Several years have passed since the beginning of the current recessionary economic cycle. By many estimates, trillions of dollars have been spent worldwide to attempt to jump start the business cycle. In the United States and in many other western countries, this spending has caused a very real risk to sovereign finances. From our viewpoint, it appears that in many cases institutions have not done enough to write down bad debt or increase capital.
We would argue that we have learned over the past several years that below market interest rates and monetary expansion potentially have dangerous side effects. Look no further than the price of oil, food, and other essential commodities for evidence that central banks simply cannot “print at will” without very real economic consequences. Many would argue that there is an effective limit to monetary expansion and that these policies are showing diminishing returns as of late.
We live in a highly interconnected global economy and the impact to Europe and other world economies will be significant as these challenges are resolved. In the US and many areas of the world, financial services companies will operate in an environment of deleveraging and regulatory scrutiny not seen in many decades.
The political environment and macroeconomic factors will combine to present opportunities to organizations that can understand and manage risk profitably. Many product areas and customer segments are going to be under-served or completely ignored as this transformation evolves in the financial services industry. As with many aspects of our daily lives, organizations are simply going to have to return to optimizing the basics of their business to prosper during this transition.
Strategic Cost Management a Key Element
We believe one of the key basic elements of managing risk profitably will be Strategic Cost Management (SCM). In practical terms, organizations have three broad levers to increase profitability: pricing power, product mix, and efficiency. Given the commodity nature of many financial services’ products and the economic backdrop, we believe opportunity to broadly leverage pricing power and product mix will be limited for quite some time. Much of the opportunity in the near future will be how to deliver products and services more effectively to the right customers. Understanding how to efficiently meet the needs of the customer and the highest and best use of scarce capital will be essential in this environment.
We feel that Strategic Cost Management is an important tool to improve tactical and strategic decision making for companies across all industries. Given some of the unique challenges of the financial services industry, we believe Strategic Cost Management is going to be critical for companies to survive and thrive.
Data collection has been a vital part of business process for decades. For the past 50 years, the process of collecting data has evolved to where it is today. With the use of early computers, companies were finally able to collect large amount of data in one location efficiently. In the 1980’s, data collection moved to data access. It was no longer good enough to just have the data; businesses needed the ability to access the data and report on it thus emerged the relational databases, SQL, and ODBC, and etc. In the 1990’s, data access took the form of Data Warehouses and Decision Support systems. Today, the question is “now what?” Companies have massive quantities of data which can be accessed easily, but what good is the data? What insight is gained from the company’s data? At Armada Consulting, we have a saying that “information is only as good as the action it initiates.”
Using the Data to Make Forward Decisions
Companies are learning to develop insight and create value by using analytics on the massive amount of data they possess. Through the uses of simple and complex statistical research methods, companies are able to use their data to provide proactive information delivery. Predictive analytics is one of the most successful and powerful analytical uses of data. Predictive analytics’ definition can be as narrow as “understanding why a variance occurs in real time and what to do about it moving forward” or as broad as “delivering the right insight to the right people in real time for making decisions.” Regardless of how narrow or broad the definition, two common aspects exist:
- It explains the impact of changes in interacting variables and
- It provides for real time actionable information.
The early adapters of predictive analytics were insurance, telecommunications, retail, travel, healthcare and pharmaceuticals business sectors because of ease to understand the effect of interacting variables. For example, in the travel industry it is easy to relate seasonality to the amount of visitor at a beach town. Thus, creating seasonal models to predict the need for staff at hotel in the beach town during different times of the year makes perfect sense. However, the uses of predictive analytics are not limited to easily definable relationships and can have lasting impacts across the organization.
Newton’s third law of motions states, “For every action, there is an equal and opposite reaction.” All activities of an organization are reactions to an event. Without customer demand, an organization would not exist. The key step to creating an effective and accurate predictive model is the identification of actions that drive business activities. IT departments are one of the large consumers of capital within organizations because creating and maintaining data collection systems and warehouses take a lot of time, effort, and money. A common folly of a corporation is viewing this department, and others, as the cost of doing business and as an expense to the company. By identifying the driving activity and forces behind the IT department, and combining it with predictive analytics, corporations can begin to understand IT cost and use it for a more effective business decision making process.
For many years, corporations have had excess data they have collected. It is now time for them to be put it to use. Predictive analytics is more than predicting future events, if done thoroughly it can help explain the causational relationship between activities in all areas of the organization. The next phase in the evolution of data uses is here. It is time to start using predictive analytics to deliver insight in real time to the right people for making a positive financial impact in all areas of the organization.
Demanding IT Cost Controls
Rising costs within the IT organization is an issue facing most every Chief Financial Officer in the country. Expenses continue to rise and the absence of clarity has many executives stumped in methods to get expenses under control. This competitive market pressures for innovation and economic pressures to reduce costs continues to place high demands on companies IT organizations. The growth economy that supported innovation and infrastructure projects in the past is disappearing, and narrowing margins shifts Finance’s focus inwardly to drive cost reductions and improve profitability. These complexities in today’s information technology organization requires that strategic cost improvement initiatives move beyond financial transparency exercises of service catalogs and cost modeling to the proactive identification of improvement opportunities in both IT operational and project spending.
The problem may not be as much about the IT organization as it is the corporate culture and system it operates. The IT organization is simply responding to the demands and meeting the expectations of the established system, rewarded on timely delivery of projects, system up-time, and other non-financial measures. Trivial issues such as financial performance and cost reduction are not high priorities for IT management as there is little accountability built in to performance management to reduce unit costs for services provided to the organization. From our Fortune 100 experience, Armada Consulting is encouraging Finance to move beyond transparency and build accountability and control into the Finance functions for spending decisions.
Armada Consulting recognizes that every organization is unique and must adapt within their environment, and has developed a framework for IT Cost Management that enables a company to transform the way IT costs are controlled. With IT Cost Transformation, we take finance beyond the transparency of understanding:
- operation vs innovation spending
- technology contribution to products and customers
- activity cost per unit
- resource capacity
- productivity measures
- cost to serve
- key profit drivers
By integrating that information into a framework that has an impact on IT costs. Finance cannot assume to solve today’s cost management problems with yesterday’s expense management methods. What is needed is a comprehensive approach that builds efficiencies into Finance, focuses on unit costs and consumption, and promotes accountability in IT spending. Move beyond transparency and puts strategy back into finance, contact Armada about the first step to IT Cost Transformation.
Travelers experience it every day—the forecast is calling for terrible weather in a few days…exactly the same time their trip is going to begin. Travelers are then faced with two big decisions: Number one, change travel plans in advance and divert the weather, or number two, do nothing and hope for the best. Regardless of the decision made, the point is that the forecast plays a major role in the decision process of the traveler, just like it should play a major role in the decision process of businesses.
Financial statements, balanced scorecards, and benchmarks are all good methods of tracking the performance of a company over time, but they provide only a snapshot of the organization at a specific point in time which limits insight into the future performance of the organization. Too often, the impact of a change is not felt in an organization until it hits the bottom-line; by this time it is too late. Managers need a way to be proactive into today’s constantly changing environment instead of being reactive to the change around them.
What is Predictive Analytics?
To address this constant problem, companies are turning to predictive analytics. Predictive analytics is the use of a variety of techniques from statistics and data mining that analyze current and historical data to make predictions about future events. Predictive Analytics uses a forward-looking approach to help firms identify the impact of changes before they reach the bottom line, giving managers time to adjust and plan for the future. Predictive models exploit patterns found in historical and transactional data to identify risks and opportunities. Models capture relationships among many factors to allow assessment of risk or potential associated with a particular set of conditions and events. These relationships then guide decision makers to identify and prepare for future events.
Predictive analytics has historically been used in insurance, telecommunications, retail, travel, healthcare, pharmaceuticals and credit scoring. The use of predictive analytics has even crossed into the sports world; Italy’s A.C. Milan uses predictive models and techniques to prevent injuries by collecting and analyzing orthopedic and psychological data from various sources. More and more companies and industries are identifying the need and uses of predictive analytics in their company breaking away from its traditional uses. One emerging area that predictive analytics is being used is the starting point for financial planning and forecasting exercises. For example, companies are using predictive analytics to predict cost on consumption-based recovery items, allowing them to identify the effect of changes in volume forecasts before it hits shared services recovery and the bottom-line.
Used to Predict Future Trends and Patterns
Predictive analytics deals with extracting relational information from data and using it to predict future trends and behavior patterns. The core of predictive analytics relies on capturing relationships between identifiable variables and predicted variables from past occurrences, and exploiting them to predict future outcomes. To feed an accurate financial planning or forecasting predictive model requires a advanced Strategic Cost Model. Strategic Cost Management (SCM) models identify the activity and cost drivers that link activities to an organization’s products, services, and customers.
Combining a company’s current strategic cost management initiative with the foresight provided by predictive analytics provides managers with a new way to view their costs, enabling them to make better decisions and increase the overall profitability of the firm. Predictive analytics give managers the capability to plan using demand from customers to build budgets bottom-up instead allowing budgets to be set from the top-down. Managers are able to quickly determine the impact of change to an organization and adjust accordingly without waiting to see the impact on the company’s bottom line. Knowing the impact of the change in advance allows managers to better plan and to align resources to forecasted expectations and decrease wasted expense and eliminate unnecessary costs. Finally, providing an interactive dashboard report with key performance indicators directly to managers allows for managers to do their own scenario analysis and minimizes the need for ‘back and forth’ between front-line managers and financial planners or cost modelers.
Predictive analytics allows managers and organizations to be prepared for an uncertain future. They can become proactive with their decisions instead of reactive to the current climate. Just like the traveler who can adjust plans to avoid weather delays, organizations no longer have cross their fingers and hope they can get through the turmoil, they can by using predictive analytics now avoid it all together.
Customers demand customized services across increasingly complex channels, making it difficult to accurately identify product and customer costs. With personnel expenses representing the largest single component in service institutions, it follows reason that the companies are searching for improved methods of cost assignments to products and customers. A detailed understanding about your organization’s costs provides a competitive advantage and empowers management with valuable information that can be used to implement process improvements throughout the organization.
Expanding on Activity Based Costing
An expansion of the traditional Activity Based Costing (ABC) approach imparts service organizations with the ability to provide improved unit cost information across their value chain. Activity Based Costing—as developed in the manufacturing sector—typically was based on a 3 stage cost assignment approach: resources, activities, and cost objects. This approach is still applicable to services organizations, but must be adapted carefully to accommodate the complexities in costing which will increase customized services. There are a number of differences between service and manufacturing costs and transaction structures, which require up-front model design, planning, stakeholder support, and careful consideration prior to implementation. With the right model design, an organization can construct a truly strategic cost model which aligns to process re-engineering practices, profitability measurement, staff deployment, and other strategic initiatives. In our experience, this Strategic Cost Modeling approach employs an advanced modeling methodology that is adapted to the unique requirements of an organization, which can provide true cost transparency across the enterprise. The desired outcome is a comprehensive and consistent enterprise cost model that provides actionable information to reduce costs by strategically aligning the following initiatives:
When combined with data warehousing, business intelligence technologies, and integrated with performance management and compensation, Strategic Cost Modeling becomes a powerful tool for navigating the company through economic change.
The Next Step
Have you ever found yourself asking “why,” “what,” or “how” when thinking about driving rapid cost takeout or continuous cost control? Contact the Armada Consulting Team to discuss the benefits that exist by engaging us in a Strategic Cost Management initiative.