Product Development:

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Peter Njuguna

Deputy Program Director WOCCU SACCO Cap Project

Nairobi, Kenya

- Loan pricing

October 2008

Product Development:

- Loan pricing

October 2008

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Course objectives

– Identify the two ways a SACCO can charge for loans.

– Recognize two key factors that influence loan pricing.

– Identify key cost drivers in a SACCO

– Identify four methods of pricing financial products

– Distinguish between different pricing strategies – Discuss the different pricing techniques

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Pricing Basics

Two ways a SACCO can charge for loans: 1. charging an interest rate – the SACCO

charges an annual percentage rate (APR) for the member to borrow money.

2. Charging fees – the SACCO charges

specified amounts for loan transactions. e.g a fee to cover the costs of processing a loan.

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Two key factors on pricing

Cost of doing business Supply and demand

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Cost of doing business (1)

What are the key drivers of costs in a financial institution?

1. Cost of funds

2. Administration costs 3. Default

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Cost of funds 1.1 Interest rate

Money used for loans comes from member savings & deposits

• The loan rate charged will be influenced by the interest rate paid on savings

• High interest rates to depositors, logically

implies a higher interest rate for the loan and vise versa

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Cost of doing business (3) 1.2 Cost of funds other than savings

– If loan money comes from sources other than members deposits, the cost of these funds will influence the loan pricing.

• Which are these other sources of funds? • The more you pay to use this money, the

higher or lower the loan rate will have to be, depending on the cost of these funds.

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Cost of doing business (4) 2. Administrative costs:

Associated with making the loan

– Includes marketing, application, screening Associated with maintaining the loan

– Includes monitoring, collections, statements

Administrative costs must be factored into the loan price.

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3. Defaults

– Some loans a SACCO makes will default.

– The SACCO must somehow recover the cost of these losses

– Best practice requires that these loan losses be factored into the loan price.

4. Capital requirement

Capital is primarily built from retained earnings

SACCO must factor in the loan price the capital needs as business grows

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Supply and demand (1)

Two variables at play: the price of an item & the volume at which it is produced

Buyers determine the demand for products and services with what they choose to buy

Sellers determine the supply for products and services with what they choose to produce

As a rule, buyers will try to get as much as they can

for as little as possible

In turn, sellers want to sell as much as they can for as high a price as possible

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If buyers demand more products and services than the sellers can supply, the sellers are in control, and prices will tend to go up.

If sellers supply more products and services than the buyers demand, the buyers are in control, and prices will tend to go down.

When supply exactly equals demand, prices will stabilize.

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When a SACCO prices loans, it needs to be sensitive to supply and demand of credit.

If a loan is priced too high it will be unaffordable to most people, and demand will drop

If a loan is priced too low, this may lead to a lot of people rushing to get a loan.

– This could make fulfilling the demand difficult for the SACCO.

– It might also cause members to take out loans they don’t need.

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How does a SACCO

decide what to charge for

a loan?

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Methods of Pricing loans

Session objectives:

At the end of the session the participants will: Understand the four pricing methods

know the advantages and disadvantages of each pricing method

Identify which method they are using in pricing their products

Know how to use the different pricing methods in pricing their products

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Four Methods of Pricing loans

Pricing based on costs

Pricing based on the competition Pricing based on value

Pricing based on product and service relationships

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Loan pricing: Cost based (1)

• Most common method for determining price.

• The SACCO determines what it costs to provide loans to members, then prices the loans to recoup those costs.

• To set a price, the SACCO must first identify all the costs relating to lending.

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Remember the cost factors:

– Cost of funds

– Administrative costs – Cost of defaults

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Additional cost considerations:

– Direct costs – Indirect costs – Fixed costs – Variable costs

And the costing methods

– Allocation based costing – Traditional based costing – Functional based costing

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Advantages of pricing based on costs

– It’s simple. The information a SACCO must use to set the price is easy to obtain.

– The price is tied directly to the cost of doing business; therefore, if done properly, the

SACCO should remain financially viable.

– A good method to ensure that the SACCO’s cost of doing business does not exceed its income.

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Disadvantages of pricing based on costs

– It’s completely internal and therefore not sensitive to market prices.

– If the SACCO’s prices end up being

higher than market prices, there will be low or no demand for its loans.

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Suggestions for using the pricing based on costs method.

– When determining costs, include both direct and

indirect costs.

– Calculate total indirect costs, and then allocate a portion of these costs to the lending function.

– If your SACCO provides a higher level of service than other financial institutions, you can expect the price to be higher.

– Use more than just Cost Basis to determine the price of a loan.

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Loan pricing: Competition based (1)

SACCO researches what other institutions are charging for loans and then prices its own loans accordingly.

– SACCO may choose to price the loan exactly as the competition has priced it,

or

– the SACCO may choose to undercut the

competition by pricing the loan slightly below competition.

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Advantages of pricing based on the competition

– It’s simple. The information a SACCO must use to set the price is easy to obtain.

– It involves the least amount of data collection. The only thing a SACCO needs to do is shop around for competitors’ prices.

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Disadvantages of pricing based on the competition

– It’s completely external and therefore ignores the costs of doing business.

– Can be misleading if the competition’s internal cost are different from the SACCO, and

– If this happened, the SACCO’s financial viability would be threatened.

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Suggestions for using pricing based on the competition

– Use this method in conjunction with the cost method. This gives a balance between staying abreast of the competition while at the same time covering the costs of doing business.

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Loan pricing: Value based (1)

Pricing based on value is less common than pricing based on cost or competition.

The SACCO researches what consumers are willing to pay for loans (their perceived value), then prices its own loans accordingly.

Appropriate method for pricing because it is sensitive

to consumers.

It is also the most difficult because determining perceived value is complex and subjective.

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Advantages of pricing based on value

– It is customer focused.

– Loan price likely to be optimal as the customers have identified the value.

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Disadvantages of pricing based on value

– Ignores the need to ensure financially viability of the loan product & SACCO

– Loss of money if the perceived value of a loan is less than the cost to make/maintain the loan

– Difficult to identify the perceived value. It requires extensive market research and even then, the

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Pricing based on product and service relationship (1)

This method of pricing views financial services as a relationship, not a transaction business.

Products and services are not priced one at a time, but rather as a package.

The belief is that the consumer will want the entire package instead of just one or two products.

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Example: Diva Club Account by Standard Chartered Bank (K) Ltd

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You’re a woman who deserves the best. We will make sure you get it! A flat monthly fee of $10 Only!

Standing orders

Local and foreign telegraphic transfers Ledger fees

Traveller’s cheques

Local ATM cash withdrawals Cheque books

Local ATM cash withdrawals

Purchase and sale of foreign currency notes Free International Debit Card

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Lifestyle Benefits * from:

Africa Breast Health Programme

Signature Spa Xenihealth Clinic

Auto Insurance Co Ltd Africa Shell

Top of the World

Cont………….

Designers Outlet

Multichoice Africa Ltd

Episode Video Ltd

Indoors East Africa Ltd Africa Hair Finesse Ltd Aromatics Spa

Wines of the World Royal Court Hotel

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Pricing based on product and service relationship (2)

Advantages:

– A complete package of products and services can be appealing to members.

– Research has shown that consumers want a relationship with their financial institution. They want to be able to conduct all their financial

business in one location.

– If the pricing is done correctly, the SACCO will enjoy financial benefit through selling a

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Time for some brain exercise

Group exercise:

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Pricing strategies

Session objectives:

At the end of this session, the participants will:

differentiate between the two most common pricing strategy.

understand the Relationship between pricing strategy and pricing methods.

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What must a SACCO do to be the lender of choice to the people in its community?

The pricing method a SACCO chooses is informed by its pricing strategy.

Two pricing strategies:

– Cost leadership strategy, and – Differentiation

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Cost leadership strategy:

Make the SACCO the low-cost lender of choice. – Products consistently priced at or below the

competition

– Should not compromise product quality or service otherwise cost advantage is lost

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To excel at cost leadership:

SACCO must be outstanding at running its operations effectively and efficiently.

– Processing time must be fast,

– Processes must be continually streamlined, – Errors must be kept to a minimum,

– Overhead must be low,

– Labor costs must be kept at a minimum, and

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b) Differentiation:

– A SACCO attempts to set itself apart by offering a

distinctive product or service that is considered of value to the member.

– Members are willing to pay a higher price for differentiation.

– However, they must perceive that they are getting

something of value for the extra amount they are

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To excel at cost differentiation:

– SACCO must determine which product or service it will offer as unique.

– Product or service must be truly unique.

Otherwise,

– Members will perceive that they can get the same product or service anywhere and at a lower cost. – SACCO must also be cost competitive

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Can a SACCO apply the two pricing strategies together?

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Balancing the two pricing strategies:

Regardless of the pricing strategy it chooses, a

SACCO must pay some attention to the other strategy. If a SACCO chooses to be a cost leader, it must still differentiate to a degree. Otherwise,

– members might feel the product or service isn’t worth the reduced price.

– E.g., if a SACCO chooses to maintain cost leadership by

cutting back on member services, a member might resent

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Balancing the two pricing strategies:

Similarly, if a SACCO chooses to differentiate, it must still pay attention to price.

– a member is willing to pay more for added value, but only if the additional price stays reasonable.

– E.g., If a SACCO offers a debit card because members have said they want it but they charge too much for the card, members won’t afford it and therefore they will not take advantage of the SACCO’s differentiation.

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Pricing strategies & pricing methods

Cost leadership and pricing method:

To be an effective cost leader, price products and

services based on costs and competition. Constantly monitor,

– Costs: To ensure that prices charged are ‘affordable’ and – Competitor activities: Ensures that pricing is always

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Pricing strategies & pricing methods

Differentiation and pricing method:

To be effective at differentiation, price its products

and services based on value and on product and

service relationships.

Constantly monitor:

– what the member wants, the SACCO learns how it should differentiate, and also

– a SACCO may be able to differentiate by offering a variety of products and services in a package.

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Pricing techniques

Session objectives:

List and differentiate the different pricing techniques Understand the rationale for each pricing technique

Understand where it is appropriate to apply each of the pricing techniques

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Six common pricing techniques:

Tiering Fractional pricing Skimming Penetration Loss leader Discounting

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1) Tiering

– Tiering is the practice of charging different prices for different sizes of loans.

– The higher the loan amount, the lower the loan interest rate.

– A member who needs to borrow a large sum of money benefits from tiering.

– Unfavorable to members who don’t need a large loan amount

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2) Fractional pricing

– Fractional pricing is the practice of using non-whole numbers for pricing.

– Goal is to have the member perceive that he is getting a lower price.

– Has the effect of causing the member to think the SACCO is offering every possible fraction of

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3) Skimming

– Applicable in a market segment that lacks price sensitivity

– Often used with the differentiation pricing strategy, because the business can target a high-end

market segment, and then offer a unique product at a high cost.

– A SACCO may choose skimming by identifying some of its best members, then offering them a

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4) Penetration

– Aims at capturing a market share or a larger base of consumers

– As the business gains market share, it becomes the industry leader.

– Having successful penetration allows a SACCO to control product pricing, design and distribution.

– Businesses often gain penetration by slashing prices, causing consumers to switch.

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5) Loss leader

– A SACCO using this technique sells one product at a loss in order to attract consumers.

– Technique effective where a SACCO can cross-sell

– Used to introduce a new product to quickly gain market share.

– Generally, a product is sold at a loss for only a short period of time

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6) Discounting

– With this technique, the business will discount the price of a product or service for a period of time. – During this time, the volume for the product or

service increases.

– A SACCO might discount a popular product or service in order to get a large number of new members.

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Group exercise:

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Peter Njuguna

Deputy Program Director

[email protected]

www.woccu.org

Product Development for Competitive

Advantage

October 2008