Stop Focusing So Much on Cost Assumptions

August 8, 2019 Dallas Wells

Overhead costs are frequent sources of dispute and challenge, even though they are relatively easy to understand (compared to capital allocation models or profitability of default curves). We completely understand the concern. It costs money to make money, and it’s important to know what those costs are, right?

We often hear from concerned bankers who are stressed over nailing down their overhead cost assumptions. They believe that in determining overhead costs, the bank will better be able to pinpoint how profitable their deals are, and which deals to make or walk away from. They also believe that to price deals well, overhead assumptions need to be exact.

So they spend an exorbitant amount of time and money working to understand and figure out what these costs are in the hopes that this knowledge will lead to more revenue.

But these costs don’t move the needle. What matters is the relationship manager’s ability to understand the relative value of all deal terms. Those are the items that can actually be negotiated and changed (unlike overhead), leading to deals that are beneficial to both the bank and the client.

Do Overhead Costs Really Matter?

“Our relationship managers don’t trust our pricing tools because they think the costs are unfair and don’t show their deals as being profitable enough.”

“We don’t have good enough cost numbers to accurately measure profitability, so we just let the RMs price with the market.”

If you’ve heard comments like these at your bank, you’re not alone. We hear these concerns often and cringe as banks get tangled around the axle trying to haggle overhead allocations, letting it derail their entire sales process, instead of focusing on what will drive revenue.

For perspective on the impact overhead costs have on a deal’s profitability, we ran a test.

A Simple Test: Part 1

We priced a standard $5 million CRE loan within PrecisionLender using our benchmark configurations. These benchmarks include “average” origination and servicing costs that we get from our partners at The Kafafian Group¹.

The loan was structured as so:

  • 5-year balloon
  • 20-year amortization
  • 75% LTV
  • Acceptable credit
  • 4.25% fixed rate

We assumed (based on our Kafafian assumptions) that the loan costs $10,218 to originate and $1,962 per year to service. With that overhead, the loan generates $63,220 in annualized income with 14.06% RAROC.

But let’s say the cost assumptions are wrong. Very wrong. We’ll cut them in half, even, and leave everything else the same.

So, we’ll say it costs $5,109 to originate and $981 per year to service. This scenario would generate $64,802 in annualized income with 14.41% RAROC.

That’s a difference of $1,582. Dare we say that the amount of time and money you’d be spending on updating your overhead cost assumptions is far greater than $1,582? Okay, we’ll say it. It’s FAR more than that amount.

The cost of originating and servicing loans is among the least important of all the assumptions. The key is to be directionally correct and logical.

If We Don’t Focus on Cost Assumptions, What Do We Focus On?

We often call the need to focus on perfect assumptions “death by accuracy.” In fact, it’s number four on our list of the 7 Deadly Sins of Pricing. When debits and credits don’t balance, bankers tend to get very uncomfortable. Focusing too much on making sure your numbers are balanced is just fine for much of the business, but for pricing it’s detrimental.

Handicapping relationship managers with an inefficient process will cost far more revenue from lost deals than you could ever gain by nailing the economic capital allocation or overhead costs out to four decimal points.

A Simple Test: Part 2

Let’s return to our example loan scenario from above and bring in our virtual insights analyst, Andi®. She gathers data on what’s winning and what’s losing and delivers in-the-moment advice to help craft winning, profitable deals. Andi provides impactful coaching by suggesting multiple pricing and structuring options to meet both the client’s goals and the bank’s return target.

When this deal was priced within PrecisionLender, Andi offered the following suggested actions for the RM, each of which improved deal profitability ABOVE what it what would have been if the overhead costs were 2X (i.e. back to $10,218):

•    Reduce the deal term by 3 months

•    Reduce LTV by 2%

•    Add 15 bps of origination fee

•    Add 4 bps of rate

All of those are simple, quick, impactful actions the RM has the ability to carry out. The alternative - arguing over cost assumptions with other bankers in the hopes of achieving some consensus – is the opposite. It’s complicated, slow, and has only a minor affect on profitability.

How do we start pricing this way?

Remember what matters. It isn’t accuracy… it’s action. It is about delivering insights to your RMs and speaking to them in deal terms that they can negotiate to actually change the deal for the better. If they are getting hung up on the overhead assumptions, then change them. Lower them so that they are no longer a point of contention, or an excuse. Don’t let that small insignificant assumption derail all the value that can be generated by focusing your RMs on the stuff that is really important to the bank, and that they actually can control.

In fact, in a recent PrecisionLender report, we noted that the best relationship managers act like trusted advisors, deliver tailored solutions, provide alternatives, and utilize the best negotiation tactics.

Banks that implement PrecisionLender are able to see the impact the deal is making. Their RMs have Andi and her coaching at their fingertips, showing them ways to make the deal and have more thorough conversations.

The Bottom Line

Don’t let angst over overhead costs derail the entire process. It is far more important that RMs use the pricing solution and trust it than it is that your cost models are 100% accurate. Use marginal costs (not fully allocated overhead), and if in doubt, use industry numbers so they are defensible. Or just have Kafafian do it. This is surely not a hill to die on.


¹The Kafafian Group is a finance, strategy, and operations consulting firm that specializes in performance measurement, profitability outsourcing, strategic and business planning, regulatory assistance, profit and process improvement, and investment banking advisory services for the financial industry. www.kafafiangroup.com

 

About the Author

Dallas Wells

Dallas is a writer, speaker and former consultant who has held executive roles at two banks with experience in capital planning, liquidity forecasting, investments, budgeting, financial reporting and mergers and acquisitions.

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