The Importance Of Costs In The Pricing Strategy Accounting Essay
It is very important for companies to have a good pricing strategy as it than permits them to earn good profit margin on its product or services and at the same time making it appealing to the customers. Pricing strategies are very important part of business and different organisation spend large sum of money and effort to devise effective and efficient pricing strategies.
Following are different types of pricing strategies that different business organisations use in order to attract customers and at the same time to earn profit:
Cost based Pricing;
The formula that is used by different organisations to calculate the price is:
Selling price. = Cost + profit
Cost based pricing:
One of the strategies is cost based pricing. This strategy involves first the calculation of the fixed cost and the variable cost of the specific product or service that is offered by an organisation. Once the total cost is calculated than the profit margin is added to each unit i.e. it can 5%, 7% or 9%. The cost based pricing strategy is very efficient strategy as it covers all the costs related to product and service and it also covers the desired profit.
Although this strategy looks very simple and easy to use and managers only have to do some financial calculations in order to determine the price of the product or service that is being delivered. But the problem with this strategy is that it doesn’t consider the external factors such as market or the competition that also have massive impact on pricing. But as this strategy is very old and the organisation only has to process the internal information to calculate the price that’s why it is very popular. The organisation can also justify the prices that have been allocated on the basis of their cost and also prove that the price is the sum of the total cost and the profit.
Absorption costing principles:
Absorption costing is another costing technique that is widely used it involves the allocation of all the costs that have been incurred by the business organisation to each of its product or the service they offer. This strategy enables them to estimate whether the product will make profit in future or not. During the cost allocation process some assumptions are also made as some costs are fixed and some are variable which depend on the level of production.
When absorption costing system is used the profit that are reported by the organisation depend on the level of production and the level of sales by the firm, this is due to the fact the fixed manufacturing overhead is absorbed in the value of work in progress goods and also in the finished goods. But if at the end of the accounting period the stock is not sold out than the fixed manufacturing overhead cost is transferred to the next period.
Marginal costing principles:
Marginal costing is another significant costing strategy. This strategy gives importance to the behavioural characteristics of the costs. The two elements of the cost are first separated i.e. variable cost in which the cost per unit is same and the total cost changes depending on the level of production and the second element is fixed cost in which the total cost is same irrespective of level of production. It is not very easy to separate fixed and variable costs, the organisation simplify the information to do this and sometimes it is not very accurate. But this costing strategy is very helpful for business organisations to perform different activities such as decision making and short term planning. In this costing system the variable cost is subtracted from the sales revenue to calculate the contribution margin of each product i.e. the amount each product has contributed to cover the total fixed cost that business organisation has sustained. And then the fixed cost is subtracted from the contribution margin as fixed cost is treated as period cost and then the net profit is found.
1.2 Design a costing system for use within an organization.
The world was hit by the recession in 2007. Now it is been more than six years but still many countries are not able to get rid of it and most of the countries are facing the after effects. The economy has been badly affected by the recession. And therefore business organisations are also giving more attention to the financial aspects of the firm. The business organisations are trying to be prepared for such kind of disasters by using various accounting tools that helps them to closely evaluate their performance whether it is financial or management performance. This also helps them to identify various opportunities. According to Datar et.al (2008) business organisations are giving more attention to cost accounting these days in order to make their financial as well as their strategic decisions. The costing system enables the organisation to easily record the expenses that have been incurred or will be incurred in future. But the other financial technique limits the business organisations to sales, marketing and human resource management and does not give the accurate cost of the business activities.
There are different costing systems some of them are mentioned above but the three costing systems that are gaining more attention are very popular among business organisations are:
Activities-Based Costing System
Absorption Costing System
Direct Costing System
TESCO is a multinational grocery store with millions of turn-over every year; they have been using traditional costing system which is used to cover their huge sales. But now as the competition is increasing in the market due to globalisation and various other factors the number of challenged TESCO is facing is also increasing. Therefore the best costing system for TESCO is activity based costing or ABC system. According to Dekker (2003) the fundamental principle of the activity based costing revolves around value chain analysis and integrated cost evaluation and the sales information that is associated with the supply chain of the organisation.
TESCO requires the main costing hub rather than small different departments. It has more than 30,000 products and therefore it is very difficult to keep track of all of them. Any business firm offering this much number of products cannot keep track of the cost and they can be in difficult situation due to overhead cost allocation. Activity based costing system has two divers volume based and non-volume based. The most suitable costing system for TESCO is activity based costing as it helps the organisation to get the exact summary of cost of sales.
1.3 Propose improvements to the costing and pricing systems used by an organization
The competition-based pricing policy should be used by TESCO. This strategy helps the firm to finalize the price of the product after analysing the prices set by the other companies that are currently competing in the market. Therefore TESCO should first identify its present competitors that are giving it a cut throat competition. Than after calculating the costs of its products TESCO sets the price of each product. The prices are set either higher, lower or exactly the same prices that are offered by competitors. This decision is actually based on how the competitor will respond to the set price. If there are few competitors in the market than the response of the competitor is very important part of this pricing strategy. Because if this is the case than, when one competitor lowers the price the other competitor will also lower theirs in order to be more competitive.
By using this this pricing policy the companies can relatively quickly set their prices and as this strategy does not require accurate market data therefore it requires very little effort to carry it out. Competitive pricing also makes distributors more receptive to a company's products because they are priced within the range the distributor already handles. Furthermore, this pricing policy enables companies to select from a variety of different pricing strategies to achieve their strategic goals. In other words, companies can choose to mark their prices above, below, or on par with their competitors' prices and thereby influence customer perceptions of their products.
2.1. Apply forecasting techniques to make cost and revenue decisions in an organization
Assumptions for Forecasted Income Statement:
The revenues have increased by 5%.
The cost of goods sold has increased by 2%
The selling, general and admin expenses has been managed to bring down by 3%
No further borrowing took place therefore interest expense is same
Interest income, income on equity investment and non-operating income has increased by 1%.
All the unusual items will be same.
Income tax will be 25%.
Minority interest in earning and earning from discounted operations will be same.
NOTE: All the figures are rounded off to one decimal place.
(Millions of British Pounds)
Feb 25 2013
Cost Of Goods Sold (cogs)
Selling General & Admin Expenses, Total
Total OPERATING EXPENSES
Interest Income And Investment Income
NET INTEREST EXPENSE
Income On Equity Investments
Other Non-Operating Income (Expenses)
Impairment Of Goodwill
Gain On Sale Of Assets
Other Unusual Items
EBT, INCLUDING UNUSUAL ITEMS
Income Tax Expense
Minority Interest In Earnings
Earnings From Continuing Operations
EARNINGS FROM DISCOUNTINUED OPERATIONS
NET INCOME TO COMMON INCLUDING EXTRA ITEMS
NET INCOME TO COMMON EXCLUDING EXTRA ITEMS
Assumptions for Forecasted balance Sheet:
All assets will increase by 3% except the current assets. Current assets will increase by 5%.
All current liabilities will increase by 4%.
All long term liabilities will increase by 3.95%.
Equity will increase by 5%.
Millions of British Pounds
Feb 25 2013
Cash And Equivalents
TOTAL CASH AND SHORT TERM INVESTMENTS
Other Current Assets
TOTAL CURRENT ASSETS
Gross Property Plant And Equipment
NET PROPERTY PLANT AND EQUIPMENT
Accounts Receivable, Long Term
Loans Receivable, Long Term
Deferred Tax Assets, Long Term
Deferred Charges, Long Term
Other Long-Term Assets
LIABILITIES & EQUITY
Current Portion Of Long-Term Debt/Capital Lease
Current Portion Of Capital Lease Obligations
Current Income Taxes Payable
Other Current Liabilities, Total
TOTAL CURRENT LIABILITIES
Pension & Other Post-Retirement Benefits
Deferred Tax Liability Non-Current
Other Non-Current Liabilities
Additional Paid In Capital
Comprehensive Income And Other
TOTAL COMMON EQUITY
TOTAL LIABILITIES AND EQUITY
2.2 Assess the sources of funds available to an organization for a specific project:
There are two sources of capital:
Public stock sale
Venture capital companies
Asset based financing
But all of the above sources are not suitable for Tesco. It already has floated its stocks in the market therefore only following few sources of funds available to Tesco:
The retained earning directly affects the amount of dividend paid to the shareholders. Company can either use its profits as retained earnings or reinvest them or they can give it away as dividend. There are different reasons because of which it is better to use retained earnings to finance the new project instead of giving it as dividend such as company does not have to borrow it and then pay interest on the loan which will incur extra cost. The dividend policy is devised by the directors and they prefer to use retained earnings as an attractive source of fund.
Banks are also another important source of funds these days. They lend money to business organisation and charge interest rate on it. The banks lend short term loans in terms of overdraft and short term loans. An overdraft is given by bank which company has to pay back within the set limits. The interest is charged but at a variable rate. Whereas the short term loan is the loan extended by bank for the period of up to three years. Medium loans are another type of loans that are given by banks for the time period of more than three years. The type of loan extended by the bank depends on the credit history of the company.
There are two types of parties in a lease agreement i.e. lessee and lessor. Lessor is the person who is the owner of the asset and lessee is the person who is willing to use that asset with the payment of certain amount of money. The agreement is signed between two parties after which lessee is allowed to use the asset but he has to make certain amount of payments for certain period of time. We can say that lease is another type of rental. There are different types of assets that can be leased out such as building, house, land furniture, equipment and vehicles etc. There are two different types of lease; operating lease and finance lease. Operating lease is the lease of the equipment for the specified period of time and the lessor has the responsibility of the maintenance of that equipment. The lease period is fairly short. Whereas in finance lease the agreement of lease is relatively long in most cases it is the expected life of the asset that is to be leased.
This is another attractive source of financing the new business venture for many business organisations. This method requires less financing for business organisation to expand. Two parties are involved in franchising agreement that is franchisor and franchisee. The franchisor gives a right to franchisee to operate its business using the franchisor’s name but in return franchisee has to pay certain amount of money. The franchisee has to pay an upfront fee to franchisor that covers the business set up cost and then monthly or yearly payments are made that is certain percentage of the franchisee profit.
3.1 select appropriate budgetary targets for an organization
The budgeting is very important and essential part of any organisation as it is similar to financial plan that shows the allocation of the financial funds that are available to an organisation to different expenditures. The main drivers of the budget of any organisation are the mission, vision and objectives of that specific organisation. The budget of the business organisation includes different variables
The budget of the organisation of the coming year is based on certain key assumptions that are made about the most likely business conditions of the organisation. This help to produce a detailed budget of the organisation which includes monthly sales level, the overall production and also the different expenditures. Business organisations should have flexible budget so that they can easily mould with changing external conditions. For example the actual sales can be higher than the expected value so it is important to change the budget and to increase the costs related to it such as overhead cost, variable cost, labour cost etc.
3.2 participate in the creation of a master budget for an organization
Sales (in billions):
1st Quarter £33,000
2nd Quarter £30,000
3rd Quarter £32,000
4th Quarter £36,000
Costs (in billions):
1st Quarter £29,000
2nd Quarter £29,800
3rd Quarter £29,970
4th Quarter £31,250
Selling Expenses (in billions):
Variable cost: 3% of Sales
Fixed cost: (divided in four quarters)
Rent expense £500/year
Advertising expense £165/year
Depreciation Expense of the Office £35/year
Administration Expenses (in billions):
Variable expenses: Bad Debts Expense it is calculated at 0.7% of Sales
Fixed expenses: (divided equally in four quarters)
Salaries costs £675/year
Insurance expense £48 / year
Supplies £150 /year
Other Expenses £190 /year
Income Tax is estimated at 25% average.
Dividend is paid bi-annually of £4.63p in April 2013 and £5.58p in October 2013.
From the beginning Balance Sheet:
Plant and equipment= £18,000
Building = £16,00
Accumulated Depreciation = £9,600
Retained Earnings = £13,600
Capital Stock = £450
3.3 compare actual expenditure and income to the master budget of an organization
The actual expenditure and the income of the TESCO are slightly different than the budgeted expenditure and income. The differences are due to some of the factors that cannot be actually quantified and then taken into account during the budgeting process. But overall there is a slight difference in the actual and expected budget which shows the financial managers have forecasted the budget in a right way. Following are the differences:
The sales were 5% more than expected budget
Therefore the revenue was also 4% more than expected
The expenses were overvalued in budget by 2%
The depreciation in the expected budget was calculated correct.
evaluate budgetary monitoring processes in an organization
Budget Monitoring is an on-going process which is used by business organization to make sure the plan is achieved, in terms of expenditure and income. The monitoring process of an organization should be in place to ensure no mistakes are made and even if they are made they must be identified and rectified on time. Similarly Tesco should also make sure to monitor its budget regularly. Tesco should do variance analysis to monitor budgeting. When there is a difference between actual and budget figures variance arises. There are two types of variances; favorable and adverse variances. Favorable variance is when costs were lower than expected in the budget or revenue/profits were higher than expected and adverse variance is when costs were higher than expected or revenue/profits were lower than expected.
4.1 recommend processes that could manage cost reduction in an organization
There are few cost reduction techniques that can be used by the organisation. One of the techniques is Value Analysis. It is an effective tool for cost reduction and the results accomplished are far greater. Value analysis is a very efficient technique that helps to improve the effectiveness of work. This technique helps to identify the unnecessary and extra costs that an organisation is bearing. These costs can be hidden or they can be obvious. These costs adversely affect the image of the product and should be eliminated. Value analysis can be used anywhere on any product or activity. Therefore the business organisation should apply value analysis to the processes or item that can bring maximum annual savings. This means those activities with high level of annual expenditure must be on the top of the list. Value analysis is applied to all activities turn by turn. There are different categories of items on which an organisation an apply value analysis technique to bring about considerable amount of total cost reduction:
Capital goods which includes plant, equipment, machinery and equipment etc.
Raw and semi-processed material
Printing and Stationery items
Purchased parts, components, sub-assemblies
Maintenance, repairs, and operational items
4.2 evaluate the potential for the use of activity-based costing
Activity Based Costing (ABC):
Activity based costing is the costing technique that is used by different business organisation. It involves identifying the different activities that are carried out in the organisation and then allocating the cost to each type of activity. These activities are related to the production and delivery of the products to the end costumers.
By using such type of costing technique organisation can accurately evaluate the cost of the different activities that are related to every product or service the organisation is producing. And then organisation can decide whether to keep the product that is not earning profit or to even to reduce the price of the specific product or service if it is over-priced. The ABC model helps to understand about the product, the cost the customer is paying and the profit earned. This model is also used to make the strategic decisions that are very critical to the success of the business organisation. The strategic decision includes the decisions regarding the price of the product, whether to outsource or not etc.
Tesco is a retail store and it is involved in selling of the grocery products. Tesco almost sell more than 3000 products to its customer. With this wide range of products that are in the market activity based costing is the most appropriate costing technique for Tesco. This model will help Tesco to understand the cost of its different products. This technique also helps to identify whether the product is overpriced or under-priced. It also helps the organisation to increase its profit margins.
5.1 Apply financial appraisal methods to analyses competing investment projects in the public and private sector
Following are the two options Tesco plc. has:
Option A: To open a Tesco groceries store in East London on Ilford Lane. The initial cost will be £360,000. Following are the cash flows.
Net Cash flows
Discount factor at 10%
Total NPV= £852,300
Discounted Payback period: 2 Years
Option B: To open a Tesco Groceries in west London. The initial investment will be of £450,000. Following are the cash flows.
Net Cash flows
Discount factor at 10%
Total NPV= £324,150
Discounted Payback period= 4 Years
5.2 Make a justified strategic investment decision for an organization using relevant financial information
Among the two options that are available to Tesco plc. The most attractive and profitable one is option A as its total NPV is almost double than the total NPV of the option B and its discounted payback period is shorter than other option. NPV and Discounted Payback period are best appraisal techniques, because their key advantage is that they take into account the time value of money – the fact that money you expect sooner is worth more to you than money you expect further in the future. In this case both are higher in Project A, so Tesco must choose Project A.
5.3 Report on the appropriateness of a strategic investment decision using information from a post audit appraisal.
For every business organisation decision making regarding the investment is very crucial and important. The ability for an organisation to operate and also to cope up with changing business environment depends on how much the organisation is investing. If the investment expenditures are high than the organisation is left with little operating budget. Post auditing appraisal is an evaluation technique that is used by business organisation it is a detailed analysis of the actual cost incurred and revenue generated from an investment project and then comparing it with the expected costs and revenues. If the gap between the expected and actual expenditure is more than post audit helps to identify where things went wrong, so that same mistakes are not made in future. It also helps to identify how the project can be rectified and fixed if any uncertainty occurs.
It is very important to make final decision regarding investment by assessing the post audit report as well. If the investment decisions are made only by analysing the financial values it may possible the investment may turn out into epic failure. The post audit report shows that even though project A seems to be attractive but the Ilford lane already has a big Tesco grocery store that is catering the needs of the customers but as Tesco didn’t perform overall last year so this is not the year to make investment. Tesco will open its branch but in coming year.
6.1 Analyze financial statements to assess the financial viability of an organization
The analyses of the financial statements of Tesco plc of last five years give a good picture of overall financial performance of the company. Tesco has performed well in last five year and has shown steady growth.
Current Ratio & Acid Test Ratio: in 2008 Tesco was not utilizing its assets efficiently that’s the reason in 2008 the current ratio of the firm was very high. But from 2008 onward Tesco has performed very well in bring down its current ratio. But again in 2009 the firm had huge liabilities which is the reason Tesco had high quick ratio but in one year time the firm overcame its debt issues and brought down the liabilities as a result of which they were able to have normal current ratio and good quick ratio.
Gross Profit Margin & Net Profit Margin: the profitability analyses of the financial statements of the Tesco for last five year shows that the revenues of the firm has steadily increased every year as a result of which the gross profit has also increased. But overall the gross profit ratios of the company were satisfactory in the recent years.
Dividend ratio: the dividend policy that Tesco has devised is very good and attracts the investors. The Tesco has shown consistent growth in the amount of dividend paid to the shareholders in last few years. The dividend paid per share has also steadily increased over the years. In fact Tesco has good history of paying dividend to its shareholder in last 26 year Tesco has increased its dividend every year.
Asset Turnover: The asset turnover of any firm helps to determine how efficiently the organization is utilizing its assets in order to earn revenue. From the financial statements we can see that for every one pound that is invested by Tesco in its assets has returned almost £ 3.9. The asset turnover ratio of the firm was stable over the years with slight rise and fall in year 2009 and 2010. This can be due to the fact that Tesco has made more investments in these years and the revenue generated due to these investments showed good asset turnover in year 2011.
Stock turnover: The financial statements of Tesco show that its stock turnover is high which is a good sign for a company but at the same time it is slightly declining every year. The value of stock turnover is different from sector to sector and from industry to industry.
6.2 apply financial ratios to improve the quality of financial information in an organization’s financial statements
Return on Assets 4.24%
Return on Equity 16.26%
Return on Capital 7.30%
Gross Margin 7.79%
Levered Free Cash Flow Margin 0.32%
EBITDA Margin 7.62%
SG&A Margin 2.53%
Total Assets Turnover 1.3x
Accounts Receivables Turnover 12.1x
Fixed Assets Turnover 2.5x
Inventory Turnover 16.6x
Current Ratio 0.7x
Quick Ratio 0.5x
Total Debt/Equity 72.1x
Total Liabilities/Total Assets 66.1x
Growth over Prior Year
Total Revenue 3.63%
Tangible Book Value 1.23%
Gross Profit -3.82%
Diluted EPS before Extra -4.18%
Capital Expenditures -4.67%
Cash from Ops. -17.84%
Levered Free Cash Flow -71.27%
6.3 make recommendations on the strategic portfolio of an organization based on its financial Information
Tesco has a diversified portfolio which is the best technique to minimize the systematic risk. There are different factors because of which Tesco has entered in the retail industry of UK and these factors have helped Tesco from coming out of its bad position. One of the important factor is the business model that is used by Tesco it is kept as a secret and the competitors of the firm have no idea about it therefore they are also able to hide their weaknesses from the competitor companies. This acts as an effective shield for Tesco.
Tesco should make some strategic decision to gain competitive edge in the market and also to become the dominant player because the local market of UK is growing rapidly and it is moving internationally. This step help Tesco to not only create its good brand name all around the world but also helps to increase the level of customer satisfaction.
The last five years of performance were outstanding. In the last five years the level of sales have increased as a result of which there was also an increase in the turn over but at the same time VAT remained same. The Tesco’s stores in UK are very different from the one all around the globe. More number of stores has opened in UK as compared to the number of stores opened in other countries. This growth can easily be determined by the profit Tesco has made over last five years. One cannot easily ignore the growth and the success TESCO has shown in these years. The calculations have also shown that for every eight pound spent in UK one pound is spent in Tesco. This is a big achievement for any organization. Tesco can enter new markets and while doing so it is important to keep the local culture in mind and shopping behavior and spending power of the customers.
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