Key components of an actionable profitability framework
By Peri Pierone
While member service remains paramount, profitability is the foundation of any credit union’s sustainability and long-term strategy, and in today’s economic climate, determining key profitability drivers is more important than ever before. With compressed margins and increasing competition, it is imperative that credit unions have a complete understanding of how members, branches and products contribute to the bottom line.
So what are the key components of an actionable profitability framework? From a credit union’s standpoint, there are four basic components that drive profitability:
Funds transfer pricing (FTP). The key driver in a credit union’s profitability—allocates the credit union’s net interest margin to each account on its balance sheet based upon its cash flow characteristics. FTP is the most essential piece in understanding the profitability of members, products, channels, etc. An accurate FTP spread at the account level is essential for ascribing the value of funds providers and funds users with the credit union—it is essential for evaluating performance and making better product and pricing decisions.
Expense and income attribution allocates a credit union’s operating expenses to the various dimensions of profitability. This allocation is typically necessary for when certain account-level fees are booked to a single account for a group of members or products. The attribution of operating expenses has typically been associated with what is known as activity-based costing (ABC) methodologies. The ABC process results in a greater understanding of the overall costs of delivering products and services, as well as the key drivers and their effects on overall profitability. When done properly the organization understands its key cost drivers and areas of excess capacity. This information can then be used to support strategic decisions, indentify and measure process improvement initiatives and evaluate whether outsourcing certain operations would be more beneficial.
Capital assignment is the key ingredient to understanding the return on capital – a critical performance indicator for all businesses—by assigning economic capital based on the risk profile of an instrument or portfolio, along with the member and account type. Not all members and products carry the same risk, so to get an accurate risk-adjusted return on capital (RAROC) calculation, credit unions must take into account the appropriate risk profile. Economic capital assignments and the corresponding RAROC reveals how the credit union’s members, branches and products are performing based on their true contribution given their risks.
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