U.S. merchant acquirers’ cost per transaction has fallen dramatically over time, and nearly every acquirer has benefited from this phenomenon in some respect. Of course, some acquirers have benefited more than others, which makes it an interesting question to examine the different cost-competitiveness strategies acquirers pursue.
Cost reduction results from many factors, but one of the factors is scale. There is a school of thought that players that insource, or handle all major processing functions themselves, have a scale advantage over those that outsource functions to third-party processors or bigger acquirers. First Annapolis Consulting set out to see if we could quantify this concept.
Scale is an important factor driving acquiring costs, but it is not the only factor. Acquirer efficiency has been an enormous source of expense reduction for the industry over the past years.
Think of efficiency as being a reduction in variable costs—being able to perform discrete operational functions for less. For example, acquirers drove down the cost of processing a chargeback through the application of rules-based systems that, among other benefits, resolved certain technical chargebacks without human intervention. Depending on the company, acquirers now resolve up to 40% of chargebacks in this manner.
Similarly, acquirers have implemented automated approval tools in their underwriting processes, approving merchant applications with little or no human intervention. Depending on the acquirer, as many as 70% of applications can be handled with such automation. These are both examples of great leaps forward in efficiency—the variable cost to perform an activity.
Who’s Scale-Sensitive?
Third-party processing expense reduction is a form of efficiency, in a sense. If an outsourced acquirer renegotiates its pricing with a third-party processor, the acquirer’s variable costs fall. However, third-party processor expense reductions typically occur only automatically in the billing elements that are volume-tiered, which is only a portion of the fees in a typical back-end/front-end processing contract. These fees also are tiered with a shallow scale curve, if you will—they are not particularly scale-sensitive.
A simple way to think of scale is that it results primarily from the leveraging of fixed costs—so as an acquirer grows, its overall cost per transaction declines as the fixed component of expenses is spread over a larger base. Therefore, the theory arises that insourced acquirers will have much more in fixed costs and scale sensitivity than outsourced acquirers that make their processing expenses variable in third-party processor billing elements.
Scale and efficiency are related in many ways, which makes the distinction a little artificial. For example, it is the larger acquirers that are most able to make the technological investments that generate efficiency in the back office. In the course of making such investments, these acquirers improve efficiency, but they also interject fixed costs into labor-intensive functions and create more opportunity for scale, etc. Acknowledging these interdependencies, our rough estimate is that half of the expense reduction in the business since the early 1990s is related to scale versus efficiency.
To evaluate the impact specifically of insourcing on scale, we created two samples of acquirers. The first sample included 10 acquirers with outsourced core processing— meaning the front-end (authorization and draft capture) and the back-end (clearing, settlement, statementing, etc.). These acquirers included both large and small players, the largest of which is a Top 10 acquirer.
We also created a sample of five insourced acquirers that also ranged from very large acquirers to quite small ones, the smallest of which was not in the Top 20. We looked at five years of data for each acquirer, relating the increase in sales volume to the decrease in operating expense per transaction.
We are admittedly dealing with a relatively small sample, but our simple regression analysis suggested material differences in scale sensitivity between the two groups. Regression in this context is a statistical approach to quantify the relationship between increases in volume to decreases in operating costs. Our first conclusion is that the insourced group was materially more sensitive to scale than the outsourced group (that is, the slope of the regression line was steeper for the insourced players). This means that increases in volume tend to result in a greater decrease in cost per transaction for the insourced set.
In addition, the R2 was much higher for the insourced group. An R2 is a measure of the quality of the regression analysis, in a sense. Think of a higher R2 (0.65 for the insourced acquirers vs. 0.27 for the outsourced acquirers) as indicating that scale simply explains more of the reduction in cost per transaction for the insourced acquirers than the outsourced acquirers.
The outsourced acquirers also had declining costs, but the decline was not much related to scale, per se—scale was not very explanatory of reductions in costs per transaction. This makes some intuitive sense. An outsourced acquirer tends to generate a material initial benefit on the initial outsourcing decision and then reaps periodic benefits every three or five years during contract renegotiations.
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