Managing Financial Principles and Techniques Assignment - Essay Example

? Managing Financial Principles and Techniques Assignment ……………………… College………………………………. …………………. Table of Contents Table of Contents 2 Introduction 3 Importance of Costs in Pricing Strategy 3 An appropriate costing system 4 Improvements to the costing and pricing systems 5 Forecasting Techniques for cost and revenue decisions 6 Funds available to a firm for a project 6 Budgetary Targets 8 Creating master budget 8 Actual expenditure and income to the master budget 9 Budgetary Monitoring Process 10 Processes to reduce costs in a firm 10 Activity-Based Costing 11 Financial Appraisal 11 Strategic Investment Decision 11 Financial Statements 12 Financial ratios 13 Strategic Portfolio of the Organization 13 Conclusion 14 References 15 Introduction To carry on business and stay competitive in today’s complex business environment, companies need always to keep on updating information relevant to costing, pricing, budgeting, estimating and so on. Those companies that take strategic and effective decisions regarding financial and costing issues in relation to pricing and budgeting are found to be highly successful as compared to others that don’t. This paper briefly explains the importance of costs in pricing, forecasting techniques in relation to costs and revenues, most appropriate budgetary targets for a firm, methods to reduce costs, financial appraisal and financial statement to assess financial viability in the firm. Importance of Costs in Pricing Strategy Pricing is an extremely important strategic issue since it is closely related to product positioning and customers’ perception about value and utility. From marketing point of view, a customer is willing to pay a specific amount for a product or service only if that price is worth enough for the value or utility they expect from it (Ferrell and Hartline, 2010, p. 246). Therefore, the organization is required to evaluate how customers value their products or perceive the utility from that and thus to strategically think about a pricing that can help it achieve better competitive advantage. The very basic two approaches to pricing are ‘cost-plus’ pricing and ‘market-demand’ pricing (Grossman and Livingstone, 2009). There are various pricing strategies such as low or high pricing, permanent or changing prices, penetration or skimming pricing, fixed or variable pricing. No matter whether it is cost-plus or market-demand based pricing, firms are required to constantly estimate the true costs incurred for developing their product. An underestimation of fixed or variable costs can lead to loss. Firms, in order to stay competitive, are to generate a reasonable amounts of profits. Profit is the difference between selling price and total costs. If a firm simply fixes a price without due care of total costs incurred for making or marketing of that product, it is more likely not to generate a reasonable amounts of profit. Most organizations need to make strategic decisions about setting or accepting the selling prices for the products or services they market. If firms are in marketing condition where the price is automatically set by the market demand and supply forces, the firm will have little or no influence over the selling prices of its products or services. Coffee, sugar, rice markets are of this example. The firm in such condition is required to evaluate the total costs incurred and attempt their maximum to keep per unit costs below the per-unit selling price. In contrast, firms that make highly differentiated or customized products or are market leaders have relatively greater influence in pricing decisions. In such a marketing condition, the pricing decision will be influenced by the cost of the product (Drury, 2007, p. 248) An appropriate costing system Most organizations are depending on marginal costing system since it has long been found to be very effective for management in taking appropriate decisions and understanding accurate cost structures. Marginal costing, in contrast to absorption costing, considers direct materials, direct labor and variable manufacturing overheads as product costs. Under this method, costs are attributed to cost units for a specific period of time and fixed costs are written off against the total contribution (Lucey and Lucey, 2002, p. 296). As Glautier and Underdown (2001, p. 441) stressed, marginal costing is an important tool for management accounting as it can effectively be used for providing managerial information about costs incurred in the business operation, volume and profit relationship. Profit estimation, profit planning and cost management can easily be carried out if management uses marginal costing method. Bendrey, Hussey and West (2003, p. 127) found that marginal costing is quite suitable in most businesses as it takes in to account cost behavior. Improvements to the costing and pricing systems In recent years, there have been several changes in approaches to pricing as well as costing. Earlier, firms used to price a product or service purely based on cost-plus pricing by which they only considered total costs incurred for producing that product or service. Profit maximization has long been a focus among many businesses. But in recent years, almost all the businesses turn the way they approached making profit, fixing price and analyzing costs. For instance, Activity Based Costing is a new trend in costing by which accuracy in allocating the activity-driven costs to cost objects can be improved. Activity based costing has been developed with a view to identify and classify each activity within a firm, estimate the cost that may be incurred for resources of each activity, recognize cost driver for each activity, calculate activity cost for individual activity and assign costs to cost objects (Warren and Reeve, 2006, p. 441). In recent years, firms have become more aware about market forces such as competition, quality concerns of consumers, technology changes, customers’ access to wide varieties of goods, globalization etc. all these forces directly or indirectly influence even the pricing decisions of management. Financial management became concerned about comprehensive cost analysis such as marginal costing, fixed costing, activity-based costing etc and all these information are strategically used for pricing as well. Forecasting Techniques for cost and revenue decisions When it comes to cost accounting, forecasting is a prediction of future events, outcomes and variations in production, cost structures etc. it is required for preparing budgets. Normally, forecasting starts from projected sales volume and market share of present or future products (Davies and Pain:, 2002, p. 411). There basically two techniques for forecasting- qualitative and quantitative. Qualitative forecasting depends on expert opinion regarding future events or changes. This can further be classified in to three: 1 Delphi method, in which a panel of highly expert and recognized people will be used, 2- Technological comparisons, whereby individual forecasters predict changes in one specific areas or costs structure by monitoring changes in another area, and 3- Subjective Curve fitting, in which similarity between two objects will be considered. For instance, CD players and mini disc players may be taken for product life cycle similarity. In quantitative forecasting, historical data will be used for predicting the future. For quantitative forecasting, either univariate or causal models can be used. Univariate models predict future trends of time series, whereas casual models involves using of the identification of other variables related to already predicted variables (Davies and Pain:, 2002, p. 412). Funds available to a firm for a project A firm may require funds for various purposes such as starting or launching a new project, expanding the current business, add fixed assets to the business etc. Following are some of the major sources of funds available to a firm: 1- Sort term sources: These funds are available for short period of time, say up to three or maximum of six months. Examples are: a- Trade Credit: Purchasing assets on credit b- Over draft: Withdrawing more money than available balance from Bank Current Account 2 – Medium as well as Long term sources of funds: These funds are available from six months to as long as 25 or 50 years. Examples are: a- Hire Purchase: Assets like vehicles or building can be purchased on credit for a condition of repayment through equal installments. b- Leasing: Mostly technology and related assets are purchased on leasing, where the asset becomes under the ownership of the buyer after a specific period of time and after the completion of repayment. c- Bank Loan, include both normal and mortgage loans. d- Shares or Debentures: A business can also raise funds by issuing shares or debentures. Shares are investments whereas debentures are credits from the public. e- Retained earnings: Dividends that are to be distributed to shareholders can be retained and used for projects in the business (Davies and Pain:, 2002, p. 478). Budgetary Targets Budget establishes a basic for internal audit by constantly evaluating results in various concerned departments. An effective budget process should evaluate and ensure better resource allocation in an appropriate way. The main targets of budgeting are detailed below: 1- Compelling the strategic planning: Management can look ahead and set short term targets. 2- To coordinate various functions within the organization: Management can effectively coordinate different activities across departments. 3- To have a free flow of communication between top level and lower level managements. 4- Providing a basis for responsibility accounting, whereby the management can identify the budget centers and achieve stated targets. 5- A basis for control mechanism, because management can compare the actual performance with planned performance and take corrective actions. 6- As a means to motivate employees because employees can be encouraged to attain a specific level that management expect them to be (Berry, Jarvis and Jarvis, 2005, p. 408- 409). Creating master budget A master budget is the very basic output of a budgeting system. It is the comprehensive profit plan that is aligned with all phases of a firm’s overall operations. A master budget comprises of many various sub-budgets such as sales budget, production budget, cost budget, cash budget, capital budget, marketing budget etc. Sales budget seems to be the starting point. Forecasting sales, required staff, market research, Delphi technique are required for sales budget. A general format of master budget is depicted below. As shown in the figure, the operational budget component comprises of elements in relation to meeting the demands for goods or services being marketed. Actual expenditure and income to the master budget A master budget is prepared by adding together the trading account, manufacturing account and profit and loss account, that in turn provide detailed month by month information about the expenditures and incomes statements. Both income and expenditures future projections will be included in the maser budget. Expenses such as interest paid, rent, salary, wages, etc will be shown in the debit side whereas income such as interest received, donations, rent received etc will be shown in the credit side of the profit and loss account. Budgetary Monitoring Process A budgetary monitoring process comprises of evaluating the actual performance with the projected performance. As Davies and Pain (2002, p. 427) observed, a budgetary monitoring will help the management ensure optimal allocation of resources, yardstick of performance, provide motivation for improved performance, improve communication, think ahead to achieve long term goals etc. Processes to reduce costs in a firm A firm may take many different strategic actions to reduce costs. In order to ensure maximum efficiency in operation and to increase the potential for earning reasonable amounts of profits, the firm is required to reduce costs. Following are some of the strategies to reduce costs: 1- Kaizen Costing: Hilton, Maher and Selto (2005, p. 670) identified kaizen costing as an effective way to reduce costs. It is a process of cost reduction during the manufacturing phase of the product as there can be continual and gradual developments through small betterment activities. 2- Cost reduction budget: a specific cost reduction budget may also help the firm atain cost reduction target. 3- Use effective costing method: by using effective costing method, cost management can identify the comprehensive aspects of cost structures and accordingly to take actions to reduce costs. Activity-Based Costing Activity based costing is a method o costing that measures the cost and performance of process-related activities that occur within the firm and various cost objects. It also assigns cost activities based on their consumption of various resources and recognizes the basic relationship between cost drivers and related activities. Activity based costing is a system that is based on a basic belief that a firm’s activities are causing the cists to be incurred and hence there will be a link between activities and products by assigning costs of such activities to the related products (Armstrong, 2006, p. 363). Financial Appraisal Financial Appraisal is a scientific as well as systematic evaluation of the profitability and financial strengths of a firm through financial analysis that reveals the significant operating and financial characteristic of the firm. In both private and public sector businesses, the following methods of financial appraisal can be used. Mathematically classifying the data given in the financial statements, Comparing of various inter-connected figures with each others in relation by varying tools of financial analysis Strategic Investment Decision A firm can take strategic investment decision based on the financial appraisal and its results. For instance, in order to take strategic decision regarding whether to invest or not in a specific project, the financial performance and future predictions of the same would be useful for it. For instance, after evaluating the results of financial appraisal, if the firm finds that investing in a new product development may not be printable since costs incurred for that will be higher than expected, it may not be better for the firm to invest in the same. A post-audit appraisal will not only consider the outcome of a particular project, but also the process by which the project can be approved. A post-audit appraisal must cover tow major areas, they are monitoring as well as appraisal. Monitoring is related to gathering the information for appraisal, where as appraisal is formal judgment of how a project may be performing in relation to its predetermined standards. Financial Statements Financial accounting is concerned with preparing, handling and using of three key financial statements: the balance sheet, profit and loss account and cash flow statement. These three financial statements assist the management ensure that financial statements are included in published reports and accounts so that company’s financial performance can be easily interpreted (Davies and Pain, 2002, p. 19). Financial statements play critically important role in maintaining the scorecard for the entity because it helps the firm classify and record monetary transactions based on well-established accounting concepts. These statements not only provide means of financial information, but also serve as fundamental standards of meeting specific legal requirements and management decision making. For instance, profit and loss statement of a firm depicts overall income as well as expenditures and this helps the management identify the real financial structure of the firm. the gross as well as net profit resulted in a profit and loss account shows the exact financial viability of the firm. Financial ratios Financial statements show the overall and general financial performance of a firm, knowing company’s specific objectives such as satisfactory return on capital employed, profitability or financial position of the firm to maintain sufficient working capital etc can be recognized only from financial ratio analysis. Ratio analysis thus serves subjective assessment of the company, cross sectional analysis, inter firm comparison, establishing models for loan and credit rating etc. Profitability, Efficiency, Liquidity and Investment are the main four aspects for which ratio analysis is carried out. All the different ratio analysis tool, such as debt equity ratio, return on investment ratio, net profit ratio, return on capital employed ratio etc provide information regarding the quality and standards of financial viability in the firm. Strategic Portfolio of the Organization Strategy is becoming one most widely used buzzword in business literatures today. Strategic portfolio of the organization comprises of all the different strategies that an organization takes in terms of achieving its ultimate business goal. The ultimate business goal will be, for instance, to continually serve the customers by providing quality goods or services for reasonable price. In order for the company to achieve this target, it may have to take various strategic plans and actions. Most of the critically important business activities are therefore required to be coordinated strategically. Strategic pricing, strategic budgeting, strategic costing, strategic selling, strategic marketing, strategic brand building etc are the imperative components of a firm’s strategic portfolio. Conclusion This piece of research has broadly detailed various concepts related to costing, pricing and financial accounting. This paper explained the importance of costs in pricing and has chosen marginal costing as an appropriate costing method. Forecasting techniques and budgetary targets are well-detailed in this paper. Cost reduction, financial appraisal, financial statements and financial ratios are also detailed in the paper. . 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