Eenee, meenee, mainee, mo, catch a tiger by the toe . . .

As children, we’d sing this little rhyme and wait with anticipation while pointing at a variety of choices to see which one we’d eventually select. It sometimes seems we have that same uncertainty when asked which of our banking products are profitable. 

In its simplest form, product profitability is a function of revenue and expense. The goal is to identify the return on assets (ROA) and the return on equity (ROE) for each product.

A good system allows you to determine the profitability of each product by identifying the components of revenue and expense for each product. The analysis should isolate the fixed and variable product costs associated with an activity and the resulting impact on ROA or ROE, such as interest payment frequency. Once those elements are isolated, you can then start to evaluate whether product characteristics should be modified for the sake of lower costs.

The assumptions used by the system are the backbone of every subsequent decision you make related to product profitability. The previous customer profitability article identified some considerations regarding understanding assumptions and how your model computes profitability. It’s worth revisiting these items when evaluating this type of measurement system.

Remember, any ten people are likely to measure product profitability differently.

You need to understand what is considered in your measurement system and then decide how you are going to use what you’ve learned.  When interest rates climbed to 20% and banks struggled for earnings, they deployed a variety of strategies to improve profitability.  One large bank in particular decided to fire its cost accountants.  Perhaps it was a symptom of not understanding what to do with the cost information they developed.

Never lose sight of why you are doing the measurement.

Here’s a list of some of the better ways to use product profitability information.

• Identify ROA for every earning asset and source of funds.
• Determine the ROE on minimum risk-based capital along with another calculation on risk-based capital in excess of statutory minimums.
• Rank products based on profitability and understand what contributes to the varying profitability of different product lines.
• Understand the amount of fixed and variable components of costs and determine the impact of alternative servicing activities, fee income, or interest rates on a product’s profitability.
• Understand how much of the costs allocated to products reflect costs related to “excess capacity,” such as people, systems, or facilities.
• Understand the minimum balance required to meet the bank’s ROA and ROE objectives. This insight will not only change your tiering matrix, but will also encourage rethinking current pricing strategies for deposit balances over $25,000.   I believe the rate differential is too high relative to lower tiers based on what I have learned from studying product profitability.
• Rank products by profitability and determine your local market’s demand for these products and services.  Then target-market existing customers and census groups most likely to desire your profitable products.
• Develop marketing plans to increase volumes in profitable products.
• Restructure the features or pricing of underperforming products to improve profitability.

When you understand the components of profitability, you will start to evaluate when fees are required to move a product line to your ROA or ROE expectations.  You will also begin to rethink and determine the breakeven balance for a product line.  Product profitability measurement often reinforces the notion that your Bank cannot be all things to all people.