P1 Explain management accounting and give the essential

requirements of different types of management accounting

systems.
Management Accounting
Management accountants (also called managerial accountants) look at the events that
happen in and around a business while considering the needs of the business. From this,
data and estimates emerge. Cost accounting is the process of translating these estimates
and data into knowledge that will ultimately be used to guide decision-making.

The main difference between financial and managerial accounting is whether there is an
internal or external focus. Financial accounting focuses on creating and evaluating financial
statements that will be reported externally, like creditors and investors. In contrast,
managerial accounting analyses and results are kept in-house for business leaders to use to
drive decision-making and run the company more effectively. Managerial accountants
handle many facets of accounting. These include margins, constraints, capital budgeting,
trends and forecasting, valuation and product costing.

Management accounting definition (Cima saying)

Management accounting combines accounting, finance and management with the business
skills and techniques you’ll need to add real value to any organization. Management
accountants are qualified to work across the business, not just in finance, advising managers
on the financial implications of big decisions, formulating business strategy and monitoring
risk – much more than just crunching numbers. Management accountants use information of
all kinds, not just financial, to lead and inform business strategy and drive sustainable
success.

The seven roles and principles of management accounting are:

 Stewardship Accounting
 Long-term and Short-term Planning
 Developing Management Information System (MIS)
 Maintaining Optimum Capital Structure
 Participating in Management Process
 Control and
 Decision-making.

Stewardship Accounting:

Management accountant designs the frame-work of cost and financial accounts and
prepares reports for routine financial and operational decision-making.

Long-term and Short-Term Planning:

Management accountant plays an important role in forecasting future business and

economic events for making future plans i.e., long-term plans, strategic management
accounting, formulating corporate strategy, market study etc.
Developing Management Information System (MIS)

The routine reports as well as reports for long-term decision-making are forwarded to
managerial personnel at all levels to take corrective action at the right time. The
management accountant also uses these reports for taking important decisions.

Maintaining Optimum Capital Structure:

Management accountant has a major role to play in raising of funds and their application. He
has to decide about maintaining a proper mix between debt and equity. Raising of funds
through debt is cheaper because of tax benefits. However, it is risky as because interest on
debt has to be paid whether the firm earns adequate profits or not. Management accountant
has, therefore, to maintain an optimum capital structure and give due consideration to
various cost of capital theories, leverage and possibility of trading on equity

Participating in Management Process:

The management accountant occupies a pivotal position in the organisation. He performs a

staff function and also has line authority over the accountant and other employees in his
office. He educates executives on the need for control information and on the ways of using
it. He shifts relevant information from the irrelevant and reports the same in a clear form to
the management and sometime to interested external parties.

Control:

The management accountant analyses accounts and prepares reports e.g., standard costs,
budgets, variance analysis and interpretation, cash and fund flow analysis, management of
liquidity, performance evaluation and responsibility accounting etc. for control.

Decision-Making:

Management accountant provides necessary information to management in taking short-

term decision e.g., optimum product mix, make-or-buy, lease or buy, pricing of product,
discontinuing a product etc. and long-term decisions e.g., capital budgeting, investment
appraisal, project financing etc.

The basic function of management accounting

The basic function of management accounting is to assist the management in performing its
functions effectively. The functions of the management are planning, organizing, directing
and controlling.

Management accounting helps in the performance of each of these functions in the following
ways:

Provides data:

Management accounting serves as a vital source of data for management planning. The
accounts and documents are a repository of a vast quantity of data about the past progress
of the enterprise, which are a must for making forecasts for the future.
Modifies data:

The accounting data required for managerial decisions is properly compiled and classified.
For example, purchase figures for different months may be classified to know total
purchases made during each period product-wise, supplier-wise and territory-wise.

Analyses and interprets data:

The accounting data is analyzed meaningfully for effective planning and decision-making.
For this purpose the data is presented in a comparative form. Ratios are calculated and
likely trends are projected.

Serves as a means of communicating:

Management accounting provides a means of communicating management plans upward,

downward and outward through the organization. Initially, it means identifying the feasibility
and consistency of the various segments of 8 the plan. At later stages it keeps all parties
informed about the plans that have been agreed upon and their roles in these plans.

Facilitates control:

Management accounting helps in translating given objectives and strategy into specified
goals for attainment by a specified time and secures effective accomplishment of these
goals in an efficient manner. All this is made possible through budgetary control and
standard costing which is an integral part of management accounting.

Uses also qualitative information:

Management accounting does not restrict itself to financial data for helping the management
in decision making but also uses such information which may not be capable of being
measured in monetary terms. Such information may be collected form special surveys,
statistical compilations, engineering records, etc.

Management accounting system

Financial accounting focuses on preparing information for external parties, such as

stockholders, public regulators and lenders, in accordance with generally accepted
accounting principles. Managerial accounting, on the other hand, takes a company's
financial information and develops reports for internal and confidential use by managers for
decision-making and identifying ways to run the company more efficiently. These reports are
based on management's informational needs and include budgeting, breakeven charts,
product cost analysis, trend charts and forecasting.

Types of management accounting system

Cost accounting system

Cost accounting is the process of determining and accumulating the cost of product or
activity. It is a process of accounting for the incurrence and the control of cost. It also covers
classification, analysis, and interpretation of cost. In other words, it is a system of
accounting, which provides the information about the ascertainment, and control of costs of
products, or services. It measures the operating efficiency of the enterprise.
Objectives of cost accounting system

There is a relationship among information needs of management, cost accounting

objectives, and techniques and tools used for analysis in cost accounting. Cost accounting
has the following main objectives to serve

1. Determining selling price

2. Controlling cost
3. Providing information for decision-making
4. Ascertaining costing profit
5. Facilitating preparation of financial and other statements.

There are two types of traditional costing systems used by companies in determining product
costs. They are job order costing and process costing.

Job order costing is a method of assigning costs to a specific unit or product. An example
would be an auto mechanic repair shop rebuilding an engine. Each engine is an individual
item, and the car it came out of is individual. What's wrong with this engine? Probably not
the same thing that was wrong with the last engine. For this reason, the cost that the auto
repair shop charges is time plus material. It will be different for each engine it rebuilds.

Process costing is a method of assigning costs to mass quantities of a product or service.

Consider the same auto repair shop, but now let's look at the oil changes it offers. The cars
and customers may be different, but the oil change is the same every time. First the oil and
old filter come out, and then the new ones go in

Inventory management system

Inventory management is a complex process, particularly for larger organizations, but the
basics are essentially the same regardless of the organization's size or type. In inventory
management, goods are delivered into the receiving area of a warehouse in the form of raw
materials or components and are put into stock areas or shelves.

Compared to larger organizations with more physical space, in smaller companies, the
goods may go directly to the stock area instead of a receiving location, and if the business is
a wholesale distributor, the goods may be finished products rather than raw materials or
components. The goods are then pulled from the stock areas and moved to production
facilities where they are made into finished goods. The finished goods may be returned to
stock areas where they are held prior to shipment, or they may be shipped directly to
customers.

Inventory management uses a variety of data to keep track of the goods as they move
through the process, including lot numbers, serial numbers, cost of goods, quantity of goods
and the dates when they move through the process.

Job costing system

A job costing system involves the process of accumulating information about the costs
associated with a specific production or service job. This information may be required in
order to submit the cost information to a customer under a contract where costs are
reimbursed. The information is also useful for determining the accuracy of a company's
estimating system, which should be able to quote prices that allow for a reasonable profit.
The information can also be used to assign inventor able costs to manufactured goods

Price optimization system

Price optimization is the process of finding that pricing sweet spot, or maximizing price
against the customer’s willingness to pay. Companies up and down the supply chain, both
in B2B and B2C settings, rightly dedicate a massive amount of time towards price
optimization to ensure that their products will sell quickly at the right price while still making a
decent profit.

If an item is priced too high, it may not sell at all, while if the price is reduced too much, the
business will not make a profit. Businesses use a price optimization formula based on the
overall demand for their product, their level of competition, and (in the case of
manufacturers) the cost of manufacturing their goods. Finding the perfect balance between
profit and value is essentially what price optimization is all about, and because the relative
values of goods and services constantly change, this is a never-ending task for most
businesses.
The Distinction between management and financial accounting

Conclusion on Difference between Financial Accounting and Managerial Accounting

Financial accounting is concerned with the principles, practices and systems employed to
compile transactions of an entity and present financial information for use by an entity’s
internal and external stakeholders. Managerial accounting on the other hand is done to help
its managers make business decisions that affect the entity’s future profits and cash flows.
Understanding both financial accounting and managerial accounting is crucial to have a well
developed understanding of business for a management executive. The average business
school student will be exposed to both financial accounting and managerial accounting
concepts during their program, including those involving budgeting and long-term financial
planning. The average student majoring in Accounting will complete courses not only in
financial accounting and managerial accounting but also other topics such tax accounting (or
taxation), auditing, international taxation, MIS, etc.
P2 Explain different methods used for management accounting
reporting.
P3 Calculate costs using appropriate techniques of cost analysis to
prepare an income statement using marginal and absorption costs.

Cost
In business and accounting, cost is the monetary value that a company has spent in order to
produce something Cost denotes the amount of money that a company spends on the
creation or production of goods or services. It does not include the markup for profit. From a
seller’s point of view, cost is the amount of money that is spent to produce a good or
product. If a producer were to sell his products at the production price, his costs and income
would break even, meaning that he would not lose money on the sales. However, he would
not make a profit.

From a buyer’s point of view the cost of a product is also known as the price. This is the
amount that the seller charges for a product, and it includes both the production cost and the
mark-up, which is added by the seller in order to make a profit.

Different classification cost

 Fixed cost

A fixed cost is also associated with cost accounting. A fixed cost does not vary with the
number of goods or services a company produces. For example, suppose a company leases
a machine for production for two years. The company has to pay $2,000 per month to cover
the cost of the lease. The lease payment the company pays per month is considered a fixed
cost as it remains unchanged.

 Variable cost

A variable cost fluctuates as the level of production output changes. This type of cost varies
depending on the number of products a company produces. A variable cost increases as the
production volume increases, and it falls as the production volume decreases

 Direct cost

A direct cost is related to producing a good or service. A direct cost is the material, labor,
expense, or distribution cost associated with producing a product. It can be accurately and
easily traced to a product, department or project. For example, suppose a worker spends
eight hours building a car for a car manufacturing company. The direct costs associated with
the car are the wages paid to the worker and the parts used to build the car

 Indirect costs

Those that cannot be traced to a particular object of costing. They are also called common
costs or joint costs. Indirect costs include factory overhead and operating costs that benefit
more than one product, department, or branch.
  Material cost

Material cost is the cost of materials used to manufacture a product or provide a service.
Excluded from the material cost is all indirect materials, such as cleaning supplies used in
the production process. If the material cost has been established as a standard, then you
can subsequently calculate the material yield variance to see if actual materials usage was
as expected, or you can calculate the purchase price variance to see if the purchase price of
the material was as expected. These variances are useful for investigating problems in the
production and purchasing areas of a business.

 Labor cost

Labor cost plays a prominent role in small-business operations. Business owners often hire
employees to complete various business functions. Management accounting provides
business owners with a specific analysis of labor cost. Each type of business labor is broken
down into groups for cost-accounting purposes. Business owners use cost accounting to
allocate labor cost to the goods or services produced by the company

 Inventory cost

Costs associated with the maintenance of inventory. Inventory cost may include shrinkage,
insurance, storage fees, taxes, and depreciation, and is typically estimated as a percentage
of the total value of the inventory. A business must balance inventory cost against the risk of
not being able to fulfill customer requests in a timely manner.

 Operating cost

An operating cost is an expense associated with day-to-day business activities and may be
variable or fixed. An example of an operating cost is a company's inventory. Suppose a
company produces and sells microchips. The microchips must be stored and maintained,
which is an operational cost to the company. Operating costs can also be used to calculate a
company's operating expense ratio, which shows how efficient a company is in generating
sales

Different Costing System Such as

 Marginal Costing system

Marginal Costing, also known as Variable Costing, is a costing method whereby decisions
can be taken regarding the ascertainment of total cost or the determination of fixed and
variable cost to find out the best process and product for production, etc. It identifies the
Marginal Cost of production and shows its impact on profit for the change in the output units.
Marginal cost refers to the movement in the total cost, due to the production of an additional
unit of output.

 Absorption costing system

Absorption Costing is a method for inventory valuation whereby all the manufacturing
expenses are allocated to the cost centers to recognize the total cost of production. These
manufacturing expenses include all fixed as well as variable costs. It is the traditional
method for cost ascertainment, also known by the name Full Absorption Costing. In an
absorption costing system, both the fixed and variable costs are regarded as product related
cost. In this method, the objective of the assignment of the total cost to cost centre is to
recover it from the selling price of the product.

 Job costing system

Job order costing is a cost accounting system that accumulates manufacturing costs
separately for each job. It is appropriate for firms that are engaged in production of unique
products and special orders. For example, it is the costing accounting system most
appropriate for an event management company, a niche furniture producer, a producer of
very high cost air surveillance system, etc.

 Batch costing system

Batch costing is a form of specific order costing. Job costing refers to costing of jobs that are
executed against specific orders whereas in batch costing items are manufactured for stock.
A finished product may require different components for assembly and may be manufactured
in economical batch lots. When orders are received from different customers, there are
common products among orders; then production orders may be issued for batches,
consisting of a predetermined quantity of each type of product. Batch costing method is
adopted in such cases to calculate the cost of each such batch.

 Process costing system

Process costing is used when there is mass production of similar products, where the costs
associated with individual units of output cannot be differentiated from each other. In other
words, the cost of each product produced is assumed to be the same as the cost of every
other product. Under this concept, costs are accumulated over a fixed period of time,
summarized, and then allocated to all of the units produced during that period of time on a
consistent basis. When products are instead being manufactured on an individual basis, job
costing is used to accumulate costs and assign the costs to products. When a production
process contains some mass manufacturing and some customized elements, then a hybrid
costing system is used.

 Activity-based costing (ABC) system

Activity-based costing (ABC) is a methodology for more precisely allocating overhead to

those items that actually use it. The system can be used for the targeted reduction of
overhead costs. ABC works best in complex environments, where there are many machines
and products, and tangled processes that are not easy to sort out. Conversely, it is of less
use in a streamlined environment where production processes are abbreviated.
P4 Explain the advantages and disadvantages of different types of
planning tools used for budgetary control.

a. Definition budgeting & budgetary tool

Budgeting

Budgeting for a business is a process. It is the process of preparing a detailed statement of

financial results that are expected for a given time period in the future. There are two
keywords in that statement. The first keyword is "expected." Expected means something that
is likely to happen. The second keyword is "future" which is a period in the time to come. So,
budgeting is the process of preparing a detailed statement of financial results that are likely
to happen in a period in a time to come.

Budgetary Tool

Budgetary control is the process of determining various actual results with budgeted figures
for the enterprise for the future period and standards set then comparing the budgeted
figures with the actual performance for calculating variances, if any. First of all, budgets are
prepared and then actual results are recorded. The comparison of budgeted and actual
figures will enable the management to find out discrepancies and take remedial measures at
a proper time. The budgetary control is a continuous process which helps in planning and
co-ordination. It provides a method of control too. A budget is a means and budgetary
control is the end-result.

b. Different types of budgets

Capital Budgeting

Capital budgeting is budgeting for the large expenses in a business firm. Capital budgeting is
budgeting for the fixed assets that the firm needs to work such as plant and equipment. It is
the process of budgeting for, obtaining, expanding, and replacing fixed assets. Doing a good
job budgeting for fixed assets like buildings, equipment, tools, and other fixed assets that last
more than one year is important simply because they last a long time. If you make a mistake
in capital budgeting, it will haunt you for a long time.

Operating Budget

The operating budget is based primarily on the firm's sales forecast. It is a budget of sales
revenue minus expenses and essentially ends up with gross profit. In the operating budget,
you have to determine what you need in sales revenue to meet your expenses and achieve
your profit goal.

Cash Flow Budget

The cash flow budget is incredibly important for the business firm. It is a budget showing
expected cash inflows (receipts) and cash outflows (expenses). The cash flow budget shows
whether or not enough cash will be available to meet monthly expenses.
 c. Advantage and disadvantage of budgeting
Advantages

 The major strength of budgeting is that it coordinates activities across departments.

 Budgets translate strategic plans into action. They specify the resources, revenues,
and activities required to carry out the strategic plan for the coming year.
 Budgets provide an excellent record of organizational activities.
 Budgets improve communication with employees.
 Budgets improve resources allocation, because all requests are clarified and justified.
 Budgets provide a tool for corrective action through reallocation.

Disadvantages

 The major problem occurs when budgets are applied mechanically and rigidly.
 Budgets can demotivate employees because of lack of participation. If the budgets
are arbitrarily imposed top down, employees will not understand the reason for
budgeted expenditures, and will not be committed to them.
 Budgets can cause perceptions of unfairness.
 Budgets can create competition for resources and politics.
 A rigid budget structure reduces initiative and innovation at lower levels, making it
impossible to obtain money for new ideas

d. Alternative methods of budgeting

Zero based budgeting

Zero-based budgeting (ZBB) is a method of budgeting in which all expenses must be

justified for each new period. The process of zero-based budgeting starts from a "zero
base," and every function within an organization is analyzed for its needs and costs. Budgets
are then built around what is needed for the upcoming period, regardless of whether each
budget is higher or lower than the previous one.

Strategic budgeting

Strategic budgeting is the process of creating a long-range budget that spans a period of
more than one year. The intent behind this type of budgeting is to develop a plan that
supports a long-range vision for the future position of an entity. This may, for example,
involve the development of new geographic markets, the research and development needed
to introduce a new product line, converting to a new technology platform, and the
restructuring of the organization. In these examples, it is not possible to complete the
required activities within the period spanned by a single annual budget. Also, if only annual
budgets are used, it is possible that the funding needed for a multi-year initiative will not be
continued for the necessary full duration of the initiative, so that the project is never
completed. Thus, only by engaging in strategic budgeting can an organization hope to
achieve long-term improvements in its strategic position.
Rolling budgets

A rolling budget is continually updated to add a new budget period as the most recent
budget period is completed. Thus, the rolling budget involves the incremental extension of
the existing budget model. By doing so, a business always has a budget that extends one
year into the future. A rolling budget calls for considerably more management attention than
is the case when a company produces a one-year static budget, since some budgeting
activities must now be repeated every month. In addition, if a company uses participative
budgeting to create its budgets on a rolling basis, the total employee time used over the
course of a year is substantial. Consequently, it is best to adopt a leaner approach to a
rolling budget, with fewer people involved in the process.

Activity based budgeting

Activity-based budgeting is a planning system under which costs are associated with
activities, and budgeted expenditures are then compiled based on the expected activity
level. This approach is quite different from the more traditional budgeting system, where
existing cost levels are adjusted for inflation and major revenue changes in order to derive
the annual budget. An activity-based budgeting system allows for a high degree of
refinement in cost planning, and focuses attention on the volume and types of activities
occurring within a business. A likely outcome of using this system is management planning
to reduce the activity levels required to generate revenue, which in turn improves profits. It
also means that managers are forced to have a detailed knowledge of company processes if
they want to enhance the cost structure of a business.

e. Approaches of budget
Output/Input Approach

The output/input approach budgets physical inputs and costs as a function of planned unit-
level activities. This approach is often used for service, merchandising, manufacturing, and
distribution activities that have defined relationships between effort and accomplishment.

For example, if each unit produced requires 2 pounds of direct materials that cost $5 each,
and the planned production volume is 25 units, the budgeted inputs and costs for direct
materials are 50 pounds (25 units X 2 pounds per unit) and $250 (50 pounds X $5 per
pound). The budgeted inputs are a function of the planned outputs. The output/input
approach starts with the planned outputs and works backward to budget the inputs. The
downside of the output/input approach is, that it’s difficult to use this approach for costs that
do not respond to changes in unit-level cost drivers.

Activity-Based Approach

The activity-based approach is a type of output/input method, but it reduces the distortions in
the transformation through emphasis on the “expected cost” of the planned activities that will
be consumed for a process, department, service, product, or other budget objective.
Overhead costs are budgeted on the basis of the cost objective’s anticipated consumption of
activities, not based only on some broad-based cost driver such as direct labor hours or
machine hours.
The amount of each activity cost driver used by each budget objective (for example, product
or service) is determined and multiplied by the cost per unit of the activity cost driver. The
result is an estimate of the costs of each product or service based on cost drivers such as
assembly-line setup or inspections, as well as the traditional volume based drivers such as
direct labor hours or units of direct materials consumed. Activity-based budgeting predicts
costs of budget objectives by adding all costs of the activity cost drivers that each product or
service is budgeted to consume. In evaluating the proposed budget, management would
focus their attention on identifying the optimal set of activities rather than just the output/input
relationships.

Incremental Approach

The incremental approach budgets costs for a coming period as a dollar or percentage
change from the amount budgeted for (or spent during) some previous period. This
approach is often used when the relationships between inputs and outputs are weak or
nonexistent. The incremental approach is widely used in government and not-for-profit
organizations. In seeking a budget appropriation, a manager using the incremental approach
need only justify proposed expenditures in excess of the previous budget. The primary
advantage of the incremental approach is that it simplifies the budget process by considering
only the increments in the various budget items. A major disadvantage is that existing waste
and inefficiencies could escalate year after year.

Minimum Level Approach

As the portion of non-variable costs increased for most companies throughout the twentieth
century, an increasing portion of costs was budgeted using the less precise incremental
approach. This lack of good budgetary controlled to further increases in costs. Management
attempted to better control costs by employing a number of variations on the incremental
approach. The minimum level approach is representative of these attempts to control the
growth of costs not responding to unit-level drivers.

Using the minimum level approach, an organization establishes a base amount for budget
items and requires explanation or justification for any budgeted amount above the minimum
(base). This base is usually significantly less than the base used in the incremental
approach. It likely is the minimum amount necessary to keep a program or organizational
unit viable.

The minimum level approach improves on the incremental approach by questioning the
necessity for costs included in the base of the incremental approach, but it is very time
consuming. All three approaches are often used within the same organization. A
manufacturing company might use the output/input or the activity-based approach to budget
distribution expenditures, the incremental approach to budget administrative salaries, and
the minimum level approach to budget research and development.

f. Pricing
Pricing is the method of determining the value a producer will get in the exchange of goods
and services. Simply, pricing method is used to set the price of producer’s offerings relevant
to both the producer and the customer. Every business operates with the primary objective
of earning profits, and the same can be realized through the Pricing methods adopted by the
firms.

Pricing Objectives

Survival: The foremost Pricing Objective of any firm is to set the price that is optimum and
help the product or service to survive in the market. Each firm faces the danger of getting
ruled out from the market because of the intense competition, a mature market or change in
customer’s tastes and preferences, etc.Thus, a firm must set the price covering the fixed and
variable cost incurred without adding any profit margin to it. The survival should be the short
term objective once the firm gets a hold in the market it must strive for the additional
profits.The New Firms entering into the market adopts this type of pricing objective.

Maximizing the current profits: Many firms try to maximize their current profits by
estimating the Demand and Supply of goods and services in the market. Pricing is done in
line with the product’s demand in the customers and the substitutes available to fulfill that
demand. Higher the demand higher will be the price charged. Seasonal supply and demand
of goods and services are the best examples that can be quoted here.

Capturing huge market share: Many firms charge low prices for their offerings to capture
greater market share. The reason for keeping the price low is to have an increased sales
resulting from the Economies of Scale. Higher sales volume lead to lower production cost
and increased profits in the long run.This strategy of keeping the price low is also known as
Market Penetration Pricing. This pricing method is generally used when competition is
intense and customers are price sensitive. FMCG industry is the best example to
supplement this.

Market Skimming: Market skimming means charging a high price for the product and
services offered by the firms which are innovative, and uses modern technology. The prices
are comparatively kept high due to the high cost of production incurred because of modern
technology. Mobile phones, Electronic Gadgets are the best examples of skimming pricing
that are launched at a very high cost and gets cheaper with the span of time.

Product –Quality Leadership: Many firms keep the price of their goods and services in
accordance with the Quality Perceived by the customers. Generally, the luxury goods create
their high quality, taste, and status image in the minds of customers for which they are willing
to pay high prices. Luxury cars such as BMW, Mercedes, Jaguar, etc. create the high quality
with high-status image among the customers.

g. Pricing Strategies
Price is the value that is put to a product or service and is the result of a complex set of
calculations, research and understanding and risk taking ability. A pricing strategy takes into
account segments, ability to pay, market conditions, competitor actions, trade margins and
input costs, amongst others. It is targeted at the defined customers and against competitors.

Type of pricing strategies

Premium pricing

High price is used as a defining criterion. Such pricing strategies work in segments and
industries where a strong competitive advantage exists for the company. Example: Porche in
cars and Gillette in blades.

Penetration pricing

Price is set artificially low to gain market share quickly. This is done when a new product is
being launched. It is understood that prices will be raised once the promotion period is over
and market share objectives are achieved. Example: Mobile phone rates in India; housing
loans etc.

Economy pricing

No-frills price. Margins are wafer thin; overheads like marketing and advertising costs are
very low. Targets the mass market and high market share. Example: Friendly wash
detergents; Nirma; local tea producers.

Skimming strategy

High price is charged for a product till such time as competitors allow after which prices can
be dropped. The idea is to recover maximum money before the product or segment attracts
more competitors who will lower profits for all concerned. Example: the earliest prices for
mobile phones, VCRs and other electronic items where a few players ruled attracted lower
cost Asian players.

h. How do competitors determine their prices?

Pricing Strategy Options

Competitive pricing is one of four major pricing strategies. Other options include cost-plus
pricing, where a set profit margin is added to the total cost of a product -- including materials,
labor and overhead. Markup pricing is where a percentage is added to the wholesale cost of
a product. Demand pricing is determined by establishing the optimal relationship between
profit and volume; a smaller per-unit profit is acceptable if volume is increased significantly.
Competitive pricing is charging a price that is comparable to other vendors selling the same
item.

Factors to Consider
Product prices determine the revenue stream of a business. Prices must be sufficient to
cover the costs of product production, company overhead and profit. Before lowering prices
it's preferable to lower costs to maintain a stable profit margin and a stable cash flow into the
business. Any pricing strategy must be chosen to ensure a maximum of profit. Knowing your
market and customer base are key elements to choosing the right pricing strategy.

About Competitive Pricing

Vendors use a competitive pricing strategy when several other businesses sell the same
product and there is little to distinguish one vendor from another. A market leader will
generally set the price for the product and other vendors will usually have no option but to
follow suit in order to remain competitive. Vendors will either match the pricing of the market
leader or set prices within a comparable range.

Establishing Competitive Pricing

Vendors who are not market leaders can use the accepted price as a starting point. From
there they can opt to charge slightly more on the basis of factors such as superior customer
service or an extended warranty on a product. Retailers must be fully informed of the prices
their competitors charge and also know how discerning their customers are on price alone.
Once price is established, sales volume must be monitored to see if the strategy is working.

Risks of Competitive Pricing

For many small businesses in particular, competitive pricing results in a narrowing of profit
margins. This makes the business vulnerable to a sudden rise in costs. Therefore,
independent retailers competing with high-volume, big box stores may choose an alternative
pricing strategy that affords them a larger cushion on their profit margin and justify it on the
basis of their niche advantage -- for example, being local and customer-focused.

i. Supply and demand considerations.

Having a sophisticated understanding of the supply and demand of your goods and services
is a crucial element in running a successful business. Supply accounts for the quantity of
goods or services your business supplies. Demand accounts for the amount of goods or
services that will be purchased at a given price. Typically, if prices fall sharply, demand will
increase because more buyers will be willing or able to purchase the product. Similarly, if the
supply of a good or service is dwindling, the price rises; whereas if there is an excess of a
good or service, the price falls because there are plenty of suppliers to meet the demand.

Analyzing supply and demand will lead you to a better understanding of your market and the
needs of your customers, helping you find an equilibrium price for your product. Failure to
properly analyze supply and demand could leave you with a product surplus or shortage, or
it could cause you to price your product improperly.

Factors Influence Demand

When determining the demand for your product, you will want to take a number of elements
into consideration. Researching your market (its size and scope), analyzing the sales of your
competitors and determining how much your target audience spends on your product every
year will help you understand the overall demand for your good or service. You will also want
to research past fluctuations in demand and watch for trends that can help you gauge when
demand may rise or fall. If your business already has customer information, you have an
advantage, as you can use sales records and information about where they live to segment
your marketing and improve its effectiveness. You can also talk to your employees or look at
your website’s analytics (here are some helpful analytics tools) to determine which items or
services are frequently requested to gain a better understanding of your consumers.

Consider using surveys or interviews to gain more information about your customers’
experiences and desires. This will help ensure you are meeting your customers’ needs and
will give you immediate feedback regarding their levels of demand for your offerings. Mail,
email or telephone surveys can also be an effective way to gain information from customers
or from people in your target market. You can also use secondary sources from trade
associations, government agencies, public records, books or magazines to cross-reference
your own research. Ideally, you want to fulfill a demand that isn’t being fully met by the
market or that simply has a high-enough demand that your product can be a part of the
solution. Keep in mind, however, that a low demand does not necessarily signify an
oversaturated market. Sometimes, your target market will be small, but because of their
specific needs, they may be underserved by current competitors.

A large demand also does not mean a “sure thing” in terms of success; sometimes, a market
has a high demand but also has a very large supply to meet it, along with a slew of
experienced competitors focused on meeting this need

Factors Influence Supply

Factors that can influence the supply will depend on your specific good or service. For
example, the supply of agricultural products can be impacted by weather, insects and pests.

Other factors could include changes in the price of materials or a major change to the supply
chain, such as the delay of products due to a natural disaster, a drop in the availability of the
fundamental “building block” materials, or a change in the price of labor (for instance, due to
outsourcing). In the digital realm, for example, the supply of software engineers has boomed
with the advent of websites like oDesk, which increases the accessibility of outsourced and
international workers

Product

When a business has flexibility in the choice of materials to put into a product, it makes
sense to use items that are abundant rather than scarce. Having a steady supply of
necessary materials also makes ordering and inventory control simpler, allowing a business
to get what it needs when it needs it rather than juggling and keeping track of multiple
suppliers and investing unsustainable sums in inventory to avoid running out.
Price

Using readily available supplies ensures that a business will not pay too much for materials,
enabling it to either increase profits or keep prices low. Conversely, using scarce materials
that customers see as valuable by virtue of their scarcity allows a business to charge higher
prices. If a business manufactures a popular product and can't keep up with demand, this
supply shortfall could also justify raising prices to raise additional revenue and invest in
infrastructure that allows the business to increase production.

Consistency

Choosing to use materials that are abundant allows a business to provide customers with a
steady supply of inventory, offering them consistency and predictability. If a business
wholesales fresh mushroom pate using rare and expensive wild mushrooms, it can expect to
not always be able to provide customers with what they need, even though the business
created a demand for the exotic food. The decision to use a more readily available
mushroom allows customers to plan their menus around the business's offerings, in turn
providing consistency to their customers.

Marketing

A demand that exceeds available supply provides the basis for a compelling marketing
message, influencing decisions about advertising and outreach. Customers who truly want a
product but cannot know whether supplies will last can be motivated to take advantage of
short-term availabilities. A popular item that is not always available makes a great story, one
that may be picked up by the media, providing the basis for subsequent marketing
campaigns.