UK interest rate dilemma

The ongoing debate on the base rate by the BoE has gained much interest, and has moved the markets in both positive and negative directions.

BoE’s governor Mark Carney has decided to keep the interest rates at all-time low, at least for a three year period, until the unemployment level falls to 7% or low, which currently stands at 7.7%. But there are chances of the BoE using interest rates as a monetary tool if due to over spending (which they believe low interest rates would result in) the inflation rate got out of hand. The markets on the other hand, have reacted in a different manner and have anticipated a rise in the interest rates soon.

Adding to it, Carney and BoE’s policy makers have voted against adding to the £375 million as they say that the economic recovery is on track and the growth in US and Europe has boosted the growth efforts (the previous UK retail sales numbers saw 0.9% fall).  Whether or not, keeping the interest rates low will result in increased spending will be determined in the near future. The point to note here is that, people’s incomes are not rising in the manner to increase spending.

Moreover, low interest rates are favourable for the government as in helps in servicing its debts. The reason being, that the current UK national debt has risen to an alarming rate of £1.387 trillion (up by 7% compared to last year) and is equal to 90% of the entire economy. There is no possibility of seeing a fall in the level of debt in the near future, but there is a possibility of seeing the government repaying their debts after a couple of years, mainly due to the difference between the level of government spending and government borrowing narrowing down. The gap between the borrowing and spending peaked at £161 billion in 2009, whereas in 2012 the difference fell to £98 billion, an 18% fall on average each year. 

Balanced Score Card

There are several ways to measure the performance of a business, both financially as well as non-financially. This article is based on a form of measure, the “BALANCED SCORE CARD”.

The Balanced score card concept was developed by, Dr Robert Kaplan and Norton. Balanced cord categorizes the performance of a business into four parts:

1.       Financial Perspective

2.       Customer Perspective

3.       Internal business

4.       Innovation and learning

Financial Perspective:

          Financial perspective as the name suggests, looks at how the business has done financially in a certain time period. Financial performance can be measured with the help of different, profitability, liquidity and other relevant ratios, like:

1.       ROCE

2.       ROI

3.       Net profit margin

4.       Gross profit margin

5.       Quick ratio

Customer Perspective:

        The customer perspective can be split into many different parts, like customer satisfaction, customer loyalty, customer complaints etc. Basically the customer perspective overall measures, how the customers views the business and how can the business retain them.

Internal Business:

       Internal business measures the internal efficiency of the business. How the business is carrying out its main objectives, for which the business was made in the first place.

Innovation and learning:

1.       How many Products has the company launched in a certain time period?

2.       Has the launch of the new product increased the sales?

3.       When did the recent training take place?

4.       How efficient are the employees?

These are some few examples of innovation and learning, which are focused upon.

Make Or Buy Decision

 
Lets suppose you are a car manufacturer, and you all have the components needed to make a car except one. Now you have two options to consider:

• Either to make the component internally
• Or buy it from an outside supplier

 Making the product internally would give the management more control over the production, they can continually inspect the product for its quality. On the other hand, contracting the work to an external suppliers may mean better and efficient product, as the external supplier may possess specialist skills and the expertise in the area. 


As stated in my 'Shutdown Decision' article, that when making a decision, financial as well as non-financial aspects should be taken into consideration. The same concept applies here, when considering make or buy, don't just consider the cost savings.


What Financial aspects should consider?

From a financial perspective, first you should look at the variable saving cost per unit.e.g. the total variable cost of making product A is $17 and an external supplier has quoted a price of $15 per unit. Buying would result in a $2 cost saving per product, but if instead of $15 he quoted a price of $20, than it would increase the cost by $3. 

Moving on after variable cost, you consideration should move onto the directly attributable fixed cost, because closure of producing the component internally could result in saving the directly attributable cost (only directly attributable fixed cost can be saved not the general fixed cost).


.e.g 
        the unit variable cost of making component A is     $12
        And the variable cost of buying the product is         $14
        The directly attributable fixed cost is:                 $8,000
        Annual demand is:                                                 3,000 units
       
Although buying the component externally would increase the total variable cost by ((14-12) x 3000) $6,000. But as sub contracting the work externally would result in a $8,000 cost savings (directly attributable fixed cost) the net saving would be (8000 - 6000) $2,000.


What Non-Financial aspect should you consider?


Non-Financial decision that should be taken into consideration are:

1. Will the external supplier be reliable, in terms of quality and delivery on time?
2. Will the company lose its control over the production process, by sub contracting the work?
3. Sub contracting the work to external suppliers will result in spare capacity, how should this spare capacity be used to maximize the profits?
4. Are the cost estimates accurate, on which the decisions are based?

These are just a few points to consider, a management of a company should closely look at the financial and non-financial matters regarding the make or buy decision. 


A detailed analysis should be carried out considering all the aspects before making a sound decision.


Please leave a comment below, if you have any queries or suggestions.
Thank You

ShutDown Decision (Short term Decision)

What Things To Consider Before Shutting Down?

What things would you take into consideration before shutting down a department, product etc. Will the decision be permanent closure or just a temporary closure?.

In practice shutdown decisions may involve taking capital expenditures and revenues into consideration. Like maybe shutting down a department could resulting in saving its annual operating costs, or you could use the fixed assets which are idle due to the closure, in other projects which are more beneficial or could also sell them off. Also closure of department means making the employees redundant which results in redundancy payments.

You need to analyze the financial aspect of the closure properly before making a decision, .e.g closing a department would result in $50,000 saving but redundancy payments add up to $70,000 resulting in a net loss.

Remember, while making business decisions considering financial aspects is not enough, non-financial aspects should be given equal importance. In modern time, business focus more on non-financial side than on financial side, .e.g better customer support, better quality goods, environmental friendly goods. In recent times non-financial side of the business has gained immense importance.

What Else Should I consider before making a shutting down decision?

• Timing
• Qualitative Factors
• Judging Relative Profitability

Timing:
An Organization should consider the most appropriate time for its shutting down. Appropriate means, the time when closure would result in low closure cost. Some of these costs can be avoided while others cannot. The management should consider both the avoidable and unavoidable costs, and make a sound decision.

Qualitative Factors:
As stated above, that when making a decision not only financial but non-financial aspects must also be considered. Before closing down a business should consider a few points such as:

• How will employess react to the closure?
• How will this affect the image of the company?
• Will customers lose their confidence?

This is not an exhaustive list, there are many other factors to consider.

If you have any queries or suggestions please leave a comment below.
Thank You

Calculating the Profit Maximising Price

 If you would have studies economics, you would be familiar about the concept of marginal cost (MC) and marginal revenue (MR). Profit is maximized when MR = MC.


There are two equations which would be used to determine the profit maximising price:


Equation 1:
     P = a - b x q ,
           where P = Price
                     Q=Quantity Demanded
                     A=The price at which demand would be Nil
                     B= change in price / change in quantity


Calculation of A:
        current price + ( current quantity at current price / change in quantity when price is changed by $b  x $b)


Equation 2:
      MR = a - 2b x q
                 all the variables are the same.




Lets calculate a profit maximizing price by using this methods,


Current Price charged by the company: $20
Current demand at current price: 1000 units
Change brought about in price by: $3
Change in quantity demanded due to change in price: 250 units
Variable cost per unit (marginal cost) $8


Required:
Calculate the profit maximizing price.


First lets calculate a, 20 + (1000/250 x 3)   =   $32
calculate b = 3/250 =  0.012


Substituting the values in the Marginal Revenue equation:


As profit is maximized when MR=MC, therefore as MC = $8 therefore MR is also $8.


      MR=a - 2b x q
      $8 = $32 - 2(0.012)q
        q = 1000, this is the quantity that should be demanded for profit maximizing price.


Substituting 'q' in price equation:
       
       P=a - b x q
       P = $32 - 0.012(1000)
       P = $20


To sum it up, if a price of $20 is charged at a demand of 1000 units than the company will maximize it profit to the maximum. $20 is the profit maximizing price and 1000 units are the profit maximizing demand.

Pricing (Part 3)

Complementary Pricing:

              Complementary goods are one which is jointly demanded .e.g. Petrol and Car, therefore a complementary price set can affect both the goods jointly demanded, .e.g. if the price of car rises people might stop buying car, resulting in a fall in the demand of cars plus few cars means few people consuming petrol, which in turn also reduces the demand for petrol.   

How do businesses use complementary pricing to make a profit? Let’s take a look at an example, let’s say Gillette sells a razor at price which is just a bit above its cost line, but the blades which are jointly demanded are sold a high profit margin, therefore although they do not make a good profit by selling razors but they do earn a good profit by selling the blades.

Volume Discounting:

             Volume discounting is when you charge lower prices on bulk purchasing.

Price Discrimination:

              The use of price discrimination means that the same product can be sold at different prices to different markets, but it largely depends on market conditions. Market can be segmented in 4 ways:

1.       By Country Markets

2.       By Product Version

3.       By Place

4.       By Time .e.g. off peak call charges

Minimum Pricing:

               Under this method, the firm charges the minimum price which covers its costs. The costs includes: The incremental costs and the opportunity costs. This method would only be used by firms when entering into a market, as this methods results in no profit being made, which is against the basic aim of businesses ‘PROFIT MAXIMISING’.

Pricing (Part 2)

What Pricing Strategies do I have?

1.       Full Cost Plus Pricing

2.       Marginal Cost Plus Pricing

3.       Market Skimming Pricing

4.       Market Penetration Pricing

5.       Complementary Product Pricing

6.       Product Line Pricing

7.       Volume Discounting

8.       Price Discrimination

9.       Relevant cost Pricing

10.   Minimum Pricing

Full Cost Plus Pricing:

              Full cost plus pricing is a method where by a certain percentage of profit mark up is added to the total cost, remember total cost includes all variable costs plus the FIXED COSTS as well. This method is a popular method used because of its easiness. But there are some disadvantages of using this method.

 If you would have read the pricing part 1 article than you would have come across many factors influencing the price, sadly this method does not take into account most of those factors and therefore this type of pricing method is mostly suitable for contract works or jobbing works.

Nevertheless this method is a quick and simple method to use.

Marginal Cost plus Pricing:

              Marginal cost plus pricing is the same as the full cost plus pricing method, the only difference is regarding the fixed cost. As the name suggests ‘MARGINAL’, which only includes variable costs therefore fixed cost is not taken into consideration when setting the price.

For your knowledge, deciding on contribution is fairly better than to base a decision on profit, because contributions are flexible and are more helpful in decision making. As this method uses contribution instead of profit therefore it can be more better than the full cost plus pricing.

Market Skimming Pricing:

                Market skimming is used when a new product is launched. But it cannot be used for every new product launched. Market skimming means setting high profit margins in the initial stages of the product launch, this can only be done when you are absolutely sure that you product is one of a kind and there is no other product like it. Price Skimming helps maximize the short term profitability of the product but requires extensive advertising and promotion as well. It is equally important in the market skimming to being able to identify the market segments, as this will enable the management to decide which market segments reap higher profits.

 Market Penetration Pricing:

                Penetration pricing can be said to be a total reverse of the market skimming. Here the company enters the market by charging relatively low prices, so as to gain early market share. This policy may also be adopted to discourage new entrants or selling higher volumes early to gain economies of scale.

One advantage of using this pricing is, if the company has spare production capacity, selling higher units means having to produce more, which results in a fall in the unit cost in turn raising the profits earned.