Measuring business value at BPM

Italy's Banca Popolare di Milano (BPM) serves the Lombardia region, whose economic success has attracted powerful foreign competitors. BPM set out to understand the process of value creation in order to maximize its shareholders' return on investment, and to this end, it implemented a cost allocation system using SAS. This system links costs and revenue to generate accurate information about the value created by each of the bank's business units.

How does a small to medium-sized bank with strong local traditions compete effectively against the global players? Banca Popolare di Milano (BPM) is a significant regional Italian bank with 1.3 million customers and €32 billion total assets. Its 700 branches are heavily concentrated in Lombardy, one of the wealthiest regions in Europe. BPM's core activities include retail, corporate and investment banking. Since the bank also has several subsidiaries with branches in London and New York, focused on wealth management, home loans and so on, its range of activities is quite complex.

Based in a region of high economic growth, BPM faces strong competition from banks that are interested in taking its business and that can easily outspend its investments. "Our competitors typically have parallel capital expenditures at least several times our own capability," says Andrea Rovellini, Chief Financial Controller at BPM. In order to compete effectively, it is imperative that BPM has a very accurate picture of its cost base, as well as a clear idea of the linkage between costs and revenues. BPM is a listed company, and if it is to continue to attract the support of investors, it must ensure that capital achieves at least an average return.

SAS meets objectives
BPM's first cost allocation project commenced in 2001, in conjunction with a credit risk management solution; at this stage, it had already achieved a good overview of revenue flows into the company. In 2002, BPM implemented its first cost allocation system, and in 2003, it started a project with SAS and Deloitte to link cost allocation to the profit and loss accounts at the business or service unit level. "Our main objective was to develop a cost transfer model that shows the real contribution to the creation of value by both the business and the service units," says Rovellini. In fact, the cost allocation system achieves a broad range of objectives that can be grouped under four broad headings:

• Manage and control costs to make processes more efficient, and optimize the sizing of operations and the usage of distribution channels.
• Support the management process with reference to product pricing decisions, new product design and rollout, and internal transfer pricing.
• Measure results according to various analytic dimensions such as business or service unit, products, and customer segments.
• Make strategic decisions on insourcing and outsourcing, capital allocation, and acquisitions and divestments.

Allocating costs per product
BPM built up the cost allocation model in four stages. First, it defined the dimensions of the analysis (such as responsibility centers and branch offices). Next, it defined the cost transfer methodologies, such as how to allocate indirect costs; it then implemented a set of procedures to price products. Finally, it designed the analytic tools that represented the results. "Our approach to defining the dimensions of the analysis can be viewed as a kind of ‘virtual outsourcing' model. We classify internal service units according to the type of services they provide to the various business line operations, simulating an organizational structure for the complete outsourcing of operating processes," explains Rovellini.

The five business units (such as retail and corporate banking, investment banking, asset management and others) reallocate their financial revenues and costs according to their role in revenue generation. The 40 service units (such as IT, back-office functions, credit control and central purchasing) reallocate costs to business units or other service units by offering "products" that represent production, commercial, distributional and managerial processes. These products are the structural element of cost allocation in the system, so each service unit has to define a "product catalog" setting out the content of the service provided, the costing and pricing methodologies, and so on. BPM has identified 100 macro products, 400 elementary products and 1,000 consumer items (subject to precise invoicing) that are exchanged between service and business units.

"Products have to be 'sold' in line with market conditions or as the result of negotiation between customers and suppliers," explains Rovellini. "We have an internal market in operation, with costs allocated either directly or at market values." Costs to the business and service units are then represented on profit and loss accounts, either "above the line" or "below the line" according to whether they are direct costs of sale or overheads. "For the first time in our company's history, we can treat every part of the organization as a profit center, rather than just as a cost center. We know what contribution our service units make to our profitability, so we have a much better understanding of value creation capacity along the entire value chain of our banking processes," comments Rovellini. SAS Financial Intelligence provides the basis for the cost allocation system and the implementation of the pricing methodology, as well as simulation capabilities for strategic planning. Multidimensional reporting also enables BPM to get a complete view of detailed cost allocation data from a variety of perspectives.

Attracting strong returns
Rovellini has identified several critical success factors in the project, most notably the consistency with value measurement principles, which ensure that the system is complete, transparent and consistent with external benchmarking. "People have to be able to feel comfortable with the way costs are being allocated," he says. It also had to be flexible enough to meet differentiated levels of sophistication. In terms of the technology, BPM was already very comfortable with SAS. "We wanted to be able to exploit data already available in our databases, and reuse existing tools and instruments. And we wanted to ensure that our analysis methods were transparent for those in charge of reporting," he says.

Rovellini is convinced that transparency of cost and revenue allocation is critically important to the future success of BPM. "Banca Popolare di Milano is not a single entity but rather a small, complex group of businesses up against some major competitors. Therefore, we have to achieve maximum profitability in each business line. The only way to do this effectively is through detailed cost and revenue allocation.

"We are only just starting to use the cost allocation solution, but we are already starting to see results," says Rovellini. In addition to supporting better internal decision making, the cost allocation system is helping BPM communicate with the wider financial community and meet external requirements, such as improved standards of risk management. "There are considerable direct economic benefits to effective risk management; it also inspires confidence in the market if you can demonstrate that you are evaluating risk according to industry requirements, such as Basel II," comments Rovellini.

"It is unusual for a bank to be measuring such service activities as IT or back-office functions," concludes Rovellini. "But these functions also contribute to the final cost of bringing our products and services to market. If we know the true costs and revenues, we know where we are generating profit, and we can allocate capital with a high probability that it will attract strong returns."

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