Professional Documents
Culture Documents
costing_and_pricing_of_financial_services toolkit
costing_and_pricing_of_financial_services toolkit
www.MicroSave.org
info@MicroSave.org
Version 4
Last Updated
July 2004
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
MicroSave – Market-led solutions for financial services
Toolkit Costing and Pricing of 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.
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.
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:
Kshs. Kshs.
Kshs. Million % Million % 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 75.0 291.0
Interest 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 266.0 103.9 162.1
Net Result 100.0 (28.9) 128.9
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 Based on the actual number of staff positions allocated directly to a product. E.g.
numbers 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 – The relative average proportions of the product portfolios over a defined period of
deposit base 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 – The relative average proportions of the product portfolios over a defined period of
investment time in terms of direct income or expense by product. This is particularly useful
income base 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.
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?
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.
Kshs. Kshs.
% Million % 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 75.0 291.0
Interest 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 266.0 103.9 162.1
Net 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.
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.
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:
¾ 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.
¾ 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.
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.
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.
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.
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.
1.3 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).
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.
Outreach
Investment Pricing
Budgeting
Customer Service
Operational Efficiency
Promotion and Marketing
Product Costing
Figure 6: The Strategic Context of Product Costing (Cracknell and Sempangi 2002)
¾ 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.
¾ 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.
¾ 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.
¾ 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.
¾ 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.
¾ Promotion and Marketing: Promotion and marketing is strategically tied to developing the
institutions ideal product mix. See MicroSave’s “Marketing for MFIs” toolkit.
¾ 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.
¾ 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.
¾ 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.
¾ 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 pricing of financial services is an important part of the product development cycle.
MicroSave sees the product development cycle in four distinct phases:
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)
There are two product-costing methodologies, Allocation Based Costing and Activity Based Costing
(ABC), this section introduces the concepts briefly.
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).
Portfolio Volume
Non-Staff Costs
Saving
Product #1
Core Process C
Non-Staff Costs
Saving
Sustaining Product #1
Activities
Figure 7: Allocation and Activity Based Costing. Helms and Grace (2002)
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
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.
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.
Further details on Activity Based Costing can be found in CGAP’s Product Costing Toolkit.
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.
Table 1: Advantages and disadvantages of different costing methods. (Helms and Grace 2002)
4. PREPARATORY ACTIVITIES
To ease the work of the team, the operations and accounts departments should be represented on it.
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.
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.
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.
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:
¾ The mission and scope of the work of the organisation
¾ The degree of centralisation in the organisation
¾ The degree of autonomy of the branches
¾ 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
¾ The functions and responsibilities of all departments.
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.
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.
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.
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:
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.cgap.org).
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
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 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.
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 Based on the actual number of staff positions allocated directly to a product. e.g. when
numbers 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 – The relative average proportions of the product portfolios over a defined period of
deposit base 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 – The relative average proportions of the product portfolios over a defined period of time
investment in terms of direct income or expense by product. This is particularly useful when
income base 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.
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.
Mbale Savings and Credit (MSC) is a small MFI and maintains a simple structure of accounts
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
Exercise 1: Solution
Interest Income– Direct (OLA) Interest received from loans is directly attributable to the
Ordinary Loan Account loan product
Interest income – Savings
investments Portfolio (OSA Interest received from investments made with clients’
and SSA) savings can best be allocated on the basis of the average
Commitment fees Direct (OLA) portfolio of each savings account type
Commitment fee income is derived directly from loans
Interest Payable – Direct (OSA) Since this interest is paid directly to ordinary savings
Ordinary Savings account holders and is directly attributable to this product.
Account Since this interest is paid directly to special savings
Interest Payable – Direct (SSA) account holders and is directly attributable to this product.
Special Savings Interest paid on capital fund loans from donor agencies is
Account a direct cost of providing loans to clients
Interest expense – Direct (loans) Since all staff deal with all the products, it was necessary
donor funds to develop timesheets and allocate these costs on the basis
Staff salaries & Staff time of the percentage of time each category of staff spent on
allowances each product.
As above
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
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.
(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.
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 OLA Salary costs allocated to:
% time % time % time OSA SSA OLA
Manager 10,000 30% 10% 60% 3,000 1,000 6,000
Accounts 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 0
Office Assist. 3,000 30% 20% 50% 900 600 1,500
Total 32,000 10,775 4,225 17,000
Staff 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.
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.
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% 291.0 291.0
Interest income – Portfolio 175.0 80% 140.0 20% 35.0 0% - 175.0
Investments
Commitment fees Direct 36.0 0% - 0% 0.0 100% 36.0 36.0
TOTAL INCOME 502.0 140.0 35.0 327.0 502.0
Interest expense-OSA Direct 62.0 100% 62.0 0% 0.0 0% - 62.0
Interest expense-SSA Direct 20.0 0% - 100% 20.0 0% - 20.0
Int. expense–donor funds Direct 136.0 0% - 0% 0.0 100% 136.0 136.0
Staff salaries and Staff time 56.0 35% 19.6 15% 8.4 50% 28.0 56.0
allowances
Staff pensions Staff time 10.0 35% 3.5 15% 1.5 50% 5.0 10.0
Staff medical Staff time 15.0 35% 5.25 15% 2.3 50% 7.5 15.0
Staff training Modified 9.0 30% 2.7 5% 0.5 65% 5.9 9.0
Transaction
Rent – Commercial Transaction 75.0 30% 22.5 15% 11.3 55% 41.3 75.0
Rent – Residential Equal 5.0 33% 1.65 33% 1.7 34% 1.7 5.0
Motor vehicle expenses Actual 20.0 25% 5 20% 4.0 55% 11.0 20.0
Marketing Equal 10.0 33% 3.3 33% 3.3 34% 3.4 10.0
Insurance – money Portfolio 5.0 80% 4 20% 1.0 0% - 5.0
Insurance – premises Transaction 10.0 30% 3 15% 1.5 55% 5.5 10.0
Postage & telecomm. Actual 6.0 30% 1.8 5% 0.3 65% 3.9 6.0
TOTAL EXPENSES 439.0 134.3 55.6 249.1 439.0
Net Result 63.0 5.7 -20.6 77.9 63.0
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.
The modified MSC example below should help illustrate this exercise.
4
i.e. capital received at below the T-bill rate
These amounts are then allocated into the costing exercise giving the following results:
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.
12.1 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.
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.
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.
¾ 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.
¾ 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.
¾ 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).
¾ 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.
¾ 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).
¾ 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.
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:
Adjusted for the cost of capital, this marginal cost analysis would appear as follows:
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.
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.
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.
¾ 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.
¾ Customers often cannot determine the price they pay for services.
¾ Clear charges by banks are only a recent phenomenon, many banks and MFIs still maintain a
price structure that lacks transparency.
¾ 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.
¾ 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.
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.
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 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.
5
This is very similar to a technique used in MicroSave’s “Marketing for Microfinance Toolkit” called Writing
Benefit Statements.
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.
Sections Taken From: Competition Analysis Matrix - Savings Accounts - Other Banks in Mbale
Saving Account Mbale Savings and Post Bank Tropical Bank The Rural
Credit Development Bank
PRODUCT
(DESIGN)
Opening Ordinary Savings Ordinary Passbook Shs.60,000 Shs.10,000
Balance Account Shs.20,000 Account Shs.20,000,
Special Savings Trust Account
Account Shs.100,000 Shs.50,000
Minimum Ordinary Savings Ordinary Passbook Shs.50,000 Shs.5,000
Balance Account Shs.20,000 Account Shs.10,000,
Special Savings Trust Account
Account Shs.100,000 Shs.50,000
Other 2 passport photos, 2 passport photos, 3 passport photos, 3 passport photos,
Requirements Introduction letters Introduction letters A current identity card, Recommendation from
from the employer and from the employer and An introducer with an a customer of the bank,
L.C.1, L.C.1, account at Tropical Bank. with an account of at
A valid driving permit A valid driving permit least 3 months or
and an identity card. and an identity card. 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/ Mag stripe card A flexible long-lasting A free passbook. A savings pass
Services 5 ATMs passbook, No ATMs book/card – costs the
A speedy transfer of client Shs.2,000.
funds at Shs.10,000 or Western Union Money
1% of the amount to Transfers,
Shs.25,000. No ATM's.
No ATM's.
Deposit Policy Any number of times Any number of times Any number of times and Any number of times
and amount during and amount during amount during office and amount during
office hours. office hours. hours. office hours.
Withdrawal As many times as As many times as Once a day. As many times as
Policy possible during office possible during office possible during the
hours. hours. office hours.
PRICE
Interest Rate Interest earning amount Interest earning amount Minimum interest earning The Rural
Paid Shs.100,000 Shs.10,000 and balance is Shs.50,000. Development Bank
Interest rate 16.67% Shs.50,000 depending Interest 12-14% per pays interest rate on the
on the product, interest annum. entire balance.
rate is 10% per annum Interest is 3% every 3
tax free. months.
6
See MicroSave’s Market Research for MicroFinance toolkit for an example of this.
Service Fees Salary processing Salary posting A charge of Shs.3,000 per Withdrawals >2 times
Shs.2,000 for a card. Shs.3,000 in a month for balances a month a charge of
passbook, below Shs.50,000. Shs.2,000 per month,
Salary processing A ledger fee of Shs.1,000 Bank drafts 0.5%of
Shs.2,000 for a card. per month. value or a minimum of
Other charges: Salary posting is Shs.10,000,
Bounced cheques Shs.1,500. Stop payments
Shs.15,000, Shs.10,000,
Post office service fees Cheques returned un
Shs.300. paid for lack of funds
Account Shs.5,000 for the card Shs.5,000 for the None Shs.2,000 for the
Opening Fees passbook passbook
Ledger/ None Shs.750 per month Shs.1,000 per month. None.
Statement card/book
Slogan/Vision Time is Money – Save Save and prosper None known. Saving to Grow -
Both! Growing to Serve
Corporate Targeting small savers, Attracts formal and Attracts both formal and Targeting small savers,
Image low income salaried informal small scale informal small scale low income salaried
employees as well as savers. Salaried and savers, salaries and employees as well as
the informal sector. unsalaried. unsalaried. the informal sector.
Product Image The premium account Account attracts The low income earner's Identifying with
for low income (and interest and charges account attracts interest salaried, low income
even some higher e.g. premature on the minimum balance. earners and those in the
income) earners. withdrawals Ush.5,000 Good for savers targeting informal sector.
Associated with cutting across the counter. to accumulate a lumpsum.
edge technology
(ATMs) and quick
service.
On the basis of the above the MSC made a series of decisions following the 3 Steps to Pricing Financial
Services.
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
Examples Examples
Target rate of return (illus.8) Market share (illus 9)
Mark up pricing (illus 14)
Examples Examples
Competition Pricing (illus 10) Examples Survival pricing (illus 7)
Penetration (illus 11) Demand oriented pricing
Skimming (illus 12) (illus 16)
Keep Out pricing (illus 13)
Target return pricing (illus 15)
Pricing methods
3. How important is price in your marketing mix? Why / (Remember the demand curve and
price elasticity?
5. To what extent are your pricing methods influenced by cost, by demand, by competition?
What is the relative influence of these three forces?
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.
• 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.
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.
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.
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.
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.
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.
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.
• High short-run profits little affected by • High total contribution through fast sales growth in
discounting. spite of low unit contribution margins.
• Quick pay-back for real innovation • Takes advantage of positive intrapersonal (durable
during the period of monopolistic market goods) carryover effects, builds up a strong market
position, reduces long-run competitive position (with the potential of higher prices and /or
risk, quick amortization of R&D higher sales in the future).
expenses. • Takes advantage of short-run cost reductions
• High profit in early life-cycle phases through (static) economic of scale.
reduces the risk of obsolescence. • Allows for fast increase of the cumulative quality
• Allows for price reduction over time. by accelerating the experience curve effect. Achieves
• High price implies positive prestige and a large cost advantage that competitors will find
quality. difficult to match.
• Requires fewer financial resources. • Reduces the risk of failure; low introductory price
• Requires lower capacity. gives some assurance of low probability of failure.
• Deters potential competitors from market entry, or
delays their entry.
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.
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.
It is assumed that the level of operations in illustration 3.3.4 will remain unchanged in the subsequent
period.
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%.
The calculation:
Assume the level of operations in the illustration above remains unchanged.
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%.
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:
¾ Cost savings: Customers no longer have to take a bus into town to access banking
services.
¾ Time savings: The convenient location of the mobile banking service saves customers
time in accessing services
¾ 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.
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.
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.
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.
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.
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.
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)
“Allocation based costing allowed Equity Building Once a cost for a particular core process has been
Society to obtain a range of “quick wins”…[it] determined based on staff time, costs are then driven
enabled us to identify some of the factors that are through to products on the basis of a logical cost
driving costs within the institution.” driver. For example, once you have determined the
cost for processing a loan application – the cost driver
Why bother to cost products? In the right would be the number of loan applications. Each
environment, the benefits of product costing can be product then absorbs costs for processing loan
considerable. Identifying sources of profitability (and applications in proportion to the number of loan
losses) allows a financial institution to focus on applications made by each loan product. Different
promoting their winning products, and redesigning processes will have different cost drivers.
those less profitable. Understanding of processes
facilitates improvements in efficiency and a detailed Sustaining activities cannot be driven directly to
understanding of cost structures allows more informed particular products. The costs of sustaining activities
pricing decisions to be made. need to be allocated to the different loan and savings
products using allocation based costing techniques.
MicroSave’s work with its Action Research Partners More details about ABC can be found in CGAP’s
(ARPs) has clearly demonstrated that product costing Product Costing Tool.
interacts strategically with a huge and diverse range of
business areas including pricing, efficiency, outreach, Although, ABC allows a microfinance provider to
the design of incentive schemes, the identification of assess the cost of key processes, which Allocation
the most suitable product mix, marketing, customer based costing cannot, the choice of which method to
service, staffing patterns, profit centre accounting and introduce should also be considered in relation to
budgeting. The strategic dimensions of costing are institutional capability and range of other institutional
rarely well recognised. factors. Introducing product costing, especially ABC,
which is technically more demanding, requires most
Traditionally, greater attention has been placed on institutions to have access to training and technical
justifying high interest rates than towards ensuring that support, which in East Africa is in very limited supply
microfinance programmes operate efficiently. Until and expensive.
MicroSave started working with its ARPs, though
several had costing systems, none fully costed What were the results of costing? In MicroSave’s
products. ARPs, the identification of loss making products had a
significant and immediate impact. Investigation
Which costing method? Both allocation based costing revealed a range of explanations for losses including,
and Activity Based Costing (ABC), each has poor investment efficiency, inappropriate pricing, an
advantages and disadvantages. unwillingness to decrease rates to depositors when
treasury bill rates fell, inappropriate allocation of staff,
Allocation Based Costing is a method whereby each as well as expensive processes and internal control
line of the profit and loss account is allocated to procedures. Once a loss-making product has been
different financial products on the basis of a logical identified further investigation proved necessary,
criteria called an Allocation Base. More details of especially in the case of Allocation based costing.
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
ABC traces costs through significant processes to profitable products. Fees are also charged for the
products. Product delivery comprises a number of provision of specific services within individual
separate processes, for example, loan application products (loan application fees, withdrawal fees etc.).
processing, loan disbursement, and loan monitoring Whilst costing was the major focus of investigation,
and loan recovery. Staff costs and non-staff costs are few of the MicroSave Action Partners coherently
allocated to core processes upon the basis of staff time relate the price of a product with its cost of provision,
spent. Where members of staff do not directly spend the most common pricing strategy appears to be to
time on core processes but rather provide support perform review of the interest rates of the competition
functions this time is booked to a general category and base decisions on this.
called “sustaining activities”.
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 Accounts Marketing TOTAL
Department Department Department
Wages 100 150 500 750
Utilities 200 150 250 600
Transport 300 0 350 650
TOTAL 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.
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:
Information available:
¾ 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
¾ 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)
¾ Chart of accounts – see table below
(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 Savings Portfolio basis – since the interest income in these line
and Fixed Deposits items is all directly associated with the savings products (OSA and
FDA) in proportion to the savings generated.
Commissions – Ordinary Savings Direct basis to OSA – since this source of income comes directly
Accounts from the OSA
Commissions, Penalties and Direct basis to OLA – since this source of income comes directly
Commitment Fees – Ordinary from the OLA
Loans Accounts
Interest Expense – OSA, FDA and Direct basis to OS, FDA and OLA – since the interest expense can
OLA 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 salary basis
• Staff medical and training Staff time basis
• Security expenses Direct basis to Ordinary Savings Account – most cash transactions
which call for this expense are to do with Ordinary Savings
Account
• Repairs & renewals Savings basis – most of the equipment in the department is there
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
methodologies.
Carmen sees that MicroFin's present interest rate, 1% per month, can't come close to covering its costs.
MicroFin 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 structure MicroFin's loan terms to yield the
rate she needs? And will her poor clients be able to pay this rate?
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”
8
The 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.
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 personnel.
(2) MicroFin expects its average loan size to ncrease, especially as its growth rate slows down, because its
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 formula.
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.
ASSETS: LIABILITIES:
Simple Method:
For a rough approximation of the "shadow" price of funds, multiply financial assets11 by the higher of (a)
the effective rate which local banks charge medium-quality commercial borrowers, or (b) the inflation
rate which is projected for the planning period by some credible (usually, this means non-governmental)
economic analyst. Then divide this result by the projected loan portfolio.
A Better Method:
For a somewhat more precise result, a "weighted average cost of capital" can be projected by
distinguishing the various sources that are likely to fund the MFI's financial assets in the future. For each
class of funding (deposits, loans, equity), estimate the absolute amount of the MFI's annual cost.
• For all loans to the MFI, use the commercial bank lending rate to medium-quality borrowers. Even
low-interest donor loans should be treated this way: then the MFI's lending rate will be set high
enough so that it won't have to be raised further when soft donor loans diminish to relative
unimportance in the MFI's funding base.
• For deposits mobilised by an MFI with a licence to do so, use the average local rate paid on
equivalent deposits, plus an allowance for the additional administrative cost of capturing the deposits
(i.e. administrative costs beyond the costs reflected above as Administrative Expenses for the credit
portfolio)12. This additional administrative cost can be quite high, especially in the case of small
deposits.
• Equity, for purposes of this cost-of-funds calculation, is the difference between financial assets (not
total assets) and liabilities in other words, equity minus fixed assets. The projected inflation rate
should be used as the cost factor, since inflation represents a real annual reduction in the purchasing
power of the MFI's net worth.
Calculate the total absolute cost by adding together the costs for each class of funding. Divide this total
by the Loan Portfolio to generate the cost of funds component (CF) for the Pricing Formula above.
11
Funding for fixed assets is excluded from cost of funds calculations without much distortion of the result, since
fixed assets' appreciation in value-in line with inflation-more or less approximates the cost of the funds, which
finance them.
12
Administrative costs associated with deposits can be omitted from this part of the formula if they were included
earlier under Administrative Expense (AE). Either way, it is crucial to recognize that mobilization of deposits,
especially small deposits, requires some level of administrative resources over and above those required to manage
the loan portfolio.
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.
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.)
14
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.
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.
13
The formula in this paper generates the interest rate which will be required when the MFI moves beyond
dependence on subsidies. An MFI that wants to reach commercial sustainability should charge such an interest rate
even though it may be receiving subsidized support over the near term. Note that as long as an MFI is receiving
significant subsidies, its net worth will actually grow faster than the "capitalization rate" projected here, because the
computations in this paper do not take into account the financial benefit of those subsidies.
14
MFIs often grow much faster than 25% per year. However, rapid growth can bring serious management
problems, 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.
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
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
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 exercise.