NCV 4 New Venture Creation Hands-On Support Slide Show - Module 5

Module 5: Apply the principles of costing and pricing to a business venture

Module 5: Apply the principles of costing and pricing to a business venture After completing this module, you will be able to: identify and apply the criteria of a price-setting policy for a new venture identify and analyse internal and external factors that impact upon pricing decisions demonstrate an understanding of the relationship between costs, revenue and profits

1. IDENTIFY AND APPLY THE CRITERIA OF A PRICE-SETTING POLICY FOR AN NEW VENTURE After completing this subject outcome, you will be able to: explain and illustrate the flow of the trading cycle for a new venture distinguish accurately between the concepts capital, costs, revenue, profits, costing, pricing and tendering demonstrate and explain the difference between fixed costs, variable costs and total costs in context of a new venture

Financial vs cost accounting Finance accounting The object of financial accounting is to ascertain the result (profit or loss) of business operations during the particular period and to state the financial position (Balance Sheet) as on a date at the end of the period. Cost accounting The object of cost accounting is to find out the cost of goods produced or services rendered by a business. It also helps the business in controlling the costs by indicating avoidable losses and wastes. Management accounting The object of management accounting is to supply relevant information at appropriate time to the management to enable it to take decision and effect control.

1.1 Explain and illustrate the flow of the trading cycle for a new venture

Activity 1 How much do you think Hector and Mavis could shorten the operating cycle in the example above? Are there things they can do something about and are there others that they have no control over?

Value of inventory Month beginning Purchases Used Month end Average Credit sales Accounts Receivable Jan R 5 000 R 37 600 R 36 050 R 6 550 R 5 775 R 126 200 R 20 400 Feb R 6 550 R 34 500 R 32 950 R 8 100 R 7 325 R 115 300 R 23 600 Mar R 8 100 R 31 400 R 31 400 R 8 100 R 8 100 R 109 900 R 27 400 Apr R 8 100 R 31 400 R 34 500 R 5 000 R 6 550 R 120 800 R 35 500 May R 5 000 R 37 600 R 41 200 R 1 400 R 3 200 R 144 200 R 21 100 Jun R 1 400 R 50 200 R 42 350 R 9 250 R 5 325 R 148 200 R 36 400 Jul R 9 250 R 34 500 R 36 050 R 7 700 R 8 475 R 126 200 R 21 500 Aug R 7 700 R 37 600 R 37 600 R 7 700 R 7 700 R 131 600 R 30 200 Sep R 7 700 R 37 600 R 44 300 R 1 000 R 4 350 R 155 100 R 32 500 Oct R 1 000 R 51 000 R 51 000 R 1 000 R 1 000 R 178 500 R 39 400 Nov R 1 000 R 62 700 R 54 850 R 8 850 R 4 925 R 192 000 R 33 700 Dec R 8 850 R 47 000 R 47 850 R 8 000 R 8 425 R 167 500 R 30 800 Cost of goods sold = R 490 100 Average inventory R 5 929 R 1 715 500 R 352 500

Activity 2 Making use of the formulae above plus the information contained in the table calculate the average Operating Cycle for the year for the business concerned. (The answer is given below to allow you to check if you have worked it out correctly). Your challenge is to see if you can get to the right final answer. Tip : Remember you are working this out for the YEAR in question (i.e. use Totals) Inventory Turnover Ratio = 83 times Collection Period = 75 days Age of Inventory = 4 days Operating cycle = 79 days

1.2 Distinguish accurately between financial concepts: capital, costs, revenue, profits, costing, pricing and tendering Capital Revenue Costs Profits Costing Pricing Tendering

1.2.1 Capital Cash or goods used to generate income by investing in a business The net worth of a business, that is, the amount by which its assets exceed its liabilities The money, property, and other valuables which collectively represent the wealth of an individual or business

1.2.2 Revenue For a business, revenue is the total amount of money received for goods sold or services provided during a certain financial period. Revenue is not profit. It is simply how much money you receive for selling of goods or services. You should recognise this by now as a Cost Accounting definition! For Financial Accounting and tax paying purposes, revenue also includes all net sales, exchange of assets, interest earned and any number of other things. For example, if you put your spare cash in a savings account and it earns interest, then that interest is considered “revenue” by the South African Revenue Services (SARS) and you will pay tax on it.

1.2.3 Costs The total money, time and resources associated a purchase or activity

1.2.4 Profits Profit = Total revenue – Total costs

1.2.5 Costing Any business will need an accounting system which – amongst other things – will be used to keep track of the company's costs and provide management with information on operations and performance. So “costing” can cover a number of different aspects all of the same thing. “Costing” can mean: to assign a price to something the process of identifying the costs of the business and of breaking them down and relating them to the various activities of the organisation the process of assessing the costs and benefits of a particular action - not only in monetary terms, but in terms of time, resources looking at and defining the costs involved in producing a product or service

1.2.6 Pricing Pricing involves creating a policy for setting agreed rates to charge customers This policy can depend on factors such as: buying a fixed amount breaking up quantities promotion or sales campaigns different prices for multiple orders better prices for favoured customers

1.2.7 Tendering Tendering is when big firms or government will invite businesses to make offers to do business The reasons for this are: They do not have the time to “shop around” They want to test the market They are looking for innovative ideas They want to be sure they are getting a competitive price To reduce corruption

1.3 The difference between fixed costs, variable costs and total costs

Costs Variable costs Costs which change directly in proportion to the number of products you produce Fixed costs Are going to remain significantly unchanged irrespective of how many articles you produce Direct fixed costs Indirect fixed cost

Total costs Fixed Costs Variable Costs Total Costs Quantity produced Quantity produced Quantity produced

Example Imagine you are running a car wash and provide two services. One (washing) uses a lot of water (400 litres per wash) while the other (vacuuming) uses none at all. You only get one water bill (R2 150,00) from the municipality which charges R 5,00 per kilolitre (1 kl = 1000 litres) You wash 1000 cars per month @ R 12 per wash and vacuum only 500 @ R6 per car. How much of the water bill goes directly to washing cars? How much goes to be used for other things (toilets, hosing down the forecourt etc)? Will you regard the cost of water as a fixed or variable cost as regards car washing? How will you recover the remaining R 150 of the bill? Remember, you have two sources of revenue – washing and vacuuming

Example The total cost of water used for washing is R2 000 (400l/wash x 1000 washes ÷ 1000l/kl x R 5,00 per kilolitre) The remaining R150 needs to be covered somehow between the two products you sell The water you use per car costs R2.00. This is a significant part of the R12 you charge per wash so you would be right to consider it a variable cost This is where your costing policy kicks in (Remember Learning Point 1.2.5 above?). There are many ways of doing this and it is up to you to decide. Two possibilities are shown below: The total revenue from washing is R 12 000 and the total from vacuuming is R 3 000 i.e. 4/5 and 1/5 respectively. You could allocate the R 150 in the same proportion i.e. R 120 and R 30 respectively You could say you spend as much time on washing as on vacuuming so split the remainder 50/50 i.e. R 75 each

Activity 3 What will the total cost of water be per wash for each of the two ways of allocating the remainder of the water bill? (R2,30 & R 2,19) What will the total cost of water be per vacuuming for each of the two ways of allocating the remainder of the water bill? (R 0,06 & R 0,15) If you were in charge of the washing action and got a bonus depending on the nett profit you made, which of the two costing methods would you prefer ? (Tip : Remember, Nett profit = Revenue – All costs) If the shoe was on the other foot and you were in charge of the vacuuming, which would you prefer? Would the way in which you split the remaining R 150 alter the overall profitability of your business? Discuss and explain your conclusion to the rest of the class What type of cost is the remaining R150? (refer to the last paragraph of Learning Outcome 1.3.2)

2. Pricing decisions After completing this subject outcome, you will be able to: identify and discuss the internal and external factors impacting upon pricing decisions in relation to the profitability of own venture identify business activity levels and specify limitations calculate variations in pricing decisions in terms of the impact on the break-even point

2.1 Internal and external factors impacting upon pricing decisions

2.1.1 How internal factors impact upon pricing decisions Company objectives Return on investment Cash flow Market share Maximising profits Marketing strategy Costs

2.1.2 How external factors impact upon pricing decisions Elasticity of demand The higher the prices of a good the less likely people are going to buy it (under normal circumstances) The price elasticity of demand tells us how much the quantity demanded changes with price

Elasticity of demand Demand Demand Q 1 Q 2 Q 1 Q 2 P 1 P 1 Elastic Demand Inelastic Demand

2.1.2 How external factors impact upon pricing decisions Customer expectations Competition Same products Related products Completely different products Government regulation

2.1.3 The relation of internal and external factors to the profitability of the business venture Profit = Total revenue – Total costs Revenue = Price x Quantity sold

High demand elasticity Demand Q 1 Q 2 P 1 P 1 Elastic Demand Demand Q 1 Q 2 P 1 P 1 Elastic Demand R 1 R 1

High demand elasticity Demand Q 1 Q 2 P 1 P 1 Revenue lost Revenue gained

Elasticity of demand Demand Demand R 1 R 2

Elasticity of demand Demand Revenue lost Revenue gained

Activity 4 In Appendix 5.1 you will find a bigger copy of the graph shown here, which is the Price / Demand line for a certain product For each of points A, B & C calculate the revenue that would be earned if you were selling the product at those prices Calculate the change in revenue for each point if the prices were to increase by R5 Calculate the change in revenue for each point if the prices were to decrease by R5 Do you think there would actually be a type of product that would have such a price / demand relationship?

Before After Price Demand Revenue Price Demand Revenue Nett A R 60 34 A+5 R 65 32 A R 60 34 A-5 R 55 36 Price Demand Revenue Price Demand Revenue Nett B R 25 108 B+5 R 30 85 B R 25 108 B-5 R 20 143 Price Demand Revenue Price Demand Revenue Nett C R 40 60 C+5 R 45 51 C R 40 60 C-5 R 35 71

Activity 5 In which of the three broad areas of business activity does? SASOL operate? The Bee-Bop Milk Bar & Ice cream Palace Operate

Activity 6 How many other resources can you think Hector is making use of in producing the milk shake?

2.2 Identify business activity levels and specify limitations What is a business activity? Primary activities Secondary activities Tertiary activities A business activity is a group of actions, operations, procedures, techniques, functions, steps, tasks and processes

2.2 Identify business activity levels and specify limitations What is a business activity level? A level of activity is how often you do something Why should a business specify limitations to any of its activities? Limitations are standards and are useful because if the business sets standards and records are kept on a continuous basis then at any time the owners can compare the records against the standards and take action if they are not being met.

2.2 Identify business activity levels and specify limitations How should a business specify limitations to its business activities on a broad economic view? Identify other business with similar activities Find out about sector as a whole Find out if this business is the same as others in the sector – or different in some way. If so, why? Compare their activities and other trends with yours and make conclusions

2.2 Identify business activity levels and specify limitations How should a business specify limitations to its business activities on a microeconomic view? Identify core business activities Ask is doing this is going to significantly help you to manage your business better Give each group a name Define how you will describe and measure the activity Exam how each group affects various aspects of you business Identify trends which can affect the business Continually measure performance against the standard and take corrective action if necessary

Activity 7 Aunty Bee has worked out that the overheads on the catering side of the Bee-Bop Milk Bar & Ice Cream Palace are ±R 4 000 per month. The ingredients for each platter costs R 45 to make and they charge R 125 per platter. They set a standard that at least 80% of the overheads must be covered per month. How many platters must they sell in order to meet this limit? (Answer = 40) How much must the selling price be if they set their limit at covering 120% of overheads (Answer = R 165)

2.3 Calculate variations in pricing decisions in terms of the impact on the break-even point Fixed Costs Variable Costs Total Costs Quantity produced Quantity produced Quantity produced

Activity 8 The school holidays are over. In early April, Mavis goes to visit a friend in Amanzimtoti, leaving Hector to run the shop with the three waitresses. At the Beach Café in ‘Toti she has a milkshake for which she pays R 11,50. At the Bee-Bop Milk Bar & Ice Cream Palace they also charge R 11,50. She gets talking to the owner who tells her that his break even point for milkshakes is 125 per day. She also finds out that: They both use exactly the same ingredients for which they both pay R 4,50 per milkshake. Both business sell about 200 ‘shakes per day at this time of year; Rent and other expenses amount to R 665 in both businesses The Beach Café only keeps two waitresses on during the off season and pays them the same R 105 per day that Bee-Bop does. She goes home and she and Hector calculate their breakeven point to be 140 per day. Calculate the profit each of the businesses would make if selling 200 milkshakes per day? What could be making the difference? What could they do?

3. DEMONSTRATE AN UNDERSTANDING OF THE RELATIONSHIP BETWEEN COSTS, REVENUE AND PROFITS After completing this subject outcome, you will be able to: review available costing methods in relation to own business calculate product/service costs and prices accurately determine break-even point for business venture calculate and analyse profit mark-up for own business distinguish between types of profit in relation to own business venture review costing and pricing methods to ensure correct application classify and categorise revenues and expenses for the new venture investigate and compare competitive markets to inform effective costing and forecasting of operating expenses assess suppliers and new products in terms of potential contribution to profit and market share investigate competing products/services to identify opportunities for development/improvement

Case study You have bought a business in which you make concrete products which you sell to other businesses as well as directly to the public. You paid the previous owner R 250 000 for everything which you financed from (a) your Lotto winnings (R 50 000) and a loan (R 200 000) from your bank. The business has a good reputation with a number of regular customers and has been trading as set out further on. The products you make are concrete paving blocks, building blocks, garden tables as well as ornamental features like statues and fountains. To keep your business simple you decide to make only one type of each product. You run your business from a small industrial property in your town that you rent from a property developer. He pays all the municipal rates but you are responsible for paying the water and electricity bill. You of course pay for all the normal running expenses like telephone, salaries, stationery, refreshments, cleaning materials and so forth. You have had to buy a 3 ton lorry for collecting some materials and making deliveries. Most of your bulk supplies (Cement, Sand, Stone) are delivered to your factory by your suppliers and the delivery costs are included in their prices. You buy all your main supplies on credit with terms of payment “nett 30,2” (which means you must pay within one month or pay 2% interest compounded per month after that for late payment).You also sell on credit to other businesses at the same terms but direct sales are “cash only”.

3.1 Review available costing methods in relation to own business

Activity 9 Study the various tables compiled by the owner and answer the following questions by simply reading the answers of the tables or by doing simple calculations” How many garden tables were sold during the year? How many paving blocks were sold during the same period? What is the direct material and labour cost for each paving block What is the price of each paving block Calculate the gross profit for each paving block

Table 3 Item Revenue Direct costs Gross profit Total cost Contri-bution to net profit Net profit margin Paving blocks R718 750 R326 600 R392 150 R552 426 R166 324 23.1% Building blocks R533 750 R245 830 R287 920 R413 530 R120 220 22.5% Garden tables R14 256 R9 168 R5 088 R13 647 R609 4.3% Statues R6 624 R 3 360 R3 264 R5 441 R1 183 17.9% Fountains R17 550 R9 801 R7 749 R15 315 R2 235 12,7% R1290930 R1000359 R290 571

Activity 10 Calculate the breakeven point in both Rands and in units for building blocks with overheads spread as in table 4 If, in tables 2, 3 and 4, the revenue brought by building blocks dropped to R455 000, what percentage would building blocks and garden tables then contribute to total revenue? Why do you think that labour and materials don’t change with the change in revenue? What would fountains then contribute to total overheads?

Revenue Direct labour costs Direct material costs Item Unit Units sold Price Amt Cost / unit Amt Cost / unit Amt Paving blocks 1000 575 R1250 R718 750 R341 R196 075 R227 R130 525 Building blocks 1000 R1750 R455 000 R488 R318 R96 990 Garden tables Each 48 R297 R14 256 R115 R5 520 R76 R3 648 Statues Each 24 R276 R6 624 R95 R2 280 R45 R1 080 Fountains Each 27 R650 R17 550 R218 R5 886 R145 R3 915 R1 212 180 R358 601

Item Revenue Contri-bution to revenue Contri-bution to overheads Direct labour Direct materials Total cost Paving blocks R718 750 R240 496 R196 075 R567 096 Building blocks R455 000 R152 245 R148 840 R96 990 R398 075 Garden tables R14 256 R4 770 R3 648 R13 938 Statues R6 624 R 2216 R 2 280 R1 080 R5 576 Fountains R17 550 R 5 886 R3 915 R1 290 930 R405 600 R358 601 R236 158 R1 000 359

Activity 11 If you increase the number of paving blocks sold to 900 units, what would the revenue be for paving blocks You have now made all these products. How many statues do you need to sell just to cover the direct material costs for statues from the sales made of statues alone? How many more statues do you then need to sell just to cover the direct labour costs for statues? How many more statues do you then need to sell just to cover the overheads you have now allocated to statues? Everything has now changed and you first need to recalculate how much statues will now contribute to overheads if you sell all 24 – complete the tables to find how much this is If for some reason you were not able to sell any tables and everything else except building blocks stayed the same how many extra building blocks would you need to sell to make up the loss in revenue? Pretend the labour was just casuals that you could let go but that you had already bought the material, how many extra building blocks would you then need to sell to make the same gross profit for the business?

Revenue Direct labour costs Direct material costs Item Unit Units sold Price Amt Cost / unit Amt Cost / unit Amt Paving blocks 1000 900 R1250 R341 R306 900 R227 R204 300 Building blocks 1000 260 R1750 R455 000 R488 148 840 R318 R96 990 Garden tables Each 48 R297 R14 256 R115 R5 520 R76 R3 648 Statues Each 24 R276 R6 624 R95 R2 280 R45 R1 080 Fountains Each 27 R650 R17 550 R218 R5 886 R145 R3 915 R1 618 430 R469 426 R309 933

Item Revenue Contri-bution to revenue Contri-bution to overheads Direct labour Direct materials Total cost Paving blocks R1 125 000 R281 940 R306 900 R204 300 R739 140 Building blocks R455 000 28.1% R114 029 R359 859 Garden tables R14 256 R3 573 R5 520 R3 648 R12 741 Statues R6 624 0.4% R 2 280 R1 080 R5 020 Fountains R17 550 1.1% R4 398 R 5 886 R3 915 R14 199 R1 618 430 R405 600 R469 426 R309 933 R1 184 959

Statues only Materials Labour Overheads R1 080,00 R2 280,00 R1 660,06 Revenue per statue R276,00 R276,00 No to sell to cover cost 3,913 6,0147

Revenue Direct labour costs Direct material costs Item Unit Units sold Price Amt Cost / unit Amt Cost / unit Amt Paving blocks 1000 900 R1250 R1 125 000 R341 R306 900 R227 R204 300 Building blocks 1000 R1750 R R488 R130 855 R318 R85 271 Garden tables Each 0 R297 R115 R5 520 R76 R3 648 Statues Each 24 R276 R6 624 R95 R2 280 R45 R1 080 Fountains Each 27 R650 R17 550 R218 R5 886 R145 R3 915 Gross profit = Revenue – Direct costs = R875 341 R1 620 369 - R446 462 - 298 566

Revenue Direct labour costs Direct material costs Item Unit Units sold Price Amt Cost / unit Amt Cost / unit Amt Paving blocks 1000 900 R1250 R1 125 000 R341 R306 900 R227 R204 300 Building blocks 1000 R1750 R488 R130 855 R318 R85 271 Garden tables Each 0 R297 R R R R76 R3 648 Statues Each 24 R276 R6 624 R95 R2 280 R45 R1 080 Fountains Each 27 R650 R17 550 R218 R5 886 R145 R3 915 Gross profit = Revenue – Direct costs =R875 341 R1 620 369 R446 462 298 566

Revenue Direct labour costs Direct material costs Item Unit Units sold Price Amt Cost / unit Amt Cost / unit Amt Paving blocks 1000 575 R1250 R718 750 R341 R196 075 R227 R130 525 Building blocks 1000 R1750 R455 000 R488 R318 R96 990 Garden tables Each 48 R297 R14 256 R115 R5 520 R76 R3 648 Statues Each 24 R276 R6 624 R95 R2 280 R45 R1 080 Fountains Each 27 R650 R17 550 R218 R5 886 R145 R3 915 R1 212 180 R358 601 R236 158

Revenue Direct labour costs Direct material costs Item Unit Units sold Price Amt Cost / unit Amt Cost / unit Amt Paving blocks 1000 575 R1250 R718 750 R341 R196 075 R227 R130 525 Building blocks 1000 305 R1750 R533 750 R488 R148 840 R318 R96 990 Garden tables Each 48 R600 R28 800 R115 R5 520 R76 R3 648 Statues Each 24 R276 R6 624 R95 R2 280 R45 R1 080 Fountains Each 27 R650 R17 550 R218 R5 886 R145 R3 915 R1 305 474 R358 601 R236 158

Activity 12 Go back to Table II and calculate the effect on Surplus / Deficit of dropping the price of Building Blocks to R 1300 per unit of 1000 blocks. The answer is given in Appendix 5.3 Be warned, this is very complicated and you need to go back to the Learning Outcome where you learned about VAT to be able to come to the right answer. [You can ignore the effect of labour sitting around for the purposes of this activity] What other ways can you think of distributing the overheads. Appendix 5.4 shows two different ways. Look at the effect this has on final surplus after tax. What does this tell you about dealing with fixed costs in a business that makes a number of products

3.5 Distinguish between types of profit in relation to own business venture

3.5 Distinguish between types of profit in relation to own business venture Gross profit Profit before selling, general and administrative costs like depreciation and interest Operating profit Gross Profit les costs such as wages, rent, fuel, raw materials but before the deduction of interest payments and tax Net profit before tax Operating profit less interest and depreciation Net profit after tax Net profit before tax less tax

3.5 Distinguish between types of profit in relation to own business venture Economic profit Net profit after tax minus the equity charge Amortisation The amount your pay off on loans Equity charge added back The “virtual” amount that you calculated to see if you are really doing as well as you should Depreciation added back Depreciation is the value lost from fixed assets. It is added back to work out your cash situation Cash available from the year’s trading The amount that is left at the end

3.7 Classify and categorise revenues and expenses for the new venture Revenues Operating revenues Other revenues Non-operating revenues Expenses Operating expenses Capital expenditure Financing expense

3.9 Assess suppliers and new products in terms of potential contribution to profit and market share

NCV 4 New Venture Creation Hands-On Support Slide Show - Module 5

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NCV 4 New Venture Creation Hands-On Support Slide Show - Module 5