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Service Profitability: for Pricing Strategies, Cross-Service Discounting and Optimization

Journal 35: Zicklin-Capco Institute Paper Series in Applied Finance

Natasha Leigh Giles

With the financial industry facing economic turmoil, a squeeze on margins and a wave of new regulatory policies, there are many companies facing an urgent need for change to improve their profitability. There are also firms benefiting from the new era with a significant growth in business, prompting decisions about how to grow their range of services to achieve the highest profitability. Any decisions taken in the process of change or growth are best made where there is clear visibility of the effects of the proposed new model. Knowledge and visibility of the profitability of a service are essential inputs for increasing the probability of a successful decision as part of a change or investment for growth.

The profitability of a service is the balance of income received for the receipt of that service minus the costs to provide that service to the client. This relationship between income and costs can be used to drive pricing strategies, relationships or discount pricing and is a valuable starting point for reviewing any changes in sourcing. For the purposes of this study, a service can be interpreted as the processes related to providing an offering of a particular product. For example, the service provided to clients which allows them to invest in hedge fund products would include the full end-to-end business processes needed. These involve researching the hedge fund providers, maintaining the product listing, selling the position to the client, supporting the client during the investment lifetime and closing out any client investment in a hedge fund.

All companies have a form of pricing strategy, but in reality there are many variances from their rate cards or “expected” levels of income and the “actual” received income. This variance can be described as revenue leakage.

Actual income versus costs
The income received from a client can be direct in the form of fees, commissions, margin on interest or even penalties for early redemptions or banking charges. However, there are also additional sources of income which can be received on behalf of the client investments. These include revenue-sharing arrangements with external parties, such as introducing brokers, product-based income including hedge funds or mutual fund trailer fees, or kick-backs from structured product investments. Internal cross-selling arrangements within the company can also lead to additional layers of income for a service. Such transfers of revenue are often executed on a periodic basis and can be a percentage allocation relating to assets or activity across multiple services.

The costs of the service are much harder to identify. In our experience of working within the financial services industry, they are infrequently calculated or tracked against the income. Many companies have their front office remuneration packages linked to income or amount of assets under management. However, we see few examples where the managers are remunerated against the profitability of a service where it takes into account the combined effect of cost and income. Departmental or team costs are most generally tracked in the back office or operational areas, but these do not always clearly represent a “cost of service” as the team can be working across many services. This lack of visibility means that it is hard to identify where the company is losing profitability or where there is an opportunity to diversify the services to increase profitability.

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