What Morgan Stanley’s E*Trade Purchase Teaches Us About Activity-Based Costing

Buying another firm may create synergy, which can lead to higher sales and profits.

 

The combined firms can produce better results that if each business operated separately.

 

But if you don’t get costs assigned correctly, you won’t know if a company purchase is working as planned.

 

Morgan Stanley’s recent purchase may be wise move.

 

What Happened

 

As the Wall Street Journal wrote:

 

“Morgan Stanley MS -3.87% is buying E*Trade Financial Corp. ETFC -3.81% in a $13 billion deal that will reshape the storied investment bank and firmly stake its future on managing money for regular people.

 

E*Trade ETFC -3.81% brings five million retail customers, their $360 billion in assets and an online bank with cheap deposits that Morgan Stanley can funnel into loans.

 

Its crown jewel is a comparatively low-profile business: managing the stock that employees at hundreds of companies receive as part of their pay. Those shares are typically locked up for a few years and when they become available, E*Trade aims to move those employees into brokerage accounts.

 

Morgan Stanley expects to recoup that premium through $400 million of cost cuts and additional savings of $150 million from using E*Trade’s low-cost deposits to replace more expensive funding.”

 

Why The Purchase Makes Sense

 

Morgan Stanley can generate interest income on loans from E*Trade’s online bank deposits. The firm also has a potential pipeline of new brokerage business from stock awarded to employees as deferred compensation.

 

But the key to making the purchase work is cutting costs. You can’t intelligently reduce costs unless you understand the source of the spending.

 

Think about it.

 

The two firms will eliminate duplicate costs. There’s not longer a need for two accounting departments, two legal staffs, two payroll firms. Sure, there’s more work to be done in a much larger company, but some roles will overlap and not be necessary.

 

Before the combined firms start cutting costs, management needs to take a careful look at the activities that cause expenses to be incurred.

Activity-Based Costing

 

In my Accounting All-In-One For Dummies book, I explain that activity-based costing (ABC) allocates costs based on an activity level. ABC helps a business to assign costs more specifically.

 

Consider the stock-trading department for the combined firms.

 

Morgan Stanley and E*Trade serve different types of investors, but each company needs traders who can buy and sell stocks for clients. Now, much of the activity is automated, but the sheer volume of trading requires an investment in technology, and smart people who can monitor trading, and get the right trades assigned to the correct investors.

 

So, how can you allocate the stock-trading department costs?

 

By thinking about the activities that require more time and effort.

 

Morgan Stanley caters to larger clients, including institutions, who are placing much larger trades than individual investors at E*Trade. Larger trades involve more risk, and more effort to get the customer the right price.

 

If the stock-trading department spends 60% of its time on Morgan Stanley trades, 60% of the cost may be allocated to Morgan Stanley.

 

Other examples of ABC costing:

 

Legal costs are allocated, based on the total time spent on legal cases between the Morgan Stanley and E*Trade.
Payroll costs are assigned based on the number of employees at each company division.

 

The Lesson

 

Before you start to cut costs after a merger, you need to understand the activities that cause the businesses to incur expenses. If not, you may cut cost in the areas that drive the most revenue.

 

Food for thought.

 

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Ken Boyd

Author: Cost Accounting for Dummies, Accounting All-In-One for Dummies, The CPA Exam for Dummies and 1,001 Accounting Questions for Dummies

(email) ken@stltest.net

(website and blog) http://www.accountingaccidentally.com/

 

Image: Dmitry Moraine

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