How to Accurately Conduct a Profitability Analysis
December 2017

Profitability analysis is central to your financial institution’s very existence. A powerful blend of introspection and market assessment and comparison, profitability analysis findings should be applied to channel every aspect of your operation toward long-term viability — a positive for your members and customers as well as your bottom line.

Profitability analysis is an element of enterprise resource planning, which aims to collect, evaluate, and present accurate and insightful data that drives business decisions. In doing so, you provide various departments the perspective they require to properly handle internal accounting and decision-making.

The importance of accurate accounting is self-evident. But you also can’t underestimate the value of preventing poor decisions that ostensibly are fact-based, but don’t take into account the whole picture. Ponder this example, derived from a DB Marketing case study: Because it’s been proven that branch visits are more costly per instance than using ATM, online, or mobile banking, some banks have tried to discourage this practice by charging branch visitors a fee. However, because branches are heavily used by the most profitable customers, as well as the least profitable, these fees stand a considerable chance of backfiring.

One point worth noting before turning toward the specifics of profitability analysis: Because of their cooperative structure, many credit unions blanch at words such as “profitability,” concerned it conflicts with the credit union mission of putting people before profit. But really, we’re talking about viability; just like banks, credit unions need to make money if they are to continue to exist. The difference is credit unions don’t pay shareholders but rather return that money to members by providing dividends, improving rates, and/or lowering fees. In fact, many argue that profitability analysis is more important for credit unions; lacking the ability to raise supplemental capital, they must rely solely on operational efficiency and improvements to build capital.

In a bank or credit union setting, profitability analysis has five main goals:

1. Segment and analyze members/customers

Segment and analyze members/customers into appropriate groups for marketing and sales programs. Historically, many organizations have used top-down analysis, but the prevailing trend is to evaluate from the member up. One effective wrinkle to that technique is identifying the most profitable households, discerning the factors that put them in that category, and then strategizing how to mold other member households in their likeness. This technique focuses on the member rather than the individual because often products and services are complementary. Remember, this analysis can be accomplished from a needs-based, not product-pushing, perspective; loyal members/customers also benefit most from your services, so this exercise can quantify the savings realized by these ideal members.

2. Segment and analyze branches, employees, and third parties such as auto dealers

By analyzing the effectiveness of separate entities such as auto dealers, credit unions can understand how to optimize their resource allocation to each group. Just like members/customers; branches, employees and auto dealers can be very profitable or very costly. Knowing where to allocate capital for marketing, employee incentives, building new branches, or furthering auto dealer relationships can make the difference between growth and stagnation or worse a decline in assets and membership.

3. Establish product pricing

According to the consulting firm Deloitte, fewer than 3% of businesses effectively manage, execute or communicate prices. The goal is to provide value for customers and members in a way that incentivizes them to conduct more business with you, which is why you should avoid rate-chasers that will use only your “loss leader” products and bolt at the next best offer. Notably many companies miss out on charging opportunities based on intangible factors like customer service or convenience provided by their product or service. Take a long view here — think of “lifetime value” of a loyal customer, projecting out which items are worthy loss leaders. Remember that a discount is an investment in a member; are you receiving return on that investment?

4. Optimize operational inefficiencies

From a servicing resource perspective, ideally, you have a cost-accounting system in place to paint an accurate picture of the amount of time staff invests in performing various tasks; the fallback is to conduct annual job audits, which are considerably less precise. The impact of staff resource costs is considerable, typically accounting for 35% to 50% of noninterest expenses to provide services.

From a lending perspective, it’s important to understand which loan types are currently profitable and which are not. To often we see lenders who have outdated policies in place which are costing them money by either not taking into account any increase in costs with certain loan types or by preventing them from buying more D or E paper loans out of fear of higher charge-offs or delinquency rates. Having a current analysis always at your fingertips helps you make optimal decisions on which loan types perform best and ultimately what the ROI is on each loan type.

5. Perform efficient and cost effective analysis

Comprehensive, deep-dive studies provide a brilliant picture of your financial institution’s practices and market presence, but aren’t cheap. Some industry experts posit that profitability analysis simply isn’t cost-effective for the smallest of credit unions, but they almost universally agree that mid-size and large institutions will benefit considerably. This is a common misconception and an outdated philosophy that technology has solved. Because profitability analysis accuracy depends on collecting data into a central location and confirming its integrity manycredit unions, struggle to accurately merge various spreadsheets and databases together from their Core, L.O.S., Credit Bureau, and other third-party vendors. This does not have to be the case, using an analytics software company that also acts as a data warehouse such as Visible Equity, provides all sizes of financial institutions the ability to efficiently and accurately perform a thorough profitability analysis.

The required data includes information such as loan balances, loan type, application approval & denials, delinquency history, unpaid balance, charge-offs, interest rates,, fees and costs, recovery rates, unique identifiers for loans, applications, members, etc.,, and non-interest income. These fields are then analyzed using various statistical methods such as cluster analysis and regression.. Through this process, a financial institution can determine facts such as total direct cost per loan, per application, per member, per auto dealer, etc.

The mere process of collecting this modeling data often sparks productive conversations and epiphanies about how to streamline a particular product or service to become more efficient.

Through the profitability analysis process a financial institution can set the appropriate rates and fees for products and services, determine the merits of strategies such as risk-based pricing, evaluate the return on capital investments, and set a course for growth.

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