Accounting essay on: Costs and pricing strategy – Dynamic models PLC

Task 1:

1.1  The importance of costs in the pricing strategy of Dynamic Models Plc:

Costs are important in the pricing strategy of Dynamic Models Plc. The company needs to deliver products at competitive prices. Without controlling costs, it won’t be able to do so. Having the right costing system helps in controlling costs. Currently Dynamic Models Plc charges the full costs of the product and adds a percent as its mark-up.

Two of the main reasons behind the poor performance of Dynamic Models Plc over the past two years are poor cost management and lack of pricing strategy.

1.2  A costing system for use within Dynamic Models Plc:

Dynamic Models’ costing system is based on absorption costing system. In this costing system both the fixed and variable costs are included in the costing to determine prices. Variable costs are those costs which vary with the change in production level while fixed costs are those which remain unchanged with the production levels. An absorption costing system for Dynamic Models Plc will look like:

Direct Material Costs

Plus: Direct labor costs

Plus : Variable manufacturing overheads

……………………………………

Total Variable costs

Add:  Fixed production costs

Add : Fixed non-production costs

………………………………………..

Total cost = Total fixed cost + Total variable costs

Average cost per unit = Total cost / Total output

Add: Mark-up (say 20 %)

…………………………………..

Total price per unit

1.3 Recommendations on improving the costing and pricing systems used by Dynamic Models Plc

In 2011 Dynamic Models Plc charged a mark-up of a whopping 64.015 percent (for calculations see below) on its total cost per unit for setting the price per unit. However, the net profit margin was only 3.04 per cent.

In 2010 Dynamics Models Plc charged a mark-up of 63.93 per cent on its total cost per unit for setting the price per unit. However, the net profit margin was only 3.68 per cent.

In spite of the high mark-up, the net profit margin is very low because of the very high selling and administrative expenses. It is imperative that the company cuts down its selling and administrative expenses.

A better pricing strategy may be one where the company charges only variable cost. On the variable costs it may charge the same mark-up which it is currently charging (around 60 per cent). This will have the effect of lowering the price per unit charged from customers. A lower (more competitive) price may translate into much high revenues for Dynamic Models Plc if the price elasticity of demand of its products is greater than one. In such a case variable costing strategy will transfer into higher profits for the company.

Calculation of mark-up:

Mark-up charged = ((Sale – cost of goods sold) / Cost of goods sold)) * 100

Mark-up charged in 2011 = ((2990 – 1823 ) / 1823) * 100 = 64.01 per cent

Mark-up charged in 2010 = ((3500 – 2135)/2135) * 100 = 63.93 per cent

Net profit margin = (Net Profit / Sales) * 100

Net profit margin in 2011 = (91/2990) * 100 = 3.04 per cent.

Net profit margin in 2010 = (129/ 3500) * 100 = 3.68 per cent.

Task 2:

2.1 Forecasting techniques for decision making

Analysis of the above data reveals that minimum cost per unit occurs at production level of 1000 units. Per unit production cost rises as production is increased above 1000 units. This rise is mainly due to the rise in variable costs per unit. The increase in variable costs per unit offsets the decline in fixed cost per unit as production is increased.

Another forecasting technique which can be used by Dynamic Models Plc is to forecast sales and set production according to the sales forecasts. Sales however are dependent on price which in turn depends on per unit costs. Per unit cost is dependent on level of production. So Dynamic Models Plc can set production at the level at which it expects its Marginal Revenue will be equal to marginal costs. At this level of production its profits will be maximized.

2.2 Funding options available for public limited companies in UK

Public limited companies can tap both debt and equity for raising funds. Debt can be raised as loans from banks or financial institutions or through floating of corporate bonds. There is an active primary and secondary market for both debt and equity in United Kingdom.

Total debt on the balance sheet of Dynamic Models Plc in 2011 = Total short term debt + Total long term debt = 125000 + 75000 + 625000 = 825000

Total equity = 995000

Total preferred equity = 150000

Total capital employed = Total debt + total equity + total preferred equity = 825000 + 995000 + 150000 = 1970000

Debt to equity ratio of Dynamic Models Plc = 825000 / 995000 = 0.829

Debt to total capital employed ratio of Dynamic Models Plc in 2011 = 825000 / 1970000 = .418 or 41.8 %

If Dynamic Plc uses more debt for raising funds then the interest costs will increase further. This may have the effect of putting further pressure on the net profit margin of the company. Net profit margin is already low.

Raising funds through equity may dilute the earnings per share if it is not followed by a proportionate increase in earnings.

Net income available to common equity shareholders in 2011 = 76000

Total equity in 2011 = 995000

Return on equity in 2011 = 76000 / 995000 = 7.6 per cent

The return on equity in 2011 can be taken as the cost of equity for raising more funds through equity (those buying more shares of the company will expect at least this much return).

The after-tax cost of debt of Dynamics Plc in 2011 (assuming a tax rate of 25 %) = {Interest (1 – tax rate)} / Total debt = 40500/ 650000 = 6.23 per cent.

Debt therefore is a much cheaper source of funding for Dynamics Plc than equity. Therefore it will be better if the company raises the needed funds through the debt equity route. However if the equity markets are booming and valuations are extraordinarily high then the equity route may be better.

Task 3:

3.1 How to select appropriate budgetary targets for an organization

One way to select appropriate budgetary targets for an organization is to do scenario analysis. For instance in three possible scenarios (optimistic, pessimistic and least likely) the cost of production can be estimated. Say:

In this way the expected cost and revenues of all the elements in the budget can be determined.

Often organizations simply set their budgetary targets by increasing the previous year’s numbers by the expected inflation. This is not a very sound way of setting budgetary targets and should be avoided. It does not take into consideration the unique circumstances of the current years. The external environment is a highly dynamic one and to set budgets in such a scenario by assuming that the external environment will remain static is a blunder, which no organization can afford to make.

3.2 Creation of master budget for an organization

Master Budget of an organization :

3.2 Comparison of actual expenditure and income of the organization with the budgeted expenditure

Thus we can see that the total variance of the organization in terms of expenditures incurred is unfavorable i.e.actual expenditures exceeded the budgeted estimates. In terms of income the variance is zero.

3.3 How to evaluate budgetary monitoring process in an organization

The budgetary monitoring process can be evaluated on the basis of its effectiveness in minimizing adverse variances. In case of such adverse variances, the budgetary monitoring process should identify the causes of these variances and report them in detail.

Task 4:

4.1 Recommendation on processes which can manage cost reduction in Dynamic Models Plc

Dynamic Models Plc needs to control its selling, general and administrative costs. These have become a big drag on its profitability. Trimming them will improve operating profits and operating profit margin of the company.

Dynamic models needs to deliver best quality products at the most competitive prices. This can be achieved by implementing lean manufacturing at every step of operations. The lean philosophy is about minimizing wastage in all the processes.

4.2 Evaluation of the potential for using Activity Based Costing at Dynamic Models Plc

In Activity based costing, the costs associated with each activity in the operations are identified. Activity based costing is a very effective tool for controlling costs (M.Y Khan, P.K.Jain, 2012). At Dynamic Models Plc, the objective of the management is to control costs and Activity-Based-Costing can be a very effective tool in achieving this objective. By assigning costs to each activity, those activities which are taking up too much cost can be identified and steps can be taken for controlling these costs.

5.1 Analysis of competing projects for Dynamic Models Plc

Net present value = Cash inflow in year 1 * Discount rate + ………+ Cash inflow in year 4 * discount rate in year 4 – Initial cash outflow.

Rate of return = Net present value / Initial investment

5.2 Strategic Decision based on the above financial appraisal

The net present value of both Project Alpha and project Beta is positive. However project Alpha’s net present value of 11166 is much higher than Project Beta’s NPV of Rs 2742. The targeted or required rate of return for Dynamic Plc is 20 %. Project Alpha’s rate of return at 21.47 per cent, is above the required rate of return, while project Beta’s rate of return at 2.742 % is below the required rate of return. Hence Dynamic Plc should accept or invest in Project Alpha while it should reject project Beta.

5.3 Appropriateness of a strategic decision using information from a post-audit appraisal

Post-audit appraisal involves analysis of the actual costs and benefits that have accrued from undertaking an investment or project. It is conducted after the completion of the project. Post-audit appraisal compares the actual costs and benefits from a project with the expectations set while making the decision to invest in the project (Perman Stephen H, 2001). The appropriateness of a strategic investment decision (whether the calculated NPV and other expectations have turned right) is determined by the post-audit appraisal process.

6.1 Analysis of the financial statements of Dynamic Models Plc