The Importance Of Costs In The Pricing Strategy Accounting Essay

5204 words (21 pages) Essay

1st Jan 1970 Accounting Reference this

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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:

Competition Pricing;

Psychological Pricing;

Cost based Pricing;

Price Skimming.

Absorption costing

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.

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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.

Currency

(Millions of British Pounds)

As of:

Feb 25

2012

GBP

% Change

Feb 25 2013

GBP

Revenue

64,539.0

5%

67,766.0

TOTAL REVENUE

64,539.0

67,766.0

Cost Of Goods Sold (cogs)

59,278.0

2%

60,464.0

GROSS PROFIT

5,261.0

7,302.0

Selling General & Admin Expenses, Total

(1,634.0)

(3%)

(1,585.0)

Total OPERATING EXPENSES

(1,634.0)

(1,585.0)

OPERATING INCOME

3,627.0

5717.0

Interest Expense

(417.0)

Same

(417.0)

Interest Income And Investment Income

114.0

1%

115.0

NET INTEREST EXPENSE

(303.0)

(302.0)

Income On Equity Investments

91.0

1%

92.0

Other Non-Operating Income (Expenses)

44.0

1%

44.0

EBT

3,459.0

5,551.0

Impairment Of Goodwill

Same

Gain On Sale Of Assets

376.0

Same

376.0

Other Unusual Items

Same

EBT, INCLUDING UNUSUAL ITEMS

3,835.0

5927.0

Income Tax Expense

879.0

(25%)

1482.0

Minority Interest In Earnings

(8.0)

Same

(8.0)

Earnings From Continuing Operations

2,956.0

4,445.0

EARNINGS FROM DISCOUNTINUED OPERATIONS

(142.0)

Same

(142.0)

NET INCOME

2,806.0

4,295.0

NET INCOME TO COMMON INCLUDING EXTRA ITEMS

2,806.0

4,295.0

NET INCOME TO COMMON EXCLUDING EXTRA ITEMS

2,948.0

4,437.0

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%.

Currency in

Millions of British Pounds

As of:

Feb 25

2012

GBP

% Change

Feb 25 2013

GBP

Assets

 

http://investing.businessweek.com/research/images/px.gifhttp://investing.businessweek.com/research/images/px.gifhttp://investing.businessweek.com/research/images/px.gifhttp://investing.businessweek.com/research/images/px.gif

Cash And Equivalents

2,305.0

5%http://investing.businessweek.com/research/images/px.gifhttp://investing.businessweek.com/research/images/px.gifhttp://investing.businessweek.com/research/images/px.gifhttp://investing.businessweek.com/research/images/px.gif

2420.25

Short-Term Investments

1,243.0

http://investing.businessweek.com/research/images/px.gifhttp://investing.businessweek.com/research/images/px.gifhttp://investing.businessweek.com/research/images/px.gifhttp://investing.businessweek.com/research/images/px.gif5%

1305.15

TOTAL CASH AND SHORT TERM INVESTMENTS

3,548.0

http://investing.businessweek.com/research/images/px.gifhttp://investing.businessweek.com/research/images/px.gifhttp://investing.businessweek.com/research/images/px.gifhttp://investing.businessweek.com/research/images/px.gif5%

3725.4

Accounts Receivable

2,502.0

http://investing.businessweek.com/research/images/px.gifhttp://investing.businessweek.com/research/images/px.gifhttp://investing.businessweek.com/research/images/px.gifhttp://investing.businessweek.com/research/images/px.gif5%

2627.1

Notes Receivable

http://investing.businessweek.com/research/images/px.gifhttp://investing.businessweek.com/research/images/px.gifhttp://investing.businessweek.com/research/images/px.gif–http://investing.businessweek.com/research/images/px.gif

Other Receivables

2,244.0

http://investing.businessweek.com/research/images/px.gifhttp://investing.businessweek.com/research/images/px.gifhttp://investing.businessweek.com/research/images/px.gifhttp://investing.businessweek.com/research/images/px.gif5%

2356.2

TOTAL RECEIVABLES

4,746.0

http://investing.businessweek.com/research/images/px.gifhttp://investing.businessweek.com/research/images/px.gifhttp://investing.businessweek.com/research/images/px.gifhttp://investing.businessweek.com/research/images/px.gif5%

4983.3

Inventory

3,598.0

http://investing.businessweek.com/research/images/px.gifhttp://investing.businessweek.com/research/images/px.gifhttp://investing.businessweek.com/research/images/px.gifhttp://investing.businessweek.com/research/images/px.gif5%

3777.9

Prepaid Expenses

420.0

http://investing.businessweek.com/research/images/px.gifhttp://investing.businessweek.com/research/images/px.gifhttp://investing.businessweek.com/research/images/px.gifhttp://investing.businessweek.com/research/images/px.gif5%

441

Other Current Assets

551.0

http://investing.businessweek.com/research/images/px.gifhttp://investing.businessweek.com/research/images/px.gifhttp://investing.businessweek.com/research/images/px.gifhttp://investing.businessweek.com/research/images/px.gif5%

578.55

TOTAL CURRENT ASSETS

12,863.0

http://investing.businessweek.com/research/images/px.gifhttp://investing.businessweek.com/research/images/px.gifhttp://investing.businessweek.com/research/images/px.gifhttp://investing.businessweek.com/research/images/px.gif5%

13506.15

Gross Property Plant And Equipment

34,772.0

http://investing.businessweek.com/research/images/px.gifhttp://investing.businessweek.com/research/images/px.gifhttp://investing.businessweek.com/research/images/px.gifhttp://investing.businessweek.com/research/images/px.gif3%

35815.16

Accumulated Depreciation

-9,062.0

http://investing.businessweek.com/research/images/px.gifhttp://investing.businessweek.com/research/images/px.gifhttp://investing.businessweek.com/research/images/px.gifhttp://investing.businessweek.com/research/images/px.gif3%

-9333.86

NET PROPERTY PLANT AND EQUIPMENT

25,710.0

http://investing.businessweek.com/research/images/px.gifhttp://investing.businessweek.com/research/images/px.gifhttp://investing.businessweek.com/research/images/px.gifhttp://investing.businessweek.com/research/images/px.gif3%

26481.3

Goodwill

3,449.0

http://investing.businessweek.com/research/images/px.gifhttp://investing.businessweek.com/research/images/px.gifhttp://investing.businessweek.com/research/images/px.gifhttp://investing.businessweek.com/research/images/px.gif3%

3552.47

Long-Term Investments

1,949.0

http://investing.businessweek.com/research/images/px.gifhttp://investing.businessweek.com/research/images/px.gifhttp://investing.businessweek.com/research/images/px.gifhttp://investing.businessweek.com/research/images/px.gif3%

2007.47

Accounts Receivable, Long Term

1,901.0

http://investing.businessweek.com/research/images/px.gifhttp://investing.businessweek.com/research/images/px.gifhttp://investing.businessweek.com/research/images/px.gifhttp://investing.businessweek.com/research/images/px.gif3%

1958.03

Loans Receivable, Long Term

http://investing.businessweek.com/research/images/px.gifhttp://investing.businessweek.com/research/images/px.gifhttp://investing.businessweek.com/research/images/px.gifhttp://investing.businessweek.com/research/images/px.gif3%

Deferred Tax Assets, Long Term

23.0

http://investing.businessweek.com/research/images/px.gifhttp://investing.businessweek.com/research/images/px.gifhttp://investing.businessweek.com/research/images/px.gifhttp://investing.businessweek.com/research/images/px.gif3%

23.69

Deferred Charges, Long Term

677.0

http://investing.businessweek.com/research/images/px.gifhttp://investing.businessweek.com/research/images/px.gifhttp://investing.businessweek.com/research/images/px.gifhttp://investing.businessweek.com/research/images/px.gif3%

697.31

Other Intangibles

492.0

http://investing.businessweek.com/research/images/px.gifhttp://investing.businessweek.com/research/images/px.gifhttp://investing.businessweek.com/research/images/px.gifhttp://investing.businessweek.com/research/images/px.gif3%

506.76

Other Long-Term Assets

3,717.0

http://investing.businessweek.com/research/images/px.gifhttp://investing.businessweek.com/research/images/px.gifhttp://investing.businessweek.com/research/images/px.gifhttp://investing.businessweek.com/research/images/px.gif3%

3828.51

TOTAL ASSETS

50,781.0

http://investing.businessweek.com/research/images/px.gifhttp://investing.businessweek.com/research/images/px.gifhttp://investing.businessweek.com/research/images/px.gifhttp://investing.businessweek.com/research/images/px.gif

52304.43

 

http://investing.businessweek.com/research/images/px.gifhttp://investing.businessweek.com/research/images/px.gifhttp://investing.businessweek.com/research/images/px.gifhttp://investing.businessweek.com/research/images/px.gif

LIABILITIES & EQUITY

 

http://investing.businessweek.com/research/images/px.gifhttp://investing.businessweek.com/research/images/px.gifhttp://investing.businessweek.com/research/images/px.gifhttp://investing.businessweek.com/research/images/px.gif

Accounts Payable

5,971.0

http://investing.businessweek.com/research/images/px.gifhttp://investing.businessweek.com/research/images/px.gifhttp://investing.businessweek.com/research/images/px.gifhttp://investing.businessweek.com/research/images/px.gif4%

6209.84

Accrued Expenses

2,612.0

http://investing.businessweek.com/research/images/px.gifhttp://investing.businessweek.com/research/images/px.gifhttp://investing.businessweek.com/research/images/px.gifhttp://investing.businessweek.com/research/images/px.gif4%

2716.48

Short-Term Borrowings

415.0

http://investing.businessweek.com/research/images/px.gifhttp://investing.businessweek.com/research/images/px.gifhttp://investing.businessweek.com/research/images/px.gifhttp://investing.businessweek.com/research/images/px.gif4%

431.6

Current Portion Of Long-Term Debt/Capital Lease

1,423.0

http://investing.businessweek.com/research/images/px.gifhttp://investing.businessweek.com/research/images/px.gifhttp://investing.businessweek.com/research/images/px.gifhttp://investing.businessweek.com/research/images/px.gif4%

1479.92

Current Portion Of Capital Lease Obligations

32.0

http://investing.businessweek.com/research/images/px.gifhttp://investing.businessweek.com/research/images/px.gifhttp://investing.businessweek.com/research/images/px.gifhttp://investing.businessweek.com/research/images/px.gif4%

33.28

Current Income Taxes Payable

416.0

http://investing.businessweek.com/research/images/px.gifhttp://investing.businessweek.com/research/images/px.gifhttp://investing.businessweek.com/research/images/px.gifhttp://investing.businessweek.com/research/images/px.gif4%

432.64

Other Current Liabilities, Total

8,412.0

http://investing.businessweek.com/research/images/px.gifhttp://investing.businessweek.com/research/images/px.gifhttp://investing.businessweek.com/research/images/px.gifhttp://investing.businessweek.com/research/images/px.gif4%

8748.48

TOTAL CURRENT LIABILITIES

19,249.0

http://investing.businessweek.com/research/images/px.gifhttp://investing.businessweek.com/research/images/px.gifhttp://investing.businessweek.com/research/images/px.gifhttp://investing.businessweek.com/research/images/px.gif4%

20018.96

Long-Term Debt

9,777.0

http://investing.businessweek.com/research/images/px.gifhttp://investing.businessweek.com/research/images/px.gifhttp://investing.businessweek.com/research/images/px.gifhttp://investing.businessweek.com/research/images/px.gif3.95%

10163.19

Capital Leases

134.0

http://investing.businessweek.com/research/images/px.gifhttp://investing.businessweek.com/research/images/px.gifhttp://investing.businessweek.com/research/images/px.gifhttp://investing.businessweek.com/research/images/px.gif3.95%

139.293

Minority Interest

26.0

http://investing.businessweek.com/research/images/px.gifhttp://investing.businessweek.com/research/images/px.gifhttp://investing.businessweek.com/research/images/px.gifhttp://investing.businessweek.com/research/images/px.gif3.95%

27.027

Pension & Other Post-Retirement Benefits

1,872.0

http://investing.businessweek.com/research/images/px.gifhttp://investing.businessweek.com/research/images/px.gifhttp://investing.businessweek.com/research/images/px.gifhttp://investing.businessweek.com/research/images/px.gif3.95%

1945.944

Deferred Tax Liability Non-Current

1,160.0

http://investing.businessweek.com/research/images/px.gifhttp://investing.businessweek.com/research/images/px.gifhttp://investing.businessweek.com/research/images/px.gifhttp://investing.businessweek.com/research/images/px.gif3.95%

1205.82

Other Non-Current Liabilities

788.0

http://investing.businessweek.com/research/images/px.gifhttp://investing.businessweek.com/research/images/px.gifhttp://investing.businessweek.com/research/images/px.gifhttp://investing.businessweek.com/research/images/px.gif3.95%

819.126

TOTAL LIABILITIES

32,980.0

http://investing.businessweek.com/research/images/px.gifhttp://investing.businessweek.com/research/images/px.gifhttp://investing.businessweek.com/research/images/px.gifhttp://investing.businessweek.com/research/images/px.gif3.95%

34319.36

Common Stock

402.0

http://investing.businessweek.com/research/images/px.gifhttp://investing.businessweek.com/research/images/px.gifhttp://investing.businessweek.com/research/images/px.gifhttp://investing.businessweek.com/research/images/px.gif5%

422.1

Additional Paid In Capital

4,964.0

http://investing.businessweek.com/research/images/px.gifhttp://investing.businessweek.com/research/images/px.gifhttp://investing.businessweek.com/research/images/px.gifhttp://investing.businessweek.com/research/images/px.gif5%

5212.2

Retained Earnings

12,164.0

http://investing.businessweek.com/research/images/px.gifhttp://investing.businessweek.com/research/images/px.gifhttp://investing.businessweek.com/research/images/px.gifhttp://investing.businessweek.com/research/images/px.gif5%

12772.2

Treasury Stock

-18.0

http://investing.businessweek.com/research/images/px.gifhttp://investing.businessweek.com/research/images/px.gifhttp://investing.businessweek.com/research/images/px.gifhttp://investing.businessweek.com/research/images/px.gif5%

-18.9

Comprehensive Income And Other

263.0

http://investing.businessweek.com/research/images/px.gifhttp://investing.businessweek.com/research/images/px.gifhttp://investing.businessweek.com/research/images/px.gifhttp://investing.businessweek.com/research/images/px.gif5%

276.15

TOTAL COMMON EQUITY

17,775.0

http://investing.businessweek.com/research/images/px.gifhttp://investing.businessweek.com/research/images/px.gifhttp://investing.businessweek.com/research/images/px.gifhttp://investing.businessweek.com/research/images/px.gif5%

18663.75

TOTAL EQUITY

17,801.0

http://investing.businessweek.com/research/images/px.gifhttp://investing.businessweek.com/research/images/px.gifhttp://investing.businessweek.com/research/images/px.gifhttp://investing.businessweek.com/research/images/px.gif

18,701.00

TOTAL LIABILITIES AND EQUITY

50,781.0

http://investing.businessweek.com/research/images/px.gifhttp://investing.businessweek.com/research/images/px.gifhttp://investing.businessweek.com/research/images/px.gifhttp://investing.businessweek.com/research/images/px.gif

52304.43

2.2 Assess the sources of funds available to an organization for a specific project:

There are two sources of capital:

Equity financing

Retained earnings

Public stock sale

Partners

Venture capital companies

Corporations

Debt financing:

Asset based financing

Vendor financing

Commercial banks

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:

Retained earnings

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.

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Bank lending:

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.

Leasing:

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.

Franchising:

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

Revenues

Expenses

sales

output

operating cost

fixed cost

profits

cash flow

capital investment

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 fo

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