FEATURE
ARTICLE
Price
as a Strategic Business Tool: 10 Lessons
Bankers Can Learn from Retailers
BY WILLIAM D. MILLER
Vice President, Financial Services, Khimetrics, Inc.
Overall
profitability can be enhanced by taking
a broader view. For a more effective
approach to pricing, consider customer
demand and marketplace factors along
with internal costs.
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SYNOPSIS | Banks
and retailers both operate in a low-margin,
highly competitive environment with
shifting consumer needs, constantly
changing competitors, new technologies,
relentless demands on cost control
and emerging national powerhouses.
But financial institutions stand to
improve their profitability by as much
as 15 basis points by emulating pricing
methods and approaches of industry-leading
retailers. Included among the 10 lessons
are the need to convert to a demand-driven
pricing model, improve volume forecasting
under different pricing scenarios and
the use of price as a more effective
promotion technique.
When it comes to marketing
and branch design, banks have been trying
to emulate mainstream retailers for quite
a few years — from the de-emphasis
of teller lines to the reliance on Wal-Mart-style “greeters” at
their entrances to the installation of
Starbucks-style coffee kiosks. Bankers
seem to be saying that “retailers
know something that we don’t.”
But there are additional
areas where bankers can learn from retailers,
such as in the pricing of products in order
to achieve volume targets and maximize
profit. Banks, by and large, still use
the “cost-plus” method. This
method involves the addition of some margin
to the cost of producing and delivering
a financial product, like a loan or checking
account or certificate of deposit, with
some typically ad hoc consideration of
competitive forces. Our study earlier this
year found that executives at more than
35 of the top 100 U.S. bank holding companies
use some variation of a “cost-plus” pricing
method; none was explicitly and regularly
accounting for variations in customer price
sensitivities when setting rates and prices.
(See “A
Look at How Financial Institutions Price”)
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This, in essence, is
where mainstream retailing was in the
1970s and 1980s. But bankers would be advised
to take note of the changes that have
occurred
since then. In order to drive profitable
revenue and reinforce their broader strategies,
retailers must now look at pricing from
the customer’s perspective, not
just at their internal cost. Most leading
retailers
now use a combination of customer demand
modeling, volume forecasting, price optimization
and analytics to segment their customer
base more explicitly. These analyses
enable retailers to look at demand patterns,
elasticities,
promotional mix impact on demand and
other aspects of pricing that were impossible
just a few years earlier. The objective:
to find the optimal price for each product.
A skeptical banker might
ask, “I understand why retailers
might have insights for bankers on marketing
and promotions and dealing with customers,
but why pricing? After all, retailers sell
clothes and cereal and lawn mowers, but
bankers sell relationships and intangible
services.”
The answer is that banking
and general retailing both operate in a
low-margin, highly competitive environment
with shifting consumer needs, constantly
changing competitors, new technologies,
relentless demands on cost control and
emerging national powerhouses. We believe
the pricing strategies of successful retailers
apply very well to banking, which is why
we have developed the following 10 lessons
for more effective pricing in financial
services.
Lesson
1: Price Based on What the Customer is
Willing to Pay, Not Just Your Own Costs
Successful retailers
set prices at which the customer is willing
to buy, not the prices at which the retailer
is willing to sell. This is the most important
of the 10 pricing lessons; banks must transform
pricing from a “cost-plus” to “demand-driven” model.
This transition can provide an improvement
in margins of between five and 15 basis
points.
A demand-driven pricing
approach requires that the bank dissect
customer price elasticities (i.e., the
sensitivities to price changes) exhibited
by different customer segments for different
products, then find the “best” price
that will maximize profits at a targeted
volume. Investments in technology and staff
are required for understanding and leveraging
customer elasticities.
The “demand-driven” pricing
approach does not ignore costs, and in
fact explicitly considers costs when finding
the best prices for products so as to maximize
profits. For bankers this means, for example,
that a loan rate reflects costs (costs
of funds, costs of credit loss, cost of
capital and operating costs) and what customers
are willing to pay (demand elasticities).
Demand-driven prices may sometimes be lower
than cost-plus prices when demand is elastic
(i.e., sensitive to price changes). When
that’s true, increased volumes more
than offset lower rates per deal, causing
overall profits to increase. Conversely,
demand-driven prices may be higher than
cost-plus pricing when demand is inelastic
(i.e., relatively insensitive to price
changes). In those instances, the percent
change in price is greater than the percent
reduction in volume, so total profits increase.
The financial impact
of more precise pricing based on differing
elasticities can be enormous, as shown
in our model bank constructed from the
average performance ratios for all banks
over $5 billion in assets (see
sidebar). Based on this $25 billion
bank model, for every one basis point improvement
in yield and reduced funding costs, the
pre-tax bottom line improvement is about
$1.2 million annually. If price optimization
can improve just five basis points, the
impact is nearly $7 million pre-tax annually,
and this is assuming only 50% of loans
and 33% of deposits could be impacted by
price optimization.
Lesson
2: Improve Your Ability to Forecast Volume
with Different Pricing Scenarios
Because of supply chain
considerations, retailers have a need to
accurately forecast volumes that result
from a price or promotional action. Without
this capability, retailers take actions
to increase demand and then “wait
to see what happens.” This leads
to problems with inventory, frustrated
customers and lost business.
Financial institutions
experience the same issues. In order to
manage staffing, backroom volumes, equipment
needs and risk management requirements,
bankers need to be able to answer questions
such as: “If we lower or raise our
CD rates by X basis points, what type of
volume can we expect?” or “How
will a promotional move impact the volume
of other products, and how might our competitors
respond?”
The ability to forecast
demand accurately requires that demand
be understood, which is at the heart of
Lesson 1. With a good understanding of
demand patterns and product interrelationships,
along with the proper technology, the impact
on volume from price moves can be forecasted
with reasonable accuracy.
Lesson
3: Define and Sustain Your Price Image
Price image is a concept
that reflects the price positioning a retailer
has in its market relative to competitors.
Retailers’ pricing strategies run
the gamut from “High-Low” (using
discount promotions across some percentage
of products and regular prices across the
balance) to “EDLP” (every day
low prices). But all retailers cultivate
a unique price image in three primary ways:
- THE ACTUAL
PRICES;
- CONSISTENCY OF PRICES;
- INDICATORS OF PRICE
IMAGE.
The first way, the actual
prices, includes consistent pricing strategies
that align with branding and overall perception
of the retailer in the marketplace. For
example, if the retailer is taking a high-low
strategy, it would be inconsistent to try
to be “the low price leader.” Conversely,
an EDLP retailer tends to focus on consistent
lower prices on many of its core products.
Indicators of price
image are those aspects of the business
that reflect the pricing strategy, such
as store design, service levels, advertising,
locations and the like. Target Corp., for
example, has done a good job of moving
up the scale in the discounter space using
attractive and open store design and a
slightly better merchandising mix.
Bankers likewise need
to decide what they want their price image
to be and then develop the characteristics
that match that image, along with the appropriate
prices. One bank, for example, could take
the low-cost/high-rate position on deposits
with rates that are “always” in
the top quartile and offer limited offices
and less staff. Another bank could establish
the “high service” position
and not compete on price, but rather offer
more branches and service. Each of these
banks is establishing an image that needs
to be consistent with its pricing strategy.
Lesson
4: Know How and Where to Use Price as
a Promotion Technique
Promotions are a proven
retailing technique to drive increased
volume. What retailers promote is not based
on hunches. Rather, they research and analyze
demand patterns to promote the right product
that draws in customers at the right time
and the right place — and at the
right price that achieves the objectives
without leaving money on the table.
Financial institutions’ use
of price promotions is limited. Some offer
teaser rates on loans and the like, but
for the most part it’s unusual to
see a “sale” at a bank. This
will change. To use price promotions effectively,
bankers must understand the demand patterns
and the interaction among products. The
effect must be to improve the business
performance, not just to offer reduced
prices on randomly selected products.
And, banks cannot forget
that price is just one potential promotional
technique. Bankers can use many of the
same methods retailers do to drive volume,
such as coupons, advertisements, mailings
and special tie-ins with other services.
The bank has a critical need to understand
what impact each promotional technique
has on demand when used in conjunction
with, or independent of, price promotion.
Every year, banks spend
about 1% of their noninterest expenses
on promotions and advertising, according
to Khimetrics estimates. For an “average” $25
billion bank, this equals $5 million annually.
To use these investments wisely, bankers
must be able to know which promotional
technique drives the best results. If the
bank could increase the effectiveness of
promotion spending by just 10%, the “average” $25
billion bank could add $500,000 to the
bottom line (see “The
Potential Value of More Precise Pricing”).
Lesson
5: Look at Your Product Line, Not Just
the Individual Products
Retailers understand
how buyers react to variations in a product
line. They know that if there are three
sizes to a product, consumers expect the
largest size to have a lower unit cost.
If not, they buy the smaller size. In other
words, these three products are not independent
of each other.
When pricing within
a product line, retailers take into account
pricing elasticities within a product family.
It would make no sense for them to price
each size individually without taking into
account the demand for and pricing of the
other two product sizes. Retailers have
learned that they cannot look at products
individually.
Bankers need to consider
the same issues when pricing related products,
such as CDs with different terms, or loans
with different loan-to-value ratios. They
must know how elasticities interact among
similar products. Bankers cannot, for example,
price a one-year CD in isolation from two-year
CDs.
The key lesson is that
the entire product line must be analyzed
simultaneously looking for the interaction
among individual products and how pricing
of one affects demand for another. Analyzing
the demand patterns for one variant of
a product without taking a total portfolio
view will lead to sub-optimal pricing every
time.
Lesson
6: Know How Products Link In the Mind
of Your Customers
Retailers use the term “affinity” and “cannibalization” to
describe how products from different product
lines relate to one another. Affinity means
that the sale of one product, (e.g., hot
dogs) tends to drive the sale of another
(e.g., buns). Cannibalization is the opposite.
The sale of one product, (e.g., chicken)
diminishes sales of another (e.g., pork).
The economic principle
underlying affinity and cannibalization
is “cross-elasticity of demand.” This
is the academic name for a behavior easily
observed — that a change in price
for one product impacts the amount demanded
for another product. Understanding these “cross-elasticities” across
products is critical for bankers.
Cross-elasticity often
reveals itself as cannibalization for bankers
when, for example, a promotion in one type
of CD creates the desired result for that
account, but the funds came from the bank’s
money market accounts. Conversely, cross-elasticity
can reveal itself as affinity when an auto
loan drives an insurance sale.
Lesson
7: Group and Manage Branches In Demand-Based
Pricing Zones
Retailers group stores
into “zones” for a variety
of reasons, such as management structure,
media planning, supply chain considerations,
regional merchandise variations, etc. One
of the primary drivers, however, is the
need for price consistency within zones.
Retailers align their stores in such “price
zones” so that stores generally have
the same pricing levels and strategies.
Retailers know that
maximum profit could be generated if each
store were its own zone. This would give
the most flexibility to prices based on
unique demand patterns and demographics
at the local level. Research has found
that going from national zoning to store-level
zoning could raise retail margins on sales
by 400 basis points while maintaining sales
volume.
If profits could be
raised by 400 basis points by store-level
zoning, why wouldn’t retailers do
this? There tend to be four main reasons:
- CROSS-SHOPPING: Retailers
do not want customers to see different
prices in stores in close proximity.
It confuses the customer and can harm
the price image strategy of the retailer.
- OPERATIONAL LIMITATIONS:
The retailer’s systems simply may
not be able to handle the potentially
millions of possible prices that could
be necessary for store-level zoning and
the required interaction with vendors
and store staff.
- MANAGEMENT STRUCTURE:
Retailers typically have zone managers
who are responsible for a cluster of
stores and the associated revenue. It
is complex to manage stores that have
different pricing strategies.
- MEDIA MARKETS: Because
retailers rely on advertising so heavily,
the ad zones of newspapers are important
considerations in defining zones.
The optimal result,
then, is to manage the fewest zones that
maximize profitability, within parameters
of competition, ad zones, cross-shopping
exposure and sensible geographic considerations.
Like retailers, bankers
tend to vary prices by some level of geographic
zone or region. This may be as large as
a state, or as small as a metropolitan
statistical area (MSA). No bank of any
substantial size has uniform pricing across
all geographies it serves. And bankers,
like retailers, know at least intuitively
that if they could vary prices based on
unique demand patterns branch by branch
they could probably increase profits. But
the same limitations of cross-shopping,
media markets and internal management,
limit branch-by-branch pricing for bankers.
Moreover, banks have a very real limitation
that retailers do not have — regulatory
concerns, especially on the loan side.
If a bank is pricing a loan at one rate
in one branch, it cannot charge a different
rate for the exact same borrower and product
characteristics at another branch in the
same geographic area.
Nonetheless, understanding
demand patterns by branch, grouping branches
by demand characteristics, and optimizing
prices accordingly (within, of course legal,
marketing and sensible operational limitations)
can add another two to four basis points
to spreads, in addition to the five to
15 or more basis points from price optimization
alone.
Lesson
8: Anticipate Competitor Responses to
Your Pricing Moves
The capability to anticipate
competitors’ responses to pricing
moves is a rapidly emerging priority in
retailing. Through advanced mathematical
and statistical analysis, patterns emerge
that enable retailers to anticipate competitor
responses to pricing actions. Armed with
this insight, retailers can anticipate
and counter competitor responses. Pricing
becomes a real-world, high-stakes chess
game where smart players think multiple
moves ahead.
Retail bankers can use
the same approach. Knowing how and when
competitors respond to pricing moves enables
counter-moves to be planned.
Lesson
9: Manage Pricing Strategy as Diligently
as Anything You Do
Retailers give little,
if any, latitude to local store managers
to change prices. There is a good reason
for this lack of flexibility. Store managers
do not see the big picture and rarely are
local price changes good for the store’s
bottom line.
Bankers, on the other
hand, give enormous flexibility to branch
managers to change prices almost arbitrarily.
Branch managers and local loan officers
can waive fees, bump CD rates a little,
and drop a fee here and there. It happens
all the time. The lesson from retailers
is: Be cautious of too much flexibility
at the point of sales for overriding prices.
Yet bankers often recoil
at the idea of “centralized” pricing.
Often, loan officers or new accounts staff
view pricing flexibility as a “competitive
advantage” or part of “customer
service.” The lesson from retailing
is to allow discretion cautiously and track
variations. Very seldom will the result
of field-level pricing discretion result
in a higher margin for the bank.
No matter which strategy
is followed, there are two important aspects
of this lesson. One is that centralized
pricing does not mean common pricing. Just
because prices are established by a central
group does not mean that the prices are
common across the branch network — in
fact, just the opposite. Sophisticated
pricing mechanisms recognize and take advantage
of local variations in demand patterns
and elasticities.
Secondly, you need to
track actual vs. recommended prices. In
our experience, when actual vs. recommended
prices were not tracked well, revenue leakage
could be as much as 1%. This can be a substantial
hit to the bottom line. Even if the leakage
is only 0.5%, on a $6 billion loan portfolio
yielding 450 basis points, that could be
nearly $1.5 million annually lost due to
lack of adherence to optimized pricing.
Lesson
10: Use Technology, Not a No. 2 Pencil
or PC Spreadsheet
The final lesson is:
use technology to your advantage. Understanding
customer demand involves sophisticated
mathematical and statistical analyses that
require strong computing power.
In retailing, the number
of stockkeeping units (SKUs) is enormous,
and it is impossible without robust computing
capabilities to assess and quantify all
the interactions and impacts of pricing
and other demand drivers. Retailers that
have invested in technology have gained
a significant competitive advantage.
Likewise, in retail
banking, the number of possible product
combinations is also enormous. For example,
a “simple” auto loan might
have tens of thousands of different possible
combinations of attributes that can be
priced differently. There is simply no
way that manual analyses or spreadsheets
can possibly be used to find the optimal
prices for all products while taking into
account competition, seasonality, affinity,
cannibalization and the host of other factors
that drive demand and profits.
Putting
the Lessons Together
How does a financial
institution apply these 10 lessons? A “Proof
of Value” process can step through
the analyses to gauge the potential value
and determine where and how to proceed.
The key steps in a Proof of Value process
are:
SCOPE THE PROOF OF
VALUE: Define the portfolio, profit metrics
and business rules for the project so
that you know what you are aiming for
and what success will be;
MODEL DEMAND: Gather two years of historical “sales” volume
information and competitive data, and quantify the elasticities
and cross-elasticities of demand for the products, making
certain that the non-price factors impacting demand are
fully accounted for and quantified;
TEST OPTIMIZED PRICES: Find two groups of customers that
have behaved similarly in the past with respect to pricing,
and roll out optimized prices to the test group, while
the control group receives prices as currently developed.
After six to eight weeks, compare results.
The Proof of Value Process
is low-risk and low-cost, and can find
millions of dollars of bottom line improvement
potential. With the process complete, you
will have a solid foundation to move forward
with full price optimization.
Questions
or comments about this article? Post
them at the Banking
Strategies blog.
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