Why We Use Marginal Profitability for Pricing Decisions

March 30, 2016 Dallas Wells

 

driving-mirror-235570_960_720“You can’t drive forward by looking in the rear view mirror.”

This is one of those pithy quotes that tend to make it onto lots of inspirational posters. You know the ones, with the artsy photography and scenic backgrounds. In this particular case, though, there is some real merit to the statement.

When we work with banks to improve their pricing process, there are a couple of common areas where bankers get stuck. Sometimes that’s because pricing improvement  takes lots of planning and purposeful action, like making sure that lenders will consistently use the new tools in the way that management intended. Other times, though, getting stuck happens because of bankers’ perpetual pursuit of accuracy.

We freely admit that pricing loans can be a little messy. After all, we are attempting to measure the profitability of a financial instrument on a forward-looking basis. We have to guess at not only what the markets around us will do, but also how the humans and businesses involved in the deal will behave. Good luck with that. All of that uncertainty makes bankers understandably nervous. They get compensated for managing risk, so a murky and unknown future can be a little unsettling.

To compensate for the unknowns, bankers tend to want to perfect the “easy” parts of the calculation, specifically the overhead costs. Bankers generally know their own costs cold, especially after the widespread cost-cutting endeavors of the last several years. Overhead costs are an easy concept, and they are highly visible in any profitability calculations. But that also means they are one of the most commonly disputed inputs. Lenders argue, “There is NO WAY we are spending that much to book and service loans,” while the finance team counters, “We aren’t including everything we should be.”

The most common method for settling the argument is to break out the T-account style analysis, and simply make sure we balance back to our financial statements. If we can take everything we are spending and divide it amongst the current business activity, we might argue over some of the allocation, but we can’t argue about the totals. They balance, after all, and everyone likes a nice clean balancing of debits and credits.

The problem is that we have now spent a lot of time (and possibly political capital) measuring the wrong thing.

Making a pricing decision is about optimizing the return on the capital and funding currently available to lend. If we focus on matching total overhead for the bank (or even the loan function), we are falling headfirst into the sunk cost fallacy. The money we have already spent on buildings, insurance, executive salaries, or marketing really should have no impact on the decision in front of us. At the point of pricing, those dollars are already long gone.

Instead, we need to make the best decision based on where we stand and what happens from here. If we make this loan, how much revenue will it generate? How much will it cost us to originate and service just this loan. This allows us to optimize returns based on the things that we can control with this decision.

If our loans are not profitable because we have already spent too much on existing overhead, then that is definitely an issue we should address. However, that is a separate problem, and those costs should not cause us to say no to a loan that is marginally profitable. If anything, high overhead should dictate that we do more of these marginally profitable loans so that the additional net positive revenue can help carry the overhead burden.

Instead of worrying about balancing backwards to historical cost numbers, spend the effort getting everyone on board with what we REALLY are trying measure. How much extra return will we generate if we book this loan at the proposed price? That number won’t “match” the bank’s ROE, nor should it. Instead, we set ROE targets so that we can decide if that incremental profit is sufficient use of the capital, or if we should look for a higher returning investment instead.

This process takes a little education, but once it is in place, the focus can be on the road ahead and the pricing decisions that will make sure the bank is making incremental progress toward its big picture goals.

In this case, the inspirational poster really did lead us to better pricing.

The post Why We Use Marginal Profitability for Pricing Decisions appeared first on PrecisionLender.

 

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