costing and pricing of financial services a toolkit · costing and pricing of financial services iv...

Costing and Pricing of Financial Services A Toolkit

David Cracknell, Henry Sempangi and Graham A.N. Wright

Version 4

Last Updated March 2004

MicroSave – Market-led solutions for financial services

Costing and Pricing of Financial Services

INDEX INTRODUCTION TO THE COSTING AND PRICING OF FINANCIAL SERVICES FOR MFIS TOOLKIT .......... ii

Section 1: A Quick Overview of Allocation Based Product Costing........................................................... iii a) Choosing Allocation Units ..................................................................................................................... iii b) Deciding on Allocation Bases................................................................................................................ iv c) Quantifying Allocation Bases ................................................................................................................. v d) Making a Transfer Price Adjustment ..................................................................................................... vi e) Final Costing of Products...................................................................................................................... vii f) Marginal Costing ................................................................................................................................... vii

Section 2: – Costing Explained ..................................................................................................................... 1 1. INTRODUCTION............................................................................................................................................... 1

1.1 Objective ............................................................................................................................................... 1 1.2 Target users ........................................................................................................................................... 1 1.3 Application ............................................................................................................................................ 1 1.4 Development of the toolkit.................................................................................................................... 1 1.5 Advantages of Costing Products ........................................................................................................... 2 1.6 The Strategic Context of Product Costing............................................................................................. 2

2.0 PRODUCT COSTING METHODOLOGIES ............................................................................................................ 4 2.1 Allocation Based Costing...................................................................................................................... 4

2.1.1 Why Allocate Costs? .................................................................................................................... 4 2.1.2 Outputs of the cost allocation exercise......................................................................................... 7

2.2 Activity Based Costing.......................................................................................................................... 7 2.2.1 Steps in Activity Based Costing......................................................................................................... 8 2.3 Which Costing Method: Allocation or Activity Based Costing?........................................................... 9 2.4 Circumstances favouring adoption of Allocation or Activity Based Product Costing.......................... 9

3. STAGES OF THE COST ALLOCATION EXERCISE ........................................................................................... 10 4. PREPARATORY ACTIVITIES ....................................................................................................................... 11

4.1 Order of activities ................................................................................................................................ 11 4.2 Communicating the purpose................................................................................................................ 11 4.3 Choosing the team leader .................................................................................................................... 11 4.4 Assembling the team ........................................................................................................................... 11 4.5 Choosing the period............................................................................................................................. 11 4.6 Choosing the representative branch site .............................................................................................. 12 4.7 Assembling necessary information ..................................................................................................... 12 4.8 Completion of time sheets ................................................................................................................... 13 4.9 Preparing the work plan ...................................................................................................................... 13 4.10 MicroSave’s Approach to Allocation Based Product Costing.......................................................... 13

5.0 FAMILIARISATION WITH THE STRUCTURE AND FUNCTIONS OF THE ORGANISATION............. 15 5.1 Objectives............................................................................................................................................ 15 5.2 Commencing the exercise ................................................................................................................... 15

6.0 DECIDING ON THE ALLOCATION UNIT ................................................................................................... 15 6.1 What is an allocation unit? .................................................................................................................. 15 6.3 What are the advantages or disadvantages of allocating by line or by department?........................... 16

7.0 IDENTIFYING POSSIBLE ALLOCATION BASES ...................................................................................... 16 7.3 Examples and applications of allocation bases ................................................................................... 17 7.4 Coverage of the bases.......................................................................................................................... 18

8.0 SELECTING A SET OF ALLOCATION BASES FOR THE EXERCISE...................................................... 18 8.1 Expected Outcomes............................................................................................................................. 18 8.2 The procedure...................................................................................................................................... 18 8.3 Reviewing the allocation units ............................................................................................................ 18

Exercise 1: MSC - Selecting allocation bases .................................................................................... 19



9.0 QUANTIFYING THE ALLOCATION BASES............................................................................................... 21 9.1 Expected Outcome .............................................................................................................................. 21 9.2 Procedure............................................................................................................................................. 21

Illustration 1: Quantifying allocation bases at MSC ........................................................................... 21 Illustration 2: Allocating staff costs for MSC across the three products............................................. 23 Results from illustrations..................................................................................................................... 24

10.0 APPLYING ALLOCATION BASES TO ALLOCATION UNITS.................................................................. 24 10.1 Expected Outcome ............................................................................................................................ 24 10.2 Procedure........................................................................................................................................... 24

Illustration 3: Applying MSC allocation bases to the Income & Expenditure Statement................... 25 11.0 ALLOCATING THE COST OF CAPITAL BACK TO SAVINGS PRODUCTS THROUGH TRANSFER PRICING ........................................................................................................................................................................ 26

11.1 Objective ........................................................................................................................................... 26 11.2 Procedure........................................................................................................................................... 26

Illustration 4: Calculating MSC’s cost of capital ................................................................................ 27 12.0 REVIEWING THE RESULTS ......................................................................................................................... 28

12.1 Objective ........................................................................................................................................... 28 12.2 Procedure........................................................................................................................................... 28

13.0 THE MARGINAL COST APPROACH ........................................................................................................... 28 13.1 The case for marginal costs approach ............................................................................................... 28 13.2 Procedure........................................................................................................................................... 28 13.3 Advantages ........................................................................................................................................ 29

Illustration 5: Selecting, quantifying and applying bases of MSC, under the marginal costs approach.29 Illustration 6: Marginal costing with a transfer pricing adjustment on the cost of capital.................. 30

PART II: PRICING OF FINANCIAL SERVICES........................................................................................................ 33 14.1 When is pricing necessary? ............................................................................................................... 33 14.2 Who should be responsible for the task?........................................................................................... 33

15. PRICING PRODUCTS UNDER VARYING PRICING OBJECTIVES AND STRATEGIES ....................... 33 15.1 Pricing policy, objectives and methods............................................................................................. 33 15.2 Price’s role in the marketing mix ...................................................................................................... 38 15.3 Exercise: Pricing policy, objectives and methods ............................................................................. 39

16. PRICING IN PRACTICE – WORKED EXAMPLES ...................................................................................... 40 16.1 Pricing to meet set objectives............................................................................................................ 40 16.1 .1 Survival ......................................................................................................................................... 40

Illustration 7: Survival pricing ............................................................................................................ 40 16.1.2 To achieve a target Rate of Return................................................................................................ 41

Illustration 8: Pricing to achieve a target Rate of Return .................................................................... 41 16.1.3 To Maintain or improve market share............................................................................................ 41

Illustration 9: Pricing to maintain or improve market share ............................................................... 41 16.2 Pricing under set strategies................................................................................................................ 41 16.2.1 Competitive pricing strategy .......................................................................................................... 42

Illustration 10: Competitive pricing strategy....................................................................................... 42 16.2.2 ‘Skimming the cream’ pricing strategy .......................................................................................... 42

Illustration 11: Skimming the cream .................................................................................................. 42 16.2.3 Penetration pricing strategy............................................................................................................ 43

Illustration 12: Penetration pricing...................................................................................................... 43 16.2.4 Keep out pricing strategy ............................................................................................................... 44

Illustration 13: Keep out pricing strategy............................................................................................ 44 16.2.5 Mark-up pricing strategy ................................................................................................................ 45

Illustration 14: Mark up pricing .......................................................................................................... 45 16.2.6 Target-return pricing strategy......................................................................................................... 46

Illustration 15: Target return pricing strategy ..................................................................................... 46 17. HOW DO FEE STRUCTURES IMPACT ON CUSTOMER BEHAVIOUR?........................................................ 47

18.0 COMMON MISTAKES.............................................................................................................. 48



18.1 The Danger of Low Pricing............................................................................................................... 48 18.2 So What Do Customers Want?.......................................................................................................... 49

Pricing: The Resistance Principle................................................................................................................................... 49 Annex 1: MicroSave Briefing Note 16 ....................................................................................................... 50 Annex 2: Departmental Allocation.............................................................................................................. 52

Illustration A2 Microfinance Inc. MFI................................................................................................ 52 Annex 3: Setting a Sustainable Interest Rate .............................................................................................. 56 Introduction ............................................................................................................................................... 56 Pricing Formula:........................................................................................................................................ 56 Administrative Expense Rate: ................................................................................................................... 57 Loan Loss Rate:......................................................................................................................................... 57 Cost of Funds Rate: ................................................................................................................................... 58 Simple Method: ......................................................................................................................................... 58 A Better Method:....................................................................................................................................... 58 Capitalisation Rate: ................................................................................................................................... 60 Investment Income Rate:........................................................................................................................... 60 The Computation:........................................................................................................................................ 2


Costing and Pricing of Financial Services ii

Introduction To The Costing And Pricing Of Financial Services Toolkit

Part I – Costing Financial Services

Section 1: Overview of Allocation Based Costing

Section 1 provides an overview of the allocation based costing process - it is intended to assist users to grasp the essential concepts of allocation based costing quickly and efficiently.

Section 2: Allocation Based Costing Explained Section 2 takes the user through allocation based costing in detail, whilst introducing Activity Based Costing. It uses the simple most commonly applied model of allocation based costing where each line of the Income and Expenditure Account is allocated to products individually.

Part II – Pricing Financial Services

Part II explains different pricing strategies. It starts by explaining the link between costing and pricing of financial services. It shows how sustainable interest rates can be set. It then highlights the complete range of strategies commonly adopted for pricing financial services. Illustrations are used throughout to clarify each pricing strategy.

Annex 1: Briefing Note #16 Product Costing In Practice The overview “Briefing Note #16 Product Costing in Practice – the Experience of MicroSave” is one of a series of MicroSave briefing notes that summarise the lessons learned by the project. This briefing note summarises why organisations should cost products, introduces allocation and activity based costing, examines key results of the costing exercises and looks at critical factors for a successful costing exercise.

Annex 2: Allocation Based Costing – by departments Annex 2 takes the user through an example of allocation based costing where instead of allocating individual lines of income and expenditure some costs are allocated on a department-by-department basis. This method is typically used in larger MFIs, which maintain separate accounts for each department. Annex 3: Setting Sustainable Interest Rates Annex 3 reproduces work by Richard Rosenburg of CGAP on how a financial institution can go about setting sustainable interest rates on its loan portfolio – to enable it to achieve a target capitalisation rate.

Sample Costing - Salama Microfinance Company An Excel Spreadsheet and Word file accompanying this toolkit document a worked example of allocation based costing – Salama Microfinance Company. Using these documents the user can:

a) See how spreadsheets are used to construct an allocation based costing model. b) Change variables to see how this would affect the outcome of the costing exercise. c) See an short example of a Report to the Directors of Salama Microfinance Company.


Costing and Pricing of Financial Services iii

Section 1: A Quick Overview of Allocation Based Product Costing This illustrative example provides an easy introduction to costing products using allocation based costing. In the example, Costly Bank's costs are allocated to products by working down the profit and loss account line-by-line, deciding on what basis each line or allocation unit should be assigned. The allocation bases are quantified and used to allocate costs to different products. Next a notional charge or transfer price is levied on loans and applied to savings products, reflecting the fact that capital for lending is mobilised from savings. Lastly, marginal costing analysis is used to assist Costly Bank's management in making decisions related to loss-making products. This example picks up with Costly Bank after it has already completed the first two steps of the allocation based costing process. Costly Bank has planned for the costing exercise and identified the products for costing. The stages covered here are as follows:

• Choosing allocation units. • Deciding on allocation bases. • Quantifying allocation bases. • Making a transfer price adjustment. • Final costing of products. • Marginal costing.

a) Choosing Allocation Units Allocation units are the items of income and expenditure that are going to be allocated across Costly Bank's different products. In most cases, as in the case below, this follows the institution's chart of accounts.

Figure 1: Choosing Allocation Units ― Costly Bank

Allocation Allocation AmountUnit Basis in accounts

Kshs. Million %Kshs.

Million %Kshs.

MillionInterest Income - Loan Product Direct 316.0 0% 0.0 100% 316.0 Interest Income – Investments Portfolio 50.0 100% 50.0 0% - Transfer Price Adjustment 25.0 (25.0) TOTAL INCOME 366.0 75.0 291.0Interest Expense Direct 35.0 100% 35.0 0% - Staff Salaries Etc. Staff Time 115.0 35% 40.3 65% 74.7 Rent Area 75.0 20% 15.0 80% 60.0 Motor Vehicles Staff Time 25.0 35% 8.8 65% 16.2 Insurance Transaction 10.0 45% 4.5 55% 5.5 Communications Actual 6.0 5% 0.3 95% 5.7 TOTAL EXPENSES 266.0 103.9 162.1Net Result 100.0 (28.9) 128.9

Product ProductSavings Loan


Costing and Pricing of Financial Services iv

b) Deciding on Allocation Bases Allocation basis refers to the method by which the allocation units are spread between different products. Descriptions of different allocation bases are provided in Table 1.

Figure 2: Deciding on Allocation Bases―Costly Bank

100%

Allocation Allocation Amount inUnit Basis Accounts

%Kshs.

Million %Kshs.

MillionInterest Income - Loan Product Direct 316.0 0% 0.0 100% 316.0 Interest Income – Investments Portfolio 50.0 50.0 0% - Transfer Pricing Adjustment 25.0 (25.0) TOTAL INCOME 366.0 75.0 291.0Interest Expense Direct 35.0 100% 35.0 0% - Staff Salaries Etc. Staff Time 115.0 35% 40.3 65% 74.8 Rent Area 75.0 20% 15.0 80% 60.0 Motor Vehicles Staff Time 25.0 35% 8.8 65% 16.3 Insurance Transaction 10.0 45% 4.5 55% 5.5 Communications Actual 6.0 5% 0.3 95% 5.7 TOTAL EXPENSES 266.0 103.8 162.2Net Result 100.0 (28.8) 128.8


Table 1: Examples of Allocation Bases Basis

Application

Direct Where the expenditure or income item relates solely and entirely to one product, and it would normally vary directly with transaction activity or value on that product. E.g. loan loss provisions, interest paid on savings products or (in some cases) transport.

Staff time Where staff are involved in transactions at a detailed or direct level, the estimated split of their time across the different products. E.g. office stationery or utilities such as electricity.

Direct staff numbers

Based on the actual number of staff positions allocated directly to a product. E.g. when some staff are specifically responsible for specific products or for utilities such as water, the consumption of which is unlikely to vary with differing staff levels.

Direct staff cost Based on the salary costs of staff positions allocated directly to a product. E.g. when different levels/salary structures of staff deal with different products.

Transaction The total number of transactions per product over a defined period as a percentage of all transactions. E.g. computer systems costs.

Actual For account lines consisting of ad hoc individual items which need to be allocated on an actual transaction-by-transaction basis, rather than in total. E.g. accounts entitled “sundries”.

Portfolio – deposit base

The relative average proportions of the product portfolios over a defined period of time, using amounts on deposit and/or amounts loaned (i.e. balance sheet basis). E.g. the costs of the CEO’s office to the products of the organisation.

Portfolio – investment income base

The relative average proportions of the product portfolios over a defined period of time in terms of direct income or expense by product. This is particularly useful when products do not result in balance sheet assets/ liabilities. E.g. money transfer services/remittance products. E.g. the costs of the CEO’s office to the products of the organisation.

Area Based on the actual office space consumed by the product or department in terms of area allocated. E.g. rent or depreciation charge for buildings.

Equal Where each product is given an equal share of an item of income or expenditure. E.g. for generic institutional advertising.

Absorption Where the costs of a department are first absorbed into other departments or cost lines before then being allocated using another basis, i.e. a two-step process.


Costing and Pricing of Financial Services v

Basis

Application

“Core product” Where a fixed, high proportion of any item is allocated to the core (or primary) product and a small residual element is split across the other products - mainly used in marginal costing.

Fixed Where a cost or income item is taken to be fixed and therefore independent of product performance, and it is allocated to the core product under the marginal costing.

In choosing which allocation basis to use it is important to consider what makes the most sense for your institution. This will depend in part on your access to information about the exact nature of the expense incurred and about particular allocation bases. What information can your information system provide? What information can be gathered relatively easily using a manual process?

c) Quantifying Allocation Bases Information related to the allocation bases is gathered and then applied to the different products. In the Costly Bank example, it is possible to separately identify all of the interest income from the loan product, so this is allocated 100% to the loan product using the "direct basis". The direct basis relates costs specifically to a particular product. Similarly, since investment income is earned by investing the savings of depositors, this income is allocated to the savings product. If there were two savings products, Costly Bank would use the "portfolio basis" to apportion investment income to each product in the ratio at which each product contributed to the funds being invested.

Figure 3: Quantifying Allocation Bases―Costly Bank

Allocation Allocation Amount Unit Basis in accounts

%Kshs.

Million %Kshs.

MillionInterest Income - Loan Product Direct 316.0 0% 0.0 100% 316.0 Interest Income – Investments Portfolio 50.0 100% 50.0 0% - Transfer Price Adjustment 25.0 (25.0) TOTAL INCOME 366.0 75.0 291.0Interest Expense Direct 35.0 100% 35.0 0% - Staff Salaries Etc. Staff Time 115.0 35% 40.3 65% 74.7 Rent Area 75.0 20% 15.0 80% 60.0 Motor Vehicles Staff Time 25.0 35% 8.8 65% 16.2 Insurance Transaction 10.0 45% 4.5 55% 5.5 Communications Actual 6.0 5% 0.3 95% 5.7 TOTAL EXPENSES 266.0 103.9 162.1Net Result 100.0 (28.9) 128.9


In Figure 3, staff salaries are divided between the savings and loan product. Costly Bank measures the amount of time that the staffs spend on each product and determine that 35% of staff time is spent on the savings product and 65% of time is spent on the loan product. In practice this step takes time, as each grade of staff needs to be considered separately. Normally different allocation bases are used for allocating the costs of front line staff and senior management. In this example the space that each product takes up within each branch is used as a proxy to determine how much of the rental income should be allocated to each product. Where this information is available, area is frequently used as the basis for allocating rental costs.


Costing and Pricing of Financial Services vi

At this stage the costing exercise becomes more subjective. On what basis should motor vehicle expenses be allocated between the savings and loan products? It is not at all obvious. The basis will differ from institution to institution, but should be based on logical and defendable criteria. In the Costly Bank example, vehicles are used predominantly by loans officers to follow up on defaulting clients and by savings officers to market the savings product; hence "staff time" becomes a reasonable proxy for the products use of motor vehicles. d) Making a Transfer Price Adjustment Financial institutions make money from accumulating the savings of their depositors and lending a proportion of these funds to their borrowers. A transfer price adjustment reflects the fact that funds for lending have been generated by mobilising deposits. The adjustment makes a notional interest charge against loan products and credits this to deposit products. In this example, Costly Bank's loan product is “charged” Kshs.25 million for the money it has effectively borrowed from depositors’ savings, and the Kshs.25 million is credited back to the savings product. Figure 4: Making a Transfer Price Adjustment ― Costly Bank

Allocation Allocation Amount Unit Basis in accounts

Kshs. Million %

Kshs.Million %

Kshs. Million

Interest Income - Loan product Direct 316.0 0% 0.0 100% 316.0 Interest ncome – Investments Portfolio 50.0 100% 50.0 0% - Transfer Price Adjustment 25.0 (25.0) TOTAL INCOME 366.0 75.0 291.0Interest Expense Direct 35.0 100% 35.0 0% - Staff Salaries Etc. Staff Time 115.0 35% 40.3 65% 74.8 Rent Area 75.0 20% 15.0 80% 60.0 Motor Vehicles Staff Time 25.0 35% 8.8 65% 16.3 Insurance Transaction 10.0 45% 4.5 55% 5.5 Communications Actual 6.0 5% 0.3 95% 5.7 TOTAL EXPENSES 266.0 103.8 162.2Net Result 100.0 (28.8) 128.8


The transfer price adjustment is calculated on the basis of (a) the average outstanding loans whose funds have been sourced from deposits multiplied by (b) a notional interest rate. The notional interest is allocated back to savings products in proportion to their contribution to the source of funds. The question becomes what rate of interest should be applied as a transfer price. Two rates to consider are:

The marginal rate at which an institution can borrow funds – This approach argues that institutions should charge the full opportunity cost of capital (the cost at which an institution would have to borrow funds in order to finance its loan portfolio were deposits not being used). This approach is appropriate in markets where either subsidised funds are available, as in the case of many donor supported MFIs, or where funds are rationed internally.

The long-term investment rate – This approach argues that the long-term interest

forgone on deposits that are instead used to finance loans should be charged to loan products. It is the rate MicroSave normally applies.


Costing and Pricing of Financial Services vii

e) Final Costing of Products After applying the allocation bases, Costly Bank finds that the savings product is making a loss! The first step should be to review the allocation exercise to see if some mistakes have been made and to reconsider some of the more subjective indicators, such as motor vehicles costs and insurance. Assuming this has been done, Costly Bank now has a dilemma: what should it do? f) Marginal Costing One of the things that Costly Bank should consider is the contribution that the savings product makes towards covering the costs of the institution. Looking at each line of income and expenditure, the questions Costly Bank needs to ask are “What income would we forgo if we did not have the savings product?” and “What costs would we save if we did not have the savings product?” In this case, Costly Bank would save only 10% of its total salary bill. Although Costly Bank will be able to save the salary of a few cashiers management costs would largely remain the same. The costing is revised so only the element that can be saved is attributed to the savings product. Moreover, if the savings product were closed down, Costly Bank would not make any savings on rent (at least in the short to medium term). In terms of motor vehicles, some running costs would be saved, but probably Costly Bank would still require the same number of vehicles. Allocation Allocation AmountUnit Basis in accounts

Kshs Million %

Kshs Million %

Kshs Million

Interest Income - Loan Product Direct 316.0 0% 0.0 100% 316.0 Interest Income – Investments Portfolio 50.0 100% 50.0 0% - Transfer Price Adjustment 25.0 (25.0) TOTAL INCOME 366.0 75.0 291.0Interest Expense Direct 35.0 100% 35.0 0% - Staff Salaries Etc. Core 115.0 10% 11.5 90% 103.5 Rent Fixed 75.0 0% 0.0 100% 75.0 Motor Vehicles Core 25.0 15% 3.8 85% 21.3 Insurance Core 10.0 35% 3.5 65% 6.5 Communications Actual 6.0 5% 0.3 95% 5.7 TOTAL EXPENSES 266.0 54.1 212.0Net Result 100.0 21.0 79.1

Savings Loan Product Product

Figure 5: Marginal Costing ― Costly Bank Completing the exercise, Costly Bank can see that although the savings product is losing money as a product, it should be kept on as a product in the short term because it is contributing Kshs.21 million to the net income of the organisation as a whole.


Costing and Pricing Of Financial Services 1

Section 2: – Costing Explained 1. INTRODUCTION 1.1 Objective Part 1 of the toolkit is intended to provide guidelines on the costing of the products offered by MFIs, by re-analysing the Income and Expenditure Statement by product. This allows MFIs to “full cost” their products through allocating the indirect costs associated with delivering each of those products. The basic stages of the process are outlined, with suggestions and examples also being given from costing exercises that have actually been carried out with MFIs.

Direct/Indirect Costs and Fixed/Variable

Sometimes there is confusion over the difference between direct/indirect and fixed/variable costs. This box seeks to define these terms precisely: Direct costs are those costs incurred specifically as a result of providing a specific service or product. Direct costs can be fixed or variable. These are the most easy to allocate to products. Examples include: interest payable on savings generated by each savings product, advertising/promotional materials developed for individual products, vehicle use attributable to each product, loan losses associated with each loan product etc. Indirect costs are those costs that do not relate directly to a specific service or product but are necessary to run the organisation as a whole. Examples include overheads such as rental of premises (head office and branch), utilities, central management costs, legal, audit and consultant fees etc. Fixed costs are those costs incurred that (in the short-run at least) do not vary with the number of transactions or products. Examples include rental of premises (head office and branch), depreciation on existing fixed assets, most staff salaries (but not commission-based ones)/training etc. Variable costs are those that are incurred with each transaction for each product. Examples include staff time and stationery used to make each transaction etc. Box 1: Direct / Indirect Costs and Fixed/Variable Costs explained. 1.2 Target users This Toolkit is designed for Micro Finance Institutions (MFIs), which, for the purposes of this Toolkit, are defined as any financial institution offering financial products (normally loans and/or savings) that are accessible to poor people. While this has been developed in Uganda, it is relevant across Africa and indeed the World. 1.3 Application The costing of products is essentially a management tool and some pointers are given as to how management could make good use of this tool including for product pricing, cost control, product appraisal etc. (see the case studies in Part 3). The Toolkit is accompanied by a specific training course, which can be run for any individual MFI, or for a group of MFIs. Further details can be obtained from MicroSave or Aclaim Africa Ltd (Aclaim). 1.4 Development of the toolkit The development of this Toolkit began with a leading Ugandan MFI that had been providing savings services and micro loans for several years throughout the country. The funds generated by the savings services had been invested in fixed deposits/Treasury Bills and a reasonable level of interest was earned up to the middle of 1998. However, the rate of interest receivable on the fixed deposits dropped around that time, and the question arose: Can the MFI really afford to provide savings services to the economically disadvantaged that it tries to serve? Are the savings operations cost effective? MicroSave commissioned an exercise to look into this, and consultants from Aclaim worked with MicroSave and the MFI to assess the situation. The process of discovery and costing enabled a first draft of this Toolkit to be developed so that other MFIs could do their own costing of MicroFinance services, should they so desire. This version of the Toolkit has been developed after testing the original version in another MFI, a large savings bank in



Kenya offering a wide variety of products. The bank is a very different organisation compared with the first MFI in the sense that it has more products and handles a larger volume of business and therefore provided a good vehicle for testing the Toolkit to see how applicable and relevant it would be for larger MFIs. It was found that the basic procedures and principles were equally relevant for larger MFIs, although further refinement was needed to cater for a more complex organisational structure and for a multi-product (rather than bi-product) environment. 1.5 Advantages of Costing Products

Advantages of Costing Products (as described by MicroSave’s Action Research Partners)

1. Determines the full-costs of delivering products 2. Determines the profitability/contribution of the products (including over time) 3. Assists making informed decisions about selection of products (including cost/benefit analysis) 4. Promotes a high quality MIS 5. Facilitates development of cost/profit centres 6. Reveals hidden-costs (especially at the departmental level) 7. Instils cost-consciousness amongst product/service department managers – enhances productivity 8. Facilitates the pricing of current/future products 9. Provides basis for business planning and investment decisions (e.g. which product to market etc.) 10. Can be used as a basis for variance analysis (budget v. actual comparisons etc.) Box 2: Advantages of Costing Products 1.6 The Strategic Context of Product Costing For all of these stated benefits the significance of product costing is only apparent when you consider the strategic context within which product costing is considered. Figure 2 indicates the range of strategic issues that knowledge of product costs and profitability can influence.

Figure 6: The Strategic Context of Product Costing (Cracknell and Sempangi 2002)

Pricing

Profit Centre Accounting

Promotion and Marketing Operational Efficiency

Budgeting

Incentive Schemes

OutreachInvestment

StaffingProduct Mix

Customer Service

Profitability

The Strategic Context of Product Costing

Product Costing

Product Development



Budgeting - Once product costing has been completed the next logical step is to create budgets for individual products, and to set targets and expectations – measuring, for example, the impact of allocating increased resources to marketing on the profitability of the product.

Operational Efficiency: Particularly in the case of ABC, the financial institution has the ability

to increase their operational efficiency through the close examination of the product processes, in the case of Allocation Based Costing this entails an additional step of process auditing a particular product or routine/system to deliver that product.

Customer Service: An improved understanding of products and processes is a significant step to

improving customer service, especially when combined with MicroSave’s “Market Research for MicroFinance” tools.

Pricing: Product costing enables you to directly relate the pricing of a product with the costs of

providing the product, ABC goes a stage further and allows institutions to set charges of particular services according to the costs of an individual process. See MicroSave’s “Pricing of Financial Services” toolkit.

Profit Centre Accounting: Using allocation based costing it is a simple matter to extend the

costing analysis to allocate costs to profit centres, understanding the profitability of certain locations or functions enables strategic decisions to be made.

Product Mix: Once the profitability of individual products has been determined, the institution

can work to promote its profitable products and either remodel or improve the efficiency of delivery of its less profitable products.

Promotion and Marketing: Promotion and marketing is strategically tied to developing the

institutions ideal product mix. See MicroSave’s “Marketing for MFIs” toolkit.

Investments: Under MicroSave’s Allocation Based Costing – the efficiency of the investment process was examined in two Action Research Partners as part of product costing.

Staffing Levels and Allocation: Examining staff allocation against activity levels reveals

considerable differences in performance in different locations and offers considerable opportunities for saving costs.

Design and Implementation of Incentive Schemes: Having a better picture of optimal

performance, and having the tools to measure this performance, enables the design and implementation of more appropriate staff incentive schemes. See MicroSave’s “Staff Incentive Systems” toolkit.

Outreach: Having efficient processes, high investment efficiency, the correct product mix, the

optimal allocation of staff, can increase outreach depending on the objective of the product.

Profitability: Product costing can lead to increased efficiency, improved staffing levels and allocation, rationalise product pricing, target promotion to profitable products, and improve the design of staff incentive schemes, it should reflect in the profitability of the institution.



Costing and Product Development: (see below)

Product Development: Where Costing/Pricing Fits In From Wright, Graham A.N. “Beyond Basic Credit and Savings:

Developing New Financial Service Products for the Poor” Costing and pricing of financial services is an important part of the product development cycle. MicroSave sees the product development cycle in four distinct phases: 1. Research to identify needs and opportunities This includes a review of the competition and products offered by both the formal and informal sectors, conducting market research as an integral and on-going part of staff’s interactions with the clients, and through contacting other market leaders in the MicroFinance industry. 2. Design and pilot testing This includes the detailed design, costing and pricing of existing and new products, prior to their initial implementation on a pilot-test basis. 3. Monitoring and evaluation of the pilot test This includes monitoring the financial and organisational consequences of the new product (including revisiting the costing and pricing of existing and new products) and conducting market research among the clients to review how the product was perceived and used. 4. Revision and scaled-up implementation Once these analyses have been completed, the MFI can make the necessary amendments to the product, its pricing, delivery, marketing etc. before going for scaled-up implementation. Box 3: Product Development where Costing/Pricing Fits In. In view of increasing professionalism of MFIs and the competition in the MFI market place, it is essential that MFIs carefully analyse exactly how much each part of their operations costs, so that they can make informed management decisions concerning them. Such decisions will include the following: • How to cut costs and raise income • The appraisal of business performance by product and where necessary modify the pricing of

existing products • Whether to accept and implement new products (as part of the product development process) • How to price new products (as part of the product development process)

2.0 PRODUCT COSTING METHODOLOGIES There are two product-costing methodologies, Allocation Based Costing and Activity Based Costing (ABC), this section introduces the concepts briefly. 2.1 Allocation Based Costing Allocation Based Costing is a method whereby each line of the profit and loss account is allocated to different financial products on the basis of a logical criteria called an Allocation Basis. In Figure 7, staff costs are passed on to Loan Product 1, Loan Product 2 and the savings product using the allocation based time taken and non-staff costs are allocated using the allocation base of the relative volume of each product. 2.1.1 Why Allocate Costs? The allocation of costs to products is in response to an important business principle: that a business (generally) exists to maximise profits, through the sale of its products, and that all costs within the business must relate to that objective, and therefore to a product or to products. Consequently, however indirect a cost may be and however seemingly unrelated to a product, it must be possible to allocate it to a product or products. This basic principle is equally applicable to MFIs, even though their objective may not be to maximise profit, but merely to achieve financial sustainability. The exercise of costing financial services, or more precisely re-analysing the Income and Expenditure Statement by product, will necessarily involve allocating the costs of indirect, or support functions, to



those services. Some common reasons given by managers for carrying out this type of cost allocation exercise are to:

• remind profit centre managers that indirect costs exist and that profit centre earnings must be adequate to cover some share of those costs

• encourage the use of central services that would otherwise be under-utilised • stimulate profit centre managers to put pressure on central managers to control service costs • use it as a basis for staff compensation (for example when product managers/field staff salaries

are linked to product profitability).



Allocation Based Costing

Activity Based Costing

Income and Expense

Product Costs

Core Process B

Sustaining Activities

Portfolio Volume

Staff time sheet

Allocation Bases

Saving Product #1

Loan Product #2

Loan Product #1

Non-Staff Costs

taff Costs Staff Costs S

Product CostsIncome and Expense

# transactions

# loan applications

Core Process A

Core Process C

DriversActivitiesStaff Time Allocation

Saving Product #1

Loan Product #2

Loan Product #1

Non-Staff Costs

taff Costs Staff Costs S

Figure 7: Allocation and Activity Based Costing. Helms and Grace (2002)



Compulsory v. Voluntary Savings Services

It is important to distinguish between compulsory savings, which are an integral part of the lending methodology and thus part of the cost structure of the loan product, and voluntary savings which are offered as a separate service and product. The costs associated with collecting and administering compulsory savings should be allocated to the loan product(s)/service(s). The costs associated with voluntary savings should be allocated to the voluntary savings product(s)/service(s). In some cases clients voluntarily save more than the compulsory minimum required by the MFI’s lending methodology. Clearly there is a continuum between MFIs that collect only compulsory savings (which should be costed as part of the loan product cost) and those that do not collect any compulsory savings but offer entirely voluntary savings services (which should be costed as savings products). In the middle of the continuum are MFIs that require compulsory savings as collateral but allow their clients to use these accounts as voluntary savings accounts to the extent that they are not pledged as part of the collateral/group guarantee system. In these latter cases, disentangling the additional transactions and activities necessary to offer the voluntary component of the savings service (for costing as a separate savings product distinct from the loan product) is likely to be complex and will require careful analysis. Unless these voluntary savings are substantial and/or tracked separately from the compulsory savings, there is limited benefit from costing them separately. However, if these voluntary savings are tracked separately or are substantial, the MFI may want to cost this service. Box 4: Compulsory verses Voluntary Savings 2.1.2 Outputs of the cost allocation exercise The cost allocation exercise can produce at least two, different, financial analyses of the Income and Expenditure Statement, showing the split between the products offered by the MFI. The financial information can then be combined with other, more qualitative information and non-financial data to assist management in evaluating their operations. The two analyses are: • Total Cost Allocation – where all costs both direct and indirect are allocated across the products and

the net profit/loss of each product is shown. • Marginal Cost Allocation – where one product or more products are treated as the main/core business

activity and all other products as a secondary activity. Under this approach only additional/incremental costs are allocated to the other products, i.e. those costs that could be avoided if the secondary (or “marginal”) products were discontinued.

It is very important to realise, from the outset, that this exercise will not provide precise figures. A lot of assumptions and judgements will be made and the final figures will, to an extent, be subjective. The financial reports produced will therefore be indicative of the real situation, and if the same process is applied periodically and consistently, it will be possible to make very meaningful comparisons over time. Indeed several of MicroSave’s partner MFIs are now using this costing system as part of their monthly management reporting routines. 2.2 Activity Based Costing Activity Based Costing traces costs through significant processes to products. Product delivery comprises a number of separate processes, for example, loan application processing, loan disbursement, and loan monitoring and loan recovery. Following figure 3, staff costs and non-staff costs are allocated to core processes upon the basis of staff time spent. Where members of staff do not directly spend time on core processes but rather provide support functions this time is booked to a general category called “sustaining activities”. In most cases a significant proportion of head office costs come under this category. Once a cost for a particular core process has been determined based on staff time, these costs are then driven through to the products on the basis of a logical cost driver. To take a simple example, once you have determined the cost for processing a loan application – the logical cost driver would be the number



of loan applications. Each product then absorbs costs for processing loan applications in proportion to the number of loan applications made by each loan product. Different processes will have different cost drivers. However, sustaining activities cannot be driven directly to particular products. The costs of sustaining activities need to be allocated to the different loan and savings products using allocation based costing techniques described in detail in Annex 1. 2.2.1 Steps in Activity Based Costing

a) Plan for the costing exercise b) Identify products for costing c) Ascertain core processes and activities - identify sustaining activities. An Activities Register or

Dictionary is created that summarises activities taking up staff time. These activities are categorised into core processes.

d) Conduct staff time estimates for each activity, through timesheets, interviews and observation of processes and activities.

e) Calculate costs per activity – costs are allocated to activities using staff times. f) Assign cost drivers and determine unit activity costs – a cost driver is a logical criteria that is

used to allocate an activity cost to individual products, for example number of loan applications. g) Drive activity costs to products – the unit cost per activity is multiplied by the cost driver volume

per product, for example the cost of processing a loan application for a particular product is number of loan applications multiplied by the unit cost of making a loan application.

h) Allocate sustaining activity costs to product – these costs are directly allocated to products using allocation based costing.

Further details on Activity Based Costing can be found in CGAP’s Product Costing Toolkit.



2.3 Which Costing Method: Allocation or Activity Based Costing? Choosing between Allocation and ABC is not an automatic choice, whilst allocation based costing is simpler and easier to implement, ABC is technically superior and provides a wealth of process-based information that allocation based costing does not. MicroSave does not see a conflict between using Allocation Based Costing or ABC. Allocation Based Costing is a quick and relatively simple introduction to costing, which derives a range of benefits. ABC is a more in-depth approach, which examines core processes, but it requires greater time, skills, and institutional commitment. It is entirely possible for an institution, to start with Allocation based costing and graduate to ABC.

Advantages and Disadvantages of Allocation Based Costing Verses Activity Based Costing

Allocation Based Costing Activity Based Costing Pros • Fewer steps

• Quicker, simpler and less expensive • Consistent with income statement • Can be powerful when used to target

additional investigations

• Traces (rather than allocates) costs in a cause and effect relationship

• Allows management to understand how and why costs are incurred

• Focus on activities that are meaningful to staff and management

• Identifies drivers of costs and the circumstances or requirements that cause an activity to take longer

• Allows management to focus on where to reduce costs through reviewing the key points and expensive activities

• Helps management better understand business process

Cons • Relies on subjective input • Simplistically allocates costs • Volume-related allocation bases fail

to account for product diversity and over burden “large” products

• Incorporates an additional step of allocating costs to activities

• Is more complex, time consuming and expensive to implement

• Relies on subjective input

Table 1: Advantages and disadvantages of different costing methods. (Helms and Grace 2002) 2.4 Circumstances favouring adoption of Allocation or Activity Based Product Costing Simply considering the pros and cons of a particular costing method fails to adequately recognize that the institutional environment is also critical in making a decision about which costing method to adopt. Table 2 presents circumstances, in which one or other method may be preferable. Of course the overall institutional environment is a web of different circumstances, some of which may indicate a preference for Allocation based costing, whilst others indicate a preference for ABC.



Circumstances favouring adoption of either Allocation or Activity Based Product Costing

Circumstance Allocation Based Costing Activity Based Costing Management Information Systems

Requires moderate to strong information systems

Requires strong information systems.

Administrative burden Moderate, some staff timings may be required but generally fewer than under ABC.

Higher burden due to the requirement to timesheet activities and validate them..

Staff capabilities Appropriate where staff capabilities are limited.

Appropriate where there are a number of capable staff. Its also important to train several members of staff in ABC to ensure that institutional knowledge of the ABC process remains on departure of staff.

Experience Possibly more appropriate where there is no prior experience of costing

Probably more appropriate when there is already institutional experience in costing.

Where Head Office Costs are a high percentage of total costs

A significant portion of these costs are likely to be considered sustaining overheads, and will therefore be directly allocated.

Single product institution Not appropriate Particularly appropriate when there is one dominant process to understand.

Outputs Provides a quick overview and enables some “quick wins”

Provides a detailed picture of core processes and activities.

Requirement for training Less More Requirement for technical assistance

Less More

Need for additional investigation

Targeted investigations required, often into the processes within loss making products

Less direct investigation required, due to the extensive investigation required to complete the ABC process

Table 2: Circumstances favouring the adoption of either Activity or Allocation Based Costing (Cracknell and Sempangi 2002) 3. STAGES OF THE COST ALLOCATION EXERCISE The exercise will normally go through the following stages: • Preparatory activities (Subsection 4) • Familiarisation with the structure and functions of the organisation (Subsection 5) • Deciding on the allocation unit (Subsection 6) • Identifying possible allocation bases (Subsection 7) • Selecting the most appropriate allocation basis for each allocation unit (Subsection 8) • Quantifying the allocation bases (Subsection 9) • Applying the allocation bases to the allocation units (Subsection 10) • Reviewing the results (Subsection 11)



4. PREPARATORY ACTIVITIES 4.1 Order of activities This is the stage that prepares the ground for all subsequent activities of the cost allocation exercise. Before the exercise starts, there are certain activities that should be concluded so as to ensure the best use of time when the exercise actually begins. These are activities described below. 4.2 Communicating the purpose It is important that the CEO/senior management take the time to explain and communicate the reasons for conducting a costing exercise to ensure that institutional inertia/resistance is minimised. Costing exercises should provide accurate information that promotes accountability, and comparison between products (branches, staff etc.). This information can be very threatening to some people. Staff must be reassured that this information is not being gathered to use against them, but rather to help empower them to make better management decisions. 4.3 Choosing the team leader Costing of an organisation’s products is a vital function, which should be of great interest to top management. However this exercise requires a substantial amount of time and therefore it is probably best delegated by the CEO to another senior person in the organisation. It is essential that the CEO/Board of Directors be supportive of, and seen to be supportive of, the costing exercise … the results may well provide insights and information that are of surprise and result in controversy or the need to take difficult decisions. 4.3.1 Who should be delegated to lead this task? Ideally the person delegated to lead the task should be a member of the senior management team. If it is not possible for the CEO to give the exercise full time attention, he/she should be available to the costing team on regular basis, preferably at least half a day a week. 4.3.2 Duties of the team leader The team leader should report to the CEO, be able to access anybody in the organisation and should be familiar with basic accounting procedures. The team leader’s duties and responsibilities include the following: • to be responsible for the day to day activities of the team • to assign work to the other members of the team and supervise them effectively • to prepare regular briefs for the CEO and seek his/her input as and when needed • to prepare and present the final report about the exercise to the CEO and management team. 4.4 Assembling the team The team leader will be responsible for initiating arrangements for the recruitment of the other members of the team. Ideally the team should not be too big since it will be reporting to the management team regularly, thereby keeping all key persons in the organisation up-to-date on progress. A team of 3 or 4 members including the team leader, would be adequate1. To ease the work of the team, the operations and accounts departments should be represented on it. 4.5 Choosing the period The team will choose a period on which to base the exercise. All information to be used for the costing exercise will come from this period. Ideally the period should be representative and long enough to level out seasonal variations. A full year would be the most ideal. But in the event that there has been a long lapse of time since the latest annual figures are available, this ideal may have to be compromised and


1 The amount of time and effort to be invested in the exercise will vary from institution to institution depending on the complexity/size of the institution and the way that it is management information systems have been set up. Small MFIs will probably only take a week to ten days to complete a comprehensive costing exercise, for larger ones this may extend to a month.


recent quarterly statements will have to suffice. In the event that a great deal of data has to be generated specifically for the costing exercise, the volume of work involved would make the exercise too long, and therefore a period of 3 to 6 months would suffice. The period should be as recent as possible, i.e. up to the last month for which management accounts are available. 4.6 Choosing the representative branch site Since the exercise deals with real data, it is important to use maximum care in choosing the branch or branches whose operations will be the source of information for the exercise. If it were not for time and resource considerations all branches of the organisation would be included. Due to these constraints, only one branch will normally be selected to host the exercise. If the organisation has more than one distinct type of branch, then one of each type should be visited. The activity at these branches will be visited and reviewed to: 1) determine optimal allocation bases (through discussion with branch staff, examining the structure of

the chart of accounts, review of branch records etc.) and then 2) quantify these allocation bases (i.e. determine the percentage to be allocated to each product) for each

allocation unit (cost or income item); 3) request staff to complete timesheets to allow the team to use the staff time allocation basis where

appropriate. This sample branch(es) will be used to allocate branch-level income/costs to the individual products. Head Office income/costs will be allocated in a separate part of the exercise. Note: Analysis of branch profitability in which Head Office costs are allocated to the MFI’s branches may be conducted as a separate costing exercise. It is not generally desirable to try to allocate Head Office costs to the branches and then on to the products as this is extremely complex and likely to cause confusion. 4.6.1 Criteria for choosing the branch to host the exercise Since the results of the exercise are replicated throughout the organisation, it is important that the branch(es) selected be as representative as possible in many respects – product mix, number of clients served, maturity/age of branch etc.. This is one of the ways of maximising the accuracy of the results. 4.6.2 Suggested guidelines In keeping with this objective, it is suggested that as much as possible the following guidelines be followed in selecting the branch to host the cost allocation exercise: • the branch should not be among the smallest in the organisation in terms of transactions handled; • the branch should be equal or slightly bigger than the average branch in the organisation; • the branch should preferably not be the HO branch; • the branch should offer most, and ideally all the products of the organisation; and • the branch should be reasonably “mature”.

4.7 Assembling necessary information 4.7.1 Basic information The basic information required for use in the exercise will include the following: • chart of accounts for the Income and Expenditure accounts; • detailed Income and Expenditure Statement for the period; • staff costs by employee grade; • organisation charts; • staff time per product (the estimated average time a member of staff spends processing a product

during a given period – probably on the basis of timesheets see 3.8 below) for staff who deal directly with customers or product transactions, e.g. cashier, teller, branch manager (if this is to be used as an allocation basis – as it almost inevitably will be for salary etc. costs);

• product balances (average of month-end balances for the period); • employee numbers by grade for each department; and



• transaction statistics2 (if this is to be used as an allocation basis) 4.8 Completion of time sheets 4.8.1 Staff time Staff time per product is a major input in this cost allocation exercise. Most organisations do not maintain data on product staff time. As mentioned already this data is used to distribute staff costs across an organisation’s products. In most MFIs staff costs account for more than 50% of total costs. It is therefore necessary to distribute the expense across the organisation’s products fairly accurately in order to come out with a credible costing result. 4.8.2 Time sheets Time sheets are used to calculate staff time per product. Members of staff record the time spent processing a product or a unit of the product and for a chosen representative period (typically a week or a month) they account for all the time in the working day (including for example general administrative duties). 4.8.3 Using time sheets to calculate staff time • Each member of staff is given a blank time sheet at the beginning of the period • On a daily basis each member of staff ‘accounts’ for the time he/she spends in the office by

indicating in the time sheet how much time is spent on each activity that he/she gets involved with in the course of the day

• At the end of the day totals are made of the staff time spent on each activity or product • At the end of the period totals are made and an average calculated for each product as a percentage of

the total time available from the staff • This result (or the equivalent) constitutes the staff time per product. See Appendix A for an example of this.

4.9 Preparing the work plan 4.9.1 Drawing up the plan In order to achieve the best possible use of time, the team will identify all the major activities involved in the exercise, and for each activity:

• Estimate the time needed for its completion and attach its corresponding time targets (the time by which the activity should have commenced and the time when it should have been completed).

• Indicate the person or persons responsible for implementation • Indicate the nature and quantity of resources required to accomplish the job

4.9.2 Approval of the plan The team leader should discuss the work plan with, and obtain approval from the CEO. Thereafter the team should be guided by the work plan and endeavour to minimise avoidable deviations. 4.10 MicroSave’s Approach to Allocation Based Product Costing MicroSave has worked with seven of its eight Action Research Partners, as well as BURO, Tangail in Bangladesh to introduce product-costing systems. Table 3 gives an indication of the process required to implement an allocation based costing system. Indicative timings are provided for producing an allocation based costing system, both in respect of the establishing the product costing system for the first time and in performing a repeat costing. In the case of very large, or bureaucratic organizations, the time taken may be significantly longer.

2 In organisations where the software package in use is not able to capture transaction statistics automatically, arrangements should be made to compile daily transaction statistics covering the sample period well ahead of commencement of the exercise. Again, the data should ideally relate to the whole period selected. However, if the statistics are being compiled manually, a shorter sample period could suffice, say 2 weeks in the first selected month and 2 weeks in the last month.



Step Action Indicative Time for first costing*

Indicative time for Repeat Costing

Responsibility for first costing

1 Brief the Management of the Action Research Partner on the product costing process

2 hours Not required MicroSave

2 Choose a costing team leader and assemble the team

As before ARP

3 Choosing representative branch site ARP 4 Ensure relevant background information

is being gathered Over the course of one week

Data collection exercise built into normal reporting cycle.

ARP

5 Train / Expose the product costing team to Allocation and / or ABC normally in a workshop environment

1 day Not required MicroSave and ARP

6 Train the product costing team in direct observation, to enable the collection of data on front and back office timings – and collect data

1-2 days 1 day (validation) MicroSave and ARP

7 Complete time sheets for allocation based costing (where necessary)

3-5 days 1 day (Validation if necessary)

MicroSave input into drawing up timesheets

8 Work with the product costing team to allocate costs and summarize results

2-4 days 1-2 days, as costing spreadsheets already created.

MicroSave and ARP

9 Document the process and analyse results 1-2 days 4 hours – less extensive analysis required

ARP reviewed by MicroSave

10 Prepare a report for Senior Management, highlighting the assumptions taken, the bases of allocations made, the key results and suggestions for follow up.

1 day 4 hours – as it is possible to build on earlier reports.

ARP

11 Make a presentation to Senior Management; draw up list of Action Points, noting areas in which the costing process can be improved and strengthened.

2 hours 2 hours ARP Costing Team with MicroSave

12 Perform follow up activities As required As required ARP 13 After 3-6 months re-perform costing

exercise ARP

14 Consider making changes to your accounting and budgeting system to enable most of the Product Costing to be produced automatically

This will significantly reduce the time taken for data processing

ARP

Table 3: MicroSave’s approach to Allocation Based Costing (from Cracknell and Sempangi 2002) * Timings are indicative and are based on the elapsed time for a relatively competent, average sized MFI. However, there has not been sufficient experience in introducing ABC within MFIs for us to create representative timings for ABC. Most ARPs have required support from MicroSave on the first round of costing, and when there are staff changes, but have been able to handle subsequent costing exercises by themselves.



5.0 FAMILIARISATION WITH THE STRUCTURE AND FUNCTIONS OF THE ORGANISATION 5.1 Objectives The team must ensure that they are fully familiar with all the following aspects of the organisation by the end of this stage: The mission and scope of the work of the organisation The degree of centralisation in the organisation The degree of autonomy of the branches The nature and operations of the different branches of the organisation in order to select more

accurately the most suitable branch or branches to host the exercise The functions and responsibilities of all departments.

5.2 Commencing the exercise This stage is like the orientation course for new employees in an organisation – the team needs to revisit the basic objectives and operational systems and norms of the MFI, as well as its outreach methods and sites. Once this orientation preparatory stage is over, the team sits and studies the information and statistics assembled as its orientation before commencing actual cost allocation. 5.2.1 Studying the statistics and information collected The team starts with a study of the statistics and information collected in the previous stage so as to acquaint itself with the organisation as a whole, including: • the organisation structure, • functions and composition of departments, • transaction flow processes, • levels of authority, and • the various management systems in use in order that better judgement can be made when it comes to allocating cost items. 5.2.2 Clarifying findings with line management During the course of the study of the statistics and other information, the team may come across issues that require clarification from line management. The issues should be noted and clarified with line management at agreed times of the day in order to minimise the number of interruptions to the normal functioning of the organisation’s business. 6.0 DECIDING ON THE ALLOCATION UNIT 6.1 What is an allocation unit? The cost allocation unit is the figure or item of expense (or income) taken from the chart of accounts to be allocated or distributed across the products of the organisation. It is the starting point for the allocation exercise, the unit of raw data to be used in the exercise. 6.2 Choosing an allocation unit The choice of the allocation unit for the exercise will depend on the way the organisation’s chart of accounts is structured and on the type of standard accounting reports produced by the organisation. It is the chart of accounts that is the basis of the cost allocation exercise. If the organisation maintains a simple structure of accounts which does not provide departmental costs separately, the team should adopt the account line in the income and expenditure accounts as the allocation unit.



Simple Allocation Units Where the organisation maintains a simple chart of accounts (account lines only and not per Head Office department), it will be necessary to follow a two stage process: firstly allocating branch level costs to each product and then allocating Head Office costs to each product. For most MFIs the simple basis applies and this is the basis used in the examples, which follow.

Departmental Allocation Units

For most MFIs the simple basis applies. If the organisation maintains a departmental structure of accounts, and accounting reports show costs by department, the team should nearly always adopt the departments as the allocation units. A worked example of departmental basis is given in Annex …

6.3 What are the advantages or disadvantages of allocating by line or by department? The main advantage is in the time saved on the whole costing exercise when using one as opposed to the other. The department as an allocation unit makes the task quicker since the number of departments normally will be less than the number of accounts, and therefore the items to allocate across products will be a lot fewer. Also, since it is often easier to relate products to departments than it is to relate products to individual account lines, the logical process of selecting an allocation basis is clearer. 7.0 IDENTIFYING POSSIBLE ALLOCATION BASES These decisions tend to be subjective and it is important to devote adequate time to them, ensuring that there is a supportable reason for the decisions made. 7.1 What is an allocation base? An allocation basis is the criterion followed in allocating or distributing costs (units) to products of an organisation. The criteria will vary depending on the cost item (i.e. the allocation unit). Some cost items (allocation units) can be directly attributed to a specific product and are therefore fully allocated to that product. Others, e.g. office rent, are shared between products and criteria have to be identified to distribute the cost across the products of the organisation on the most fair and accurate basis possible. Some allocation units will be obviously direct and their allocation is very straightforward. However most cost items (allocation units) will not fall into this category and the degree to which they are indirect will vary. Some judgement will need to be applied. As a general guideline, the closer an indirect cost item is to the specific customer transaction level the more appropriate it will be to use an allocation basis based on staff time or the numbers/costs of direct staff. At the other end of the scale, strategic and overall functions, such as senior management, will typically be allocated to the products using the (usually average) portfolio basis as this gives the closest indication of each product’s contribution to the organisation’s performance as a whole. Support functions, and less direct activities (e.g. middle management) will be usually be allocated using the transaction basis. This idea can be illustrated as follows: Relationship to product: Direct Indirect Allocation Basis: Direct Time/Direct Staff Transaction Portfolio The establishment of the allocation bases can be extremely controversial, particularly when the results highlight unprofitable products or when staff salaries/remuneration is based on the performance of their cost centre. It is therefore essential that management carefully reviews the allocation bases and goes through a process to discus and resolve disputes that arise from the bases chosen. This process will provide additional information and may possibly even result in changes being made to the allocation bases. (See Appendix A for an excellent example of this drawn from the CGAP Occasional Paper No. 2”Cost Allocation for Multi-service Micro-finance Institutions”- available on the CGAP website at http://www.worldbank.org/html/cgap). The level of complexity of allocation bases should reflect the sophistication of the MFI’s systems and its level of development. Simple, easy to understand allocation bases are generally preferable. In addition, it


http://www.worldbank.org/html/cgap


is important to note that meaningful time-series analysis will usually only be possible if the allocation bases remain consistent from one period to the next. 7.2 Identifying Possible Allocation Bases This stage will come up with a list of all possible allocation bases. The team will hold brainstorming sessions, during which it will identify possible allocation bases. The sessions will be guided by: • The structure of the organisation; • Functions of departments; • The organisation’s structure of accounts; and • All the statistics and other information gathered during the preparation stage. The team should try to be as open minded as possible bearing in mind that this is not the stage for sieving but a stage for identifying as many possible bases3 as possible from which ultimately to select a set of the best and most convenient options for the organisation. Once again, it is important to re-emphasise that the selection of allocation bases is subjective in nature and it is important to consider and discuss many options in order to identify the most appropriate allocation basis for each allocation unit. Furthermore, this is often an iterative process through which several allocation bases are considered and tested as the cost allocation team works through the costing process and becomes increasingly familiar with the MFI and the details of its operations. 7.3 Examples and applications of allocation bases Possible allocation bases are tabulated below but it is important to mention that almost any basis could be used as long as it is supported by a reasonable logical argument. Basis

Application

Direct Where the expenditure or income item relates solely and entirely to one product, and it would normally vary directly with transaction activity or value on that product. e.g. loan loss provisions, interest paid on savings products or (in some cases) transport.

Staff time Where staff are involved in transactions at a detailed or direct level, the estimated split of their time across the different products. e.g. office stationery or utilities such as electricity

Direct staff numbers

Based on the actual number of staff positions allocated directly to a product. e.g. when some staff are specifically responsible for specific products or for utilities such as water the consumption of which is unlikely to vary with differing staff levels

Direct staff cost Based on the salary costs of staff positions allocated directly to a product. e.g. when different levels/salary structures of staff deal with different products

Transaction The total number of transactions per product over a defined period as a percentage of all transactions. e.g. computer systems costs

Actual For account lines consisting of ad hoc individual items which need to be allocated on an actual transaction by transaction basis, rather than in total. e.g. accounts entitled “sundries”.

Portfolio – deposit base

The relative average proportions of the product portfolios over a defined period of time, using amounts on deposit and/or amounts loaned (i.e. Balance Sheet basis). e.g. the costs of the CEO’s office to the products of the organisation.

Portfolio – investment income base

The relative average proportions of the product portfolios over a defined period of time in terms of direct income or expense by product. This is particularly useful when products do not result in Balance Sheet assets/ liabilities e.g. money transfer services/remittance products. e.g. the costs of the CEO’s office to the products of the organisation.

Area Based on the actual office space consumed by the product or department in terms of area allocated. e.g. rent or depreciation charge for buildings

Equal Where each product is given an equal share of an item of income or expenditure. e.g.


3 See Section 1.9.2 of this toolkit for a listing of the typical allocation bases.


for generic institutional advetising. Absorption Where the costs of a department are first absorbed into other departments or cost lines

before then being allocated using another basis i.e. a two step process. (see below) “Core product” Where a fixed, high proportion of any item is allocated to the core (or primary) product

and a small residual element split across the other products - mainly used in Marginal Costing. (see below)

Fixed Where a cost or income item is taken to be fixed and therefore independent of product performance, and is allocated to the core product under the Marginal Costing. (see below).

7.4 Coverage of the bases The set of allocation bases will need to cover the majority of situations satisfactorily, bearing in mind that the objective is to come up with a materially reasonable allocation, not a hundred percent accurate allocation. There are many cost allocation bases that can be used and the objective here is to identify a set of bases which can be used in the context of the organisation and which will cover all the situations within that organisation. 8.0 SELECTING A SET OF ALLOCATION BASES FOR THE EXERCISE 8.1 Expected Outcomes This is the stage when allocation bases are selected from the possibilities identified for use in the cost allocation exercise. A definitive list of allocation bases against units is produced. 8.2 The procedure 8.2.1 Introduction During this stage the set of allocation units will be reviewed on a line by line basis and a decision will be made as to which allocation basis is most appropriate to each line. As noted in xxx above, the relevance of an allocation base to a unit line will depend on that unit’s relationship with the products, with all relationships being somewhere on a continuous line between direct and indirect. As noted above, this idea can be illustrated as follows: Relationship to product: Direct Indirect Allocation Basis: Direct Time/Direct Staff Transaction Portfolio The bases shown here are the ones that were most used in the two test exercises. Other bases were also used and should be applied as considered appropriate in particular cases. One basis that works in a different way to the others is the absorption basis. The absorption basis is used when there is a simple and straightforward way of allocating one line item or department total into another line or department that is then allocated to the products. The example of how this basis is used in practice will give the best explanation. The Kenyan savings bank, with which this costing system was tested, is a large organisation with many departments. The Human Resources department is an indirect, support department and it was decided that the costs of this department could be most easily allocated firstly to all the other departments (using the absorption basis, based on the number of staff per department) and thus it is automatically allocated to products using the allocation basis applicable to each department. There may be similar or other cases where there is a clear way of absorbing the costs of indirect departments into more direct departments or cost lines, before then allocating to products. 8.3 Reviewing the allocation units The team reviews the allocation unit line by line and for each line: • determines the most appropriate allocation basis from the wide range of possibilities identified.

• enters the selected basis into the sheet alongside the unit it relates to as illustrated below:



Exercise 1: MSC - Selecting allocation bases

Mbale Savings and Credit (MSC) is a small MFI and maintains a simple structure of accounts

It offers three products namely:

• Ordinary Savings Account (OSA), • Special Savings Account (SSA), and • Ordinary Loan Account (OLA).

Using the MSC chart of accounts, and the identified possible allocation bases, select the most suitable allocation bases for the selected account lines listed in the table … and then compare the result with the one prepared by the MSC cost allocation team

Account line items

Interest income – Ordinary Loan Account Interest income – investments Commitment fees Interest Payable – Ordinary Savings Account Interest Payable – Special Savings Account Interest expense – donor funds

Staff salaries & allowances Staff medical expenses Staff pensions Staff training Rent – commercial Rent – residential Motor vehicle expenses Marketing Insurance – money Insurance – premises Postage & telecom.



Exercise 1: Solution

Selection of bases by the MSC allocation team Account line Interest Income– Ordinary Loan Account Interest income – investments Commitment fees Interest Payable – Ordinary Savings Account Interest Payable – Special Savings Account Interest expense – donor funds Staff salaries & allowances Staff medical expenses Staff pensions Staff training Rent – commercial Rent – residential Motor vehicle expenses Marketing Insurance – money Insurance – premises Postage & telecommunications

Allocation basis Direct (OLA) Savings Portfolio (OSA and SSA) Direct (OLA) Direct (OSA) Direct (SSA) Direct (loans) Staff time Staff time Staff time Modified Transaction Transactions Equal Actual Equal Portfolio basis Transactions Actual

Rationale for basis Interest received from loans is directly attributable to the loan product Interest received from investments made with clients’ savings can best be allocated on the basis of the average portfolio of each savings account type Commitment fee income is derived directly from loans Since this interest is paid directly to ordinary savings account holders and is directly attributable to this product. Since this interest is paid directly to special savings account holders and is directly attributable to this product. Interest paid on capital fund loans from donor agencies is a direct cost of providing loans to clients Since all staff deal with all the products, it was necessary to develop timesheets and allocate these costs on the basis of the percentage of time each category of staff spent on each product. As above As above Training is given on customer care and administering individual products and can therefore best be allocated on a transaction basis – modified to reflect the length of the training courses on each product Since this was felt to best reflect the need for the space to accommodate customers and the staff to deal with them and the transactions they make. Since the CEO’s house is part of his salary package and he is responsible for the institution as a whole The usage logs kept in each vehicle allowed the allocation of these directly to each product Most of MSC’s advertising is to promote the institution as a whole By virtue of the contract with the insurance company, the insurance for money held/transported by MSC and its staff is directly related to the number of value of the amounts held The insurance premium for the building is based on the size of the building and this is determined by the area needed to accommodate customers and the staff to deal with them and the transactions they make. The automatic telephone logging system and the manual system in the post-room allows MSC to use this basis



9.0 QUANTIFYING THE ALLOCATION BASES 9.1 Expected Outcome This stage will work out ratios or percentages for apportioning values of the allocation unit among the different products they relate to. 9.2 Procedure After determining the allocation bases for use in the exercise, the next step is to decide the ratios on the basis of which the value for each allocation unit will be apportioned among the products it relates to. The process entails attaching weights to each product in proportion to its fair share of that value. Each basis will be expressed as a percentage split across all the products and could be summarised in a table as follows: Basis Prod. A Prod. B Prod. C Prod. D TOTAL Transaction 15% 25% 10% 50% 100 Staff time 10% 30% 25% 35% 100 The method of quantifying allocation bases may depend to some degree on how each basis is to be applied and therefore it is suggested that bases are quantified after deciding how they will be used. Some bases are calculated using statistics and financial data, and others are estimated. The best way to demonstrate the quantification of allocation bases is to work through two examples, the first

Illustration 1: Quantifying allocation bases at MSC

Suppose that the cost allocation team at MSC selects only: • direct basis, • portfolio basis, • transaction basis • equal basis, • actual basis, and • staff time basis as the set of bases to be used in the exercise. How would the quantification of the bases proceed? The team will examine each allocation basis in the set, in turn, and as a guiding principle the team will ask the question: what proportion is due to Ordinary Savings Account, Special Savings Account, & Ordinary Loan Account? Note that for each allocation basis will require a different analysis/calculation, and that “actual” will require a separate analysis/calculation for each line item being allocated. The result reached by the MSC team appears below: (a) Direct basis – this was considered straight forward. If the cost or income item is direct to OSA then

quantification would be 100% for Ordinary Savings Account, and 0% for Special Savings Account and Ordinary Loan Account. The same principle would apply if the item was direct to Special Savings Account or Ordinary Loan Account.



(b) Portfolio basis – this will follow the same ratio as that existing between individual product turnover expressed as average end of month balances for the sample period. For example if the average of the end of month balances for the three products during the sample period were:

• Ordinary Savings Account: Shs. 800 million • Special Savings Account: Shs. 200 million • Ordinary Loan Account Shs.1,000 million

then the quantification would be 40% and 10% and 50% for Ordinary Savings Account, Special Savings Account and Ordinary Loan Account respectively. The Portfolio basis for savings accounts only would be 80% and 20% for Ordinary Savings Account and Special Savings Account respectively.

(c) Transaction basis – this was ascertained by analysing a random sample of transactions in the

representative branch studied. The ratio of transactions made, and therefore the resulting quantification of the allocation basis, was follows: 30%, 15% and 55% for Ordinary Savings Account, Special Savings Account and Ordinary Loan Account respectively.

(d) Modified Transaction basis – this was introduced specifically to allocate staff training costs since it

was important to reflect the fact that the Ordinary Loan Account required longer/more training than the Special Savings Account which is a straight-forward product. After discussion, the estimated required modification resulted in a quantification of the allocation basis, as follows: 30%, 5% and 65% for Ordinary Savings Account, Special Savings Account and Ordinary Loan Account respectively.

(e) Equal basis – the cost item will be equally distributed to each product. For example the team decided

that marketing expenditure (which promoted MSC as an institution not on a product-by-product basis) benefited all products of the organisation equally and should therefore be shared equally. Hence the resulting quantification was 33.3% for each of the three products.

(f) Actual basis – the team examined sample transactions of actual usage, like motor vehicle expenses,

and found that on average for every 100 transactions 25 could be attributed to Ordinary Savings Account, 20 to Special Savings Account, and 55 to Ordinary Loan Account. The team therefore adopted the quantification of 25%, 20% and 55% for Ordinary Savings Account, Special Savings Account and Ordinary Loan Account respectively. For postage, the team found from the post room records that most postal expenses could be attributed to pursuing loan repayments and that the actual allocation basis was 30%, 5% and 65% for Ordinary Savings Account, Special Savings Account and Ordinary Loan Account respectively

(g) Staff time basis – they followed the same procedure as described in the example under section 8.3.1

above and came up with the quantification of 35%, 15%, and 50% for Ordinary Savings Account, Special Savings Account, and Ordinary Loan Account respectively.



Illustration 2: Allocating staff costs for MSC across the three products Branch Z, was selected to host the cost allocation exercise, and handles all three of MSC’s products, the Ordinary Savings Account, the Special Savings Account and the Ordinary Loan Account. As part of the preparatory stage each member of staff completed time sheets. The cost allocation team has established the salaries for each member of staff at Branch Z from the payroll. The exercise is at the stage of quantifying allocation bases for staff expenses. Time (as opposed to number of staff working on each product or area) was chosen since most staff members are involved one way or another in dealing with each of the three products. It is therefore essential to identify what proportion of each staff member’s time is spent on each product. How should the team proceed? For each member of staff (see example below): • Establish from the time sheets how much time was spent on each of the products; • Express the time spent on each product as a percentage of the total time spent by each staff member

on all products; (e.g. [from the example below] the manager spends 30%, 10% and 60% of her time on the Ordinary Savings Account, the Special Savings Account and the Ordinary Loan Account respectively, whereas the Accounts Assistant spends 40%, 20% and 40% of his time on the Ordinary Savings Account, the Special Savings Account and the Ordinary Loan Account respectively) etc.

• Enter the resulting percentage into a worksheet against each staff member; • Apply the percentage to the actual salary to obtain the cost per product for the staff; • Enter the cost in the costs column of the worksheet. For each product: • obtain totals of costs; • express the cost as a percentage to the total staff cost. Staff Time Allocation basis: Used for a variety of staff related expenses (e.g. medical expenses, training etc.) Staff Salary Allocation basis: Used for allocating staff salary related expenses (e.g. salaries and allowances, pensions, festival bonus etc.) Staff category Salary OSA FDA OLASalary costs allocated to:

% time % time % timeOSA SSA OLA Manager 10,000 30% 10% 60% 3,000 1,000 6,000Accounts Assist. 5,000 40% 20% 40% 2,000 1,000 2,000

Credit Officer 7,500 0% 0% 100% 0 0 7,500

Teller 6,500 75% 25% 0% 4,875 1,625 0Office Assist. 3,000 30% 20% 50% 900 600 1,500

Total 32,000 10,775 4,225 17,000Staff Time Allocation Basis 35% 15% 50%

Staff Salary Allocation Basis 34% 13% 53% Although any individual allocation basis may be used for several allocation unit lines, each basis should only need one calculation e.g. wherever the transaction basis is applied it has the same value.



Results from illustrations The result was tabulated as follows:

Quantification Allocation Basis OSA SSA OLA

Total

Direct – Ordinary Savings Account - Special Savings account - Ordinary Loan Account

100% 0% 0%

0% 100%

0%

0% 0%

100%

100% 100% 100%

Portfolio 40% 10% 50% 100%Savings Portfolio 80% 20% 0% 100%Transaction basis 30% 15% 55% 100%Modified Transaction basis 35% 5% 65% 100%Equal 33% 33% 34% 100%Actual – motor vehicles 25% 20% 55% 100%Actual – postage 30% 5% 65& 100%Staff time 35% 15% 50% 100%

10.0 APPLYING ALLOCATION BASES TO ALLOCATION UNITS 10.1 Expected Outcome This stage produces an Income and Expenditure Statement that is reanalysed across the products. The statement gives details of costs and income by product in addition to the consolidated position. 10.2 Procedure After determining the allocation ratios, the next stage is to use the ratios to allocate costs across the products, using the detailed Income and Expenditure Statement. Using the format of the Income and Expenditure Statement: • insert product columns, a totals column and a column for the basis of allocation, • for each line calculate the split per product using the ratios determined above. • enter the resulting cost for the product in the corresponding product column • repeat the process for all items in the Income and Expenditure Statement. Each item of income and of expenditure must be calculated and allocated on the basis selected, and the resulting figure placed in a separate column for each product. When every line item has been completed, the totals of the product columns should equal the total Income and Expenditure Statement result. Other examples of this are given in the illustrations under Part 3 of the toolkit. This is the first financial analysis to be produced by the process – a total cost allocation to products.



Illustration 3: Applying MSC allocation bases to the Income & Expenditure Statement

The team applied the bases and their corresponding quantification to allocate the items of the MSC’s Income and Expenditure account. Below is the result of the exercise:

(Amounts expressed in Million shillings) Allocation Unit Allocation Amt. as

Basis per a/cs OSA SSA OLA TOTAL % Amt. % Amt. % Amt. Amt.

Interest income – OLA Direct 291.0 0% - 0% 0.0 100% 291.0 291.0Interest income – Investments

Portfolio 175.0 80% 140.0 20% 35.0 0% - 175.0

Commitment fees Direct 36.0 0% - 0% 0.0 100% 36.0 36.0TOTAL INCOME 502.0 140.0 35.0 327.0 502.0Interest expense-OSA Direct 62.0 100% 62.0 0% 0.0 0% - 62.0Interest expense-SSA Direct 20.0 0% - 100% 20.0 0% - 20.0Int. expense–donor funds Direct 136.0 0% - 0% 0.0 100% 136.0 136.0Staff salaries and allowances

Staff time 56.0 35% 19.6 15% 8.4 50% 28.0 56.0

Staff pensions Staff time 10.0 35% 3.5 15% 1.5 50% 5.0 10.0Staff medical Staff time 15.0 35% 5.25 15% 2.3 50% 7.5 15.0Staff training Modified

Transaction 9.0 30% 2.7 5% 0.5 65% 5.9 9.0

Rent – Commercial Transaction 75.0 30% 22.5 15% 11.3 55% 41.3 75.0Rent – Residential Equal 5.0 33% 1.65 33% 1.7 34% 1.7 5.0Motor vehicle expenses Actual 20.0 25% 5 20% 4.0 55% 11.0 20.0Marketing Equal 10.0 33% 3.3 33% 3.3 34% 3.4 10.0Insurance – money Portfolio 5.0 80% 4 20% 1.0 0% - 5.0Insurance – premises Transaction 10.0 30% 3 15% 1.5 55% 5.5 10.0Postage & telecomm. Actual 6.0 30% 1.8 5% 0.3 65% 3.9 6.0TOTAL EXPENSES 439.0 134.3 55.6 249.1 439.0Net Result 63.0 5.7 -20.6 77.9 63.0



11.0 ALLOCATING THE COST OF CAPITAL BACK TO SAVINGS PRODUCTS THROUGH TRANSFER PRICING 11.1 Objective MicroSave has found the profitability of particular products to be particularly powerful in driving change within its Action Research Partners. One challenge in deriving the profitability of individual products is how to account for the implicit cross-subsidy between deposit and loan products where deposits are a source of capital for lending. Banks recognise the need to account for “hidden” cross subsidisation through transfer pricing. Joseph F. Sinkey, Jr. (1992) adapts an example of Copeland, Koller and Murrin (1990) where a transfer price is charged to banks’ wholesale lending division and credited to a banks retail banking division, which is the source of core deposits in order to correctly value the retail and wholesale divisions. MicroSave has adopted a similar simple transfer pricing approach in its costing exercises where savings that are intermediated into loans provide an important source of capital for MFIs. This source of capital allows the MFI to earn interest income, it is therefore important to calculate the implicit cost of this capital and charge it to the loan product cost centre while allocating it back as income for the savings product. 11.2 Procedure Once again how the income should be allocated, and at what rate of interest, are subjective decisions that should be discussed in a transparent manner within the organisation. One approach is to take the following steps: 1. Calculate the average balance over the year for each savings and loan product; 2. Deduct the average balance of grant and “soft”4 loan capital from the total loans made by the MFI to

ascertain the loan funds that were financed from the savings products; 3. Using the statutory legal ratios (plus any internal prudential policies) estimate the percentage of, and

thus average, savings balances available for lending; 4. Calculate the proportion of the average savings balances available for lending derived from each

savings product; 5. Using the proportion of the average savings balances available for lending calculate the total loan

funds derived from each savings product (i.e step 4 multiplied by step 2); 6. Use the chosen valuation of capital (typically the T-bill rate or sometimes the internal funds transfer

interest rate when the MFI has one) to calculate the value of the loan funds generated from each savings product;

7. Allocate the value of the loan funds generated from each savings product to each savings product as income; and finally

8. Allocate the total value of the loan funds generated from all the savings products to the loan product as a cost.

The modified MSC example below should help illustrate this exercise.


4 i.e. capital received at below the T-bill rate


Illustration 4: Calculating MSC’s cost of capital

Mbale Savings and Credit Cost of Capital Analysis Schedule 1

Special OrdinarySavings Account

Donor"Soft" Loans

Donor Grants

TotalCapital

LoanAccount

Average Balance over the Year 120.0 650.0 100.0 200.0 1,070.0 800.0 Free and Low Cost Capital 100.0 200.0 (300.0)% Available for on-lending 85% 65% Average Savings Balance Available 102.0 422.5 Proportion of Total Savings Balances 19% 81% Loaned Funds Financed from Savings 97.2 402.8 500.0 T-Bill Rate 10.0% 10.0% Nominal Income Allocated to Savings from Loans 9.7 40.3

These amounts are then allocated into the costing exercise giving the following results:

OSA SSA OLA TOTALAllocation Unit Allocation

Basis Amt. As Per a/cs % Amt. % Amt. % Amt. Amt.

Interest income – OLA Direct 291.0 0% - 0% 0.0 100% 291.0 291.0Interest income – Investments

Portfolio 175.0 80% 140.0 20% 35.0 0% - 175.0

Commitment fees Direct 36.0 0% - 0% 0.0 100% 36.0 36.0Allocated from Loan Income

Schedule 1 40.3 9.7 50.0

TOTAL INCOME 502.0 180.3 44.7 327.0 552.0Interest expense-OSA Direct 62.0 100% 62.0 0% 0.0 0% - 62.0Interest expense-SSA Direct 20.0 0% - 100% 20.0 0% - 20.0Int. expense–donor funds Direct 136.0 0% - 0% 0.0 100% 136.0 136.0Allocated to Loan Account Schedule 1 50.0 50.0Staff salaries and allowances

Staff time 56.0 35% 19.6 15% 8.4 50% 28.0 56.0

Staff pensions Staff time 10.0 35% 3.5 15% 1.5 50% 5.0 10.0Staff medical Staff time 15.0 35% 5.25 15% 2.3 50% 7.5 15.0Staff training Modified

Transaction 9.0 30% 2.7 5% 0.5 65% 5.9 9.0

Rent – Commercial Transaction 75.0 30% 22.5 15% 11.3 55% 41.3 75.0Rent – Residential Equal 5.0 33% 1.65 33% 1.7 34% 1.7 5.0Motor vehicle expenses Actual 20.0 25% 5 20% 4.0 55% 11.0 20.0Marketing Equal 10.0 33% 3.3 33% 3.3 34% 3.4 10.0Insurance – money Portfolio 5.0 80% 4 20% 1.0 0% - 5.0Insurance – premises Transaction 10.0 30% 3 15% 1.5 55% 5.5 10.0Postage & telecomm. Actual 6.0 30% 1.8 5% 0.3 65% 3.9 6.0TOTAL EXPENSES 439.0 134.3 55.6 299.1 489.0Net Result 63.0 46.0 -10.9 27.9 63.0 Clearly this re-analysis has profound implications and shows the Ordinary Savings Account to be much (Shs. 40.3 million) more profitable than the initial calculation suggested.



12.0 REVIEWING THE RESULTS 12.1 Objective The review of results is to check that the cost allocation produced by the exercise fits in with the expectations of the organisation. Any unexpected results could be a result of errors or inappropriate judgements in the allocation process. Since the process is highly subjective it is important to review the results critically. 12.2 Procedure • An independent group of key people who have not been involved with the details of the costing

exercise should study and critique the results with a fresh and independent mind. • The independent group will carefully review the decisions and cost allocations made, and make

recommendations to the team. • The team will study the recommendations and (where appropriate) incorporate them in the final cost

allocation.

13.0 THE MARGINAL COST APPROACH 13.1 The case for marginal costs approach While it is true that the way the total costs approach allocates income and expenditure between products is valid with all of them being in operation, would it be true to say that all the expenses allocated to any one product would be saved if it were eliminated? The answer is almost certainly ‘No’. The reason is that certain expenses will not vary with the size of the business i.e. they are fixed in the short, medium, or long term. The MFI will still need a security guard. The branch manager will still be needed. But it may be possible to reduce the size, and ultimately the cost, of office accommodation, or the number of accounting staff in a large branch. In other words, some costs are marginal (also called additional or incremental) and are therefore dependent on a particular product, whereas some costs will not be affected by a substantial change in a particular product. In both our case studies, there was one or two product(s) in each MFI that were obviously the core product(s) and business activities of the MFI. Therefore it was in respect of the other products that the question of marginal costs became relevant. 13.2 Procedure The procedure and indeed the stages followed under this approach are the same as the ones under the total costs approach. The only difference comes under the stage of selecting the appropriate allocation basis for each unit and additional questions arise. Under the marginal costs approach, the additional questions asked are: • Would this expense be saved if this product were eliminated, or not? - If so to what extent? • On the basis of having only the core product(s), what is the marginal cost of providing this product?

Two new allocation bases will be helpful in marginal cost allocation, namely the core product and fixed bases. The core product basis attempts to allocate a proportion of the line item to the core product(s) and other product(s) to understand the total cost implication of discontinuing the other product(s). This basis has to be estimated and will normally be a fairly arbitrary figure, but helpful nevertheless in presenting as realistic a picture as possible. The fixed basis applies to line items that are fixed in nature, and should therefore be allocated in full to the core product in a marginal cost allocation exercise (on the assumption that the core product is certain to be continued, else the organisation itself would cease operations entirely).



13.3 Advantages The marginal cost allocation is useful to management in deciding whether it is worth continuing the MFI’s products, and also in making decisions about accepting and implementing new products and how to price them.

Illustration 5: Selecting, quantifying and applying bases of MSC, under the marginal costs approach.

The review of the MSC cost allocation results has recommended that the Special Savings Account product be discontinued because it is not making the money which it was originally expected to make. Indeed the Special Savings Account was running at a substantial loss (Shs. 10.9 million even after add backing the value of the capital generated by the SSA). Management has studied the recommendation and decided that before doing so, the exercise should be repeated using the marginal costing approach on the basis of which a final decision will be made. (a) What allocation bases should be selected? (b) How should the bases be quantified? (c) How should the bases be applied to the income and expenditure statement? The table below shows what MSC has produced as a result of the management decision. In the exercise the team has combined products OSA and OLA into ‘CORE’ product, and allocated between this and SSA. Note the critical decisions made on:

Staff Expenses: Since the same staff deal with all three products, the savings that would arise from discontinuing the SSA are very small – some reduction in overtime and in the longer run perhaps a very small reduction in the number of staff. Accordingly, staff expenses (salaries, staff medical and staff pensions) were allocated on the “core” basis with the core products absorbing 95% of these line items (up from 85% under the total allocation basis). The 5% allocated to staff training under the total cost allocation exercise remained the same, since this cost could be saved in the event that the SSA was discontinued.

Rent – Commercial and Residential: MSC would have to maintain the same branch offices and

to rent the CEO’s residence whether they discontinued the SSA or not. Therefore the rental expenses are “fixed” and allocated 100% to the core products.

Motor Vehicle Expenses: Most of the MSC vehicles are used for all three products and a

significant part of motor vehicle expenses is fixed (e.g. the depreciation charges, annual insurance and road tax etc.). As a consequence, the costing team again used a “core basis” and allocated 85% of these expenses to the core products and only 15% to the SSA. (Under the total cost allocation exercise SSA had absorbed 20% of the motor vehicle expenses).

Marketing: MFI advertises to promote the institution as a whole and management felt that the

same level of advertising effort/expenditure must be maintained whether the SFA is discontinued or not. Advertising costs were therefore considered “fixed” and allocated 100% to the core products.

Insurance – money policy: The premiums payable would only decrease marginally in the event

that the SSA was discontinued, and therefore MFI chose to allocate these costs using the “core basis” and allocate 90% to the core products. The amount allocated to the SSA thus decreased from 20% (under full cost allocation) to 10% (under marginal cost allocation).

Insurance – premises: Since the MSC offices and the CEO’s residence would be maintained

whether the SSA was discontinued or not, the insurance premiums will remain the same.



(Amounts expressed in Million shillings)

Allocation Unit Allocation Amt. as Basis per a/cs SSA CORE TOTAL % Amt. % Amt. Amt.

Interest income – OLA Direct 291.0 0% 0.0 100% 291.0 291.0Interest income – Investments Portfolio 175.0 20% 35.0 80% 140.0 175.0Commitment fees Direct 36.0 0% 0.0 100% 36.0 36.0TOTAL INCOME 502.0 35.0 467.0 502.0Interest expense-OSA Direct 62.0 0% 0.0 100% 62.0 62.0Interest expense-SSA Direct 20.0 100% 20.0 0% - 20.0Int. expense–donor funds Direct 136.0 0% 0.0 100% 136.0 136.0Staff salaries and allowances Core 56.0 5% 2.8 95% 53.2 56.0Staff pensions Core 10.0 5% 0.5 95% 9.5 10.0Staff medical Core 15.0 5% 0.8 95% 14.3 15.0Staff training Modified

Transaction 9.0 5% 0.5 95% 8.6 9.0

Rent - Commercial Fixed 75.0 0% 0.0 100% 75.0 75.0Rent – Residential Fixed 5.0 0% 0.0 100% 5.0 5.0Motor vehicle expenses Core 20.0 15% 3.0 85% 17.0 20.0Marketing Fixed 10.0 0% 0.0 100% 10.0 Insurance – money policy Core 5.0 10% 0.5 90% 4.5 5.0Insurance – premises Fixed 10.0 0% 0.0 100% 10.0 10.0Postage & telecomm. Actual 6.0 5% 0.3 95% 5.7 6.0TOTAL EXPENSES 439.0 28.3 410.7 439.0Net Result 63.0 6.7 56.3 63.0

10.0

Illustration 6: Marginal costing with a transfer pricing adjustment on the cost of capital It may also be important to re-calculate the transfer price charged in relation to the cost of capital to examine the implications of discontinuing a product. In some cases (where no other sources of capital are available) discontinuing a savings product may have implications for the capital available to lend out, and thus directly impact on the profitability of the loan operations. This is illustrated in the MSC example below:

Calculating the cost of capital adjustment in a marginal costing analysis Mbale Savings and Credit Cost of Capital Analysis

Schedule 2 Special OrdinarySavings Account

Donor"Soft" Loans

Donor Grants

CoreCapital

LoanAccount

Average Balance over the Year 120.0 650.0 100.0 200.0 1,070.0 800.0 Free and Low Cost Capital 100.0 200.0 (300.0)% Available for on-lending 85% 65% Average Savings Balance Available 102.0 422.5 422.5 500.0 Proportion of Total Savings Balances 19% 81% Loaned Funds Financed from Savings 422.5 T-Bill Rate 10.0% 10.0% Nominal Income Allocated to Savings from Loans - 42.3

Reduction in Capital Funds for Lending 77.5

Gross Interest Rate on Lending 36% Reduction in Income from Lending

27.9



Adjusted for the cost of capital, this marginal cost analysis would appear as follows: Allocation Unit Allocation Amt. as

Basis per a/cs SSA CORE TOTAL % Amt. % Amt. Amt.

Interest income – OLA Direct 291.0 0% 0.0 100% 291.0 291.0Interest income – Investments

Portfolio 175.0 20% 35.0 80% 140.0 175.0

Commitment fees Direct 36.0 0% 0.0 100% 36.0 36.0Reduction in Income From Lending

Schedule 2 (27.9) (27.9)

TOTAL INCOME 502.0 35.0 439.1 474.1Interest expense-OSA Direct 62.0 0% 0.0 100% 62.0 62.0Interest expense-SSA Direct 20.0 100% 20.0 0% - 20.0Int. expense–donor funds Direct 136.0 0% 0.0 100% 136.0 136.0Staff salaries and allowances Core 56.0 5% 2.8 95% 53.2 56.0Staff pensions Core 10.0 5% 0.5 95% 9.5 10.0Staff medical Core 15.0 5% 0.8 95% 14.3 15.0Staff training Modified

Transaction 9.0 5% 0.5 95% 8.6 9.0

Rent – Commercial Fixed 75.0 0% 0.0 100% 75.0 75.0Rent – Residential Fixed 5.0 0% 0.0 100% 5.0 5.0Motor vehicle expenses Core 20.0 15% 3.0 85% 17.0 20.0Marketing Fixed 10.0 0% 0.0 100% 10.0 10.0Insurance – money policy Core 5.0 10% 0.5 90% 4.5 5.0Insurance – premises Fixed 10.0 0% 0.0 100% 10.0 10.0Postage & telecomm. Actual 6.0 5% 0.3 95% 5.7 6.0TOTAL EXPENSES 439.0 28.3 410.7 439.0Net Result 63.0 6.7 28.4 35.1



As can be seen from the MSC example, re-analysis of the SSA service using marginal costing demonstrates that it is making important contributions towards absorbing MSC’s fixed/semi-fixed costs. While it makes losses on a full-cost absorption basis, on a marginal cost basis, the SSA is profit-making. The overall profit of MSC’s operations would reduce by Shs. 6.7million from Shs. 63.0 million to Shs. 56.3 million in the event that the SSA was discontinued. As can be seen from the MSC example above, if the cost of capital is also included in the calculation, the implications of discontinuing the SSA becomes even more dramatic. As can be seen from illustration 6 the overall profit of MSC’s operations would reduce by Shs. 34.6 million from Shs. 63.0 million to Shs. 28.4 million in the event that the SSA was discontinued. This effect can be sub-divided as follows: • 27.9 million of the reduction in profit would be as a result of loss of capital available to on-lend

(assuming that it is not be feasible to raise capital/borrow from other sources) and • 6.7 million would be as a result loss of contribution to covering the costs of the MSC operations.

Non Quantifiable Factors

It is important to remember that there are likely to be a range of non-quantifiable benefits associated with (particularly savings) products. for example: • A broader range of products is likely to increase client satisfaction and thus loyalty, retention and

loan repayment. • A broader range of products is likely to provide better opportunities for clients to improve the

management of their household budget and thus reduce their vulnerability/risk and thus create the stability to better manage loan repayments and increase income.

• A broader range of products is likely to attract a broader range of clients. These important issues cannot be quantified without sophisticated (and somewhat speculative) analysis, but are nonetheless worthy of an MFI’s consideration when looking at introducing/discontinuing products.



PART II: PRICING OF FINANCIAL SERVICES

14. 1 Introduction Pricing is a very important function in the life of an organisation. It is a critical factor in the survival and good health of every organisation that relies on sales of its products: “If prices are too high, business is lost; if prices are too low the enterprise may be lost”. In price sensitive markets an organisation’s price structure may affect its competitive position and its share of the market. Pricing has an important bearing on the organisation’s revenue and profit. However, whilst there are common issues of relevance in pricing all products, several characteristics of financial services add unique complexities.

Frequently competition in the financial services sector is not as intense as in other industries. In the formal sector regulation can limit competitive pressure by creating barriers to the entry of new companies. In the semi-formal MFI sector there remain relatively few competitive markets. Customers often cannot determine the price they pay for services. Clear charges by banks are only a recent phenomenon, many banks and MFIs still maintain a

price structure that lacks transparency. Banking services are heterogeneous a product can encompass savings, money transfer,

cheque and ATM facilities. Even within solidarity group based products, there can be significant differences, which are only likely to increase as markets become more competitive and microfinance becomes increasingly market-led. Some services demand a continuing relationship between the financial institution and its

customers; thus many MFI clients can only access larger loans through repaying a series of smaller loans. Continuing relationships offer the potential for cross- subsidising products, for example, an MFI may accept a break even position on open access savings accounts in order to generate profits on contractual savings which use the same front and back office infrastructure, and loans which mobilise savings.

14.1 When is pricing necessary? Pricing of products is essential whenever an organisation develops a new product, introduces an existing product in a new geographical location or when the organisation wishes to change the positioning of its existing product in the same market. It is essential that MFIs price their products systematically and correctly and that the price of products cover the full-cost of delivering them.

14.2 Who should be responsible for the task? Responsibility for pricing will vary from organisation to organisation depending on the size of the organisation among other factors. In small organisations top management often decides pricing, while in large organisations the responsible head of department or the product manager will handle it. In other organisations price teams specifically created for the purpose will carry out pricing decisions.

In our case the cost allocation team could do the job. In the larger MFIs with a marketing department, the team could be reconstituted to include a representative from the marketing department. 15. PRICING PRODUCTS UNDER VARYING PRICING OBJECTIVES AND

STRATEGIES

15.1 Pricing policy, objectives and methods Micro-finance Institutions should always aim at recovering their costs when they carry out a pricing exercise. Most of the approaches covered in this section seek to do this except in circumstances where survival is the objective when the MFI may temporarily fix a price below cost with the aim of capturing market share before readjusting the price once the objective has been achieved. It is essential to know why you are pricing – i.e. with what objective in mind you are pricing your product(s). MFIs can set prices for their financial services guided by a wide variety of policies for example. In “Marketing: Theory and Practice” (Baker, 1995) Diamontopolous suggests a framework for pricing objectives and methods as shown overleaf.



Pricing objectives can be divided into

a) Profit: To achieve an immediate target profit or return b) Volume: Accepting lower profitability, but achieving volume growth c) Financial: Targeting an increase in market worth d) Competition Oriented: Adopting a position with reference to that of the competition e) Customer Oriented: To generate specific client responses, goodwill, to be perceived as fair etc. f) Miscellaneous: Other objectives could include, projection of positive image, avoidance of

government intervention etc. Pricing methods split into three categories, cost oriented pricing, competition oriented pricing and demand oriented pricing, and these are discussed in turn below: Cost Oriented Under cost oriented pricing the products price equals direct costs, plus overheads, plus profit margin. The difficulty with this approach is that costs are difficult to trace. Unless you have performed a detailed product costing any cost oriented approach to pricing will be based partly on intuition. Competition Oriented Under competition oriented pricing prices are set with reference to the competition. This does not mean to say that the prices of competitors fully determine the prices charged by an MFI, but rather that prices are set only after a detailed investigation of the pricing structures and charges of the major competitors is conducted. This approach tends to be used where services provided are standard, or where there is a limited number of large competitors in the market – who effectively set the market price. Competition oriented pricing suggests that financial institutions respond when competitors change their prices, particularly if prices are moved lower. The first step in pricing your products under a competition oriented strategy, you need to look at the specific features of your products in relation to those of your competition. A competition matrix can be used as a framework for this analysis (see Annex 4). Demand/Value Oriented Demand/value oriented pricing involves setting prices consistent with customer perceptions of value – prices are based on what customers will pay for the services provided. Monetary price must be adjusted to reflect the benefit of non-monetary elements to the customer. Non-monetary benefits can include: Guaranteed loans, social acceptability (in some cultures), localised service, frequency of service, ease of access, transparency of pricing etc. So how do you go about establishing a demand-oriented price? First elicit customer definitions of value in their own words and terms - customers articulate the value of the product to them by identifying the key benefits they seek and the features of the product particularly relevant to them.5 Once you have established the features that customers particularly value, you attempt to quantify this value to your potential customers on a benefit by benefit basis (where possible), for example, if provision of a local mobile banking service is particularly valued by clients because it saves both travel time and a bus fare an additional charge may be levied based on a proportion of the bus fare saved. 3 Steps to Pricing of Financial Products MicroSave advocates that MFIs use these three categories in a step-by-step approach to assess the price of product:

first on the basis of covering the costs of delivering the product; then second on the basis of the prices in competitive market within which the MFI is operating;

and finally third on the basis of the demand for or value provided by the product.


5 This is very similar to a technique used in MicroSave’s “Marketing for Microfinance Toolkit” called Writing Benefit Statements.


Illustration 7: 3 Steps to Pricing Mbale Savings and Credit’s current Special Savings Account offers an average interest rate of 16.67% on balances. The full-cost analysis shows that it is a loss-making product, and while the marginal cost analysis demonstrates that the product absorbs an important proportion of MSC’s fixed costs, management are keen to re-price the Special Savings Account. MSC conducted a competition analysis6 and discovered the following:

Sections Taken From: Competition Analysis Matrix - Savings Accounts - Other Banks in Mbale Saving Account Mbale Savings and

Credit Post Bank Tropical Bank The Rural

Development Bank PRODUCT (DESIGN)

Opening Balance

Ordinary Savings Account Shs.20,000 Special Savings Account Shs.100,000

Ordinary Passbook Account Shs.20,000, Trust Account Shs.50,000

Shs.60,000 Shs.10,000

Minimum Balance

Ordinary Savings Account Shs.20,000 Special Savings Account Shs.100,000

Ordinary Passbook Account Shs.10,000, Trust Account Shs.50,000

Shs.50,000 Shs.5,000

Other Requirements

2 passport photos, Introduction letters from the employer and L.C.1, A valid driving permit and an identity card.

2 passport photos, Introduction letters from the employer and L.C.1, A valid driving permit and an identity card.

3 passport photos, A current identity card, An introducer with an account at Tropical Bank.

3 passport photos, Recommendation from a customer of the bank, with an account of at least 3 months or An introduction letter from the LC1, Photocopy of an identity card or passport/ a driving permit. Graduated tax tickets for at least 3 yrs.

Other Facilities/ Services

Mag stripe card 5 ATMs

A flexible long-lasting passbook, A speedy transfer of funds at Shs.10,000 or 1% of the amount to Shs.25,000. No ATM's.

A free passbook. No ATMs

A savings pass book/card – costs the client Shs.2,000. Western Union Money Transfers, No ATM's.

Deposit Policy Any number of times and amount during office hours.

Any number of times and amount during office hours.



Withdrawal Policy

As many times as possible during office hours.

As many times as possible during office hours.

Once a day. As many times as possible during the office hours.

PRICE Interest Rate Paid

Interest earning amount Shs.100,000 Interest rate 16.67%

Interest earning amount Shs.10,000 and Shs.50,000 depending on the product, interest rate is 10% per annum tax free.

Minimum interest earning balance is Shs.50,000. Interest 12-14% per annum.

The Rural Development Bank pays interest rate on the entire balance. Interest is 3% every 3 months.


6 See MicroSave’s Market Research for MicroFinance toolkit for an example of this.


Service Fees Salary processing Shs.2,000 for a card.

Salary posting Shs.3,000 in a passbook, Salary processing Shs.2,000 for a card. Other charges: Bounced cheques Shs.15,000, Post office service fees Shs.300.

A charge of Shs.3,000 per month for balances below Shs.50,000. A ledger fee of Shs.1,000 per month. Salary posting is Shs.1,500.

Withdrawals >2 times a month a charge of Shs.2,000 per month, Bank drafts 0.5%of value or a minimum of Shs.10,000, Stop payments Shs.10,000, Cheques returned un paid for lack of funds

Account Opening Fees

Shs.5,000 for the card Shs.5,000 for the passbook

None Shs.2,000 for the passbook

Ledger/ Statement

None Shs.750 per month card/book

Shs.1,000 per month. None.

Deposit Fees None None None None Withdrawal Fees

None Shs.300. None. Withdrawals >2 times per month a charge of Shs.2,000.

Account Closing Fees

None Shs.5,000. Shs.5,000. Shs.5,000.

PLACE/ ACCESS

Location Right in the city. 4 Branches on Hellal Street, Entebbe Rd. , Namirembe Rd. and Owashika Road.

Right in the city. Nkrumah Rd, No ATMs.

Right in the city Kampala Rd No ATMs.

Right in the city. 4 Branches on Entebbe Rd. , Namirembe Rd and at Mukwano shopping arcade Nakivubo and Amber House on Kampala Rd. ATMs soon.

Interior Set Up Recently re-branded. Spacious, clean and bright

Small, not so clean and poorly organised. But with good music playing.

Spacious, clean with a dull atmosphere.

Small clean and fairly attractive but disorganised. Mukwano branch is spacious.

Opening Days/Time

Monday - Friday 8.30 am - 3.30pm



Monday - Friday 8.30 am - 4.00pm, also 8:30am -5:00pm at Amber House Branch for Corporate clients.

Other Days/Time

Saturday 8.30 am-3.00pm Plus 24/7 ATMs

Saturday 9.00am - 12.30 p.m

None Saturday 8:30am - 1:30 p.m

Congestion Not congested Fairly congested Not congested Congested especially on Mondays, Fridays, Saturdays and during School fees time.

POSITIONING

Slogan/Vision Time is Money – Save Both!

Save and prosper None known. Saving to Grow - Growing to Serve

Corporate Image

Targeting small savers, low income salaried employees as well as the informal sector.

Attracts formal and informal small scale savers. Salaried and unsalaried.

Attracts both formal and informal small scale savers, salaries and unsalaried.

Targeting small savers, low income salaried employees as well as the informal sector.



Product Image The premium account for low income (and even some higher income) earners. Associated with cutting edge technology (ATMs) and quick service.

Account attracts interest and charges e.g. premature withdrawals Ush.5,000 across the counter.

The low income earner's account attracts interest on the minimum balance. Good for savers targeting to accumulate a lumpsum.

Identifying with salaried, low income earners and those in the informal sector.

On the basis of the above the MSC made a series of decisions following the 3 Steps to Pricing Financial Services. Step Original

Interest Paid Revised

Interest PaidRationale

1. Cost 16.67% 14% MSC management wanted to reduce the loss made on the Special Savings Account, but recognised that they could not halve the current interest rate to wipe out the loss indicated by the full cost analysis.

2. Competition 14% 12% Examining the competition matrix (particularly the price component) alerted MSC’s management to the fact that the competition are charging less than the 14% - and were typically charging around 12%.

3. Demand/Value 12% 10% Further examination of the competition matrix (particularly the place/positioning components) alerted MSC’s management that the Special Savings Account was, and is seen by the market as, a premium account. The ATMs have de-congested the banking halls and the re-branding efforts have made them pleasant places to be. MSC’s management concluded that they could further reduce the interest the pay on the Special Savings Account by a further 2%.

As can be seen from the above example the 3 Steps to Pricing Financial Services provides a basic framework to pricing financial services. However, some financial institutions have other objectives for the pricing decisions that also need to be taken into account. Some of the typical objectives for pricing decisions are outlined below.



Pricing Objectives

Profit

o Money profit o Gross/net margin o Contribution margin o Return on sales o Return on capital

employed o Return on net worth o Profit growth

Examples Target rate of return (illus.8) Mark up pricing (illus 14)

Volume

o Market share o Sales volume o Sales revenue o Sales growth o Capacity utilization

Examples Market share (illus 9)

Financial

o Cash flow o Earnings per share o Price earnings ratio o Dividends

Competition orientated

o Matching/undercutting competition

o Avoidance of price wars o Limit entry o Price stability

Examples Competition Pricing (illus 10) Penetration (illus 11) Skimming (illus 12) Keep Out pricing (illus 13) Target return pricing (illus 15)

Customer orientated

o Fair price levels o Goodwill o Value for money

Examples Demand oriented pricing (illus 16)

Miscellaneous

o Projection of high quality image

o Avoidance of government intervention

o Survival/security Examples Survival pricing (illus 7)

Pricing methods

Cost orientated

o Cost-plus pricing o Contribution pricing o Target (ROI) pricing o Price-minus pricing o Return on costs

Competition

o Product analysis pricing

o Value pricing o Pricing leadership/

Followership o Competitive parity

pricing

Demand/Value orientated

o Marginal analysis o Trial and error pricing o Intuitive pricing o Market pricing o Monopsonistic pricing

15.2 Price’s role in the marketing mix Price plays an important role in the marketing mix for many reasons. Reasons proposed by Simon (1989) include:

1. Price elasticity is twenty times greater than advertising elasticity; that is, one per cent change in price has a sales effect twenty times as big as a one per cent change in advertising expenditure.

2. The sales effect of a price change is often immediate, and so measurable, while changes in other mix variables are usually lagged and difficult to quantify.

3. Price changes are easy to effect compared with varying other mix variables 4. Competitors react more quickly to price changes.



15.3 Exercise: Pricing policy, objectives and methods Think through and respond to these questions for formulating your MFI’s pricing policy, objectives and methods. 1. What key issues influence your pricing decision? 2. What is your pricing objective(s)? Why? 3. How important is price in your marketing mix? Why / (Remember the demand curve and price elasticity? 4. What basic strategy – skimming or penetration – do you follow? Why? 5. To what extent are your pricing methods influenced by cost, by demand, by competition? What is the relative influence of these three forces? 6. What is your preferred pricing method? Why?



16. PRICING IN PRACTICE – WORKED EXAMPLES Prices must be set high enough to allow a financial institution to be sustainable, guidance on calculating sustainable interest rates on loan products is given in Annex 3: Setting sustainable interest rates. 16.1 Pricing to meet set objectives Assuming the prices set are sustainable, there are many other objectives that an organisation may set to guide its pricing effort some of which will be influenced by the conditions in the market where they operate. This section looks at a few objectives, which are commonly applied namely: • To ensure survival, • To achieve a target rate of return, • To maintain or improve market share, and • To meet or prevent competition. • To reflect clients’ perceived additional value of a premium product. 16.1 .1 Survival Organisations may pursue survival as their main objective when faced with: intense competition, changing consumer wants, or high fixed costs. In order to keep the organisation going they may cut their prices or in the case of savings products increase interest rates. In their pursuit of survival, organisations may consider profits to be less important than survival. However, survival is a short-term objective, and in the long run, every organisation must set prices, which cover their costs.

Illustration 7: Survival pricing Kob Savings Bank opened to the public on 1.1.1980 in a highly competitive market. It was licensed to take deposits and give loans. After making losses for two years, the bank’s working capital ran thin and the prospect of winding up became real. Fearing extinction, management sought help from a consultant in town. After studying the situation the consultant recommended a package of measures most important of which were: cutting down costs, especially staff numbers, and increasing their interest rate so as to attract deposits. They followed the advice and within a short time their deposit base started widening and in tandem their loan portfolio also started expanding. Two years down the road, the bank broke even and eventually grew into a strong financial institution.

Kob Savings Bank

(All values in million shillings) Year 1 2 3 4 5 Deposits rate of interest 3% 3% 5% 5% 5%Total deposits 800 800 1,200 2,000 2,500Total market deposits 20,000 22,000 24,200 26,200 29,300Total investments 640 640 960 1,600 2,000Investments rate of int. 10% 10% 10% 10% 10%Total income Less • interest paid • other operating costs

64

24 50

64

24 55

96

60 45

160

100 50

200

125 55

Gross profit (10) (15) (9) 10 20 The illustration shows an enterprise which was facing the prospect of extinction from accumulating losses but took a decision that, on face of it, was going to make the situation worse by increasing its interest on deposits – the equivalent of cutting its prices in merchandise trade - knowing (or at least hoping) that in the long run the measure would bring survival.



16.1.2 To achieve a target Rate of Return Organisations whose pricing objective is to achieve a target rate of return will normally set a target linked to the prevailing cost of capital. An organisation following this objective will try to build a price structure that provides for sufficient return on capital employed. An estimate is made of the return over the long run, and prices are fixed to achieve the rate of return targeted.

Illustration 8: Pricing to achieve a target Rate of Return The manager of Savings ‘R Us Ltd. was given a goal by his Board to achieve a 20% rate of return on the institution’s Shs.750 Million capital employed. His projections for the subsequent period were as follows: • Deposits Shs. 10,000 Million • Interest payable (@4%) Shs. 400 Million • Other costs Shs. 250 Million • Total costs Shs. 650 Million Since capital employed was Shs.750 Million, the target return worked out to be Shs.150 Million (750 X 20%). With this in mind, the manager worked backwards to establish the total interest income he needed to match this target from which he would then be able to calculate the corresponding rate of interest. The calculation revealed that to achieve these goals he needed:

• a total of Shs.800 Million (Shs. 800 million – Shs.650 million expenses = Shs. 150 million target return) in interest income from investments of his deposits.

• a rate of interest of 8% p.a. on investments of his deposits in order to meet the target rate of return given by his board.

Note: The above example simplifies the issue since it ignores the time value of money. Sophisticated MFIs would also want to factor this in to apply appropriate discount factors to the numbers in the analysis and reflect net present values.

16.1.3 To Maintain or improve market share This objective is normally followed by organisations operating in expanding markets. When the market has potential for growth, market share will be a better indicator of an organisation’s effectiveness than the target rate of return on investment. An organisation may be earning a reasonable rate of return, when its market share is shrinking.

Illustration 9: Pricing to maintain or improve market share An enterprise following this objective will be prepared to cut its prices just as Kob Savings Bank did in illustration 3.1.1, but with the objective of enhancing market share. The package of measures adopted by Kob after the consultant’s intervention could have been prescribed for an enterprise seeking to improve its market share. An extract from the Kob case below illustrates the point.

(All values in million shillings) Year 1 2 3 4 5 Deposits rate of interest 3% 3% 5% 5% 5%Total deposits 800 800 1,200 2,000 2,500Total market deposits 20,000 22,000 24,200 26,200 29,300Market share 4% 4% 5% 8% 9%

16.2 Pricing under set strategies There are many strategies organisations may use in pricing their products. For purposes of this exercise only a few are considered in this section.



16.2.1 Competitive pricing strategy Organisations may fix the price of a product at the competitive level under certain market conditions. This strategy is mostly used when the market is highly competitive and the product is not significantly differentiated from competing products.

Illustration 10: Competitive pricing strategy Suppose that in the Kob market there was a change in the bank rate that prompted the major banks to adjust their rates upwards leading to the scenario in the table below, what action would Kob take?

Institution Rate before The change

Rate after the change

Jumbo 3 ½% 4% Tembo 3 ½% 4 ½% Twiga 4% 5 ½% Lion 4 ½% 5 ½% Kob 5% ? Lamb 4 ½% 5 ½%

Kob will consider a number of options including adjusting its own rate to avoid an exodus of its clients to competitors. Other options include maintaining the price and increasing perceived quality. Kob may decide that increasing price is the best way to proceed and face the question; to what level 5 ½% or 6%? The difference between the two positions has cost and demand implications. 5 ½% may save money but lose customers while 6% may maintain customer base but cost money. Kob would have to assess the likely reaction of its core customers and compare the costs at these two positions before deciding where to position itself.

16.2.2 ‘Skimming the cream’ pricing strategy Organisations using this method charge higher prices during the initial stages of the introduction of a new product. This is done to enable the organisation recover its initial investment quickly. This strategy has been successful in many cases due to the following reasons: • demand is likely to be less responsive to price in the early stages than when the product is fully

grown. • introducing a new product with a high price is an efficient device for dividing the market into

segments that differ in price sensitivity. The initial high price serves to skim the cream of the market that is relatively insensitive to price. Price may be reduced subsequently to attract successfully more price sensitive segments of the market.

• an organisation may charge a higher price in order to restrict demand to a level it can easily satisfy. • the higher initial price finances the cost of raising a product family. The organisation may charge high

prices and plough back the excess profits into the business for further expansion.

Illustration 11: Skimming the cream Savings ‘R Us Ltd. is introducing a new savings product for rural savers called “FREE”. The product is an improvement on the existing rural savers schemes. The main improvement it brings on the market is that it allows rural savers to: • make their savings deposits as often as they wish. Existing schemes restrict deposits and savers are

not free to deposit as and when they want to, • deposit as much as they wish. Existing schemes restrict deposits as to amount and frequency, • permit access to the account once a month. Most existing schemes do not permit drawings except for

exits. Using guidelines outlined in the MicroSave Market Research for Micro Finance Toolkit, Savings ‘R Us Ltd. has conducted a market research and the findings reveal the following:



• 100% of those sampled would move into this product if the rate (price) was competitive. • 90% would move into this product even if there was no interest to be earned. • 75% would move into this product even if there was no interest to be earned and there was a fee to be

paid for services rendered. In a market where a major customer need is not being met, a new product meeting that need would be a typical candidate for ‘skimming the cream’. Savings ‘R Us Ltd. would have a number of options. The problem would now be its own capacity. Scenarios 1 and 2 would give rise to a high volume of business. If its capacity is low, Savings ‘R Us Ltd. would consider going for scenario 3 including setting a high level of fees in order to attract a level of demand it can satisfy.

16.2.3 Penetration pricing strategy Organisations use this method when entering a new market that is price sensitive. Because of its objective of acquiring market share, an organisation may temporarily price its product below the competition level in order to develop popularity of its brand. Unlike the skimming of the cream strategy, it facilitates higher volumes of sales even during the initial stages of a product’s life cycle. Penetration pricing may also be used to prevent entry of new organisations at the time of introducing a new product by keeping the profit margin very low. The strategy helps in developing the brand preference of customers and is useful in marketing products that are expected to have a steady long-term market.

Penetration pricing is an aggressive strategy and normally applies under the following conditions: • When demand for the product is highly sensitive to price • When turnover is large enough to achieve a low unit cost • When there is strong competition on the market • When the high-income market is too small for the ‘skimming the cream’ strategy to be sustained.

Illustration 12: Penetration pricing Imagine a situation where Savings ‘R Us is trying to introduce the “FREE” product and market research reveals the following results: • 75% of those sampled would move into this product if the rate was competitive • 15% would move into this product if there was no interest to be earned • 5% would move into this product even if there was no interest to be earned and there was a fee to be

paid for services rendered. What action would Savings ‘R Us Ltd. take? Under this strategy, Savings ‘R Us Ltd. would enter at scenario 1 or at a price below the competitive rate in order to obtain a large share of the market and popularise the “FREE” brand so as to safeguard its market share.



Comparing Skimming and Penetration Policies

Skimming strategy Penetration strategy • High short-run profits little affected by

discounting. • Quick pay-back for real innovation

during the period of monopolistic market position, reduces long-run competitive risk, quick amortization of R&D expenses. • High profit in early life-cycle phases

reduces the risk of obsolescence. • Allows for price reduction over time. • High price implies positive prestige and

quality. • Requires fewer financial resources. • Requires lower capacity.

• High total contribution through fast sales growth in

spite of low unit contribution margins. • Takes advantage of positive intrapersonal (durable

goods) carryover effects, builds up a strong market position (with the potential of higher prices and /or higher sales in the future).

• Takes advantage of short-run cost reductions through (static) economic of scale.

• Allows for fast increase of the cumulative quality by accelerating the experience curve effect. Achieves a large cost advantage that competitors will find difficult to match.

• Reduces the risk of failure; low introductory price gives some assurance of low probability of failure.

• Deters potential competitors from market entry, or delays their entry.

16.2.4 Keep out pricing strategy This is a pre-emptive pricing strategy which an organisation may use to discourage other organisations in the market from offering substitutes to a product it has developed. It is a very risky strategy, particularly when the product is offered to the public at a price which is less that its actual cost. The strategy can be followed by big organisations with huge resources at their disposal, but even then, once the price is fixed at a low level, it may not be possible to increase it for fear of the other organisations introducing substitutes.

Illustration 13: Keep out pricing strategy A good illustration of this strategy is a situation where Savings ‘R Us is competing with other MFIs namely: A, B, and C. It undertakes a two-phased strategy; initially to capture the market, and eventually to drive and keep the others out of it. The table below shows the first phase after a successful entry by Savings ‘R Us.

All values in million shillings Institution A B C Savings ‘R UsInterest income (9%) 150 90 120 1,080Interest paid (3%) 50 30 40 360Fixed costs 50 50 50 70Gross profit 50 10 30 650

After a successful entry into the market, Savings ‘R Us embarks on a strategy to drive others out of the market. Assuming that the interest on investments is fixed, the only weapon Savings ‘R Us can work with is the rate of interest to savers. Accordingly Savings ‘R Us adjusts its rate to a level where it becomes unprofitable for others to continue in the same market. The table below shows the results of the institutions one year after Savings ‘R Us launched its campaign.



All values in million shillings

Institution A B C Savings ‘ R UsInterest income (9%) 150 90 120 1080Interest paid (7 ½%) 125 75 100 900Fixed costs 50 50 50 70Gross profit (25) (35) (30) 110

16.2.5 Mark-up pricing strategy The most elementary method of pricing is mark-up pricing. The method involves adding a standard mark-up to the cost of a product. It is easy to learn , easy to use and is very popular but has some weaknesses.

Like the method in section 2 above, its weaknesses include its failure to take into account current demand, perceived value of the product, and competition, all of which make it difficult to achieve the optimal price.

Organisations introducing a new product often load a high mark-up hoping to recover their costs as rapidly as possible. But a high mark-up strategy can be fatal if a competitor is pricing low. Reasons why mark-up pricing is popular:

• Most organisations are more certain about their costs than their demand, and by tying price to cost, they simplify their own pricing task, and they do not have to make adjustments when their demand changes.

• When all organisations in the industry use this approach, their prices tend to be similar. Price competition tends to be eliminated, which would not be the case if all organisations considered demand variations in their pricing.

• Cost-plus pricing is considered fair to both customer and seller. Sellers do not take unfair advantage of customers when the latter’s demand is very high, and yet manage to earn a fair return on their investment.

Illustration 14: Mark up pricing After eliminating competition, Savings ‘R Us wish to increase their price. They find the mark-up method the ideal strategy because of the unique advantages it offers. They decide to go for a mark-up on costs of 25%. If their investment income is projected to be 1,440 million (9% earned on a deposit base of 16,000 million), what interest should they offer on their savers’ deposits to achieve the required mark-up? It is assumed that the level of operations in illustration 3.3.4 will remain unchanged in the subsequent period. The following are the basic figures for the case: • Fixed costs 70 Million • Investment income 1,440 Million • Desired mark – up (M) 25% • Interest paid ( r ) (will depend on the interest paid on deposits which is the price

to be determined.) The calculation: Mark up (M) = income - (fixed costs + interest paid (r ) ) (fixed costs + interest paid) [1,440 - (70+r)] x 100 = 25 (70 + r)



[1,440 - 70 - r] x 100 = 25[70 + r] [1,370 - r] x 4 = 70 + r 5,480 – 4r = 70 + r 5,410 = 5 r r = 1,082 Interest Rate = 1,082/16,000 = 6.7625% Interest paid would therefore be Shs.1,082 Million and the rate of interest 6.8% p.a. MFI would offer a rate of 6.8% on its savers’ deposits to achieve the target mark-up of 25%.

16.2.6 Target-return pricing strategy Under this strategy an organisation determines the price, which will yield its target rate of return on investment. So the starting point is the desired rate of return, and the price is calculated by working backwards. The biggest weakness of this strategy is its inability to take into account price elasticity and competitors’ prices.

Illustration 15: Target return pricing strategy Suppose Savings ‘R Us had invested Shs.1,000 Million in the business and wanted a target return on its investment of 25%. The calculation: Assume the level of operations in the illustration above remains unchanged. ROI would be: 1,000 x 25% = 250 The formula to establish the price (interest rate) that would yield this return would be: Income = Fixed costs + Interest paid + ROI 1,440 = 70 + r + 250 r = 1,440 – 70 – 250 r = 1,120. Savings R Us would therefore pay its savers a rate of 7% to achieve the target ROI of 25%.

16.2.7 Demand Oriented Pricing Under this strategy the organisation recognises that it offers a premium service, which it believes its clients will pay an additional fee to access. The organisation uses market research to evaluate client perceptions of the service. It then attaches a value to its clients’ perceptions. Illustration 16: Demand Oriented Pricing ABC Bank offers a mobile banking service to its customers in remote rural villages in East Africa. According to market research conducted by the Bank its customers value the service for the following reasons:

Cost savings: Customers no longer have to take a bus into town to access banking services. Time savings: The convenient location of the mobile banking service saves customers

time in accessing services



Improved relationships: The Bank staff operating the mobile banking has an in-depth knowledge of local opportunities making it easier to access loans.

ABC Bank notes that the average cost saving to customers is the Sh.10 bus fare and the time saving is one hour. Given these factors plus the popularity of the mobile banking staff ABC Bank believes it can justify an Sh.15 per transaction premium on its normal transaction fees.

17. HOW DO FEE STRUCTURES IMPACT ON CUSTOMER BEHAVIOUR? Pricing categorization Llwellyn and Drake (2000) categorize prices into three types, explicit, implicit, and spread pricing. With explicit pricing, specific and identified charges are made on the purchaser of a service. Explicit charges are charges for specific services or transactions examples include, fees on withdrawals, and money transfer products. However, many charges are implicit, implicit charges arise when a bank provides a deposit service for “free”, but does not offer an interest rate on credit balances. Spread pricing relies upon a spread charge such as in most foreign exchange transactions. Llwellyn and Drake argue convincingly that different pricing modes influence customer behavior differently. An explicit transaction charge will reduce the number of withdrawals made, is of benefit to customers with a low volume of transactions, and is transparent. In contrast a fixed fee, provides certain costs, but effectively provides a subsidy to clients with a high volume of transactions. The properties of different pricing modes are examined further in the following table.

Properties of Pricing Modes Induces

cost reducing behaviour

Implicit cross subsidies

Cost/revenue interest rate sensitive

Benefit to low volume transactions

Certainty of costs

Subsidy to large volume transactions

Transparency

Explicit transaction charge

✔ ✘ ✘ ✔ ✘ ✘ ✔

Fixed quarterly fee

✘ ✔ ✘ ✘ ✔ ✔ ✔

Zero interest on balances

✘ ✔ ✔ - ✔ - ✘

Minimum balance

✘ ✔ ✔ - ✔ - ✘

Fixed quarterly fee including x transactions

(✔ ) ✔ ✔ ✔ (✔ ) ✘ ✔

Differential transaction charges

✔ ✘ ✘ ✘ ✘ ✘ ✔

Rebates on basis of balances

✘ ✔ ✔ ✘ ✘ ✘ ✘

Source: Llwellyn and Drake (2000) The advantage to tax paying customers of implicit pricing is to save tax, as tax is not levied on implicit interest. Implicit pricing is simple for the bank and customer to administer and understand. However, it tends to encourage an oversupply of services as there is no incremental cost to the consumer of undertaking more transactions, customers are not aware of the true cost of the service, and there is no incentive for customers to use cheaper forms of payment, thereby increasing costs to the bank.



Frequently banks and sometimes MFIs recover costs through a combination of fees and charges – so the precise behavior of customers may be difficult to predict. Llwellyn and Drake argue for a two-part tariff on basic current accounts. The tariff uses explicit a fixed periodic charge aimed at recovering the fixed operational cost of the institution, combined with a transaction fee aimed at recovering the marginal cost of each transaction. This pricing structure they argue provides incentives for most clients to ration their use of the service, thereby reducing costs to the bank, whilst not discouraging frequent users of the account.

18.0 COMMON MISTAKES

Pricing as mentioned above is a critical function in the life of an organisation. It is the only element in the marketing mix that produces revenue and is ranked high among the challenges of any marketing executive. Unfortunately some organisations do not give it the prominence it deserves, resulting in serious problems that could have been avoided.

Following are some of the most common mistakes:

• Viewing pricing as being entirely cost determined • Not revising the price often enough to keep it in line with market changes • Setting the price in isolation of the rest of the marketing mix • Price not being varied enough for different product types and market segments

The team will have to monitor movements in the market to ensure that the organisations price level remains consistent with market trends all the time. 18.1 The Danger of Low Pricing Watch out for “dangerous pricing”. Building a business on low price is a time-honored custom. But it has a built-in danger. Price breeds disloyalty. If you succeed by low price, you can also fail by low price. Every new gunslinger drifting into town will want to take you down by shaving a few cents off the price. What customers long for is value, which includes not only a good product but accompanying services as well. Pay attention to price…but pay even more attention to value when building a loyal customer base.

New businesses ___ especially new service businesses ___ often price themselves too cheaply. They may start off getting lots of work… and slaving away to get it all done. Then they realize they’re not making enough money to justify their expenditure of energy. Avoid the temptation to under-price to get your business started. You’ll find it hard to raise prices too quickly, so you’ll pay for your mistakes for years.



18.2 So What Do Customers Want? Value is extremely subjective, but it can still be calculated with some exactness. Value is a balance between a fair price, a quality product and a convenient, service-oriented environment. The right combination of those factors triggers the mutually beneficial exchange between buyer and seller.

Pricing: The Resistance Principle (form Harry Beckwith, “Selling the Invisible”, Warner Books, 1997)

“Just months into business, I have made my first great discovery about business,” a young woman recently told me. “There’s one simple way to get all the business you handle: Charge almost nothing.” She’s right. If no one complains about your price, it’s too low. If almost everyone complains, it’s too high. So if no price resistance is too low and 100 percent is too high, how much resistance is just right? How much resistance tells you that your price is right? Fifteen to 20 percent - And there is one simple reason why: Close to 10 percent of people will complain about any price. Some want a deal. Others are mistrusted and assume every price is overstated. Still others want to get the price they had in their mind when they approached you, because it’s the price they hoped for and already have budgeted in their mind. So throw out the group that will object no matter what your price Then ask: In the remaining cases, how often do I encounter resistance? Resistance in 10 percent of those remaining cases __ for a total of almost 20 percent__is about right. When it starts exceeding 25 percent, scale back. Setting your price is like setting a screw. A little resistance is a good sign.

References Baker, M.J., “Marketing: Theory and Practice”, 3rd Edition, Macmillan, London, (1995) Baker, M.J., “The Marketing Manual”, 5th Edition, for Butterworth-Heinenmann forThe Chartered Institute of Marketing, UK (1998) Beckwith, Harry, “Selling the Invisible”, Warner Books, USA, (1997) Cannon, Tom, “Marketing – Principles and Practice - 5th Edition”, Cassell Publishers LKtd., USA, 1998Ferreri, Jack, “Knock-out Marketing – Powerful Strategies to Punch Up Your Sales”, Entrepreneur Magazine, USA (1999) Llwellyn, David and Leigh Drake, “Pricing” in “Marketing Financial Services” 2nd ed., Butterworth-Heinenmann, UK (2000) MicroSave, “Marketing and Product Development: Frameworks and Experience” Putter, Willliam et al., “ABC Provides Unique Advantage at Standard Bank”, Standard Bank of South Africa. (www.abctech.com/successes) Sinkey Joseph Jr. “Commercial Bank Financial Management in the Financial Services Industry”, MacMillan (1992) Wright, Graham A.N. “Market Rearch and Client Responsive Product Development”, MicroSave (2001)



Annex 1: MicroSave Briefing Note 16 Product Costing in Practice – the Experience of MicroSave

David Cracknell, Henry Sempangi Once a cost for a particular core process has been determined based on staff time, costs are then driven through to products on the basis of a logical cost driver. For example, once you have determined the

“Allocation based costing allowed Equity Building Society to obtain a range of “quick wins”…[it] enabled us to identify some of the factors that are driving costs within the institution.”


cost for processing a loan application – the cost driver would be the number of loan applications. Each product then absorbs costs for processing loan applications in proportion to the number of loan applications made by each loan product. Different processes will have different cost drivers.

Why bother to cost products? In the right environment, the benefits of product costing can be considerable. Identifying sources of profitability (and losses) allows a financial institution to focus on promoting their winning products, and redesigning those less profitable. Understanding of processes facilitates improvements in efficiency and a detailed understanding of cost structures allows more informed pricing decisions to be made.

Sustaining activities cannot be driven directly to particular products. The costs of sustaining activities need to be allocated to the different loan and savings products using allocation based costing techniques. More details about ABC can be found in CGAP’s Product Costing Tool.

MicroSave’s work with its Action Research Partners (ARPs) has clearly demonstrated that product costing interacts strategically with a huge and diverse range of business areas including pricing, efficiency, outreach, the design of incentive schemes, the identification of the most suitable product mix, marketing, customer service, staffing patterns, profit centre accounting and budgeting. The strategic dimensions of costing are rarely well recognised.

Although, ABC allows a microfinance provider to assess the cost of key processes, which Allocation based costing cannot, the choice of which method to introduce should also be considered in relation to institutional capability and range of other institutional factors. Introducing product costing, especially ABC, which is technically more demanding, requires most institutions to have access to training and technical support, which in East Africa is in very limited supply and expensive.

Traditionally, greater attention has been placed on justifying high interest rates than towards ensuring that microfinance programmes operate efficiently. Until MicroSave started working with its ARPs, though several had costing systems, none fully costed products.

What were the results of costing? In MicroSave’s ARPs, the identification of loss making products had a significant and immediate impact. Investigation revealed a range of explanations for losses including, poor investment efficiency, inappropriate pricing, an unwillingness to decrease rates to depositors when treasury bill rates fell, inappropriate allocation of staff, as well as expensive processes and internal control procedures. Once a loss-making product has been identified further investigation proved necessary, especially in the case of Allocation based costing.

Which costing method? Both allocation based costing and Activity Based Costing (ABC), each has advantages and disadvantages. Allocation Based Costing is a method whereby each line of the profit and loss account is allocated to different financial products on the basis of a logical criteria called an Allocation Base. More details of Allocation based costing can be found in MicroSave’s Costing and Pricing of Financial Services Toolkit.

With declining Treasury Bill rates fee based products were found to be consistently amongst the most profitable products. Fees are also charged for the provision of specific services within individual products (loan application fees, withdrawal fees etc.). Whilst costing was the major focus of investigation, few of the MicroSave Action Partners coherently relate the price of a product with its cost of provision, the most common pricing strategy appears to be to perform review of the interest rates of the competition and base decisions on this.

ABC traces costs through significant processes to products. Product delivery comprises a number of separate processes, for example, loan application processing, loan disbursement, and loan monitoring and loan recovery. Staff costs and non-staff costs are allocated to core processes upon the basis of staff time spent. Where members of staff do not directly spend time on core processes but rather provide support functions this time is booked to a general category called “sustaining activities”.

Costing and Pricing Of Financial Services 51 In the case of ABC, which is conceptually more difficult, the training and mentoring approach becomes even more important. Amongst our partners, those institutions with better trained, more competent and capable staff found the introduction of either costing system to be much easier.

Making a transfer pricing adjustment, which accounts for the use of internally generated savings to finance a loan portfolio proved to be important in determining the profitability of savings products, but despite this a number of savings based products proved to be losing significant amounts of money. In several instances it appeared that the savings product was priced too competitively – in other cases more process level analysis is required to determine causality.


Careful preparation: Although costing as a process differs in every organization and between costing methods, the initial preparation for the costing exercise is in practice very similar. Careful preparation significantly reduces the time and effort involved in developing a product costing system, this usually entails:

Lessons from the costing process When MicroSave started working on product costing it underestimated the challenges it would face in institutionalising costing within its partner organisations. Costing is institutionalised only when there is evidence that the process is being repeated, that the results of costing exercise are used strategically, that additional investigations are being performed. More sophisticated and capable institutions are able to take the process further and use allocation based costing as the foundation of profit centre accounting, to use costing information in financial modelling, and to move from allocation based costing to ABC. This “process of evolution” is occurring in several of our ARPs, but at very different speeds and to differing extents.

Resources: Where costing processes were introduced quickly and efficiently sufficient resources were allocated to the process. For allocation based costing the resource requirement is modest, a small team of 2-4 people can normally produce an allocation based costing system within an institution with a good management information system within a week. ABC is a more complex longer process, which requires greater data gathering and absorbs correspondingly greater resources. For example, FINCA Uganda committed five staff members for 10 days to gather and process the data. The team leader then spent several days analysing the data.

Product costing provides information for the development of new products, though in the case of both activity and allocation based costing the information generated is an imperfect estimation, and therefore needs to be reviewed regularly and against a financial model during the pilot-test phase.

MFIs with limited experience or skills in costing require short term technical assistance to introduce allocation based costing, and greater technical assistance to introduce ABC. Unfortunately, in East Africa technical assistance to support the introduction of product costing systems is limited and expensive.

Particularly in the case of allocation based costing additional investigations are required to understand the nature of certain costs, though areas of investigation are focused and targeted by the costing exercise. Initial investigations have looked into, or are investigating, investment efficiency, mobile banking operations, decreasing the cost of particular processes, improving the allocation of staff etc. Where detailed investigation is required, process audit can be used to unpack a particular process.

Conclusion Product costing is an essential tool in developing profitable and efficient financial services through identifying inefficiencies and loss making products. References: Cracknell, David, Henry Sempangi “Product Costing in Practice – The Experience of MicroSave (draft)”, MicroSave (2002)

Critical Factors for a Successful Costing Exercise Management Commitment: Management need to be fully involved and committed at all stages of the costing process. The Finance Director of one ARP noted that his heavy involvement in the process allowed him to take the costing process further and faster than otherwise would have happened.

Cracknell, David, et al “A Brief Review of the Action Research Programme (draft)”, MicroSave (2002) Helms, Brigit and Lorna Grace “CGAP Product Costing Tool (draft for comment)” CGAP (2001) MicroSave “Costing and Pricing of Financial Services” (2002)

Trained and capable staff: Allocation based costing is not a difficult exercise, however, exposure to the principles of allocation based costing in a workshop combined with technical assistance is a successful way to create a costing system (See Table 3 on MicroSave approach).


Annex 2: Departmental Allocation

Identifying possible allocation bases

Departmental Allocation If the organisation maintains a departmental structure of accounts, and accounting reports show costs by department, the team can adopt the departments as the allocation units. In this case overhead costs are coded to both an expense code and to a department as in the example below. Example Cost items Personnel

Department Accounts

DepartmentMarketing

DepartmentTOTAL

Wages 100 150 500 750Utilities 200 150 250 600Transport 300 0 350 650TOTAL 600 300 1,100 2,000 Whether we use departments or line items as allocation units, either way the same total cost is being allocated, albeit from different starting points. The following example of Microfinance Inc. (MFI), explains how department costs are allocated.

Illustration A2 Microfinance Inc. MFI

MicroFinance Inc. (MFI) has 6 departments and maintains an accounting structure showing departmental costs separately. MFI is embarking on a cost allocation exercise. Assuming that the only information available is that detailed below: (a) What would be the most appropriate allocation unit? (b) What would be the possible allocation bases? Information available: Organisation structure:

MFI is organised into 6 departments namely: 1) CEO’s office, 2) Savings, 3) Loans, 4) Finance, 5) Human Resources, and 6) Marketing

Products of the organisation: 1) Ordinary savings account (OSA) and 2) Fixed deposit account (FDA) (both under savings department) 3) Ordinary loan account (OLA) (under the loans department)

Chart of accounts – see table below

MFI’s Chart of Accounts.

Income Direct Expenses

Indirect Expenses

Savings Dep’t

Loan Dep’t

Finance Dep’t

Human Resources Dep’t

Marketing Dep’t

Interest income – Treasury Bills

X


Costing and Pricing Of Financial Services 53 Income Direct

Expenses Indirect Expenses

Savings Dep’t

Loan Dep’t

Finance Dep’t


Marketing Dep’t

Interest income – Fixed Deposits with Banks

X

Commissions – Ordinary Savings Accounts

X

Interest income – Ordinary Loan Accounts

X

Commissions – Ordinary Loan Accounts

X

Penalties – Ordinary Loan Accounts

X

Commitment fees – Ordinary Loan Accounts

X

Interest expense – Ordinary Savings Accounts

X

Interest expense – Fixed Deposit Accounts

X

Interest expense – Funds for on-lending under Ordinary Loan Account

X

Operating stationery – Ordinary Savings Accounts

X

Operating stationery – Fixed Deposit Accounts

X

Operating stationery – Loans

X

CEO’s Office X Salaries & allowances

X X X X X X

Staff pensions X X X X X X Staff medical expenses

X X X X X X

Staff training X X X X X Entertainment X Motor vehicle expenses

X X X

Water X X X X X X Security expenses X X X X Electricity X X X X X X Repairs and renewals

X X X X X X


Costing and Pricing Of Financial Services 54 Income Direct

Expenses Indirect Expenses

Savings Dep’t

Loan Dep’t

Finance Dep’t


Marketing Dep’t

Office rent X X X X X X Postage & telecommunicat’ns

X X X X X X

Printing & stationery

X X X X X X

Travelling & subsistence

X X

Insurance – money policy

X

Professional services

X

Audit fees X Advertising X (a) Allocation unit – The most appropriate allocation unit would be the Department (b) Some of the possible allocation bases would be the following: Direct basis Area Absorption Actual Staff Salary Equal Portfolio Staff time Transaction Direct staff numbers

The procedure and the set of allocation bases selected by the MFI team Allocation Unit Allocation Basis Interest Income – Treasury Bills and Fixed Deposits

Savings Portfolio basis – since the interest income in these line items is all directly associated with the savings products (OSA and FDA) in proportion to the savings generated.

Commissions – Ordinary Savings Accounts

Direct basis to OSA – since this source of income comes directly from the OSA

Commissions, Penalties and Commitment Fees – Ordinary Loans Accounts

Direct basis to OLA – since this source of income comes directly from the OLA

Interest Expense – OSA, FDA and OLA

Direct basis to OS, FDA and OLA – since the interest expense can be directly attributed to each of the products

Operating Stationery Direct basis to OS, FDA and OLA – since the operating stationery expense can be directly attributed to each of the products

CEO’s Office Portfolio basis – the CEO gives general leadership to the entire organisation and it was observed that the higher the portfolio the more the attention and time the dept. commits to a product. So the portfolio basis was considered most appropriate.

Savings Department The department produces two products the Ordinary Savings Account and the Fixed Deposit Account. Accordingly the costs have to be split between the two products on the following bases: • Staff salaries and pensions • Staff medical and training • Security expenses • Repairs & renewals

Staff salary basis Staff time basis Direct basis to Ordinary Savings Account – most cash transactions which call for this expense are to do with Ordinary Savings Account Savings basis – most of the equipment in the department is there


Costing and Pricing Of Financial Services 55 • Office rent • Postage & telecommunications • Printing & stationery • Insurance-money • Motor vehicle expenses • Utilities

because of the Ordinary Savings Account and it was decided to split the costs between the two on 9:1 basis, called “savings basis”. Savings basis Actual basis – the department maintains a register that shows purpose for each telephone call made, hence calls made in respect of each product can be identified. Actual basis Portfolio basis – the insurance premiums are calculated on the basis of average amounts held Savings basis Savings basis

Loans department Direct basis – all work in the dept. is geared towards the production, delivery and maintenance of one product, the Ordinary Loan Account.

Finance department Transaction basis – the amount of work in the finance dept., depends on the volume of transactions generated by product demands. Hence the transaction basis was considered the most appropriate

Human resources department Absorption basis - on the basis of number of staff in each of the CEO, Savings, Loans, Finance and Marketing departments

Marketing department Equal basis – since MFI’s marketing efforts promote the image of the organisation as a whole and are not geared to any specific product



Annex 3: Setting a Sustainable Interest Rate7 Introduction This section outlines a method for estimating the interest rate that an MFI will need to realise on its loans, if it wants to fund its growth primarily with commercial funds at some point in the future. The model presented here is simplified, and thus imprecise8. It assumes a situation where an MFI is operating in a non-competitive environment and may not apply in situations where an MFI is seeking to meet competition, or to enter a new competitive market, or to prevent competition - all of which are becoming increasingly common place. However, it yields an approximation that should be useful for many MFIs, especially younger ones. Each component of the model is explained and then illustrated with the MicroFin example below.

Carmen Crediticia is the general manager of MicroFin, a young institution serving 1,000 active micro loan customers after two years. Carmen wants to make MicroFin sustainable, and her vision of "sustainability" is an ambitious one. She sees a demand for MicroFin's services far exceeding anything that donor agencies could finance. To meet this demand, MicroFin must eventually be able to fund most of its portfolio from commercial sources, such as deposits or bank loans. This will be feasible only if MicroFin's income is high enough so that it can afford to pay commercial costs for an ever increasing proportion of its funding. Carmen has read that quite a few micro finance institutions (MFIs) around the world have achieved this kind of profitability, working with a wide variety of clients and lending

ethodologies.

.

ture MicroFin's loan terms to yield the lients be able to pay this rate?

m Carmen sees that MicroFin's present interest rate, 1% per month, can't come close to covering its costsMicroFin must charge a higher rate. But how much higher must the rate be, Carmen asks, to position MicroFin for sustainability as she defines it? How should she strucrate she needs? And will her poor c

Pricing Formula: The annualised effective interest rate (R) charged on loans will be a function of five elements, each expressed as a percentage of average outstanding loan portfolio9: administrative expenses (AE), loan losses (LL), the cost of funds (CF), the desired capitalisation rate (K), and investment income (II): R = [(AE + LL + CF + K) / (1 - LL)] - II Each variable in this equation should be expressed as a decimal fraction: thus, administrative expenses of 200,000 on an average loan portfolio of 800,000 would yield a value of .25 for the AE rate. All calculations should be done in local currency, except in the unusual case where an MFI quotes its interest rates in foreign currency.

7 Note that this came from CGAP’s Occassional Paper No1- “Microcredit interest Rates” 8The more rigorous-and much more challenging-method for calculating the interest rate required for financial sustainability is to build a spreadsheet planning model based on a careful monthly projection of an institution's financial statements over the planning period. 9 To average a loan portfolio over a given period of months, the simple method is to take half the sum of the beginning and ending values. A much more precise method is to add the beginning value to the values at the end of each of the months, and then divide this total by the number of months plus one.


Costing and Pricing Of Financial Services 57 Administrative Expense Rate: The limited data now available suggests that MFIs tend to capture most of their economies of scale by the time they reach about 5,000 - 10,000 clients. Thus a small, new institution like MicroFin might assume a future portfolio of this size when calculating the administrative expense component of its interest rate. Administrative expenses include all annual recurrent costs except the cost of funds and loan losses-e.g., salaries, benefits, rent, and utilities. Depreciation allowance (provision for the cost of replacing buildings or equipment) must be included here. Also include the value of any donated commodities or services-e.g., training, technical assistance, management-which the MFI is not paying for now, but which it will have to pay for eventually as it grows independent of donor subsidies. Administrative expenses of efficient, mature institutions tend to range between 10% - 25% of average loan portfolio. Loan Loss Rate: This element is the annual loss due to un-collectible loans. The loan loss rate may be considerably lower than the MFI's delinquency rate: the former reflects loans that must actually be written off, while the latter reflects loans that are not paid on time-many of which will eventually be recovered. The institution's past experience will be a major factor in projecting future loan loss rates10. MFIs with loan loss rates above 5% tend not to be viable. Many good institutions run at about 1-2%.

MicroFin's average outstanding loan portfolio last year was 300,000. It paid cash administrative expenses of 90,000, equal to 30% of average portfolio. However, in fixing an interest rate which will allow future sustainability, MicroFin must also factor in depreciation of its equipment (which will eventually have to be replaced), as well as Carmen's salary as general manager (a donor agency is currently paying this cost directly, but this is not a permanent arrangement). When Carmen adds in these costs, last year's administrative expense turns out to have been 50% of average portfolio. Carmen has not yet been able to do a rigorous financial projection of MicroFin's future administrative costs. In the meantime, for purposes of this pricing exercise she estimates administrative expense at 25% of portfolio, based on various factors. (1) MicroFin plans to grow far beyond its present clientele of 1,000, and expects to be able to add loan officers without corresponding increases in head office and support pers(2) MicroFin expects its average loan size to ncrease, especially as its growth rate slows down, because methodology involves gradual increases in size of individual loans. (3) MicroFin has identified a mature MFI whose loan methodology and salary levels are similar to its own, and learns that this institution is running with administrative costs well below 25% of portfolio. Carmen hopes that MicroFin will be below the 25% level quite soon, but uses this estimate to be conservative. Thus, AE = .25 in the pricing form

onnel. its

ula.

Thus far in its short history, MicroFin has had loan write-offs equal to less than 1% of its average portfolio. Nevertheless, Carmen and her team decide to assume a loan loss rate (LL) of 2% for this pricing exercise, because they know that the dynamics of MicroFin's rapid portfolio growth create a statistical tendency to understate the true long-term loan loss rate.

10 Loans with any payment overdue more than a year should probably be treated as losses for this purpose, whether or not they have been formally written off.


Costing and Pricing Of Financial Services 58 Cost of Funds Rate: The figure computed here is not the MFI's actual cash cost of funds. Rather, it is a projection of the future "market" cost of funds as the MFI grows past dependence on subsidised donor finance, drawing ever-increasing portions of its funding from commercial sources. The computation begins with an estimated balance sheet for a point in the medium-term future, broken out as follows: Simple MFor a routhe effecrate whiceconomi A BetterFor a somdistinguiclass of f • For a

low-enouunim

• For d

equiv(i.e. aportfdepo

• Equi

total shoupowe

Calculateby the Lo

11 Fundifixed assefinance th 12 Adminiearlier unespeciallythe loan p

ASSETS: LIABILITIES: Financial Liquid Assets Deposits Cash Loans Concessional Investments Commercial Legal Reserves Loan Portfolio Fixed Bldg/Equipment Equity

ethod: gh approximation of the "shadow" price of funds, multiply financial assets11 by the higher of (a) tive rate which local banks charge medium-quality commercial borrowers, or (b) the inflation h is projected for the planning period by some credible (usually, this means non-governmental)

c analyst. Then divide this result by the projected loan portfolio.

Method: ewhat more precise result, a "weighted average cost of capital" can be projected by

shing the various sources that are likely to fund the MFI's financial assets in the future. For each unding (deposits, loans, equity), estimate the absolute amount of the MFI's annual cost.

ll loans to the MFI, use the commercial bank lending rate to medium-quality borrowers. Even interest donor loans should be treated this way: then the MFI's lending rate will be set high gh so that it won't have to be raised further when soft donor loans diminish to relative portance in the MFI's funding base.

eposits mobilised by an MFI with a licence to do so, use the average local rate paid on alent deposits, plus an allowance for the additional administrative cost of capturing the deposits dministrative costs beyond the costs reflected above as Administrative Expenses for the credit

olio)12. This additional administrative cost can be quite high, especially in the case of small sits.

ty, for purposes of this cost-of-funds calculation, is the difference between financial assets (not assets) and liabilities in other words, equity minus fixed assets. The projected inflation rate ld be used as the cost factor, since inflation represents a real annual reduction in the purchasing r of the MFI's net worth.

the total absolute cost by adding together the costs for each class of funding. Divide this total an Portfolio to generate the cost of funds component (CF) for the Pricing Formula above.

ng for fixed assets is excluded from cost of funds calculations without much distortion of the result, since ts' appreciation in value-in line with inflation-more or less approximates the cost of the funds, which em.

strative costs associated with deposits can be omitted from this part of the formula if they were included der Administrative Expense (AE). Either way, it is crucial to recognize that mobilization of deposits, small deposits, requires some level of administrative resources over and above those required to manage ortfolio.



Last year, MicroFin maintained very little of its financial assets in liquid form: cash and investments averaged only 10% of the loan portfolio. However, Carmen now realizes that this level is imprudently low, and decides to project that liquid assets will be kept at 25% of portfolio, pending further analysis. These liquid assets include cash, income-earning investments, and a legal reserve-20% of deposits-which must be kept in an interest-free account at the Central Bank. Picking a period three years from now, MicroFin projects that its average assets of 2,400,000 will include financial assets of 1,600,000 (portfolio) and 400,000 (cash, investments, and reserves); non-financial assets (mainly premises and equipment) are projected at 400,000. Turning to the right side of the balance sheet, MicroFin expects these assets to be funded by 1,400,000 in liabilities-including 600,000 in voluntary deposits, a 300,000 donor loan at a very soft rate of interest, and a 500,000 commercial bank loan-and by its equity of 1,000,000, equivalent to its donations minus its operating losses to date. Here is MicroFin's projected balance sheet. [Note that it is the proportion among these balance sheet items, rather than their absolute amount, which drives the pricing formula.]

ASSETS: LIABILITIES: Cash 80,000 Deposits 600,000 Investments 200,000 Donor Loan 300,000

Legal Reserves 120,000 Bank Loan 500,000 Loan Portfolio 1,600,000 Bldg./Equipment : 400,000 EQUITY 1,000,000 TOTAL 2,400,000 TOTAL 2,400,000

Local banks pay 10% on deposits of the type that MicroFin plans to mobilize. Carmen estimates that mobilizing these deposits will entail administrative costs of another 5% over and above the costs projected above for administering her loan portfolio. Thus, the annual cost of her projected deposits will be 600,000 x .15 = 90,000. The cost of a commercial-bank loan to a medium-quality borrower is 20%. For the reason indicated above, MicroFin uses this rate to cost both of its projected loans, even though the actual cost of the donor loan is only 5%. The price for these loans, assuming that they were funded from commercial sources, would be (300,000 + 500,000) x .20 = 160,000. The equity amount considered in this part of the calculation is only 600,000 (financial assets minus liabilities). This equity is priced at the projected inflation rate of 15%. The annual cost of this component of the funding is 600,000 x .15 = 90,000. Dividing the combined cost of funds for debt and equity (90,000 + 160,000 + 90,000) by the Loan Portfolio (1,600,000) gives a weighted cost of funds of about 21%, which Carmen will enter as the CF component in the Pricing Formula.


Costing and Pricing Of Financial Services 60 Capitalisation Rate: This rate represents the net real profit that the MFI decides to target, expressed as a percentage of average loan portfolio (not of equity or of total assets). Accumulating such profit is important. The amount of outside funding the MFI can safely borrow is limited by the amount of its equity. Once the institution reaches that limit, any further growth requires an increase in its equity base. The best source for such equity growth is internally generated profits. The rate of real profit the MFI targets depends on how aggressively its board and management want to grow. To support long-term growth, a capitalisation rate of at least 5 - 15% of average outstanding loan portfolio is arguably advisable13. (If an MFI plans to incorporate under a taxable legal structure, it should include an allowance for taxes at this point.)

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MicroFin's cost-of-funds projection above posited a liabilities-to-equity ratio of 7-to-5. MicroFin is not likely to find commercial lenders who will be comfortable with a ratio much higher than that (at least until it obtains a license as a bank or other regulated intermediary). Thus, once MicroFin exhausts its donor sources, any increase in its portfolio will require a proportional increase in its equity. If the institution wants to target portfolio growth of, say, 25% per year, then it must increase its equity by this same percentage. Since MicroFin's portfolio is projected to be 1.6 times equity, the interest income needed to raise real equity by 25% is .25 / 1.6, giving us a capitalization rate (K) of about 16% of loan portfolio.

Investment Income Rate: The final element to be included in the pricing equation-as a deduction, in this case-is the income expected from the MFI's financial assets other than the loan portfolio. Some of these (e.g., cash, checking deposits, legal reserves) will yield little or no interest; others (e.g., certificates of deposit) may produce significant income. This income, expressed as a decimal fraction of loan portfolio, is entered as a deduction in the pricing equation.

1

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p

MicroFin's projected Liquid Assets include cash (80,000), investments (200,000), and legal reserves (120,000). Assuming that the cash and reserves produce no income, and that the investments yield 12%, then investment income (II), is 24,000, or 1.5% of portfolio.

3 The formula in this paper generates the interest rate which will be required when the MFI moves beyond ependence on subsidies. An MFI that wants to reach commercial sustainability should charge such an interest rate ven though it may be receiving subsidized support over the near term. Note that as long as an MFI is receiving ignificant subsidies, its net worth will actually grow faster than the "capitalization rate" projected here, because the omputations in this paper do not take into account the financial benefit of those subsidies.

4 MFIs often grow much faster than 25% per year. However, rapid growth can bring serious management roblems, especially as the institution moves beyond the 5,000 -10,000 client range.




The Computation: Entering these five elements into the pricing equation produces the annual interest yield the MFI needs from its portfolio.

The pricing formula, again, is

R = [(AE + LL + CF + K) / (1 - LL)] - II Carmen has projected administrative expense (AE) = .25; loan loss (LL) = .02; cost of funds (CF) = .21; capitalization rate (K) = .16; and investment income (II) = .015. Plugging these values in the pricing formula gives her

R = [(.25 + .02 + .21 + .16)/(1 - .02)] - .015 = .6381 Thus, Carmen finds that MicroFin needs an annual interest yield of about 64% on its portfolio. She is acutely aware that some of the assumptions that went into her calculation were rough estimates, so she will review her loan pricing regularly as MicroFin accumulates more experience. By next year, she hopes to have in place a more sophisticated

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model for month-by-month financial projection of MicroFin's operation over the next 3-5 years. Reviewing quarterly financial statements derived from such a projection will be a much more powerful management tool than the present exerci

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