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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 [email protected]
www.woccu.org
Product Development for Competitive
Advantage
October 2008
Product Development for Competitive
Advantage
October 2008