Application in Organization
Political
The cancellation of Textile Quota System in 2005 was the most profound effect on textile industry in these years. There have been many manufacturers all over the world moving to China to reduce the manufacturing cost since the cancellation occurred. High Fashion Textile Company is not an exception. It may wish to set up a factory in China so to reduce the cost of production as the labor cost there is low.
Economic
The economy of Hong Kong has recovered from recession. People may be more prepared to pay a higher price. Under the impact of inflation, the price level increases, and so the cost (e.g. material cost and wages). Therefore, High Fashion Textile Company may consider to set higher selling prices for its products.
Social
A concerted effort by animal rights campaigners in spreading anti-fur message had the effect that fur shops began to close down and the fur trade decreased dramatically. The anti-fur campaign will impact the fur trading business of High Fashion Textile Company but boost the artificial fur trading business. The Company may therefore plan to develop artificial fur manufacturing techniques so to increase its competitiveness in the market.
Technological
The design of existing products changes as new technology allows more efficient and effective features to be incorporated. The life-cycle of some products is shortened as they are superseded by new products that are more technologically advanced or innovative. The management accounting system must be able to provide information to help evaluate such changes and their impact on business planning and decision
making.
Summary
All organizations have to consider the factors affecting change in the business environment before making decisions. SWOT analysis may be performed so to identify the Strengths, Weaknesses, Opportunities and Threats. That is, not only the external factors, but also consider the internal factors so to help in management and strategy formulation.
THE ECONOMISTS MODELIntroduction
For organizations that sell products or services that are highly customized or differentiated from each other by special features, or who are market leaders, the pricing decisions will be influenced by the cost of product. In other organizations, prices are set by overall market and supply forces and they have little influence over the selling prices of their products and services.
The theoretical solution to pricing decisions is derived from economic theory, which explains how the optimal selling price is determined. Product pricing is relevant in both retaining market share and maintaining profit levels. The Economist’s model assumes that the firm will attempt to set selling price at a level where profits are maximised. A representation of the model may be constructed as follows:
Description
For monopolistic or imperfect competition, the model assumes that the lower the price, the larger the volume of sales. i.e. the greater the demand. This relationship may be illustrated as the demand curve. The sensitivity of demand to changes in price is described as the price elasticity of demand.
Price elasticity of demand
Inelastic demand Elastic demand
If a small change in price will result in a large change in demand, the demand for a product is elastic. Customers may look for an alternative substitute where prices change.
In opposite, if a large change in price will result in a small change in demand, the demand for a product is inelastic. Many essential items such as fuel is one of the examples.
The graph below is a economist’s model for establishing optimum price, MC, marginal cost; MR, marginal revenue; TC, total cost; TR, total revenue.
• Total revenue may be calculated by multiplying the demand curve by the quantity (units) that applies at each point on the curve.
• The total cost curve is constructed by estimating the total costs that will apply at each level of sales.
• The Economist’s model submits that the volume of production and sale should be increased to the point where additional (or marginal) revenue gained from one additional unit is equal to the additional (or marginal) costs incurred. The selling price at which this sales volume occurs can then be determined. This process may be implemented by visual inspection of a tabulation of the data, the use of a graphical approach or the application of differential calculus.
Practical problems in implementing the model
The economist’s model may be criticized as being difficult to apply in practice. The following points may be raised:
- It is difficult to quantify price: demand relationships. Only an approximation can be ventured.
- Other than price, many internal and external factors also affect the demand. These include the amount and quality of sales effort, product design and quality and customer care
- The total cost and marginal cost functions prepared by the accounting system are likely to be only an approximation of the true cost function
- The model assumes the pursuit and application of a profit-maximising strategy. However, a variety of competitive forces are likely to influence the strategy implemented during the life cycle of any product.
Application in Organization
High Fashion Textile Company has estimated that the demand/price relationship for one of its products, Sherpa fleece, is linear and the following data are available for the coming period:
Selling price per unit: $700 $450
Demand (in units): 400 1,150
The product will be marketed at a price somewhere between the above parameters
which will be a multiple of $50. A preliminary estimate for the period is as follows:
Variable cost per unit = $350
Fixed costs = $20,000
The Company wishes to determine the maximum profit and the selling price and sales volume at which it will be achieved. Tabulation of the data for selling prices between $450 and $700 in $50 multiples and a graphical solution is carried out.
The tabulation shows that total profit is maximized at *$155,000 where price is set at $600 giving a demand of 700 units.
Demand and price columns:
A price: demand relationship is established by calculating the rate of change of price per unit of demand, i.e. ($700 – $450) / ($400 – 1,150) = -0.33
This means that for each $0.33 reduction in price the demand will increase by one unit. This may also be expressed as an increase in demand of 150 units for each $50 reduction in price.
Total revenue and marginal revenue columns:
Total cost at any demand level = units × price.
Marginal revenue represents the value of incremental revenue for each additional 150 units. For example from 400 to 550 units the incremental revenue is $357,500 – $280,000 = $77,500.
Total cost and marginal cost columns:
Total cost at any demand level = units × variable cost per unit + fixed cost.
Marginal cost represents the incremental cost for each additional 150 units.
For example between 400 and 550 units, marginal cost = $212,500 –160,000 =
$52,500. A constant variable cost per unit at all levels and a constant fixed cost results in a constant marginal cost of $52,500 per 150 units.
Total profit column:
Total profit = total revenue – total cost at each level of demand.
The graphs below indicate a slightly higher price between $600 to $500 would be the optimum price.
Graphical representation of model of establishing the optimum price and demand
Summary
The economist’s model may be criticised as being difficult to apply in practice. Like in our application in the organization, the company has many different products which interrelate with each other giving a complex relationships. It therefore becomes difficult to predict the demand for individual product. Hence, it is recommended to use alternative approaches to pricing at the same time. They may be adopted in price-setting or price-taking situations in a long-term or short-term context. Alternative approaches includes traditional cost plus profit mark-up and activity-based cost, etc.
ACTIVITY-BASED COSTING
Introduction
Costing systems can vary in terms of which costs are assigned to cost objects and their level of sophistication. Typically cost systems are classified as follows:
- Direct costing systems;
- Traditional absorption costing systems;
- Activity-based costing systems
Both traditional and ABC systems allocate indirect costs to cost objects where direct costing systems doesn’t. ABC systems use sophisticated methods for allocation where the traditional ones use unsophisticated methods. Therefore, ABC systems are more accurate cost management system, they identify opportunities to improve business process effectiveness and efficiency by determining the "true" cost of a product or service.
Description
In the development of ABC systems, four steps are involved. They are:
1. Identify the major activities being carried out and their necessity
Activities may be classified as primary activities, i.e. contribute directly to the central mission of department or organization unit, or secondary (support) activities, i.e. supporting the primary activity. Activities may also be classified as value added or non-value added. Non-value added activities are tried to be eliminated in order to reduce cost.
- Assign costs to cost centre for each activity
Costs assigned to activity cost centre will include direct and indirect costs. Resource cost drivers are used to assign indirect costs. The reliability of cost information will be reduced if arbitrary allocations are used to assign a significant proportion of costs to activities.
- Determine the cost driver for each major activity
Drivers at this stage called activity drivers. They should:
- provide a good explanation of costs of each activity pool
- be easily measurable
- the data should be easy to obtain and identifiable with the product
Also, the root cause that drives the activity cost driver should be identified.
- Assign the cost of activities to products:
The cost driver must be measurable so that it can be identified with individual products.
The above diagram shows ABC systems use a two-stage allocation process.
First stage – assigns overheads to each major activity and many activity-based cost centres are established
Second stage –establish separate cost driver rates for support activities and assigns the cost of support activities directly to cost objects
As early ABC systems were subjected to criticisms of identifying the level at which costs are incurred and the degree of accuracy with which each cost driver may be identified. The hierarchy of costs categorises costs according to the level at which they are incurred viz. unit level, batch level, product level or facility level.
Application in Organization
High Fashion Textile Company makes and sells a range of fabric products. The products are manufactured in batches on a just-in-time basis to fulfill orders that are received from customers.
One of the production lines, production line A, can only manufacture one product at a time. This line A is expected to manufacture only two products, denim or canvas. Budgeted information for the next 6 months production line A is as follows:
Management has carried out an analysis of the total cost of production using an activity-based costing approach. The activities are classified into primary and support activities. A hierarchical cost analysis is also shown.
Since the total cost per unit of output for denim is lower than that of canvas, the company would likely to produce denim if they have the same profit mark-up.
The activity-based approach provides a more useful base from which potential cost savings can be investigated. For example, the production line maintenance cost in canvas is high. It may be possible to significantly reduce this by reducing the number of maintenance hours. This may be achievable by investigation of the root cause of the cost driver. Perhaps the incapability of the machine to that product should be investigated.
Based on the cost estimation, management will make decisions on the products that will yield an acceptable level of profit and those, if any, that should be discontinued unless costs can be reduced or price increases negotiated.
However, there are still some application criticisms in ABC approach. For example, the management may feel that the activity-based approach contains too many assumptions and estimates about activities and cost drivers. There may be doubt as to the degree of increased accuracy it provides.
Summary
As there are still criticisms in ABC approach, a consideration of using target costing in product price evaluation and customer-specific costs in deciding on product price strategy would arise. Organizations should select a suitable approach for its costs determination.
CONCLUSION
In this coursework, the business environment in which management accounting is used is being examined using PEST analysis. The usefulness of Economist’s model of
price/demand relationships is discussed. The approach of activity-based cost to product pricing is also discussed. Different theoretical approaches have their own limitations and strengths. Organizations should look at the whole picture and critically analyse the environment in managerial planning.
REFERENCES
Drury, Colin (2004) Management & Cost Accounting: 6th Edition (Thomson)
Kotler, P., Ang, S.H., Leong, S.M. and Tan, C.T. (2006), Marketing Managment: An Asian Perspective, Forth Edition Prentice Hall, Singapore.
12 Manage Rigor and Relevance PEST Analysis (assessed on 18/12/06)
[ONLINE] http://www.12manage.com/methods_PEST_analysis.html
12 Manage Rigor and Relevance PEST Analysis
Drury, Colin (2004) Chapter 11 Management & Cost Accounting: 6th Edition (Thomson)
Drury, Colin (2004) Chapter 11 Management & Cost Accounting: 6th Edition (Thomson)
Drury, Colin (2004) Chapter 10 Management & Cost Accounting: 6th Edition (Thomson)
Drury, Colin (2004) Chapter 10 Management & Cost Accounting: 6th Edition (Thomson)
