Importance of Product Profitability

This is one subject in the financial world that I have yet to figure out. Not how or why profit is important, however why is it that organizations that managed hundreds of thousands or even billions of dollars don't feel the importance of Product Profitability or even worst want to just bury their heads in the sand if they can't come to a conclusion as to if a model is at least directionally correct?

Being in marketing for as many years as I have, and then moved to the finance world four years ago I found that one of the reasons was "If it didn't come from finance, then it can't be trusted."  And the other is if it came from Marketing it is laughed off because that's the place with the colorful pens and paper they don't understand the numbers. Well after four years on the other side I'm here to tell you there is as much if not more voodoo science there than in marketing.


So then why is it that the financial world, where everyone is suppose to be financially savvy 60% to 75% of the products offered lose money?  And if it loses money, how heck can an operation stay in business.  There are a few reasons for it... and a lot has to do with a simple 80/20 rule, where 20% of your clients produce 80% of the profits, however it is more like 20% or less of your clients produce over 150% of the profits.

I always seem to answer a question that leads to more questions; 150% how can that be?  Well it's simple; somebody has to make up for those that are a drain to your institution or those that cost you money just to keep them around.

Here is an example:  Your Senior Management demands your branch increase the number of accounts in non-interest checking accounts, no balance requirements are given so what does marketing do? They run ads, provide give-a-ways, any thing to promote traffic.  At the end of the month your branch, which was producing 30 accounts, produced 60 accounts, twice your normal.  When reporting comes out everyone declares the program a success.

Now the real research begins, you find out the average balance of these accounts are $75 far below the $1,500 average balance your MCIF system says you have.  I will get in to product balance stratification a little later, however let's review a single account.


Here are a few more parameters; Besides being non-interest, the program provides free checks, you give a small gift valued at $5, there are no minimum balances or fees. NSF charges are at $35 each.  There are costs associated with opening an account which conservatively we will set at $25.


We can then get into a debate on whether the costs to maintain the account should be fully allocated or only relevant.  Fully Allocated would be a portion of all expenses related to the operation and salaries.  Relevant would be salaries and brick and mortar are just part of doing business and it will not be counted.  The real costs should be a combination of the two.

For this example we will use a fully allocated profit model which for a non-interest bearing account would cost right around $225 annually.  Also since a non-interest checking account provides the highest spread we will make the return at 5.34%.

Income is figured $75 X .0534 = $4.00 in annual interest  income.  The average NSF fee assessed to each account annually is 2.5 X $35 = $87.50.  Saying the average person will bounce 2.5 checks a year. The income for this account is $91.50 annually.

As for the costs, we use the Fully Allocated costs of $225 + $5 gift + 2 check orders at $8 + and a one time on boarding cost of $25 = an annual cost of $263.

($263.00) Expense
 $91.50     Income
($171.50)


For each account at $75 you lose $171.50 annually.  This is something you just can't make up in volume.


Now going back to a few things said earlier.  The average account balance for the product group was $1,500, you increase the interest income by $80, however your results are still negative.  You really need to look for those clients that will maintain an average balance of $3,300 or more just to break even.


Here are a few suggestions to look at your clients a little closer.  Most MCIF systems will allow you to look at a group of accounts and then stratify the balances of the accounts.  Once you do this you will see that although your average may be higher, you could have 60% or higher of clients that fall far below that average.


Now this piece here is what I've tried for years to get financial institutions to understand.  If you stratify your accounts, it should follow pretty true to what a client will maintain in their accounts.  So look at your break-even point and see what percentage falls below.  Budgets should be built on the majority.


Secondly NSF fees are one of those interesting facts that everyone has to look at now.  My preliminary research indicates if you have a new customer or one new within the first year and you assess an NSF fee on them one of three things will happen.  They pay the fee get ticked off and then close the account and bad mouth your company for the rest of their lives: Two they pay it and move on and most likely it will never happen again.  And three you council the client, wave the fee and hope you did the correct thing.  In all examples the one that happens the most is the client is assessed the fee and then they leave.  Producing a churn that strains budgets and staff.

I look at myself and it has only happened twice in my life.  The first stupid me I got mad at the bank and closed the account and then a few years back when I asked a teller to transfer money from my money market to my checking and for some reason it was moved from my money market back into my money market.


So don't rely on NSF fees in the future.  If financial institution are doing what is fiduciary correct for the customer we would teach them how to be better stewards to their finances.  Now I know there are some that just love to pay NSF fees, however if they don't mind bring them on.   


This brings us to the question, If checking accounts cost the institution for the majority of clients then why are they offered?  The answer is the same as any other retailer.  It is for the most part a lost leader.  At times stores will offer a product at or below cost just to bring in customers.  For the financial industry if you ask a customer were they bank 98% of the time they will tell you the company that holds their checking account.

So if this is the case checking is the core account.  Now if you can break even from it all the better, however if not, additional products and services need to be cross-sold to obtain a profit.  That is the very reason we look at households for profitability instead of a single account.


Keep in mind the more account types you make profitable the more profitable the organization becomes and this is the Importance of knowing and understanding Product Profitability.

If you have additional questions please feel free to contact me.