Authored by Daniel Groom, Senior Vice President of Finance, Umpqua Bank

Umpqua Bank is an Oregon-based institution with approximately $25 billion in assets. We primarily do business in Washington, Oregon, and California, with 4,000 employees and 350 customer-facing locations. Umpqua has four primary operating segments, including retail banking, commercial banking, wealth management, and home lending. 

As Senior Vice President of Finance, I have spearheaded initiatives to improve the profitability analysis and reporting at the bank. In our initial Axiom Software implementation of customer profitability analysis at Umpqua, we have learned some best practices that you might also find helpful.

Before we dive right in to customer profitability, think about what your institution does from the standpoint of organizational profitability analysis. By tackling organizational profitability first, we formed a broader picture of our progress against strategic goals. This order also established a foundation that helped us understand our processes and systems and formulate objectives when we moved to our customer profitability project.

I would like to share tips around six best practices that we have learned in implementing our customer profitability analysis:

  1. Establish goals and objectives up front
  2. Use standard costs for unit costing
  3. Set a common metric across products
  4. Obtain cross-functional buy-in
  5. Define the requirements
  6. Include user acceptance testing in your project plan


Establish Goals and Objectives Up Front

It is important to understand why you want to undertake implementation of customer profitability analysis at all and what you expect to accomplish. What are the hot buttons at the executive level, and what decisions will you make with the data produced? Are efficiency and capacity your primary focus? Do you want to identify less profitable customers to work on improvement strategies? 

At Umpqua, we defined goals for the project as follows:

  • Support relationship-pricing decisions. We needed to understand the value of each customer as part of the larger relationship they represent to quickly and appropriately price loans and deposits, supporting both customer retention and revenue goals. To this end, product pricing should meet hurdle rates, balancing appropriate risk with rate of return.
     
  • Set incentive compensation and performance management goals. Many of our commercial loan officers, for example, have historically been compensated based on point-to-point balance growth and, in some cases, on fees generated. To grow in the right places with the right margins, we wanted to change these models to consider customer profitability as well.
     
  • Inform strategic decisions. This is a broad category, but here are a couple of use cases. 

    Branch Consolidation: To free up capital for investments in digital capabilities and technology, Umpqua leadership decided to consolidate 100 branches. It was relatively straightforward to select the first 30 impacted branches based on performance levels. There are many factors to consider in identifying the remainder; one important one is customer profitability in different markets, helping to minimize adverse impacts of closing each additional branch.

    Evaluating Lines of Business: We also use profitability analysis to compare performance at the line of business level. At Umpqua, we had instances where lines of business were growing just to grow. Once we applied a Risk Adjusted Return on Capital (RAROC) metric to our performance analysis, we realized that one line of business was losing money. This knowledge supported our decision to exit that line of business and reinvest excess capital in lines of business with higher margins.


Use Standard Costs for Unit Costing
Part of accurate profitability analysis includes a unit-costing approach that is simple and explainable. We have adopted use of a standard cost approach to calculate unit costs, based on the prior year’s budget and assuming full capacity. Initially, we calculated unit costs using a model department survey; we plan to update unit costs on a regular basis to reflect staffing and process changes. Note that unit costs should include direct costs, such as the cost of opening a deposit account, and indirect costs, such as product support and reporting.

Set a Common Metric Across Products
To feed customer profitability analysis, it is also important to use a common metric for all product profitability contributions. At Umpqua, leadership has standardized on Risk Adjusted Return on Capital (RAROC), in combination with funds transfer pricing (FTP), which we consider the gold standard for accurately determining margin. Using RAROC gives us a consistent measure across products—loan, deposit, and fee-based—and has allowed us to establish hurdle rates for product pricing across the bank, putting everyone on an even playing field.

Obtain Cross-Functional Buy-In
At the onset, it is critical to gain buy-in across the institution to help ensure a smooth implementation of customer profitability analysis. At Umpqua, we created a profitability steering committee that encompasses upper management as well as disciplines across the company, from credit and finance to marketing and retail. Finance worked with the steering committee to establish goals, a timeline, and milestones. This, in turn, has encouraged ownership of the process, fostered communication, and provided a better understanding of the project’s value. 

Define the Requirements
Based on the goals you have established, it is important to identify your requirements to ensure a smooth implementation. Knowing what you need—and who can provide it—facilitates effective project management.

A big part of this step is defining the initial report set that you want to provide. At Umpqua, we selected the following reports, running them on various dimensions (including Officer, Instrument, Customer, Relationship, Department, and Product): 

  • Profitability Statement
  • Officer Side-by-Side
  • Instrument Detail
  • Officer/Relationship Ranking
  • Expense Allocation Detail
  • Expense Allocation Rule Summary

We also find it useful to tailor report views to support different types of analysis, such as all-in/fully allocated vs. direct/marginal profitability. To produce these reports, we identified a variety of components and determined how to get to the underlying data. These components included:

  • Net interest income (loans) – Includes interest income, tax-equivalent adjustments, deferred origination fees and costs (both amortized), and FTP charge on funding uses
  • Net interest income (deposits and repurchase agreements) – Includes FTP credit on funding sources and interest expense

  • Provision for loan and lease losses – Provides an estimate of full-cycle loss rate, recognized over the life of the loan

  • Non-interest income – Includes data generally found in source-system extracts, encompassing services charges on deposits, loan fees, international banking income (such as foreign currency exchange income), merchant revenue, and net commercial card income

  • Non-interest expense – Provides data generally allocated from model department surveys, including transaction costs, account maintenance, origination costs, FDIC assessments, system costs, supply costs, business and occupation taxes, direct third part charges (such as analyzed accounts), and local and general overhead

  • Provision for income taxes – Includes state and federal taxes

  • Allocated capital – Considers a modified regulatory approach
     

Include User Acceptance Testing in Your Project Plan
A critical component that might be overlooked by some institutions is the need to build user acceptance testing (UAT) into your project plan. UAT can uncover things that might not have been apparent in a nonproduction environment and exercises the process for a variety of roles and use cases. To be realistic and allow for thorough testing—since our testers still have their day jobs—we provided three months for this stage.

To facilitate a smooth testing phase at Umpqua, we also established a contact person for access and security issues. We then clearly communicated the goals for testing and provided two logs: one for feedback on the system in its current version and one for future enhancement requests.

Be Agile
As you learn more about the system, you will find new capabilities; as end users use new processes, additional requests and requirements will undoubtedly emerge. Understand that implementing customer profitability analysis is an iterative process, and be agile to allow flexibility to optimize your process over time.