Customer Profitability Analysis

Customer profitability analysis

Presented by-

Manisha Chourasia

Rashi Agarwal

Objectives• To identify the bank which treats its complaining customers best

• To measure market performance of banks regarding satisfaction and

perceived quality among complaining customers

• To identify customer-driven areas for potential improvement to add

value to overall service offering

• To establish and analyze customers’ attitudes towards the banks and

establish the strength of relationship with the individual banks among

customers with regards to the complaints process, complaints

outcome and complaints personnel treatment

• To track performance changes against baseline metrics, established in

2001

Meaning• Analysis that assigns revenues and costs to major customers or

groups of customers rather than to organizational units, products, or other objects. The results may direct organizational resources toward more profitable uses. It is an application of segmented reporting in which a customer group is treated as a segment. It is especially helpful when combined with an activity-based costing approach that determines which activities are performed for each group and assigns costs based on appropriate drivers. For example, activities, their drivers, and their costs may be classified as order level, customer level, channel level, market level, or enterprise level.

History of CPA• The banks currently uses a mixture of first

generation (Bellis-Jones 1989) as well as Second-generation (Lifetime) customer profitability analysis (Foster and Gupta 1994)

• Customer relationship profitability is the difference between relationship revenues and relationship costs, both adjusted for risk (Storbacka 1993, Rose 1991, Hartfeil 1996, Foster et al 1996).

Banks cost• The cost of the funds• provision for losses• overhead• deposit insurance• customer’s usage of bank services.

Expense components• Noncredit services• Credit Services

• Cost of funds• Loan administration• Default risk expense

Revenue components• Banks generate three types of revenue

from customer accounts:

1. investment income from the customer’s deposit balance held at the bank

2. fee income from services

3. interest income on loans

Activity based costing• Activity-based costing (ABC), a method of determining very accurate

operational and transactional costs based upon the activities associated with a particular banking process, is a great asset in helping drive customer profitability. But while driving customer profitability from ABC is desirable, it is not absolutely essential. Because the bank did not use ABC per se (legacy systems prevented us from capturing the necessary transactional data), it used a pseudo customer profitability value to calculate the true costs of serving customers and customer segments based on assumptions and average costs or revenues. No organization has perfect data. But banks need to understand if any issues with its data are consistent. If they are, then the bank can set targets, manage performance, and drive customer profitability from this imperfect data. By understanding the starting point, even if it is not an accurate one, the bank can be successful

Customer profitability The customer profitability for banks now means the profitability at the account

level. One customer can have multiple accounts with a bank. For example, a savings account, a car loan account, a housing loan account, a locker etc. The profitability can be calculated for each of these accounts. When we say customer profitability, it is the Customer P&L for the period. Then it can be rolled up for a customer. So a customer may not be profitable for a particular product but may give more profit from the other. Bank can use this information (if it has got integration of information done) to cross sell, up-sell or provide some discounts. The customer level information can also be rolled up to a ‘household’. This helps the bank to propose various products to the members of the family at their life-stage. This also helps not to propose same product to different members of the family. For example, proposing same housing loan to the same family may be a waste of resources. Customer profitability report can be provided by each product. This information can be analyzed and utilized by the bank for various purposes.

Customer Costs

Customer costs are calculated the same way as activity costs are calculated. Each activity that is mapped to a customer brings along an associated activity cost. The accumulation of those activity costs determines the customer cost. As with resource costs, the activity cost mapped to a customer is based upon the value of that driver as a percentage of the total drivers

• Acquisition and maintenance costs are allocated on unit basis over the life of the customer;

• Administrative costs are allocated on a short-term basis;• Overhead costs are not allocated over the life of the

customer• Allocate costs on product basis and indirect cost is

averaged and allocated on the customers. For example, automatic teller machines’ transaction costs, which can be directly traced to a customer by analysing that customer’s transactions.

• Direct expenses for distribution, marketing and commission are allocated to branches, advertising and according to purchases respectively

Target profit• The target profit is then based on a

minimum required return to shareholders per account.

• Target profit= (equity/assets)(total return to share holders)(loan amount)

Methodology• Determined the profitability of each account

each month, each customer’s total profitability has to be computed by adding together the profits or losses from each of his accounts.

• Determine the per customer per account cost associated.

• Deduct the cost from the revenue and the profit will be arrived

• LCPAM may be analyzed as follows:

• Identification of lifetime revenues and costs of a customer;• Customer who are unprofitable under first generation ( Short-

term ) may be profitable over the lifetime relationship;• Higher costs shall occur at the beginning of the relationship

and higher revenues shall accumulate as the relationship develops;

• Lifetime analysis differentiates costs into cost pools to which relevant cost drivers are attached and costs can be allocated into following costs pools, such as customer specific costs, general customer costs, and general corporate costs

• In banking profit drivers include deposit balance, consistent fee income, efficient lending practices, relationship building customers, aggressive retention of profitable relationships, and quality sales and service .Customer profitability must be measured over some time period.

Determining Customer Profitability Customer Revenue • Revenue is generally the most straightforward category to

determine. Companies usually have information that captures sales/revenue associated with specific customers.

• Other information needed may include customer discounts, rebates and other deductions.

• In the banking sector customer revenue is generated through product margins and fees

• Risk• higher risk products like unsecured credit should be the primary

focus of customer profitability analysis, because the higher risk products expose the greatest customer variations.

Calculation of investment income from demand deposit balances

• Analysis of Demand Deposits: Corporation's Outstanding Balances for November• Average ledger balances = ` 335,000• Average float = ` 92,500• Collected balance `335,000 - `92,500 = ` 242,500• Required reserves (0.10) ` 242,500 = `24,250• Investable balance ` 218,250

• Earnings Credit Rate:• Average 90-day CD rate for November = 4.21%

• Investment Income from Balances: November• Investment Income

= 0.0421 (30/365) (` 218,250) = ` 755.20

Banken Industries

Loan and Deposit Activity:Number of days in period 90Average Borrowings 4,100,000Loan admin. (annual) 0.70%Risk expense (annual) 1.00%Average ledger demand dep. balance 174,516Average float 60,112

Required reserve ratio 10.00%Earnings credit rate 5.10%Weigh. Avg. cost of debt 7.04%Percent of financing in debt 92.00%Weigh. marg. cost of debt 6.48%Bank tax rate 35.00%

Customer Profitability Analysis

Customer profitability analysis for Banking industries

Banking Industries

Loan agreementLine of credit 5,000,000Conversion period (years) 3Bank's base rate 8.00%% over base rate 2.00%Contractual interest rate 10.00%

Fees:Facility fee 0.125%Conversion fee 0.250%

Compensating balances% of facility 3.00%

$ bal req for facility 150,000% of actual borrowing 2.00%

$ bal req for borrowing 82,000Total Comp Bal Req. 232,000

Customer Profitability AnalysisBanking Industries

Loan and Deposit Activity:Number of days in period 90Average Borrowings 4,100,000Loan admin. (annual) 0.70%Risk expense (annual) 1.00%Average ledger demand dep. balance 174,516Average float 60,112

Required reserve ratio 10.00%Earnings credit rate 5.10%Weigh. Avg. cost of debt 7.04%Percent of financing in debt 92.00%Weigh. marg. cost of debt 6.48%Bank tax rate 35.00%


Banken Industries

Expenses # items Cost Total

Demand Deposit Expense

Home debits 4,187 0.23 963.01Transit items 15,906 0.12 1,908.72Deposits 90 0.35 31.50Returned items 33 3.50 115.50Account maintenance 3 6.75 20.25

Total transaction exp. 3,038.98Wire transfers 336 2.00 672.00Security safekeeping 13 4.00 52.00Payroll processing 3 1,500 4,500.00

Loan expense: Rate

Days in Period Amount

Total Expense

Loan administration 0.70% 90 4,100,000 7,076.71Risk expense 1.00% 90 4,100,000 10,109.59Interest expense 6.48% 90 4,100,000 65,477.79

Total Expenses ` 90,927


` per unit

Banken Industries

Revenues Rate

Days in Period Amount

Investment income from:Ledger balances 174,516

Minus float 60,112Collected balance 114,404

Minus required reserves @ 10.00% 11,440Investable balances 102,964

Investment income 5.10% 90 102,964 1,294.80Fee income 0.13% 90 5,000,000 1,541.10Loan interest 0 90 4,100,000 101,095.89

Total Revenue `103931.79

Target Profit Rate

Days in Period Amount Total

Target pretax return 18.00%Relevant fin. % of equity 8.00%

Target profit 18.00% 90 4,100,000 14,557.81

Total Profit Req. (Expenses + Target Profit) 105,484.88

Revenue - Expenses + Target Profit `(105484.88)


Conclusion• Customer cost and customer profitability is critical for a bank today.

Knowing total costs for particular processes and activities allows to

focus on reducing and controlling them. Knowing costs for a specific

customer allows to reduce, change or charge for activities/services

provided to them.

• The determination of customer costs and profitability should be

performed using activity based costing techniques. Although it

requires the availability of customer-related data, the calculation is

straightforward.

THANK YOU!

Documents

Customer Profitability Analysis