Relative compliance cost

What Is Relative Compliance Cost?

Relative compliance cost refers to the cost incurred by an organization to adhere to laws, regulations, and internal policies, expressed as a proportion of a relevant financial or operational metric. This concept falls under the broader category of financial regulation and corporate finance, providing a lens through which to assess the true burden of compliance. Unlike absolute compliance expenses, relative compliance cost provides a comparative measure, highlighting how compliance outlays impact different entities or the same entity over time, relative to their size, revenue, or other relevant indicators. Understanding relative compliance cost is crucial for businesses to evaluate their operational efficiency and for policymakers to assess the equitable application of regulatory costs across an industry.

History and Origin

The concept of regulatory compliance costs, and subsequently their relative impact, gained significant prominence with the proliferation of complex financial regulations enacted in response to market crises. Major legislative acts, such as the Sarbanes-Oxley Act of 2002 and the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, significantly increased the regulatory landscape for corporations, particularly in the financial sector. Following the 2008 financial crisis, the Dodd-Frank Act introduced extensive changes across the financial regulatory system. Studies have estimated that the Dodd-Frank Act increased banks' total noninterest expenses by an average of more than $50 billion per year, affecting both salary expenses for new hires and non-salary expenses like auditing, consulting, and legal fees.⁷ The disproportionate impact on smaller entities quickly became a key area of discussion, underscoring the importance of examining these costs in relative terms rather than just absolute figures. For instance, smaller companies reported that their Chief Financial Officers and accounting staff spent as much as 90 percent of their time on Sarbanes-Oxley Act compliance-related issues in the period leading up to their first Section 404 report.⁶

Key Takeaways

• Relative compliance cost measures the expense of regulatory adherence as a proportion of a business's size, revenue, or other relevant metric.
• This metric helps reveal whether compliance costs are equitably distributed across firms of different scales or within an organization over time.
• Small and medium-sized enterprises often face a higher relative compliance cost due to fewer economies of scale in managing regulatory requirements.
• Understanding relative compliance cost is vital for strategic planning, resource allocation, and advocating for regulatory proportionality.

Formula and Calculation

The relative compliance cost can be calculated by dividing the total compliance costs by a chosen normalization metric, such as revenue, assets, or employee count.

Where:

• Total Compliance Costs: All direct and indirect expenses associated with meeting regulatory requirements, including salaries for compliance staff, technology, legal fees, auditing fees, training, and administrative burdens.
• Normalization Metric: A baseline figure used for comparison, such as:
  • Revenue: Often used for general businesses to see compliance cost as a percentage of sales.
  • Total Assets: Common in financial institutions to reflect the cost relative to their balance sheet size.
  • Number of Employees: Useful for understanding the per-employee compliance burden, especially in service-oriented industries.

For example, if a company incurs $100,000 in compliance expenses and has $10 million in annual revenue, its relative compliance cost based on revenue would be 1%. If another company has $50,000 in compliance costs but only $2 million in revenue, its relative compliance cost would be 2.5%, indicating a higher proportionate burden despite lower absolute costs.

Interpreting the Relative Compliance Cost

Interpreting the relative compliance cost involves comparing the calculated ratio against industry benchmarks, competitors, or the entity's historical performance. A higher relative compliance cost might indicate inefficiencies in compliance processes, a disproportionate regulatory burden for the entity's size, or operations in a highly regulated sector. For instance, studies have shown that compliance costs tend to be lighter for smaller businesses, but the regulatory burdens increase for companies as they grow up to about 500 workers. Beyond this threshold, direct compliance costs may decrease with size as larger firms can centralize compliance efforts and benefit from economies of scale.⁵

Conversely, a lower relative compliance cost could suggest effective risk management strategies, successful integration of compliance into core business functions, or a less stringent regulatory environment. Companies might analyze this metric to inform strategic decisions regarding mergers and acquisitions, entry into new markets, or investments in compliance technology. Understanding this ratio helps management assess the impact of regulatory demands on their profitability and competitiveness.

Hypothetical Example

Consider two hypothetical financial advisory firms, Alpha Advisors and Beta Brokers.

• Alpha Advisors: A smaller firm with 20 employees and $5 million in annual revenue. Its total annual compliance costs, including staff salaries, software, and legal consultations, amount to $150,000.
• Beta Brokers: A larger firm with 200 employees and $50 million in annual revenue. Its total annual compliance costs are $1,000,000.

To calculate their relative compliance costs:

Alpha Advisors:

Beta Brokers:

In this example, despite Beta Brokers having significantly higher absolute compliance costs, its relative compliance cost, whether measured against revenue or per employee, is lower than that of Alpha Advisors. This illustrates how smaller firms, like Alpha Advisors, can face a proportionally higher burden due to the presence of fixed costs associated with compliance that do not scale down linearly with business size.

Practical Applications

Relative compliance cost is a key metric in various areas of finance and business. In strategic planning, companies analyze this cost to determine the viability of operating in heavily regulated industries or to assess the impact of new regulations on their business model. It informs decisions about capital allocation towards compliance infrastructure versus other growth initiatives.

For small and medium-sized enterprises, this metric is particularly relevant because they often bear a disproportionately higher per-employee cost of compliance compared to larger competitors.⁴ This disparity can affect their ability to compete, innovate, and grow their market share. For example, the implementation of the Basel III framework, which aims to enhance global banking financial stability, can lead to increased capital requirements for banks, potentially impacting the availability of loans for small businesses and other borrowers.³ Policymakers and regulators also use relative compliance cost analyses to evaluate the impact and fairness of new rules, aiming to design regulations that are effective without unduly burdening specific segments of the economy. Research indicates that the average U.S. firm spends between 1.3 and 3.3 percent of its total wage bill on regulatory compliance, with labor costs often forming a significant portion of these expenditures.²

Limitations and Criticisms

While relative compliance cost offers valuable insights, it has limitations. A primary challenge lies in accurately quantifying all components of total compliance costs, especially indirect costs such as lost productivity due to compliance-related tasks or missed business opportunities. Distinguishing between genuine compliance expenses and general operational costs can also be difficult. Moreover, the choice of normalization metric can significantly influence the resulting ratio, making comparisons across different industries or business models challenging without careful consideration.

Critics also point out that focusing solely on cost might overlook the benefits of compliance, such as enhanced reputation, improved corporate governance, reduced legal risks, and greater investor confidence. Sometimes, a higher relative compliance cost might be a necessary investment to ensure long-term sustainability and avoid much larger penalties or reputational damage. Additionally, regulatory changes are often complex and can have unforeseen consequences, making it difficult to isolate the exact impact of a single regulation on compliance costs. For instance, the Dodd-Frank Act, while intended to reduce risk, was also criticized for its substantial and sometimes disproportionate regulatory burden on smaller banks.¹

Relative compliance cost vs. Regulatory burden

Relative compliance cost and regulatory burden are related but distinct concepts. Regulatory burden is a broader term that encompasses the entire weight and complexity of rules, regulations, and administrative requirements imposed on businesses and individuals by government agencies. It refers to the overall impact, including not just direct costs but also indirect effects like reduced innovation, diverted resources, and market distortions.

Relative compliance cost, on the other hand, is a specific quantitative measure. It expresses the financial outlay for meeting regulatory requirements as a ratio to another business metric. While regulatory burden describes the qualitative and quantitative impact of regulation as a whole, relative compliance cost provides a precise numerical proportion of the financial expense of compliance against a relevant scale, allowing for more direct comparison and analysis of the financial impact. The confusion often arises because a high regulatory burden will typically lead to higher absolute and, often, higher relative compliance costs, especially for entities that cannot leverage variable costs or economies of scale in compliance efforts.

FAQs

What drives relative compliance cost?

Relative compliance cost is driven by the volume and complexity of regulations, the industry a company operates in, the firm's size and structure, and its internal efficiency in managing compliance processes. Highly fragmented or rapidly evolving regulatory environments often lead to higher relative costs.

How does firm size affect relative compliance cost?

Smaller firms, particularly small and medium-sized enterprises, often experience a higher relative compliance cost because they may lack the resources to achieve economies of scale in compliance departments or technology that larger organizations can leverage. Many compliance requirements have fixed components that do not decrease proportionally with a company's size.

Can relative compliance cost change over time for the same company?

Yes, relative compliance cost can change due to new regulations, updates to existing rules, changes in the company's size or revenue, or improvements in its internal compliance expenses management. Investing in compliance technology or streamlining processes can help reduce this ratio over time.

Why is relative compliance cost important for investors?

For investors, understanding relative compliance cost provides insight into a company's operational efficiency and potential profitability. A consistently high or increasing relative compliance cost compared to peers could indicate inefficiencies, competitive disadvantages, or exposure to significant regulatory risks that might impact future earnings. It helps investors assess the true "cost of doing business" in a regulated environment.