Uncovering the Hidden Cost of Complexity

BY STEPHEN WILSON, BOB DELEEUW, BRYAN CAREY AND NICK REYNOLDS

Product and service expansion designed to boost revenues can introduce complexity that compromises the profitability of a diversified strategy.

| SYNOPSIS | Adding products and services often leads to excessive complexity in financial organizations. Curing this problem requires understanding what services are truly valued by customers; assessing the real cost of providing those services; developing a “complexity map” to distinguish which products and services impair productivity; designing processes to handle more variety of value-added services; and innovating around those services.

As banks became more customer-focused over the last decade, they expanded their product set rapidly — for example, by offering products and services related to retirement and investment.

While this diversification generated additional revenues, the increased organizational, operational and business portfolio complexity it introduced has severely hampered productivity. Such complexity limits the net gains from diversification efforts. The reduction of complexity needs to be an operational and strategic priority if banks intend to keep their cost structures in line with their revenue growth.

Unfortunately, controlling complexity is not an easy task. First, market pressure will continue to force ever greater diversity in offerings. Second, the organizational impact of complexity shows up in thousands of incremental delays and costs that individually can be hard to quantify but collectively impair productivity and profit. We’ve met, for example, a bank that used 3,000 spreadsheets to handle “exception processing” for retirement planning products. Establishing training for and maintaining a single spreadsheet is not much of a burden but it becomes a big problem when you’re committed to managing 3,000 of them.

The cost impact of complexity often represents the single biggest impediment to successful strategy execution, productivity growth and cost-competitiveness. Conversely, the ability to assess and manage complexity is tied to better profit performance, according to recent George Group research in collaboration with Knowledge@Wharton, the online business journal at the University of Pennsylvania’s Wharton School (see chart).

To uncover and correct excessive complexity, financial institutions must understand what services are truly valued by customers; assess the real cost of providing those services; develop a “complexity map” to distinguish the products and services that impair productivity; design processes to handle more variety of value-added services; and innovate around those services.

Banks that adopt this methodology will enjoy an ongoing competitive advantage in terms of improving their operating productivity and product and process innovation. We have found that banks often copy strategies from one another, but rarely strategic process advantages, such as those conferred by this methodology.

The Cost of Complexity

The productivity problem in banking can be seen in efficiency ratios reported to the Federal Deposit Insurance Corp. by banks over $1 billion in assets (see chart). These show that productivity has stagnated in the last five years, after steady improvement through the 1990s, despite a favorable environment for banks in recent years.

Many institutions are clearly failing to convert increased revenue to increased profitability. Our contention is that the primary culprit is the operational complexity needed to support a broader portfolio. In the past, financial institutions handled less variety so “assembly-line” processes evolved, processes that could handle volume well, but not variety. If you put variety through a process designed for “plain vanilla,” you get increased operational and quality issues, such as workarounds, re-working, cost-overruns, increased staffing levels, etc.

An example of this phenomenon is small business lending, where loans still require extensive manual input despite efforts to automate the process. One problem is that banks invested in technology, hardware and software without first addressing the underlying processes.

While technology has made many tasks in banking easier, it is not a panacea for addressing the underlying complexity. The key questions about complexity faced by managers are:

• What are the costs of complexity? What is the impact of all those varieties of offerings on branch, marketing, IT systems and management costs?
• Are the additional services worth enough to customers that you can recoup them via added fees, loan or deposit volume or assets under management? If you can, the added features, products, services, etc., represent good complexity; if you can’t, that’s bad complexity.
• What can you do to minimize the costs of operational complexity, operational costs and become more competitive?

Few banks know how to quantify the impact of complexity on cost, execution and customers, let alone take proactive measures to address the issue. There are many reasons for this. One is that complexity costs fall across many functions in the bank, yet most accounting practices reflect the siloed nature of the organization.

This obscures the cause-and-effect of added complexity and its costs. The cost of adding a mortgage product is actually the sum of added marketing materials and awareness-building costs, back-office systems programming, training of branch and back-office staff and management time. This cost doesn’t include the impact of the new product on the existing product line or the potential confusion it causes existing and potential clients.

Second, standard financial metrics do not usually capture the costs of complexity, i.e., those extra costs related to the increased coordination, management and service requirements associated with a broad portfolio of products and services. Such costs often materialize in the form of longer average fulfillment times, increased staffing levels, decreased customer satisfaction, increased re-work and higher staff turnover.

These factors feed into and compound one another, making the cost of complexity worse than any single factor alone. For example, at a large bank that handled large corporate payments via a lockbox function, every corporate customer had its own set of instructions on how to process their payments. The salespeople would do whatever customization was necessary to make the sale, which left the back-office staff to figure out how to service all the specialized requests. Service levels fell and costs increased as the back office hired additional staff to deal with the complexity of the customization (a lot of inspection and re-work).

This situation has been repeated across the banking industry in nearly every process used to support the increased service demand. For example, the cost of complexity increases with each new mortgage product, new checking account, deposit product or even a new branch or completing another acquisition.

The costs of complexity are insidious, creeping in over time with no obvious single driver, and that makes them difficult to notice and quantify. They continue to accumulate, raising costs and impeding productivity.

Telling Good from Bad

Another challenge in accounting for complexity and its impact is distinguishing the good complexity from the bad. This requires knowing which features, products, configurations, etc. are valued by the customer and which are not.

The issue with most customer analysis is that it is usually fairly rigid in the types of questions asked. Typical questions include: What matters to you most in your banking experience? What are the key service level attributes that would motivate your choice of retail account? And so on. Institutions are not accustomed to testing how much customers would value configuration A (checking account with no fees or deposit minimum) as opposed to configuration B (checking account that pays interest on deposit balances).

Banks need to identify and understand how customers use their products and what stimulates their purchasing decisions. Using the lockbox example, the bank would need to evaluate what features are used and what trade-offs customers would be willing to make between features and/or price. If they value the fully customized service and rapid turnaround enough, for example, the bank can hire additional staff.

What typically happens in these situations, though, is that the bank unwittingly absorbs the increased costs of supporting the complex service in part because it can’t quantify what it takes to deliver a specific service level — such as same-day turnaround vs. 24-hour turnaround.

Knowledge of what customers value and how much they value it must be combined with knowledge about what drives complexity. This can be used to create products and services that customers desire, but without increasing levels of operational complexity or, minimally, assuring that costs are recovered if the complexity is indicated. It’s a win-win: an opportunity to reduce the costs and increase the value proposition for customers by steering them to the configuration that is valuable to them and more cost-effective for you.

Unfortunately, it is often easier to focus instead on what competitors are doing, or address internal drivers, than assess what the customer really values. The inadvertent result is that the customer is penalized by the complexity of additional offerings, as opposed to benefiting from them. In fact, it is not unusual for complexity to be invisible to the organization because it views itself functionally and doesn’t see all the spaghetti flow and hand-offs in actual practice (see chart). Customers, however, are acutely aware of complexity as they come face to face with its impacts: impaired service levels and a confusing customer experience.

The recommended approach to addressing complexity is to analytically link the drivers and impacts of complexity while understanding the kind of variety and choice the customer truly values. This process-oriented approach enables institutions to capture the multiple cost impacts and interactions driven by the complexity. This, in many cases, drives a revised view of what things really cost. The implication is not that banks should limit the variety of options to their customers, but that they should do the following.

1. Understand what complexity is valued by customers.
   As discussed earlier, the only way to address “bad” complexity is to learn to view the banking experience and range of bank offerings through customers’ eyes. Taking a customer-centric view will shed light on the quality of the customer experience, e.g., how easy is it to open a new account? Check the status of a loan application? Get explanations of investment options? It will also reveal the features customers actually value, such as the amount that commercial customers will pay to have their invoice numbers tracked with payments.
   
   Taking a customer view will shed light on the quality of the offering portfolio, to understand if the portfolio represents appropriate breadth and depth or whether it’s just mimicking the competition.

   In the course of this, two questions must be answered:

   1. Is the institution over-delivering in terms of portfolio breadth and depth, relative to what customers really want and will pay for? For example, how do customers value a variety of mortgage or loan products? Does the value they attach to these differing offerings support the additional operating costs?
   2. Is the complexity of an offering negatively impacting critical service levels that matter to customers? For example, are administrative processes able to handle the execution on the variety promised or are customers experiencing slow response times, quality issues or product selection confusion?

   If the answer to both questions above is yes, addressing the hidden cost of complexity is both an operational and a strategic issue and requires management priority.

2. Quantify the hidden costs
   Quantifying the hidden cost of complexity is critical because, absent this understanding, banks will proceed as if complexity is free, resulting in out-of-control proliferation. One of the insidious aspects of complexity is that no one generally owns it. Therefore, it escapes attention and many of the damaging, costly side effects remain. In the lockbox example, the IT cost of providing customized solutions was never accounted for in the product P & L and was effectively free to the customer service group, although overall it was costing the bank a substantial amount.

   Begin by examining processes to identify the drivers of complexity and their effects on direct and indirect costs. Banks can adjust product or service profitability to reflect the effects of complexity. This will help establish the cost (and execution) impact of complexity and will help drive executives to focus on the issue.

3. Identify the drivers and impacts of complexity
   Complexity tends to creep into organizations for three reasons. One, gaps in critical information for identifying and quantifying complexity—such as gaps in costing systems or a lack of customer intimacy—mean that executives are acting out of ignorance about what is valued and what it costs. Two, incentives based on revenue growth or market share might encourage a proliferation of offerings without a view to overall profitability. Three, a number of critical processes are missing or insufficiently robust. Maybe there is no product portfolio review process or no process to delete products and services when new products are added.
   But these reasons vary with each situation, which is why individual banks should identify not only what is driving complexity but also where it is entering the bank and what the impact is. A Complexity Map can be used to identify and link the drivers and impacts of complexity (see chart).
   
4. Design processes to handle variety
   Internal processes must be suited to the institution’s current business model and priorities. They must accommodate any complexity that management decides to retain and they must be capable of supporting added complexity in the future at minimal costs. Many bank processes are equipped to deal with high volume and low variety, whereas the demand is for the reverse, i.e., lots of small volume/high variety tasks such as tailored investment plans, variable length CDs or specialized mortgage products.

   Bridging the gap requires an assessment of the following: What is the overall state of an institution’s processes? Are they well structured with low variation and waste? How much of process lead time or service response time is consumed by value-add activities?

   This can be a key baseline indicator and show the flexibility of processes. When very few activities would be paid for by customers (if they could see them), that indicates the need for focused process improvement or a different approach to how offerings are structured. For example, in order to drive some of the scale advantages while still keeping a lot of variety, many institutions will “stratify” their offerings around the process impact, so the high-volume transaction benefits are not impeded by the high-variety (i.e., costlier) offerings.

   The lockbox operations cited earlier, for example, created a new process for handling high-priority checks. The bank defined this as a specialized service for customers with a guaranteed service level, which in turn let them attach a premium fee for the service. The lockbox operation improved the process, in which part of the solution was creating a new process to handle high priority items. This resulted in better, more reliable service levels for both the high priority items and the regular items. But it was only after it could guarantee service levels that the bank was able to start charging premium pricing.

5. Innovate around advantages
   Banks that can develop better customer intimacy and processes that can handle variety will have a distinct competitive advantage — and one that can become a platform for growth. By developing better execution processes, banks are effectively lowering the cost of complexity. By getting closer to the customer, banks are effectively increasing the relevance of the offering portfolio. This means that future innovations will be less expensive, as the bank can build off existing “advantaged” processes — and are more likely to succeed — as they become closer to the customer to understand the previously unidentified and unmet needs.