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Peter NjugunaDeputy Program Director

WOCCU SACCO Cap Project

Nairobi, Kenya

Product Development:- 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 financialproducts

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 SACCOcharges an annual percentage rate (APR) for

the member to borrow money.

2. Charging fees the SACCO chargesspecified 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 costs3. Default

4. Capital requirements

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Cost of doing business (2)

Cost of funds

1.1 Interest rateMoney used for loans comes from

member savings & deposits

The loan rate charged will be influenced bythe interest rate paid on savings

High interest rates to depositors, logicallyimplies a higher interest rate for the loan andvise 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 thanmembers deposits, the cost of these funds willinfluence the loan pricing.

Which are these other sources of funds?

The more you pay to use this money, thehigher 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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Cost of doing business (5)

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 befactored into the loan price.

4. Capital requirement

Capital is primarily built from retained earningsSACCO 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 producedBuyers determine the demandfor products and

services with what they choose to buy

Sellers determine the supplyfor products andservices with what they choose to produce

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

for as littleas possibleIn turn, sellers want to sell as muchas they can for as

high a priceas possible

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Supply and demand (2)

If buyers demand more products and services than

the sellers can supply, the sellers are in control, andprices will tend to go up.

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

When supply exactly equals demand, prices willstabilize.

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Supply and demand (3)

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 tomost people, and demand will drop

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

This could make fulfilling the demand difficult for theSACCO.

It might also cause members to take out loans they dontneed.

Heard of the sub-prime mortgage loans?

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How does a SACCOdecide what to charge for

a loan?

Pricing of loans

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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 ofeach pricing method

Identify which method they are using in pricing

their productsKnow 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 servicerelationships

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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 theloans to recoup those costs.

To set a price, the SACCO must firstidentify all the costs relating to lending.

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Loan pricing: Cost based (2)

Remember the cost

factors: Cost of funds

Administrative costs

Cost of defaults

Capital requirements

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Loan pricing: Cost based (3)

Additional cost considerations:

Direct costs Indirect costs

Fixed costs

Variable costsAnd the costing methods

Allocation based costing

Traditional based costing Functional based costing

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Loan pricing: Cost based (4)

Advantages of pricing based on costs

Its simple. The information a SACCO must useto set the price is easy to obtain.

The price is tied directly to the cost of doingbusiness; therefore, if done properly, theSACCO should remain financially viable.

A good method to ensure that the SACCOs costof doing business does not exceed its income.

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Loan pricing: Cost based (5)

Disadvantages of pricing based on costs

Its completely internal and therefore notsensitive to market prices.

If the SACCOs prices end up beinghigher than market prices, there will be

low or no demand for its loans.

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Loan pricing: Cost based (6)

Suggestions for using the pricing based on costsmethod.

When determining costs, include both directand

indirect costs.

Calculate total indirect costs, and then allocateaportion of these costs to the lending function.

If your SACCO provides a higher level of service

than other financial institutions, you can expectthe price to be higher.

Use more than just Cost Basisto 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 loansaccordingly.

SACCO may choose to price the loan exactlyas the competition has priced it,

or

the SACCO may choose to undercut thecompetition by pricing the loan slightly belowcompetition.

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Loan pricing: Competition based (2)

Advantages of pricing based on the competition

Its simple. The information a SACCO must useto set the price is easy to obtain.

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

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Loan pricing: Competition based (3)

Disadvantages of pricing based on thecompetition

Its completely external and therefore ignores thecosts of doing business.

Can be misleading if the competitions internalcost are different from the SACCO, and

If this happened, the SACCOs financial viability

would be threatened.

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Loan pricing: Competition based (4)

Suggestions for using pricing based on the

competition

Use this method in conjunction with the cost

method. This gives a balance between stayingabreast of the competition while at the sametime covering the costs of doing business.

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Loan pricing: Value based (1)

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

The SACCO researches what consumers are willingto pay for loans (their perceivedvalue), then pricesits own loans accordingly.

Appropriate method for pricing because it is sensitiveto consumers.

It is also the most difficult because determining

perceived value is complex and subjective.

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Loan pricing: Value based (2)

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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Loan pricing: Value based (3)

Disadvantages of pricing based on value

Ignores the need to ensure financially viability ofthe loan product & SACCO

Loss of money if the perceived value of a loan isless than the cost to make/maintain the loan

Difficult to identify the perceived value. It requiresextensive market research and even then, theresults are subjective.

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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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Example: Diva Club Account by

Standard Chartered Bank (K) Ltd

Youre a woman who deserves the best. We will make sure you get it! A flatmonthly fee of $10 Only!

Standing ordersLocal and foreign telegraphic transfersLedger feesTravellers cheques

Local ATM cash withdrawalsCheque booksLocal ATM cash withdrawalsPurchase and sale of foreign currency notesFree International Debit Card

One local and foreign currency bankers cheque per month

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Example: Diva Club Account by

Standard Chartered Bank (K) Ltd

Lifestyle Benefits *from:

Africa Breast HealthProgramme

Signature SpaXenihealth Clinic

Auto Insurance Co Ltd

Africa ShellTop of the World

Cont.

Designers OutletMultichoice Africa Ltd

Episode Video Ltd

Indoors East Africa LtdAfrica Hair Finesse Ltd

Aromatics Spa

Wines of the WorldRoyal Court Hotel

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Pricing based on product

and service relationship (2)

Advantages:

A complete package of products and services canbe appealing to members.

Research has shown that consumers want a

relationship with their financial institution. Theywant to be able to conduct all their financialbusiness in one location.

If the pricing is done correctly, the SACCO willenjoy financial benefit through selling arelationship package.

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Time for some brain exercise

Group exercise:

Hand out Case study # 7.1

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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 pricingstrategy and pricing methods.

Apply the pricing strategies in their SACCOs.

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Pricing strategies

What must a SACCO do to be the lender of choiceto

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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Pricing strategies

Cost leadership strategy:

Make the SACCO the low-cost lenderof choice.

Products consistently priced at or below thecompetition

Should not compromise product quality or

service otherwise cost advantage is lost

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Pricing strategies

To excel at cost leadership:

SACCO must be outstanding at running its operationseffectively 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

Product and service choices must be kept to a minimum.

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Pricing strategies

b) Differentiation:

A SACCO attempts to set itself apart by offering adistinctiveproduct or service that is considered ofvalueto the member.

Members are willing to pay a higher price fordifferentiation.

However, they must perceivethat they are getting

something of valuefor the extra amount they arespending.

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Pricing strategies

To excel at cost differentiation:

SACCO must determine which product or serviceit 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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Pricing strategies

Can a SACCO apply the two pricing strategiestogether?

A discussion exercise

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Pricing strategies

Balancing the two pricing strategies:

Regardless of the pricing strategy it chooses, aSACCO 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 isnt worth the

reduced price.

E.g., if a SACCO chooses to maintain cost leadership bycutting back on member services, a member might resentlosing those services.

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Pricing strategies

Balancing the two pricing strategies:

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

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

E.g., If a SACCO offers a debit cardbecause membershave said they want it but they charge too much for thecard, members wont afford it and therefore they will not

take advantage of the SACCOs differentiation.

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Pricing techniques

Session objectives:

List and differentiate the different pricing techniquesUnderstand the rationale for each pricing technique

Understand where it is appropriate to apply each of the

pricing techniques

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Pricing techniques

Six common pricing techniques:

TieringFractional pricing

Skimming

PenetrationLoss leader

Discounting

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Pricing techniques

1) Tiering

Tiering is the practice of charging different pricesfor 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 dont need a largeloan amount

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Pricing techniques

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

savings to the member.

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Pricing techniques

3) Skimming

Applicable in a market segment that lacks pricesensitivity

Often used with the differentiation pricing strategy,

because the business can target a high-endmarket segment, and then offer a unique productat a high cost.

A SACCO may choose skimming by identifyingsome of its best members, then offering them afinancial products package.

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Pricing techniques

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 tocontrol product pricing, design and distribution.

Businesses often gain penetration by slashingprices, causing consumers to switch.

Works well with a cost leadership pricing strategy.

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5) Loss leader

A SACCO using this technique sells one productat a loss in order to attract consumers.

Technique effective where a SACCO can cross-sell

Used to introduce a new product to quickly gainmarket share.

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

Pricing techniques

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Pricing techniques

6) Discounting

With this technique, the business will discount theprice of a product or service for a period of time.

During this time, the volume for the product orservice increases.

A SACCO might discount a popular product orservice in order to get a large number of newmembers.

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Pricing techniques

Group exercise:

Hand out - Case study #7.2 Pricing techniques

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Peter NjugunaDeputy Program Directorpnjuguna@woccukenya.org

www.woccu.org

Product Development for Competitive

Advantage

October 2008

Product Development for Competitive

Advantage

October 2008