Cost imperative:

investing to reduce operational costs

In the wake of the global financial crisis, many investment management firms have responded to declining client loyalty, downward pressure on margins and an unprecedented wave of new regulatory requirements by sharpening the focus on operational costs and ways to trim IT budgets. Those with a more strategic approach to cost management are assessing a range of other alternatives to introduce long-term cost savings, while at the same time attempting to leverage these investments to better position themselves for growth. This article reviews some of the more common initiatives designed to help reduce operational costs and assesses their benefits and drawbacks.

by Robert Olsson, M.Sc.

Cost cutting has been high on the investment management agenda ever since the global financial crisis broke. This is evidenced by a recent SimCorp StrategyLab survey (‘Global Investment Management Growth Survey 2010’), where 71% of the investment management industry participants surveyed ranked growth as their first or second priority, with managing costs following closely behind (67%).¹ Industry observers have continued to confirm this trend through 2011; with some glimpse of light at the end of the tunnel, however, cost cutting has taken on a more strategic aspect.

A common response to the crisis was to implement quick fixes to reduce costs and improve short-term profitability. Many firms simply stopped or deferred expenditures, while others mandated cost reductions across the organisation. Such measures will of course reduce costs in the short term, but research has shown that they are typically not sustainable and may even harm future growth potential by cutting long-term investments.

COST CUTTING FROM THE TOP

When implementing strategic cost management initiatives, it is crucial to have a holistic and forward-looking view that is grounded in future revenue growth, increased profitability and shareholder value. With an increased focus on growth, a long-term perspective is needed.

To be able to run a successful cost management initiative over time, it is also vitally important to first determine where the major costs are, find ways to manage these costs, and finally, follow up if the cost management initiative actually had the intended effect.

While the focus of this article is not on project managing cost-cutting initiatives, it is notable that SimCorp Strategy­Lab’s ‘Global Investment Management Cost Survey 2009‘ indicated that 48% of participants found that they did not know what the expected savings were on their cost-cutting initiatives.² To find the most effective cost management strategies, expenditures first need to be broken down into different areas in order to gain an understanding of the underlying cost structures. For example, the typical breakdown between non-compensation and direct compensation expenses for asset managers is shown in Figure 1.

 
Fig. 1. Breakdown of asset manager's expenses. Source: Cruz, Marcelo 2010, SimCorp StrategyLab 

DIRECT COMPENSATION EXPENSES

Even though direct compensation expenses account for more than 50% of total expenses, cost cutting in this area must be carefully considered. To cut the staff and then rehire the same individuals on contract at a higher cost is not uncommon; yet counter effective to cost.³ During a downturn in the economy, cutting staff is a common way to adapt to the new level of activity, but as business once again picks up, acquiring the right talent in order to spur growth is typically done in a highly competitive labour market with increased salary demands that may hinder the pace of growth and profitability.

Centralisation and reorganisation
As a way to trim the organisation, some functions (e.g. sales and marketing) that have previously been handled locally in each business unit could be centralised. The important thing here is to ensure that local variations are not lost due to the centralisation. Another common way to cut costs is to reduce the number of hierarchical levels in the organisation and push activities down in the organisation. This could produce savings in the range of an estimated 5-10% of the cost base.⁴

Automation of processes One of the most effective ways to reduce staff costs and at the same time improve organisational productivity is to increase the level of process automation. A fully automated workflow from front to back office (and vice versa), also known as straight-through-processing (STP), is able to reduce staff costs considerably, while enabling growth. An automated flow also provides the organisation with more flexibility and agility. This in turn means that the organisation is more likely to be a first mover for new initiatives, which can help gain market share and ultimately lead to higher growth potential.

However, there are three major inhibitors to achieving true STP: internal systems fragmentations, inflexible systems and inconsistent data.⁵ And as organisations strive to implement STP, which typically involves strategic, multi-year projects, IT spending patterns indicate that these areas are currently in focus, with systems integration and modernisation of legacy systems being two of the top 10 priorities for 2011.⁶ In fact, there appears to be a trend towards better enterprise data management and STP, driven by both the weaknesses of a fragmented system architecture exposed by the global financial crisis, and more recently, by the demands of the accelerating rate of new regulations. In summary, this means that in today’s market, it is critical that investment management firms select an IT platform that not only provides consistent data among front-, middle- and back-office functions, but also is flexible enough to handle future demands, providing highly automated workflows in both directions.

NON-COMPENSATION EXPENSES

In order to understand the most appropriate areas in which to focus cost management initiatives for non-compensation expenses, an understanding of the cost structure in needed. Figure 2 shows the typical breakdown of these expenses for the asset management industry.

With the two largest costs indicated as being ‘Real estate and rents’ and ‘IT expenses’, it is therefore reasonable to assume that these two areas have the greatest potential for cost reductions overall. But here the focus is on IT expenses, which traditionally receive a great deal of attention when cost management initiatives are underway and the remaining sections of this article look at some of the more recent alternatives available.

OUTSOURCING AND CLOUD COMPUTING

One growing trend in cutting IT costs is to use IT outsourcing and cloud computing, which includes Software-as-a-Service (SaaS). With cloud computing considered to be one of the top priorities of 2011,⁷ it definitely qualifies for further discussion.

 
Fig. 2. Breakdown of non-compensation expenses. Source: Cruz, Marcelo 2010

Cloud Computing and SaaS
Cloud computing can basically be structured in four layers, starting at the lowest level with hosted services and then Infrastructure-as-a-Service (IaaS), offering virtualisation to simulate hardware on-premises, Platform-as-a-Service (PaaS), offering a computing and development platform, and finally SaaS where a full end-user application is provided in the service.

Benefits of SaaS
One of the most visible benefits of a SaaS solution is that it provides potential cost savings compared to an on-premises solution. This means that some maintenance costs and the costs for server rooms are eliminated and there is also a reduced need for full-time helpdesk, hardware and operations support.

Drawbacks of SaaS
The main issue with utilising SaaS as a cost-cutting strategy is that in the long term, say three to four years, the compounded SaaS payments generally exceed the cost of an on-premises solution.⁸ This can be acceptable for investment management firms, since much of the operational risk of driving a complicated systems environment is transferred to the vendor, which allows them to price their services at a premium to the traditional software on-premises model. While a SaaS strategy provides some relief on the balance sheet, in the long run, the actual cost savings are at least questionable and this needs to be carefully considered against the value of the solution and the level of operational risk transferred to the vendor.
One major concern with SaaS has been the security of the business data. This is the most serious risk with using a SaaS deployment strategy and it has many facets. The most crucial problem related to business data is of course a permanent data loss.

When the business data crosses international borders to some offshore data centre, problems with legislative compliance could also arise. This means that cost savings by means of cheaper labour at some SaaS vendor’s offshore operation might not be feasible.

PROCESSES

A logical way to cut costs long term is to look at the processes in the organisation and then try to optimise or at least improve these processes. This could take the form of either improving the existing internal process or to simply hire some external organisation to take over the whole process, using for example Business Process Outsourcing or Managed Services.

Business process improvement
Many companies around the globe use business process improvement as a means to reduce costs. Among investment management firms it is reported to be the most common cost-cutting methodology.² As part of the business process improvement initiatives, strategies like Lean, Six Sigma or Lean Six Sigma are used to reduce waste and reduce variation in processes.

Six Sigma
Around since the mid-1980s, Six Sigma was originally developed by Motorola to improve manufacturing processes and eliminate defects. The core concept of Six Sigma is to 1) define the problem; 2) measure the problem by quantifying the current state and analysing it to reveal the root cause; 3) eliminate the problem by improvements; and then 4) control the result of the change⁹. In a newer iteration, Six Sigma is combined with lean to become Lean Six Sigma. Lean originates from the Japanese car industry of the late-1980s and is similar to Six Sigma.

Even though both Six Sigma and Lean Six Sigma stem from the production industry, both strategies can be applied to other industries as well. All organisations have processes and there is always potential to improve these processes; it is only a matter of what kind of processes that are improved in each organisation.
By the late-1990s, around two-thirds of Fortune 500 companies had some Six Sigma initiatives in play. In the investment management industry, top performers in terms of their ability to generate profit review their cost structure every six months and use BPI or Lean Six Sigma as cost-cutting methodologies.²

Drawbacks of Six Sigma
Six Sigma’s strong focus on optimising individual processes can mean that the individual processes are optimised at the expense of overall enterprise efficiency. An alternative to Six Sigma that can help to overcome this sub-optimisation is to focus on strategic cost drivers. These strategic cost drivers could be:

• business configuration;
• organisational structure and design;
• business and process complexity;
• external spending;
• benefits.

By focusing on the above strategic cost drivers, improvements across business lines and international borders can be achieved over both the short and long term.¹⁰

Business process outsourcing
An alternative to improving internal processes is to simply outsource the entire process, i.e. using business process outsourcing (BPO). Here BPO is defined as when a company outsources the labour part of a process and retains systems and IT in-house. Although still small in absolute terms, this is one of the fastest growing segments in the investment management industry, according to a recent TowerGroup survey.¹¹

Benefits of BPO
The advantage with BPO is that it provides the company with flexibility. BPO moves some fixed costs, i.e. staff costs, to variable costs and it also enables the company to focus on its core competencies and thereby slim the organisation. This in turn can enable the company to become more agile to changing business needs. In a recent SimCorp client survey, the expenditure on own staff in the IT department was reported to make up an average 27% of the total IT budget.

The big proportion of staff costs means that BPO potentially can have a substantial influence on the entire IT budget and suggests that vendors that gain from relatively high economies of scale can provide a cost-efficient alternative to in-house staff for investment management organisations.

Compared to full outsourcing of different business functions including outsourcing of the IT systems, BPO to a greater extent also enables the company to be in possession and control of all business data. To be in control of the business data can be crucial as already discussed.
Drawbacks of BPO
Even if BPO allows the company to be in possession and control of all business data, the major issues with BPO are risks like:

• operational risks – possible slippages in quality, cost or speed of process execution;
• strategic risks – such as protection of intellectual property, security and privacy;
• composite risks – longer-term risks, such as inability or difficulty in replacing the outsourcing vendor with internal resources at a later stage due to loss of knowledge.¹²

Naturally, the risks as cited above have to be carefully considered and analysed before deciding to use BPO to cut costs. However, these risks are very much related to the BPO vendor and to a great extent can hence be eliminated by thorough due diligence during the vendor selection.

Managed Services
A form of outsourcing very similar to BPO is Managed Services. There are many definitions of what Managed Services actually includes, but a reasonable definition is a standardised service, with a relatively small labour component, delivered by a third party for monitoring and maintaining computers, networks and software. It is also common that the Managed Service is delivered as an add-on to an already existing engagement with an IT vendor.

Benefits of Managed Services
The main benefits of Managed Services from a cost-cutting perspective are, as with BPO, that the organisation can focus on its core strategic initiatives and also that the vendor can bring best practices into a project and thereby provide process improvements. In an organisation focusing on growth, an increased focus on strategic initiatives can help the organisation become more agile and possibly also shorten the time-to-market for new offerings. These benefits are very closely related to the benefits provided by BPO.

Another benefit of Managed Services takes the form of efficiencies for one-off tasks or regularly recurring but interrupted tasks like regulatory updates or system upgrades. In these cases, the company buying the service does not have to staff up for these peaks in the workload or maintain the skills for these tasks.

Drawbacks of Managed Services
On the negative side, a Managed Service agreement can be difficult to fulfil if it proves hard for the vendor to fully understand the client’s pain points and the scope of the project, maybe due to a cultural mismatch between the vendor of the service and the client. In an environment with several vendors providing different services, it can also happen that the vendors blame each other when something goes wrong.

Finally, it may prove difficult to exit an existing vendor relationship if the vendor turns out to be uncooperative. It is important to select a trustworthy vendor but also to ensure that the vendor actually understands the processes and pain points of the organisation. Without this understanding of processes and pain points it is hard, if not impossible, for the vendor to provide any useful business process improvements.

Managed Services also include the kind of operational, strategic and composite risks applying to BPO but possibly to a lesser extent since the scope of a typical Managed Service is smaller than a fully outsourced process using BPO.

MAIN CONCLUSIONS

In this article a number of different strategies have been presented to potentially help investment management organisations better manage costs while positioning themselves for growth. Some look very promising at first, but do not necessarily help to manage costs in the medium to long-term timeframe.

From the discussion it is also clear that some cost-cutting strategies have issues that could produce sub-optimisations and potentially endanger the organisation’s existence.

An important point is that any cost management programme involves both cutting costs as well as ensuring that the initiative helps the company to achieve a stronger and more competitive position in the market. Quick fixes can actually prove to be very costly solutions when the figures are finally added up.

Notes

1. SimCorp StrategyLab (2010), ‘Report on Global Investment Management Growth Survey 2010’.
2. SimCorp StrategyLab (2009), ‘Report on Global Investment Management Cost Survey 2009’.
3. Ernst and Young (2010), ‘From cost reduction to cost optimisation’.
4. Cruz, Marcelo (2010), chapter 6 in Pinedo, Michael (ed.), ‘Operational control in asset management: Processes and costs’, SimCorp StrategyLab.
5. Celent (2006), ‘European Post-Trade Processing: STP in the Back and Middle Office’.
6. Aite Group (2011), ‘2011 Capital Markets Technology Spending: Risk, Compliance, and Uncertainty Abound’.
7. Gartner (2011), ‘2011 CIO Agenda survey’.
8. Gartner (2010), ‘SaaS vs. Software: The pros and cons of SaaS pricing’.
9. Arfelt, Klaus (2010), chapter 4 in Pinedo, Michael (ed.), ‘Operational control in asset management: Processes and costs’, SimCorp StrategyLab.
10. Deloitte (2004), ‘Six Sigma’s role in enterprise cost reduction’.
11. TowerGroup (2011), ‘Rodney Nelsestuen: Sourcing, Resourcing, or Outsourcing? Globalizing Operations by 2015’.
12. Kannan, Nari (2011), ‘Reducing operational risk in business process outsourcing’, www.sourcingmag.com.

Robert Olsson, M.Sc., is Research Consultant at SimCorp StrategyLab. He has been working within the IT industry for some 10 years and four years within the financial industry. Robert Olsson has held a number of different positions ranging over software development, training, professional services and marketing. He holds a Master’s degree in Informatics as well as a Master’s degree in Business and Economics earned from Lund University in southern Sweden.