Posts Tagged ‘profitability’

Truths in Cost Management

Sunny cloudsOne of the most dramatic changes that has occurred in Institutional Banking since the financial crisis hit in 2008 is an increased focus on management of costs. This is isn’t anything incredibly new. Financial firms have been focusing on cost management for years. What has changed is an increased intensity and urgency due to margin compression driven by increased regulatory pressures and more aggressive competition for a quickly shrinking client wallet.

Many banks have created teams fully dedicated to the analysis of their costs. We’ve worked with a few of those organizations to help them define the scope of their work. It’s important to determine upfront what kinds of costs will be targeted for analysis and what will be on the table for aggressive management.[more…] The sizing of the initiative is critical in order to make sure that expectations are in line with what can realistically be achieved. Senior management have to be on board with most of the changes that the analysis identifies. It’s all too common for management to have high hopes only to back down when they perceive that they are cutting too much into meat and bone.

It’s important to get comfortable with a few truths:

  • Cost efficiencies in some cases will only come from additional investments in the platform and will be realized only some years later.
  • Cutting costs implies in many cases a cutting of some revenue streams
  • The perceived “fat” that people talk about in an organization is not a discrete element separate from the productive “meat and bone”. Most banks now are running pretty lean, so the exercise is one of objectively evaluating prioritization of businesses, functions, and initiatives.
  • Every business or project has their merits which should be fully understood before any rash decisions are made about them, especially…
  • Projects with longer horizons often have less potential impact that is less visible on the organization so they have higher risk of being cut. The long-term strategy of the organization should weigh heavily upon evaluation of these.
  • Cost and profitability analyses use a great deal of assumptions to come up with their results. All layers of management who are part of the cost management decision-making process must be well-versed in these assumptions to ensure that implications of decisions are well understood.

I’ll be writing more about cost management in the next few posts as its a topic that seams to be top-of-mind for many managers as they plan for 2014.

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Measuring Client Profitability in Institutional Equities

BPCThe Institutional Equities business is a unique animal relative to its Capital Markets peers, with the big distinction that no one individual is responsible for revenue generation for any given account. Clients pay en effective lump sum, through trading, that goes to compensate the broker for a myriad of services. Between research sales, sales trading, program traders, electronic sales, research analysts, strategists, economists, and corporate CEOs that the brokers facilitate meetings with, the contact points can be large and hard to keep track of, making it a particularly challenging business to manage profitably.

Targeting Profitability

Success in the Equities world isn’t just defined by the amount of revenue coming in the door. Strategically, brokers need to ensure that the business coming through is profitable. There are a number of implications to this statement: [more…]

– Control of a broker’s profitability is driven by a delicate balance between targeting revenue opportunity and optimally managing expensive resources. Managing how resources are distributed to clients is the most effective way to increase profitability. Costs can be managed down through expense management initiatives to some degree, but these can only go so far given that the majority of expenses are compensation related which are market-driven. This is assuming, of course, that the firm is on a growth strategy.

– Management needs to develop capabilities to measure and track profitability at the client level so that they can have an ongoing tally of the impact their resources are having on overall profitability.

– As revealing as an understanding of an account’s profitability is, it’s critical to understand the future potential revenue for each account. In addition, managers need to develop a view on what resources are required to capture that potential revenue for any given account, and develop plans to migrate resources for lowest revenue potential to highest revenue potential accounts.

– Firms need to be willing to concentrate their resources towards the highest return accounts, meaning that they need to entertain culling accounts. The idea of cutting off revenue generating accounts is not intuitive for many managers, so this has to be handled in a methodical and intelligent way. More on this is a future post.

Profitability Analysis

Developing a detailed profitability analysis of accounts is a critical step in the process to maximize profitability. First, managers need a clear understanding of revenues across all Equities business lines, specifically an agreement what contra-revenue items (CSA, commission splits, third-party broker fees, trading loses) to subtract from gross revenues to reach a net revenue number that reflects true retention. These vary from sub-product to sub-product, where the dynamics of block cash equities differ from programs which differ from equity derivatives. Differing methodologies reach different conclusions, so it’s important for managers from all business lines agree on approach.

The second step, allocation of resource costs, can range from simple approaches that allocate using simple rules to highly complex allocation methodologies that attempt to be scientific about measurement of time spent and derivation of detailed unit costs. The degree of complexity  should be dictated by the complexity of the organization and the amount of information that being captured, or are willing to invest to capture. Regardless, each resource type should be thought through individually to make sure it makes sense. Salespeople and research analysts could be done through periodic time-spent survey, through a time billing system similar to law firms, or activity capture through an integrated CRM system. Sales traders and program traders can be done through number of trade orders and time-spent survey. Middle Office can be done using number of trade order, or even better, number of trade orders weighted by client processing automation to allocate more costs to more manual accounts.

The results of the analysis should be a full income statement detailing a net income for each account. Because of the sometimes complex nature of this kind of analysis, we often find managers who want to circumvent the process, asking for instance, if we can create profitability analysis for just the top 25 or 30 accounts. While it is possible to estimate costs for a subset of accounts in order to create an income statement, we strongly advise against this because the goal of the exercise isn’t to create an income statement; the goal is to have an analysis that will allow managers to effectively manage resources by moving them from low profit/low potential accounts to high profit/ high potential accounts.

Analysis on the Analysis

The income statement is not the end of the analysis. In fact, we feel that this is just the beginning. The value of really comes from the ability to make sense of the new profitability data and create actions that change how the business is engaging with clients. A second layer of analysis using the profitability results should give deep insights into the structure and dynamics of the account base. Managers can categorize accounts based on type of revenue and intensity of resource consumption. For instance, grouping accounts that predominantly trade on block and consume a ton of research versus accounts that have send a ton of smaller orders and only consume research opportunistically. What’s important is to better understand the drivers of profitability (or lack thereof) and then create strategies around those drivers to maximize profits by targeting resources to the right accounts.

Future Potential

It’s tricky, and in some cases risky, to assume that you can easily increase profitability by taking resources away from unprofitable accounts and move them to profitable ones. Pulling resources from large, yet unprofitable accounts may risk large chunks of stable revenues and may in the end decrease profitability. Similarly, an increase in intensity on profitable accounts may not result in an increase in revenue and will effectively make these accounts less profitable. An important element in the overall analysis is estimating the future potential revenue of the account, and trying to understand what effort and what resources will be needed to capture that revenue potential. In many cases this is not a straight-forward analysis. Size of wallet, market share, right resource matching, depth of relationship – these are all considerations in identifying and quantifying opportunities. In some cases you want to make the account less profitable by dedicating resources in order to gain a foothold with a new product, which is something that many Equity houses are doing to capture chunky prime services business.

Working Smarter

We’ve seen a general reluctance by many firms to tackle the problem of understanding account profitability because they feel it’s going to be a significant investment in time and money, with results that are not immediately tangible (or at least not as tangible as hiring a salesperson who can easily bring in two million dollars or more if incremental commission just from their existing relationships). Our message to them is that there is most likely a lot of low-hanging fruit within their account base and this is the best approach to realize those returns. In addition, once the strategy and analysis are in place, which no doubt will requires some investment, the maintenance going forward will be inconsequential to even the most conservative gains.

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Measuring Profitability: Initial Questions

Over the past 10 years, the trend of measuring profitability of clients and products within financial companies has gained momentum, with a steep up-tick since the 2008 financial crisis. Managers have become interested, in some cases obsessively so, in understanding what nuclear parts (clients, products, initiatives) of their businesses are contributing to the bottom line and which are taking away from it. It’s become apparent that managing by looking only at business unit or desk level does not provide the right strategic insight necessary to compete effectively. Profitability analysis, when executed correctly, can significantly impact product pricing, resource optimization, process streamlining, and client relationship management.  We’ll talk further about uses and specific methodologies in later posts, but I want to address three main questions that I get asked when clients start looking at implementing a profitability discipline within their firm.[more…]

How complicate and detailed should the analysis be?

It goes without saying that the complexity of the analysis is largely driven by the complexity of the firm or business unit being analyzed. The key thing is to make sure that the analysis drives toward some kind of action, so it’s important to define the key questions you are trying to answer with the results. For example, the level of detail to determine whether a client is getting over-serviced is different from the detail necessary to perform a process reengineering project.

A lot of people, when in the throes of analysis, get bogged down on precision and complexity, which in many cases adds no additional directional insights.  In many cases many interesting insights can be gained from very simple analysis.  I recommend taking a look at a book by Douglas Hubbard called ‘How to Measure Anything’ which gives some useful cases studies.

Should I hire an expert or consulting firm?

I’ve often said that profitability/costing analysis is a specific skillset that is different from other finance or accounting functions. Absolutely it requires a command of the financial accounts, but it also requires a clear understanding of the underlying drivers that impact how the expenses are “consumed” by clients, products, or projects. This requires an understanding (and an ability to model) business process flows. Probably most importantly, it requires an ability to create useful insights from the model results once it has been complete. A consultant or expert in this area are usually very good at ferreting out and mapping underlying business processes and have experience turning the large mound of results data into actionable strategies. They don’t have to completely own the entire profitability initiative, but they can provide invaluable perspective on methodology at the beginning of the project and have an arsenal of profit-enhancing solutions once the profitability results have been created.

Should I bring in an ABC/ABM tool, or can I build it on Excel?

This is a tough question because most managers are extremely hesitant to invest too much at the beginning of a profitability initiative, which is completely understandable.  They want a cheap proof-of-concept first with one or two people, and Excel, which is a fine place to start. I would argue, though, that you should incorporate an ABM tool (such as Acorn ABM or SAS ABM) as soon as humanly possible, for three main reasons:

1)       As the model becomes more and more complicated, with incorporation of more clients, client segment, products, expense groups, and driver data, the harder it is to maintain and manipulate.  In the end, it’s usually one person who understands the model and if they happen to leave, it’s a massive setback.  ABM tools standardize the logic and methodology which make them much easier to endure a transfer of ownership.

2)      Allocation methodologies often lead to multiple allocations across the model, so transparency is lost almost immediately. In the end, you may be able to determine what is profitable or unprofitable, but not why. ABM tools maintain the integrity of multiple allocations, so you can always easily trace the assigned cost (to a client for instance), back to the financial account detail. Reconciliation then becomes a cinch rather than a painful two week exercise.

3)      Version control becomes a big issue as the model gets updated over time with new financial or driver data, or allocation methodologies change. ABM tools allow you to not only better organize and track version of the model, they also allow you to make changes that retroactively impact past models. This is absolutely required if you want to do period-on-period or trend analysis of results.

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Oboe Partners: What We Do

OWe established Oboe Partners as a strategy consulting firm with the philosophy that in order to deliver game-changing solutions to our clients, we need to provide not only market context, insight, and advice, but also nose-to-the-grindstone plans to realize the vision.  We have experience working closely with senior management of broker-dealers and asset managers on a variety of assignments that has helped them better operate in a market that is becoming increasingly challenging and competitive. Because of our experience in both the buy-side and sell-side, we understand the full investor value chain which helps us provide unique insights and solutions.

We start with an evaluation of the market space to understand market trends, competitor’s positioning, and most importantly a clear articulation of client needs. Next we do a full, unbiased accounting of our client’s market positioning, strengths, and gaps. Once we fully understand the market and our client, we create innovative recommendations intended to affect strategically significant change. Because of our extensive experience in not just strategy, but in implementation, we create plans for process improvements and platform investments needed to drive change and efficiency.

We’ve applied this discipline to many successful client projects, including entrance into new markets, new product launches, development of new platform capabilities, joint venture and other strategic alliances, and creation of efficiencies using technology and innovative organizational design.

Once these initiatives have been implemented, our engagements often extend to include ongoing measurement and benchmarking of performance. Because we have a strong capability in data and analytics, we help our clients develop analytical tools to help them measure success and deliver real-time information.  We’ve implemented performance dashboards, profitability analysis, and predictive modeling that helps our clients track progress and make changes that will steer their organization across the choppy competitive landscape.


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