strategic reasons.
8.4.2 The Experience Effect
In many industries a regular decline in costs has been found to occur with cumulated experience. For example, as shown in Figure 8.2 which plots the log of transaction cost in real terms against the log of the cumulative number of transactions, the marginal cost of the one millionth transaction is $1.00. As the bank gains in experience it learns how to do the transaction more efficiently as a result of improvements in systems, staff skills, mechanization, and the like. Thus by the two millionth transaction the marginal cost in real terms has fallen to only 80c and by the four millionth to only 64c. This transaction is therefore said to exhibit an 80 per cent experience effect curve, as every time the cumulative number of transactions doubles there is a 20 per cent decline in costs.
This cost decline does not occur automatically; the assumption is that management is constantly seeking to improve its productivity of operations.
Note also that the experience effect applies only to the value added element in
Figure 8.2 Transaction experience effect curve
the provision of a service; that not all competitors need be on the same curve; that
‘shared’ experience effects are possible as a result of synergy between services using the same facilities such as central processing units; and that the experience effect is volume and not time related.
Cumulative transaction volume Figure 8.3 Experience effect strategy
Traditionally, experience effects were not especially significant within the banking industry due to regulatory barriers enforcing similarities in cost and price structures. However, deregulation coupled with the introduction of technology-based alternative distribution systems is transforming this pattern.
As a result competitive strategy, especially in services affected by electronic technology, favors the adoption of an experience based strategy as illustrated in Figure 8.3. Here bank X has achieved a cumulative transaction volume of Vl7 and as a result the bank’s marginal cost of further transactions is Q. To achieve a satisfactory margin for this service the bank offers it to customers at price P, which establishes the market price. Bank Y in contrast has only a cumulative volume of transactions V2, and assuming it is operating on the same experience curve will have achieved a marginal cost of C2. However, since the bank must be competitive it can only charge price P for its equivalent service, and hence while still profitable must operate at a lower margin than bank X. Finally, bank Z, which has only achieved a cumulative volume of V3, will have a cost of C3. This is above the price P, and hence if bank Z wishes to continue to offer its service it must be prepared to lose money on every transaction.
In high experience effect markets such as electronic banking the achievement of cumulative volume therefore tends to be especially important. As a consequence pricing strategy should endeavor to develop market share rather
than achieve short-term profit maximization. Similarly, to increase the effect banks should drive for shared experience by maximizing the range of services using the common delivery system.
In both corporate and retail electronic banking the experience effect is high. As a result, banks like Citibank and Chemical Bank have driven for high market share but by different methods. Citibank has operated indepen¬
dently, building its retail ATM and corporate terminal base as rapidly as possible and utilizing shared experience effects by increasing service range and geographic coverage. Thus its corporate electronic banking is offered on a global basis and by 1984 the bank had some 14,000 terminals on customers’
desks offering an increasing array of services. A joint venture with Reuters also enabled Citibank to gain access to the financial information services market and potentially to provide services to Reuters’ 39,000 worldwide terminals.
By contrast, Chemical Bank has not sought to take on Citibank head to head but has built cumulative volume and amortized central processor and software development costs over around 8000 worldwide terminals. These terminals, however, have not been placed by Chemical Bank but rather by some 80 bank franchises of its Chemlink corporate cash management systems in the USA and elsewhere.
Competitors unable to build their cumulative experience in electronic banking face similar costs to those of the market leaders but will be unable to price their services to ensure an adequate contribution. Unless such organiza¬
tions can achieve superior productivity and so move to another, steeper experience curve they should either withdraw from the market, join franchise arrangements with other banks or non-banks, or be prepared to accept that electronic banking will not be the fee income and profit-generating service that many believe it can be.