Operational cost processes:

cost management as a strategic tool

For global investment management companies generally, and asset managers in particular, it is essential that they maintain a competitive cost position in their global operational sphere. This article discusses how implementing the right cost management strategy, supported by the right financial software solution can ensure a decisive measure of control over the operational cost base.

by Ulrik Modigh, Head of Asset Management Operations at Nordea Asset Management (AM), Copenhagen, Denmark.

Amidst the unremitting global financial malaise, of which the erupting European debt crisis is but one symptom, many investment management companies are facing a declining asset base driven mainly by outflow and the general decrease in asset market value. This development is putting pressure on many asset managers within the industry to place an increased focus on cost and efficiency in the production value chain.

For asset managers to maintain a competitive cost position in their global operations, they need to put into place the right cost management strategy in order to exercise control over the operational cost base. Here the difficult question is how to establish a cost overview that provides the necessary insight into the operational cost drivers within the production platform as a basis for improving the cost position. Further going down this path, asset managers have to decide whether overhead costs (i.e. platform costs, server costs, etc.) should form part of this cost allocation exercise, or whether the allocation should only cover direct production costs.

COST TRANSPARENCY ACROSS THE VALUE CHAIN

Viewed in the historical perspective, asset managers have typically run their businesses by monitoring and following up on total income (i.e. fees) and functional cost (i.e. investments, back office, middle office, fund accounting, etc.), which when combined gauge the temperature of the enterprise’s ability to generate gross income and net income.

However, when faced with the swathe of new challenges rolling out in the current market environment, whether of a competitive, regulatory or financial nature, there is a need to improve the understanding of cost drivers in the underlying production processes. Obtaining a clearer insight into which links in the value chain are absorbing the main resources and costs to produce the different product offerings is a categorical cost imperative that the industry simply cannot ignore in the present difficult circumstances.

If we look at the generic value chain set out in Figure 1 we have quite a good overview of the cost components for each step, but very little overview of the cost per product, because each individual product is using a small fraction of the resources in each step of the value chain.

Typically in cases like these, there is no cost follow-up on processes across the value chain, which basically means that there is no indication of the overall cost or the average cost of each product running through the value chain, and (if this is the case) only vague information about the product profitability. Furthermore, a possible consequence of the above is that the ability to make precise cost calculations of product offerings will be made on an overall estimation rather than reflecting the true cost related to the actual production cost.

Figure 1. Attributing cost drivers across the value chain. Source: Nordea Asset Management 

COST ESTIMATION ACROSS THE VALUE CHAIN

It can be a cumbersome exercise to allocate functional costs across the value chain, because typically there is no interconnection between the fund accounting systems and the backbone portfolio management systems (see Figure 2).

However, with the right financial software solution in the form of a fully integrated and automated front-to-back solution installed for core operational processes, the required valuable information (i.e. in the way of stored transaction records) is present, creating the basis for identifying and estimating the cost drivers within the production platform.

Figure 3 contains a hypothetical example of the average cost per product in the value chain by combining traditional functional cost information with information on transactions taken from the production platform. If we take the settlement process in back office as an example, the historical trade flow over 12–24 months is analysed to identify which products are the main users of the settlement services.

This exercise shows that the trading activity is much higher in equity products than in fixed-income products. The internal straight-through-processing (STP) rates on main markets were also analysed and compared with each product’s trading patterns. This was done in order to identify the differences in the resources required for settling standard European securities and those needed for settlement in exotic markets where less automation and lower STP rates proved the rule.

Combining this information makes it possible to identify the main cost drivers in the settlement process and estimate the total and average resource consumed by each product. The same exercise was conducted for each link in the value chain within back office, middle office, fund accounting, etc.

If we examine the resource consumption per product for the reconciliation process, for example, the main cost drivers identified were the number of accounts/custody accounts per product. The more accounts the reconciliation process needs to cover, the more resources are needed to support this process. Global equity products have long-range cash accounts for each market covered (whereas by comparison a Danish fixed-income product has only one account), thereby requiring far more resources from the reconciliation team.

Having an overview of the total and average cost per product makes it possible to estimate the overall profitability per product, but also allows comparison with the average cost per product, ensuring that the margin generated at the mandate level produces an adequate gross margin to cover overhead costs (i.e. IT platform costs, etc.) as well.

Such an overview also provides important input in general discussions on the scale of gross margins in the overall product mix and mandate size, ensuring that the type of complex products that are heavy users of production platform resources can also generate higher margins in relation to simple products with a smaller share of the resource consumption in the value chain.

Figure 2. Identifying and estimating cost drivers, including expenses. Source: Nordea Asset Management 

A STRATEGIC APPROACH TO COST CONTROL

By way of conclusion, it is generally true that all mandates or products need to generate sufficient gross margins, which can contribute to covering the overhead cost. If we look at typical asset management operations in the investment management industry, IT platform development costs can easily account for up to 30% of the total cost base. If these costs are allocated to the lowest level, several individual mandates or maybe even product groups will end up having negative profit margins.

If mandates with negative product margins are closed down for reasons of profitability (or the lack of it), the overhead costs will be allocated to fewer mandates and/or products; in a worst-case scenario, this exercise will end up generating even more mandates with negative profit margins.

On the other hand, including the entire cost base in the allocation process can provide important input for a number of strategic discussions about such issues as:

• Do we have the right gross margin on products with high production cost consumption?
• Do we have the necessary operational efficiency in specific products?
• Do we have the right critical mass in some products areas (i.e. are they too costly to run and too small to justify the investment required to improve operating efficiency)?
• Should we consider changing our product mix, adding higher margin products to the platform, increasing overall profitability and obtaining better utilisation of production capacity?

Figure 3. Cost allocation over the operational value chain (fictive numbers). Source: Nordea Asset Management 

Ulrik Modigh has been Head of Asset Management Operations at Nordea Asset Management (AM) since 2004. Graduating with an MBA in Finance from Copenhagen Business School (CBS) in 1992, he has held various senior positions including Risk Manager and Head of Middle Office at Nordea Markets, Consultant and Manager at KPMG Financial Services and Head of Back Office at Danish pension fund ATP.