STUDY PACK
CHAPTER 1
Economic activity and the problem of choice
Introduction
 We live in a world of great wealth and great scarcity of resources. It should
be clear to us all that there are insufficient goods and services to satisfy all
our needs and wants at any given time.
 However it is the purpose of any economic activity to provide as many of our
wants as possible yet we are still left wanting more. This shortage of products
and the resources needed to make them lead to us all to make choices.
 As we cannot satisfy all our wants then we must choose which we will satisfy
now and which will forgo. If we are careful and rational we will choose those
that will give us the greatest benefit leaving those things with less value to
us.
 This need to choose is not exclusive to people as consumers but to all
economic units such as the government, businesses, workers and charities.
Business exists to provide goods and services.
 All businesses whatever their objectives they have to make products and
provide services that satisfy consumer needs and wants.
Goods and Services
 Consumer goods are physical and tangible goods sold to the general public.
They include durable consumer goods such as cars TV’s e.t.c. None durable
consumer goods include food drinks e.g.
Consumer Services
 These are non tangible products which are sold to the public and the service
itself is not physical it’s something done for you.eg. Insurance, hair cut e.t.c.
Capital or Producer Goods
 These are physical goods used by industry to help in the production of other
goods and services such as machinery, equipment and commercial vehicles.
Classification of Business Activity
 Business activity is classified into primary, secondary, tertiary and quaternary
sectors. Primary sector business activities are those firms engaged in
extraction of natural resources so that they can be used that by other firms.

Such activities involve mining, quarrying and fishing for eg.The secondary
sector on the other hand involves firms that manufacture and process
products from natural resources to finished goods. More so the tertiary sector
involves those activities that involve trade and aids to trade.
Needs and Wants
 Needs is a state of deprivation of basic satisfaction such as food, shelter,
clothing and education. However wants are unlimited as these are the desires
for specific products for enjoyment and comfort. e.g. cell phones, cars, games
e.t.c.
Scarce Resources
 Resources in business can be regarded as any feature of our environment that
helps to support our well being. In any society resources are scarce relative to
the number of uses for which they could be put. There are too many types of
resources i.e physical and human resources.
Factors of Production
Land-includes all natural resources such as forestry, minerals, water etc.
Labour -it includes all physical and mental effort in production for which a payment
is made.
Capital- includes machinery and other items that go into further production.
Enterprise-is the art of combining three factors of production, it provides
management decision making and the coordination role.
Opportunity Cost-Because resources are scarce to meet everyone’s insatiable wants
people are supposed to make choices. What one does not choose is known as an
opportunity cost. It is therefore the next best alternative forgone in carrying out an
alternative activity.
Forms of Business Ownership
1. Sole Traders
Is a one man concern business, all business decisions are made by the owner. In
most cases the is no separation of ownership and control of the business. The owner
has no legal formalities required by him to start his business and capital raised is
from personal savings and family members leading the business with no room for
expansion.
Advantages
 The owner has freedom of flexibility in decision making.
 Decision making is faster.
 Owner has total control of his business.
 Has personal contacts with customers
 There is personal enjoyment of all profits generated.
 Less hectic since no legal requirements are needed to set up the business.
 There is personal satisfaction of good performance
Disadvantages
 There are limited sources of finance.
 The owner bears the burden of all losses made by the business.
 There is unlimited liability since personal assets are vulnerable to takeover in
the event the business fails to pay creditors.
 There is restricted growth of the business because of lack of finance and
management.
 There is limited scope of economies of scale.
 There is lack of continuity of existence.
2. Partnerships
Is the amalgamation of 2-20 partners with a common view of making a profit except
a professional partnership which has no limit e.g. auditor’s solicitors and
accountants. However the business is governed by the Partnership Deed and Act.
Contents of the Partnership Agreement
 Objectives to make profit
 Amount of capital to be contributed by each partner
 Duties of each partner
 Responsibilities and rights of each partner.
 Interest to be paid on their capital
 Interest on drawings
 Salaries and bonuses paid to each partner managing the business.
 H.I.V status of partners
Advantages of Partnership
 Management of business is shared amongst the partners.
 More capital is raised which allows for the expansion of the business.
 Wider experience/more skills are brought to the partnership, this allows for
some degree of specialization.
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Decision making is consultative i.e shared so as to reduce the burden on
management.
More ideas and initiative creates greater efficiency.
There are few legal formalities required to set this form of business.
Losses are shared by the partners
Disadvantages
 Disputes may lead to the partnership dissolution.
 Consultative decision making delays implementation of ideas.
 There is no continuity of existence of this form of business due to change and
even death of partners.
 Decision made by one partner is binding to all partners this can be costly to
the organization.
 Sharing of profits with lazy partners might discourage honest, resourceful and
hard workers.
 There is unlimited liability for members.
 Partners can be sued severally.
 Profits generated are shared.
3. LIMITED COMPANIES
Characteristics
 Liability of members is limited
 Capital is raised by selling shares to the external world.
 There is separation of ownership and control of the business.
 The company is a legal person on its own which can sue or be sued on its
own rights.
 The day to day activities of the firm is in the hands of the board of directors
of the business.
 The board of directors of the business is elected by the shareholders at an
annual general meeting.
 The company prepares the memorandum of association together with the
articles of association and submits them to the registrar of companies for
approval.
 The registrar of companies then issues a certificate of incorporation.
a. PRIVATE LIMITED COMPANIES
Characteristics
 Is formed between 2-20 members.
 It is governed by the companies act.
 Involves complex legal formalities required to set up the business.
 Must be registered through the issue of certificate of incorporation by the
registrar of companies.
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Name of the company ends with PVT LTD.
The business is a separate legal entity i.e.it exists as a legal person
independent of its owners.
It is owned by shareholders.
CONTROL AND MANAGEMENT
 It is controlled and managed by the board of directors elected by shareholders
at an annual general meeting. The managing director is elected from the
board of directors
 Directors report back to shareholders at least once per year by statements of
accounts and Directors reports. Ordinary shareholders vote at the annual
general meeting.
 Annual accounts of the private company are not published to the public but
are filed with the registrar of companies for tax purposes.
 There is strictness on the transfer of company shares. However the company
may or may not appoint an auditor.
Board of Directors
Managing Director
Production
Finance
manager
manager
Marketing
Human resources
manager
manager
Liability
 All shareholders enjoy limited liability that is shareholders only lose their
capital they have invested in the business and not their personal property.
Raising of capital and sources of finance
This done through the following ways:
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Selling of shares privately to invite individuals
Ploughing back profits from the business.
Obtaining loans and overdrafts from banks
Obtaining mortgage finance
Obtaining trade credits
Buying on higher purchase from finance houses
Leasing of assets
Debt factoring.
Advantages
 There is enjoyment of limited liability
 Can raise more capital compared to Sole traders and Partnerships
 There is continuity of existence
 Founder members can retain control of the company by holding a majority of
its shares.
 Financial affairs are not published.
 There is efficiency in operations.
Disadvantages
 Too many legal formalities are required for set up of the business activity.
 Shares cannot be traded on the Zimbabwean stock of exchange
 Can be expensive to set up
 There is a lot of inefficiency
 Inefficient or not flexible.
PUBLIC LIMITED COMPANIES
Characteristics
Formation
 Membership is open to the public; membership is by invitation through a
prospectus. It is formed by at least 2 people and no upper limit.
 However governance is done as per the stipulation of the companies act.
Promoters of the company draft and submit to the registrar of companies the
prospectus , Articles of Association and Memorandum of Association.
 The registrar of companies having approved the documents will issue a
certificate of incorporation.
 After the company issue of shares the company is granted a certification of
incorperation.
Raising of capital
 It is done through the selling of shares to the general public
 Issuing of debentures to members of the public.
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Loans overdrafts mortgage finance from banks
Hire purchase and ploughing back of profits.
Factoring /selling debts to finance houses.
Leasing of equipment
Buying of goods on credit for resale.
Control and Management
 It is controlled or regulated by the board of directors elected at an Annual
General meeting. The board of directors decides on the company’s policy and
also chooses a Managing Director.
 Managing Director is in charge of the day to day running of the business.
Joint Ventures
These occur when two businesses agree to work closely together on a particular
project and create a separate business division to do so.
This is not the same as merger, but can lead to mergers of businesses if their joint
interest coincide and if the Joint Venture is successful.
Reasons for Joint Ventures
 Costs and risks of a new business are shared-this is a major consideration
when the cost of developing new products is rising rapidly.
 Different companies may have different strengths and experiences and they
fit well together.
 They might have their major markets in different countries and they could
exploit these with newly introduced products than if they decide to go it
alone.
Risks Involved
 Styles of management and culture might be so different that the two teams
do not blend well together.
 Errors and mistakes might lead to one blaming the other for mistakes
 Business failure of one of the partners would put the whole project at risk.
Holding Companies
 This is not a different legal form of business organization, but it is an
increasingly common way for businesses to be owned.
 A holding company is one that owns and controls a number of separate
businesses, yet does not unite them into one unified company.
 Diversified interests will be achieved
 Businesses are independent of each other for major decisions or policy
changes.
Public Corporations
 Are organizations owned by the central or local government
 Have no profit objective
 Are in the public sector
Advantages
 they are managed with social objectives rather than solely with profit
objectives
 loss making services might still be kept operating if the social benefit is great
enough
 finance raised mainly from the government
Disadvantages
 tendency towards inefficiency due to lack of strict profit targets
 subsidies from government can also encourage inefficiencies.
 Government may interfere in business decisions for political reasons, e.g.
opening a new branch in a certain area to gain popularity.
PRIVATISATION
 Involves the selling of state owned and controlled business organizations to
investors in the private sector.
 The main aspect of privatization is the transfer of ownership of nationalized
(state owned) industries into the private sector by creating private limited
companies
 It also involves features like forcing schools, hospitals and local authorities to
‘contract out’ many services to private business.
 It involves denationalization, deregulation and contracting out as the road
map to privatization.
Denationalisation
It involves selling government owned enterprises to the private sector. In Zimbabwe
this is done by selling shares to private individuals. This is done so that the business
can be run on a profit basis eg DMB, CMB Dairy Board in Zimbabwe.
Deregulation
This involves lifting restrictions that prevent private sector competition. It is the
removal of government regulations
Arguments for Privatization
 profit motive of private sector businesses will lead to much greater efficiency
than when a business is supported and subsidized by the state.
 decision making in state bodies can be slow and bureaucratic
 it puts responsibility for success firmly in the hands of the managers and staff
who work in the organization. This leads to strong motivation as they have direct
involvement in the running of the organization and greater sense of
empowerment.
 Market forces will be allowed to operate; failing businesses will be forced to
change or die and successful ones will expand, unconstrained by government
limits on growth.
 There is always a temptation for governments to run state industry for political
reasons or as a means of influencing the national economy eg keeping electricity
prices artificially low, thus decisions may be taken for commercial reasons.
 Sale of nationalized industries can raise finance for government which can be
spent on other state projects.
 Regulatory bodies set up by government eg CCZ can be used to ensure free
competition and no consumer protection.
 Private businesses will have access to the private capital markets and this will
lead to increased investment in these industries.
Arguments against Privatisation
 The state should take decisions about essential industries e.g. based on the
need of the society and not just on the interest of shareholders. This may
involve keeping open business activities that private companies would
consider unprofitable.
 With competing privately run businesses it will be much more difficult to
achieve a coherent and coordinated policy for the benefit of the nation at
large e.g. railway systems, electricity grid and bus services.
 Through state ownership an industry can be made accountable to the
country i.e. by means of a responsible minister and direct accountability to
parliament.
 Many strategic industries could be operated as ‘private monopolies’ if
privatized and could exploit consumers with high prices.
 Breaking up nationalized industries, perhaps into several competing units, will
reduce the opportunities for cost saving through economies of scale.
Qn Evaluate the reasons why government should privatise business
organizations [25]
BUSINESS ACTIVITY AND ECONOMIC STRUCTURE
INTRODUCTION
 The nature and level of development in an economy depends on the type of
economic system. The growing power and influence of multinational
cooperation’s is having a significant impact on all economic systems apart from
centrally planned economies.
Economic problem
 An economy is faced with the problem of scarcity of resources; an economy
will make a choice of what to produce in an attempt to tackle the economic
problem.
Economic Systems
 Are a way of tackling economic problems
 A system is a complex whole made from a set of connecting parts. A system
processes inputs e.g. labour to produce outputs. All societies must produce a
system for dealing with three interrelated problems i.e. what should be
produced? How it will be produced? For whom will it be produced?
Market Economies (Free Market Economy) practised in USA, Taiwan
Features of free market economy
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There is private ownership of all economic resources.
Resources are allocated towards making products consumers wish to buy
Market information is obtained from price levels and price changes
Firms operate in order to make profit
Free entrance and free exit of players in the economy(no barriers to entry)
Consumers decide for a certain pattern of output and the way in which they
distribute their spending, therefore resources are allocated towards those
products that consumers wish to buy.
Forces of demand and supply determine the quantity demanded and quality
supplied.
The role of the government in such economies is very restricted to the extent
of only providing defense and police forces.
Advantages
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Products reflect what the consumers want.
The system is flexible, in the way it can respond to supply and demand.
Individuals have greater freedom to make their own demand and supply
decisions.
There is competition which leads to efficiency therefore there are low prices
and high quality products.
Disadvantages
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Negative externalities are over produced. e.g. pollution.
It does not guarantee everyone to get what they want as only those who can
afford are able to buy, leaving the sick, the poor and the elderly vulnerable.
It leads to great inequalities.
Some goods for the community might not be produced at all e.g. education.
Successful businesses might takeover small business and control major shares
of the market. This reduces competition and monopolies might crop up
leading to the charging of exorbitant prices not to the reach of many.
NB -The role of the government in such countries is very restricted. It is usually
limited to providing defense forces, internal police and justice systems, controlling
the money supply to prevent serious inflation and taking measures to limit extreme
monopoly power of businesses.
Mixed Economies
Characteristics
This system involves some private business activity driven by profit motive and some
state owned and controlled organisations often operating for non-profit reasons.
Features of Mixed Economies
 Many products and services are provided by private business not state.
 Most essential (public goods) e.g. police, defense and social services are only
provided by state and the private sector e.g. schools, health and broadcasting
 Tax is paid to the government in order to finance state operated services.
 The government sets penalties’ to control negative externalities and reducing
/restricting monopoly powers of some firms.
Centrally Planned Economies
 Are associated with communist political systems.
Features of Planned Economies
 There is state ownership and or control of most of the economic resources
 Central state decides what should be produced and the production methods
to be adopted
 No consumer sovereignty since consumers have little influence over what is
produced
 Use of prices to indicate a consumer preference is unimportant.
EVALUATION OF ECONOMIC SYSTEMS
 Understanding the advantages and disadvantages of the different economic
systems will help provide the foundation for grasping the reasons behind
government action and how to respond to it.
Economic system
a)Free market system
 Private property
 Profit motive
 Price system
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b)Planned system
 State
ownership
and
control
of
resources
and
means
of
production
 Very little private
sector
business
activity
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Mixed Economies
 Private
sector
business
is
encouraged
 State
controls
resources
and
supply of goods and
services
 Taxes
used
to
collect revenue
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Advantages
Profit motive makes
firms
operate
efficiently
Competition helps to
keep prices low and
lead to release of new
products
Consumers
have
choice
Work is encouraged
as taxes are very low
and there is no state
support
for
non
workers
Prevents duplication
and
wasteful
competition
eg
supplies
of
bus
services
Production decisions
are based on states
assessment
of
people’s needs not
consumer
spending
patterns
Allows
long-term
planning not short
term profits
State
provides
essential services for
the society (rich or
poor)
Competition improves
efficiency
Consumer
choice
exists
and
work
incentives
Inefficient
business
behavior is controlled
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Disadvantages
Monopolies erupt as
owners see the gains to
be made from reducing
competition.
No state support for the
elderly unemployed
No government control
on pollution
Income differences are
not reduced by taxes
No consumer choice
No
competition
to
improve product design
and keep costs and
prices low
Workers
are
poorly
motivated since there
are no gains from
working harder
Very
slow
and
bureaucratic
decision
making
Taxes may be heavy to
pay for sales of goods
and
services(reduces
incentives to work hard)
State organisations are
less efficient than private
firms
Excessive control might
discourage business
INTERNATIONAL TRADING
All countries, engage in international trade with other countries. This is true no
matter which economic system is in place
Benefits of trading
 Consumers are offered wider choice of goods and services by buying products
from other nations
 Additional competition is created for domestic industries as this encouraged
them to keep costs low and prices down and make their goods well designed
and as of high quality as possible
 Countries specialize in those products they are best at making and import
those they are less efficient from other countries (comparative advantage)
 Countries may build good political ties and links and these help resolve
differences amongst themselves
Drawbacks of international trade
 Loss of output and jobs from those domestic firms that cannot compete
effectively with imported goods
 Decline in domestic industries might be witnessed especially when they
produce strategic goods
 Newly established businesses may find it impossible to survive against
competition from existing importers
 Dumping of goods might be witnessed
 Loss of foreign exchange (imports>exports)
Free Trade and Globalisation
 Free trade means that no restrictions or trade barriers exists which might
prevent or limit trade between countries
Common forms of trade Barriers
i. Tarriffs – taxes imposed on imported goods to make them more expensive than
they would otherwise be.
ii. Quotas – limits on the physical quantity or value of certain goods that may be
imported.
iii. Embargoes – a complete barn of imported goods into the country.
MULTINATIONAL BUSINESS ORGANISATIONS
These are business organisations that have their headquarters in one country but
operating branches in other countries.
Why become a multinational
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Nearness to markets
Lower costs of production use of cheap local labour.
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Avoid import restrictions.
Access to local resources
Benefits of Multinational Cooperation’s
 More foreign currency is generated
 Leads to creation of employment thereby reducing the unemployment pool.
 Tax revenues for the government will be boosted
 More expertise will be imported on the locals
 Total national output (GDP) is raised
 Standards of living are improved.
Drawbacks of multinational businesses
 Exploitation of local workforce since there will be absence of strict labour
,health and safety rules
 Pollution might affect local people(Negative Externalities)
 Local competition might be squeezed due to inferior equipment than those
provided by multinationals.
 Leads to reduction of cultural identity
 Repatriation of profits
 Extensive depletion of local natural resources
How government assists or constrain business activities
 Business has a great beneficial impact for society by producing goods and
services providing employment and paying taxes.
 If businesses are not controlled serious problems for society could occur thus
the government want to encourage the positive impact of businesses but to
reduce to the minimum the negative impact
Government assistance for business
 Training programmes-organized through local colleges or supported through
government subsidies. Well trained workforce increases productivity and
profitability of business.
 Development area grants- government provide assistance to firms operating
in rural areas and growth points also allowing tax exemptions
 Support for exporters- selling of goods abroad is risky because of lack of
information about a market and chances of non-payment from customers.
Government support involves advice services based on information from
embassies
Forms of government intervention
Consumer
Protection
Monopolies
Government Control
of Business Activities
Unfair
competition
Location of
industry
Environmental
Protection
Employee
protection
Evaluation on government control
Not all businesses will behave in socially undesirable ways even if there were no
government controls. Some managers and business owners have such high ethical
and moral standards that even without government restrictions would treat staff well
but some firms will not.
This requires intervention by the government in the form of legal controls.
Arguments against government intervention
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Government controls add to business costs e.g. increasing wage rates to the
legal minimum level, purchase of pollution control equipment and health and
safety facilities at workplace
Administrative burden is imposed by government which will be characterised
by ‘red tape’ which acts as a disincentive to firms
Other countries with no government control may gain unfair competitive
advantage
ESSAYS
1. A) Examine the ways in which the government in your country
i) Controls business activities
ii) Assist business activities [10]
b) Discuss whether business activity should be more firmly controlled by
government [15]
2.To what extent should the government of your country positively encourage
multinational business to establish in your country? [25]
FORMAL AND INFORMAL BUSINESS ORGANISATIONS
Formal organisational structure
It is defined as the network of official communication channels in the enterprise and
can be shown on an organizational chart.
They are social units deliberately created by some members of the community in any
society for specific purposes
Social Units- dealing with people.
Deliberately created- formed for a specific purpose
Informal organization structure
They usually spring spontaneously from formal groups as employees interact at tea
break, lunch and going home. They constitute social relationships that develop as
people interact with one another. Such relationships cannot be presented on an
organizational chart although management may officially recognize them.
Features of formal Structures
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Have a well defined structure with clear lines of authority.
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Well defined lines of communication
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Objectives clearly stated

Tangible pay remuneration and benefits are known.

Durable and well planned life span
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Relatively flexible due to order

Convenient and can be shown on an organizational chart.
Characteristics of formal organizations

They are social units- mainly composed of people as actors
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They have origins-they are born, they grow and they die, they have historical
context.
Almost all organizations have written rules, regulations and procedures.
They have structures- the structure gives hierarchy of authority.
All organizations have positions and position holders- these are full time paid
officials.
All organizations have specific leaders at various levels.
They operate as social systems- they depend on operations of each other.
There is a separation between work and private life.
There are formal relations-social capacities.
Ownership is normally not in the hands of the workers.
Features of Informal Organizations

Undefined structure with no clear power,
responsibility and reporting relationships.
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Undefined and ever changing for example grapevines

Objective are ambiguous and ever changing
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No financial benefit benefits usually social and emotional

Non durable and unplanned life span.
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Flexible and ever changing

Since they are ever changing they are difficult to be expressed on a graphical
structure.
authority,
accountability,
Advantages of Informal Organizations

Help members to communicate.

Develop secondary channel of communication opposed to the first one used
by management

Managers may use the channel to transform information secretly

Informal groups perpetrate commonly held social and cultural values as
members are likely to share common norms and values.

They provide social satisfaction, status and security as employees are given
opportunity to share jokes, eat and socialize after work this gives them a
sense of fulfillment which reduces labour turnover and absenteeism

There is a sense of security by the members in the group.
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They help members solve personal problems
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A business can benefit when lazy and careless employees are told what do by
fellow workers.
BUSINESS SIZE AND BUSINESS GROWTH
 Businesses vary in size from sole traders to established multinationals.
Information on business size is of importance to both investors and the
government.
Measuring the size of business
 There are several different ways of measuring and comparing the size of
business, however a firm might appear large by one measure but quite small
by another.
a) Number of employees
 A firm that employs many staff is likely to be large and one that employs few
staff is likely to be small.
 Problems crops up when a large firm employs few people because of highly
automated machines that will be in use.
b) Sales Turnover
 Is also often used as a measure of size in business structure especially when
comparing firms in the same industry.
 It is less effective when comparing firms in different industries since some
might be engaged in high value production and the other in low value
production e.g. jewel production and cleaning services.
c) Capital employed
 This measure the total value of all long term finance used in the business.
Generally the larger the business the greater the value of capital needed for
long term investments.
 Misleading results are seen when two firms employ the same number of staff
but having different capital equipment needs e.g. Hairdresser and optician
(needs diagnostic and sophisticated) machines.
d) Market capitalisation
 Is applicable to businesses ‘quoted’ on the stock of exchange (public co.)
Market capitalization = current share price x total number of shares issued. Share
prices tend
As share prices tend to change everyday, this form of comparison is not a very
stable one eg. A temporary but sharp drop in the share price of a company could
appear to make it much smaller than this measure would normally suggest.
e) Market share
 It is equal to: Total sales of business/Total sales of industry x 100
 This is a relative measure, If a firm has a high market share it must be among
the leaders in the industry and comparatively large. However when the size of
the total market is small, a high market share will not indicate a very large
firm.
Which form of measurement is best?
 There is no best measure. The one used depends on what needs to be
established about the firms being compared.
 This could depend on whether we are interested in absolute size or
comparative size within one industry.
Significance of small Businesses
 There is no one universally accepted or agreed definition of small firms, it will
therefore be easy to identify them within your own economy
 Small firms are important to all economies since they can attribute to the
following:
 Many jobs are created by small firms even though they do not employ
many staff, collectively the small business sector employs a very
significant proportion of the working population in most countries.
 Most small businesses are often run by dynamic entrepreneurs with
new ideas for consumer goods and services. This helps to create a
variety in the market and improved consumer choice of goods.
 Competition is brought about by small firms and without competition,
larger firms could exploit consumers with high prices and poor
service.eg cost of air travel has been reduced in recent years due to
the establishment of small airlines companies.
 All great businesses were small at one time. Small firms are
encouraged to become established and expand, the greater the
chances that an economy will benefit from big scale organisations in
the future.
 Small firms may enjoy lower average costs than larger ones and this
benefit could be passed on to the consumer too. Costs could be lower
because wage rates paid to staff may not approach the salaries paid in
large organisations.
Government assistance for small businesses
 Reduced rate of profits tax (corporation tax) – this will allow a small company
the chance to retain more profits in the business for expansion.
 Loan guarantee schemes – are government funded schemes which
guarantees the repayment of a certain percentage of a bank loan should the
business fail. This makes banks more likely to lend to newly formed
businesses
 Providing information, advice and management support through government
departments and agencies.
 In economically deprived areas such as cities with high unemployment, the
government finances the establishment of small workshops which are rented
to small firms at reasonable rents.
Problems faced by Small Firms
 Lack of specialist management expertise – often the owner has to undertake
all management functions such as marketing, operations management,
keeping accounts and dealing with staff matters- because the business
cannot afford to employ specialist in each of these areas.
 Problems in raising both short term and long term finances – Small firms
have little security to offer banks in exchange for loans and this makes
obtaining finance more difficult than for most larger firms. In addition,
suppliers may be reluctant to sell goods on credit if the business has been
operating for a short time.
 Marketing risks from a limited product range – Many small firms produce
just one type of a good or service
 Difficulty in securing suitable and reasonably priced premises. The best
location tends to be expensive and often only affordable by large firms.
Business Growth
Chapter 2
HUMAN RESOURCES MANAGEMENT
Introduction
 Human Resources Management is the strategic approach to the effective
management of organisations workers so that they help the business gain a
competitive advantage.
 It aims to recruit capable, flexible and committed people, managing and
rewarding their performance and developing their skills to the benefit of the
organisation.
 The main human resources task is to recruit, train and utilize the
organizations personnel in the most productive manner in order to achieve
company’s objectives. It mainly focuses on the following:

Planning workforce needs of the business

Recruiting and selecting appropriate staff

Appraising training and development of staff at all levels of the organization

Developing appropriate pay systems for different groups of people

Measuring and monitoring performance

Involving all managers and their departmental staff

Establishing appropriate payment systems
Role of Personnel Officer







Maintaining employee records up to date.
Processing salaries of workers
Attending disciplinary hearing
Carrying out salary surveys
Preparing job descriptions for various employees
Recruitment and selection of employees
Designing, implementing and evaluating training
Importance of Personnel Management








Analyzing jobs to gather information that can be used in selection
Training and development of employee skills
Recruiting and selecting skilled employees
Administering systematic and fair programs for compensation
Interacting with employees unions
Designing and administering employee benefits such as retirement and
insurance programs
Planning for organizational needs for various employees
Improving motivation of the work force.
Differences between Personnel Management
Personnel Management
-Quantitative in nature
-Grievances of employees are
solved through workers committees
-view workers as liabilities
-Advisory and administrative
-not central to the organization
-mediating role between managers and
workforce
-there are specialists
-emphasizes on written rules and
procedures
-collective bargaining and negotiations
-employees must be monitored
-controlled access to training
Human Resources management
-Qualitative in nature
-grievances are solved through trade
unions
-Views workers as valued assets
-It is strategic
-seen as essential
-a central management role
-all managers are HR managers
-stress on flexibility
-consultation and participation
-they must be nurtured
-the learning organization
Human Resources Management can be divided into two broad categories namely:
1. Management of entry which focuses on Human resources planning, Job
analysis, recruitment and selection
2. Management of stay which focuses on orientation, induction, training and
development, promotions, transfers, compensation, performance appraisals
and redundancy planning.
Human Resources or Manpower Planning
The Human Resources Management must determine the organizational need and the
number of employees needed or required. The number of employees required in the
future will depend on

Future demand of the product

Objectives of the firm
 If the firm plans to expand then more employees would be required for the
expansion of the business. The firm that requires increase in service
satisfaction, short term profits will increase workers. Therefore the number of
staff required in future depends on:

Productivity levels of staff

Predicted labour turnover rate and absenteeism rate-the higher the rate the
greater will be the need to recruit replacement staff to insure adequate
number of employees available.

Changes in laws regarding workers rights-the government might set up a
minimum wage which is high thus causing firms to employ fewer workers and
substitute them with machines were possible.

Skills of staff available-this depends on complexity of machinery

Production methods used and the need for flexible, multi skilled staff thus
most firms need to recruit, train staff with more than one skill.
Why organizations undertake HR planning

To be able to attract and retain staff in sufficient number with appropriate
skills, to be able to ensure that employees receive all the training
development necessary for effective performance in the their current role and
develop the flexibility to be able undertake other roles as the need arises.
To anticipate and meet changes in the demand for its services or in the
labour supply
To be able to meet future HR requirements/ events from its own internal
resources such as resignations and death of employees.
Ensures that equal opportunities for promotion and development are availed
to staff.
To keep control of human resources costs and effectively anticipate the
staffing costs of new initiatives.
For succession planning





However






Resources are needed in carrying out HR planning that is material, financial
and human resources. Therefore it is costly to the organization.
Finance department might not avail funds in accordance with HR plans.
Some workers can absent or leave themselves unexpectedly
HR plans might be too rigid
The plans might be based on wrong forecasts.
Production time is lost trying to gather the information
HR planning follows a systematic model which comprises three elements
i.
ii.
iii.
Forecasting
Supply analysis
Balancing supply and demand considerations
Forecasting

Is the activity of predicting/estimating in advance the number of and type of
personnel needed to meet organizational objectives?
 The requirements should be both in quantitative and qualitative terms e.g.
there can be an increase in the number of employees but a decrease in a
particular type of skills or grade. It uses 2 approaches that is
1. Quantitative approach- which involves statistical or mathematical techniques
like trend analysis to predict HR needs.
2. Qualitative approach- which aims to reconcile the interests, abilities and
aspirations with the current and future staffing needs of the organization.
The skills of staff required are dependent on:
1. Pace of technological change in the industry eg production methods and
complexity of machinery used. This left traditional typists being rarely
required but computer or photocopier operators.
2. Need for flexible and multi skilled staff as the business tries to avoid
excessive specialization. Most businesses therefore need to recruit staff or
train them with more than one skill that can be applied in a variety of
different ways. The firm will be more adaptable to changing market
conditions.
Supply Analysis


Involves determining whether there are sufficient numbers and type of
employees available to staff and the anticipated job vacancies.
It involves looking internally or from external sources
Full time and Part time employees
 Some firms employ staff on a temporary basis and also outsourcing from
other firms or self employ people.
Part time contracts
Advantages

Staff required to work during busy periods and slack times this reduces
overhead costs.

Staff can be assessed before they are given full time employment

More staff available to be called upon should there be sickness or some sort
of absenteeism.
Disadvantages

Low motivation since part time employees feel less involved

It would be difficult to establish i.e. teaching them to start

Effective communication would be more difficult i.e. meeting with all staff
since the firm will be forced to use written communication.

The company may lose valuable workers to other firms.
Recruitment and Selection
 This function ensures that company’s objectives are met and new ideas are
brought into the organization through appointing the appropriate,
experienced and qualified personnel.
 Recruitment is the process of identifying the need for a new employee,
defining the job to be filled and the type of person needed to fill it, attracting
suitable candidates for the job to be filled and selecting the best
 It can be defined as a process of locating and encouraging potential
employees to apply for existing job vacancies.
 Selection is the process of determining the most suitable candidate for the job
among which would have been attracted through the recruitment exercises.
Steps in the Recruitment Process

Establish the precise nature of the vacancy

Draw up a job description which includes the following

Job title

Details of task

Responsibility involved

Place in the hierarchical structure

Working conditions

How the job will be assessed and performance measured.
NB The job description should attract the right type of people.
Job Specification
It is a profile for the ideal candidate and covers the knowledge, experience physical
characteristics, age and personality of the candidate and qualification.
Steps in the Recruitment Process
1. Defining requirements –establish the exact nature of the job vacancy, Ask if
there is a vacancy since recruitment involves filling up the gap in an
organization. The organization must look at the job analysis and job description
as well as person’s specification. This helps to understand the requirements of
the job and skills of the vacancy.
2. Attracting candidates- This is the process of identifying, evaluating and using
the most appropriate sources of applicants and sources of recruitment.
Vacancies can either be filled through internal or external recruitment
3. Selecting candidates
Advantages of Internal Recruitment

Applicants are already aware of the organizational structure.

Those selecting the candidates already know the applicants strengths and
weaknesses.

Faster than external recruitment

Saves on costs as it is cheaper than external advertising.

Applicant is familiarized with the norm ethic and values of the organization.

It give internal staff hope of carreer and chances of progressing and thereby
motivating staff.

It boost morale of employees
Disadvantages

Expensive to train staff

No new ideas or practices are brought into the organization.ie There is
stagnation (no new thinking) by ignoring new initiatives.

They may be some resentment from those who do not get the job.

Number of applicant will be lower than if it was externally advertised.

Because the applicant will be known by the selectors it can result in a less
qualified person being recruited.

It demoralizes those that are not promoted.

There is infighting for promotion, tension and enemity.

May encourage complacency because if new entrants are not invited,
employees may assume that there is automatic promotion.
Advantages of External Recruitment

New ideas are brought into the business

Cheaper than to train existing staff.

No resentments from internal staff.

Qualified and experienced staff is recruited from the pool of applicants.
Disadvantages

The organization can recruit a misfit.

There is possibility of that person demoralizing those in the organization.

It takes longer to adjust since there will be a longer orientation time to fully
equip the applicant.

There is danger that new recruitment may bring in attitude ie this is not the
way things used to be done.

Its slower than internal recruitment

It is expensive

When Human resources policy is of external recruitment internal workers who
qualify would be demotivated.
SELECTION
 It involves the picking of candidates from a group of applicants. The selection
method used within the company is important as it should not be relatively
expensive compared to the importance of the job.
 It should be non discriminatory in terms of ability, personality intelligent, race
and other factors.
Labour Management Relations
 In a business there are likely to be conflicts between employees and the
employer due to conflicting opinion and interests for example the owner of a
business simply want to make profits whilst keeping wages bill low as possible
but workers demanding pay rises.
 To this effect the owner might also want to change location of his business
but workers view this move negatively as the might fear job losses
Broad Categories to Labour Management Relations
1. Autocratic Management style-management has a take or leave attitude to
workers. Workers might be employed for very short term contracts even on a
daily basis offering no security. However if workers objects to the conditions
of work the attitude of management is seek and replace him with another.
This is common in countries with no labour protection, legislation and where
there is high unemployment rate.
2. Collective Bargaining-this is when representatives of unions and not
employers negotiate wage levels and working conditions for the whole
industry. This collective bargaining make it leader powerful because they can
call for a national strike and members obey. Collective bargaining can be
defined as the process whereby procedures are jointly agreed and wages and
conditions of employment are settled by negotiations between employer and
associations for worker organizations.
Rationale Argument for Collective Bargaining
 Individual workers are in a weak position and unable to negotiate on basis of
equality. The collective bargaining deals with procedural agreements and
substantive issues can be negotiated procedural; agreements are open ended
subject to a period of notice
Coordination between labour and Management
 Recent management thinking has not sought to oppose workers suggestions
and those of their union leader but to actively involve them in important
decision making and operational issues.
 It means the following will not happen-less confrontation, few strikes and
harmony is improved.
Trade Unions
 Are defined as all organizations of employees which include among the
functions of negotiating with employees with the object of regulating
conditions of employment and pay.
 Trade Unions act as a channel of communication between employees and
employers. They also provide assistance to individual members for example a
worker with grievances pertaining disciplinary matters.
Motivation
Of special note is Abraham Maslow’s Hierarchy of needs, Herzberg’s Two Factor
Theory and Vroom’s Expectancy Theory
2.4.1 Maslow’s Hierarchy of needs
The hierarchy is usually shown ranging through five levels. The diagram below
shows
Maslow’s
Hierarchy of need
SelfActualisation
Esteem
Love
Safety
Physiological needs
According to Abraham Maslow,s Hierarchy of needs theory, employees are motivated
by a variety of driving forces at any given time and these forces can be categorized
based on Physiological needs, safety, belonging, esteem and self acqualisation.
Maslow propounded that employees must first meet their basic physiological needs
such as food and shelter. Once all basic physiological needs are met safety concerns
become the next most important set of motivational forces. This means that when
basic needs are provided through work then employees will become aware of their
work environment. Rural schools, therefore, should provide teachers with
accommodation as shelter is a physiological need essential in life. If shelter is
provided, teachers may be retained in rural schools.
Once employees feel safe within their work site other factors such as belonging to
the group become motivational consideration. Esteem is the next threshold that has
to be met for an individual to reach fulfillment. The final level of motivation is called
self actualisation, which is when an individual reaches his or her full potential, at this
level, employees are completely motivated to do their best, as all of the
psychological and physical needs are met (Maslow, 1943).
Additionally, employees retort constructively to recognition for job performance. In
this way employees feel that the work they are doing is recognised by the
organisation that they work for. If the service that they are providing an organisation
is beneficial then the employee can feel connected to the overall operations of the
organisation. Conversely employees will not strive towards productivity in their work
environment if they feel that the organisation only responds to negative aspects of
their job performance. In this regard, contribution made by rural teachers should be
recognized by the Ministry of Education, Sport, Arts and Culture. Recognition of rural
teachers’ contribution can be in the form of awards/prizes for long serving rural
teachers. This may help in retaining teachers to rural schools.
The relationship developed between direct care staff and supervisory staff can
either increase or reduce employee morale. Therefore, there is need to create good
relations between heads and teachers serving in rural schools this may help teachers
to feel a sense of belonging to their organization and they will be motivated and may
be retained in rural schools. The more connected a person feels to the work they are
doing the closer they become to self-actualization and fulfillment. Belonging to an
organisation and feeling a connection to the service provided are chief
characteristics of motivation in organisations and this assists in employee retention.
2.4.2 Herzberg’s Two Factor Theory
According to Shultz (2006), Fredrick Herzeberg was interested in the factors that
made employees feel good about their jobs. The factors that need to be in place if
employees are to feel dissatisfaction but do not lead to job satisfaction are called
hygiene factors. The factors that lead to job satisfaction and motivate employees are
called motivators. Hygiene factors are external (extrinsic) to the employee, such as
the quality of supervision, pay, company policies and working conditions. Motivators
are internal to the employee (intrinsic) and include factors such as responsibility,
achievement and opportunities for growth. Most employees would be dissatisfied in
jobs lacking hygiene factors and if hygiene factors are addressed, most employees
would be satisfied and productive if motivators are present (Shultz 2006). Thus
some qualified teachers see opportunities for carrier development in rural areas in
terms of chances for promotion and they are attracted to rural areas and are
retained there.
2.4.3 Vroom’s Expectancy Theory
Employee expectations of the organization play a key role in motivating employees.
Victor Vroom’s theory of employee motivation is referred to as expectancy theory.
Vroom argues that individuals make conscious decisions to maximize pleasure and
minimise pain in every aspect of their lives. Therefore, working conditions in rural
areas should be such that they maximise pleasure and minimise pain to the rural
teachers in order to retain them in rural schools. Issues such as poor
accommodation and transport problems should be addressed so that working
conditions for rural teachers become presurable. He further states that the way an
individual responds to work is unique to a given individual and for that reason,
motivation is much more complex than earlier theories indicate.
Vroom states that an individual’s performance is linked to many factors, such as
skills and experience, as well as their personality and desire to accomplish
organisational objectives. Teachers may be attracted and retained to rural schools
due their personality. Some individuals have the desire to impart knowledge and
contribute to nation building not withstanding the environment they operate in. The
tenants of Vroom’s theory are that people perform better if there is a desirable
outcome or reward. Borkowsky (2005) is of the opinion that the reward must be
something that is not only desirable but also something that will make the effort
exerted worthwhile. Rural teachers, therefore need to be given worthwhile rewards
for their work and effort of enduring hardships such as traveling long distances in
uncomfortable roads and at times on foot in order to provide education to rural
communities. Worthwhile rewards may assist as a retention strategy for rural
teachers.
The organisation must first understand what will motivate their staff because what
works for one individual may not be the reward that is desirable to another
individual. The organisation must understand many aspects of individual employee
personalities in order to see what types of benefits will motivate their work force and
this helps in retaining them in the organisation. For example, some individuals may
be motivated by recognition from their supervisors while others are motivated
primarily by bonuses or benefits. In the Ministry of Education, Sport, Arts and
Culture teachers may seek to transfers from rural schools due to lack of monetary
benefits. For example, teachers in urban areas get meaningful monetary benefits in
terms of incentives.
Expectancy theory further posits that employees have a multiplicity of expectations
and that management needs to certify that employees feel confident in the jobs they
are performing. Employees presume that management will provide them with
information regarding their job and will train them amply so that they can perform
their role within an organisation. Rural teachers similarly expect to be compensated
for the job they are performing under difficult conditions. Qualified teachers,
therefore, are attracted to rural schools that pay better incentives and these are
normally urban and boarding schools. Essentially, for the Ministry of Education,
Sport, Arts and Culture to get best results from rural teachers, the Ministry must first
understand what their expectations are and ensure these expectations are met.
Expectance Theory proposes that a person will resolve to behave or act in a certain
way because they are motivated to select a specific conduct over other behaviours
due to what they expect the result of that selected behaviour will be (Stone and
Henry 1998).Locke (1975) criticizes the expectance theory by arguing that
expectance theory is little more than an attempt at understanding human behaviour
by assuming that all actions are hedonistic. Locke (1975) further explains that if all
actions were strictly made on the basis of what outcome would provide the most
amount of pleasure, then all employees would be happy in their jobs as they chose
them based on the pleasure that they would receive from the position. Locke (1975)
argues that hedonism is not the only basis for decision making and motivation based
simply on pleasurably expected outcomes is a very limiting observation of human
nature. However, there are teachers who may remain in rural areas simply because
they were deployed there and not because of benefits they get there.
Locke further refutes expectancy theory by noting that not all decisions are made
consciously. In other words, individuals are sometimes impulsive and make choices
based on emotions, not their values or beliefs about pleasure or pain that they will
receive from their actions. For example, if an employee does something against an
organisation policy based upon their anger toward a co-worker, the given act may
not have been thoroughly thought through and would result in punitive action rather
than the pleasure they may have thought that they would receive from their
behaviour (Locke 1975). Increasing instrumentality in an organisation will be part of
maintaining effective reward systems for the attainment of specific goals. Therefore,
the reward system for rural teachers should include rural hardship allowances as a
retention strategy.
2.5 Other Employee retention strategies
2.5.1 Money/pay/incentives/ and rewards
According to Swanepoel (2001) money and incentives reduce turnover, promote
team work increases productivity, organisational morale, efficiency and objective
achievement. He also states that, to encourage valuable staff to remain, the
remuneration system must provide ample rewards for those employees to feel
satisfied when they compare their rewards with those received by individuals
performing identical jobs in other organisations. The assertion is buttressed by
Davies (2003) who approves that part of the strategy of pay decision is determining
on the level of pay relative to the market, to attract, retain and motivate suitable
employees. In the Ministry of Education, Sport, Arts and Culture, urban teachers
generally get better monetary rewards in terms of teacher incentives that are paid
from 10% of the total levies collected. On the contrary most rural schools are unable
to pay any incentives due to failure by parents to pay fees for the children. Poor
incentives lead to rural teachers seeking transfers to urban schools with the capacity
to pay fees which will in turn enable them to pay teachers incentives thus the overall
package in urban areas is attractive. Mullins 2005 is of the opinion that pay
continues to be central in determining motivation to perform thus pay is a retention
tool.
Schultz (2006) theorises that in order to motivate workers, organisations must
ensure that they pay close attention to the individual development needs of the
person. Money is equally significant as a motivator. Mullins (2005) has the same
opinion when he articulates, that for infinite majority of people, money is clearly
important and a motivator but the extent and how important money is, depends
upon their personal circumstances and other job satisfactions they drive from work.
Teachers in rural areas need to be well compensated for the challenges they face.
However, their individual needs also need to be taken into consideration for
compensation to be complete so as to elicit desired performance. For example one’s
desire to further studies, desire for promotion and access to health facilities should
be enshrined in the entire package because money may not be a motivator for other
people, if this is done teachers will be motivated and they are retained in rural
schools. Horwtz (2004) is of the opinion that seeking to use money as the main
means of motivating and retaining staff is a waste of time. This is also echoed by
Booth and Hammer (2007) who say money as a motivator is short lived once it is
spent or living expenses swell to meet the raise, the reward and its motivational
values become history. Schultz (2006), Davies (2003), Taylor (2002) and Mullins
(2005) totally agree with Swanepoel (2001) in that money is seen as a sense of
accomplishment and recognition hence it can be used for the motivation of
employees.
2.5.2 Job satisfaction
Job satisfaction is a collective of attitudes of an employee to a number of aspects
related to his other job, which include work itself, workplace relationships, rewards
and incentives (Swanepoel 2001). He further state that by compensating employees
objectively,
providing
bonuses
for
high
performers,
providing
promotion
opportunities, communicating regularly, linking pay to performance and providing
opportunities for work, employees will remain in an organisation for long. This is
supported by Jubernkanda (2004) who states that job satisfaction results when a job
fulfils or helps to attain an individual’s values, expectations and standards and one
likes to stay. In order to retain teachers in rural areas, it is imperative for the
Ministry of Education, Sport, Arts and Culture to ensure that all aspects of job
satisfaction for rural teachers are addressed. These aspects include a facet of issues
such as conducive school infrastructure in terms of buildings, teachers’ houses,
sanitation, teaching and learning resources among other issues. The working
conditions and environment in rural schools can lead to job satisfaction which will in
turn lead to retention of teachers in rural schools. Evans (2001) concurs when he
looks at job satisfaction as a state of mind encompassing all those feelings
determined by the extent to which the individual perceives his or her related job
needs to be met. Pilbeam and Corbridge (2002) are further more in agreement when
they say job dissatisfaction creates a work force that is more likely to exhibit higher
turnover, higher absenteeism, lower corporate citizenship, more grievance, strike,
sabotage, and vandalism.
According to Mullins (2005), job satisfaction is the internal state and can be
associated with personal feeling of achievement either quantitative or qualitative.
Mullins (2005) further posits that job satisfaction is affected by such valuables like
individual factors, social factors, environmental factors, organisational factors and
cultural factors. Individual factors include education, age and abilities, social factors
embrace size of organisation and nature and finally cultural factors include beliefs
and values. These factors are bound to have diverse levels of job satisfaction for
different people. The Ministry of Education, Sport, Arts and Culture, should conduct
a scan of factors of job satisfaction for rural teachers in order to ensure job
satisfaction and retention of rural teachers.
Job dissatisfaction does not help in the motivation of workforce. Pilbeam and
Corbridge (2002) say job dissatisfaction creates a workforce that is more likely to
exhibit higher absenteeism, lower corporate citizenship, more grievance, strike,
sabotage and vandalism. Employee dissatisfaction amongst rural teachers is a
product of poor compensation, poor working conditions and poor benefits. These
poor working conditions in rural schools may force rural teachers to seek transfers to
urban areas. Employee satisfaction can be brought about by providing employees
with recognition, advancement, personal growth, feedback support and leadership,
this is crucial in employee retention.
2.5.3 Empowerment
Empowerment supplies people with power, strength and energy to tackle changes.
Swanepoel (2001) states that empowerment provides employees with a sense of
autonomy, which increase job satisfaction and employees make decision that benefit
the organisation. He also postulates that they need to be supported, respected, and
listened to. Odums (2007) agrees with Swanepoel (2001) when he defines
empowerment as sharing varying degree of power with lower level employees to
better produce good results. Schultz (2006) compliments on to say empowerment is
the sharing of influence and control with employees. Good leadership should allow
employees to share developing goals and strategies and the satisfaction derived
from reaching these goals. As a way of motivating retaining teachers in rural
schools, the Ministry of Education, Sport, Arts and Culture should involve rural
teachers in decision making and strategic planning. This could be done through
consulting rural teachers on policy issues pertaining to rural schools. Schultz (2006)
further agrees with Swanepoel (2001) by saying, people in contemporary
organisations want to have greater say in the workplace, henceforth feel secured.
Rural teachers should also be given the opportunity to have a say in the way rural
schools are managed.
Empowerment also entails flexibility on the part of the employer. Taylor (2002) is of
the opinion that an organisation wanting to retain their employees must be governed
by principles of flexibility, autonomy and variety of responsiveness. Taylor (2002)
further states that flexibility should apply to hours of work, recruitment and selection
and effective supervision. Flexibility on working hours of rural teachers especially on
Fridays to enable them to travel if they would like to do their business in urban
centers may be a good retention strategy for rural teachers considering transport
problems they encounter and the distances they travel to nearby towns.
Professional supervision is critical when it comes to empowerment of rural teachers.
Taylor (2002) says unscrupulous supervisors are those who abuse their positions,
who show undue favouritism to some staff, who fail to appreciate their subordinates
and those who fail to deliver their promise. It is important for education inspectors
and school heads to be professional when supervising rural teachers as this may
assist in rural teacher retention. Rural teachers also need to be treated with respect
and be guided professionally during the supervision process. If conceivable the
Ministry of Education should empower its rural teachers by, for example, an
advantageous working environment, being transparent, showing integrity and
showing commitment to its workforce. When this is done, the rural teacher possibly
will be motivated, thus can be retained in rural schools.
2.5.4 Career Development
Career Development is viewed as one of the most important drivers of engagement
and retention. Swanepoel (2001) states that one key factor in employee motivation
is giving them the opportunity to grow and develop enhancing skills. According to
Swanepoel (2001) enhancing employee’s current job performance, enables the
individual to take advantage of future opportunities, therefore, the employee will not
leave the organization as a career means security, commitment, loyalty and
performance, and this is what many employees aspire for in order to remain in the
job. Rural teachers could be given a better quarter when it comes to manpower
development programmes of the Ministry. Study leave could also be designed in
such a way that rural teachers get a fair share considering the fact that they are
located in areas that do not have resources that enable them to further their studies
as compared to their counterparts in urban areas. This may minimize the rural
teachers’ desire to transfer to urban areas. Individuals will be motivated if an
organisation clearly considers and cares for their career priorities. In the education
sector, career development can be done by providing opportunities for advancement
through promotion and the requirement for promotion should be such that those
who serve in rural schools are given the first priority when it comes to their areas.
Swanepoel (2001) and Oakland (2001) concur in that career development is all
about caring and nurturing talent in an organisation, keeping employees informed,
interested and fulfilled to prevent high turnover rates as employees take ownership
of their careers and recognise the need to continuously refine and upgrade their
skills. From the above, the irony is that the more employees feel that they are able
to grow in an organisation, the more they can be retained in that organisation. To
upsurge rural teacher commitment, loyalty, and effectiveness, the Ministry of
education, Sport, Arts and Culture must manage career development meritoriously.
The advancement of the rural teacher in training and development provides an
opportunity promotion thus career development will help in retaining valuable
employees. Taylor (2002) ropes the argument with regard to training and
development in that investment in training paid by the government or any employer
appears to reduce the desire to quit the job by employees. Training is a symbol of
employer’s commitment to staff. It has increasingly come to be recognised as an
important part of a retention tool. It appears normally factual that persistent training
tends to retain employees in an organisation. Teachers in rural schools, therefore,
can be given the opportunity for career development through various programmes
such as staff development and a higher quota when it comes to study leave for them
be retained in rural areas.
2.5.5 Job Enrichment
Swanepoel (2001) states that job enrichment means improvement in the quality of a
job such that employees are more satisfied and fulfilled through recognition,
responsibility and are stimulated to work. He correspondingly states that the
objective of job enrichment is to generate jobs employees will enjoy henceforth this
leads to employee retention. Job enrichment methods endeavour to modify the
nature of the job. The rural teachers’ job can be enriched by broadening
responsibilities, giving more autonomy for decision making, creating employee
satisfaction and direct feedback systems and generally enlarging scope of jobs.
Heads of rural schools can solicit feed back from teachers by having an open door
policy which encourage the sharing of ideas and quickens problem solving. Rural
teachers should be given the opportunity to experience achievement, recognition,
stimulating work, responsibility and advancement.
Swanepoel (2001) states that
through job enrichment employees perceive their work as treasured and worthy
while, employees feel personally responsible for the quality of their work and
ultimately they will be motivated and retained to contribute to the organisation.
Enriched will meet the requirements of progressively educated employees such as
teachers employed by the Ministry of Education, Sport, Arts and Culture.
2.6 Conclusion
The chapter reviewed literature and established from research on qualified teacher
distribution that in general qualified teachers tend to be concentrated in urban areas
due to a number of factors. These are the factors that make teachers shun rural
schools for instance; lack of decent accommodation , desire to take up further
studies, shortage of teaching and learning materials, lack of transport and
communication related problems. The chapter also discussed motivation theories
associated with employee retention which include Maslow’s Hierarchy of Needs,
Herzberg’s Two factor theory and Vroom’s Expectancy theory. The next chapter
discusses research methodology used to solve the research problem.
2.3 Causes of Low Morale
2.3.1 Poor/Inflexible working conditions
Mullins, (2005) believes that low morale result in organizations because the
atmosphere is not conducive because there are some type of work that are generally
more dangerous than others. Swaneopoel, Erasmus,Van Wyk and schenk (2000)
states that failure by organizations to adopt employee wellness into their culture will
inevitably lead to the escalation of sickness and the deterioration of organizational
performance. Swanepoel et al 2000 define employee wellness as employee state of
optimized social physical and mental health and well being. Nyoni as cited in Bates
(2000) in his investigation into the causes of accidents in given factory found that
accidents occurred to both unsafe acts and unsafe conditions workers and
supervisors felt that the causes of accidents were poor house keeping faulty
machinery, slippery floors and overloading workers.
2.3.2 Higher Pay Elsewhere
Middle brook, (1999) suggests that the prospect of getting higher pay elsewhere is
one f the most obvious contributors to low staff morale in organizations. Armstrong,
(2007) substantiates the point and writers that inadequate wage levels leads to
employees becoming dissatisfied with their jobs. Financial remuneration remain an
important factor for employees because they are attracted to buoyant local regional
and international markets offering more and perhaps more attractive opportunities
as supported by other theories of motivation.
2.3.3 Departmental Layoff or Closures
Layoff is the temporary suspension or permanent termination of employment of an
employee or a group of employees for business reasons such as the decisions that
certain positions are no longer necessary or business slow down or interruption in
work. Downsizing is the conscious use of permanent personnel reductions in attempt
to improve efficiency and or effectiveness. According to Carrell (1997) downsizing is
a catchall phrase for a variety of approaches that organizations use to reduce the
number of people they employ. Downsizing tends to have a negative impact on
morale of the remaining employees because they have to find ways to the work
performed by former employees. Downsizing can threaten employees’ sense of well
being in several ways. They see the company as having behaved unjustly or unfairly.
They obviously feel secure and may also lose the belief that their contribution to the
business will be rewarded in future and thereby threaten business performance.
Employees feel unsettled during downsizing. However just accepting loss of morale
as an inevitable consequence may under mine productivity gain intended by the
change.
2.3.4 Poor Communication /Information
If the communication is poor then the message received will be hard to understand
and can easily lead to confusion and too much information can seriously affect the
concentration of the listener thus may result in low employee morale. Information is
defined as the collection of data that have been interpreted and understood by the
recipient of the message. It is very vital to the sustainability of a business or office
or organization, for its growth as well as for proper planning, controlling, directing
and forecasting. It is hypothesized that information that is not concise relevant and
timely can lower morale and productivity of employees in an organization. It is
equally observed that information is the bedrock of efficient management of any
organization because it depends on processed data, which is translated into
information for decision making.
2.3.5 Lack of Training and Development and Career Opportunities
Organizations find it difficult to measure the effectiveness of training and
development. The reality is that while training does cost money, failing to train
almost always costs more and results in poor performance (Carrell 2007).Training
and developing of employees in organizations directly impact service quality and
stakeholder satisfaction. Failure to recognize talent skills and endeavor can also
result in disgruntled employees thus resulting in low staff morale. Cole (2000)
further emphasizes that employees whose training needs or on the job issues are
not dealt which are likely to be dissatisfied and frustrated. Failing to train also tends
to have a poor effect on employee morale lowering productivity still further.
2.3.6 Conflicts
Low morale could be because of personal conflict between employees or because
one person is disruptive. Conflict is defined as natural disagreement resulting from
individuals or groups that differ in beliefs, attitudes values or needs. This can be
caused by lack of cooperation, communication failure, goal differences, and inflexible
work schedules excessive overtime and sub standard performance differences
regarding to authority and difference regarding to responsibility (Swanepoel et al
2000). Swanepoel et al (2000) further point out that behavior based conflict occurs
when certain patterns of role behavior are in conflict with expectations of behaviors’
in other roles. For a example a male manager is expected to be self reliant
emotionally stable and some what aggressive whiles the managers family expects
him to be warm and caring.
2.3.7 Stress
Stress also affects morale. It can result in emotional and physical fatigue and a
reduction in work motivation involvement and satisfaction. Feeling over stressed can
result in erosion of one’s idealism, sense of purpose and enthusiasm. Swanepoel et
al (2000) define stress as the arousal of mind and body in response to an
environmental demand. Carrell concurs with Swanepoel et al (2000) on the definition
of stress as discrepancy between an employees perceived state and desired state
thus stress influences the employees psychological and physical well being therefore
this can result in low staff morale since employees may not be able to meet their job
demands. Swanepoel (2000) that stress is a person’s adaptive response to excessive
psychological or physical demands caused by one stimulus. Apart from the stress
that arises from the work situation other sources of stress may relate to personal
factors such as relationships with others.
2.3.8 Poor Management
Swanepoel et al (2000) also highlight the importance of front line managers and how
their behavior relates directly to employee engagement job satisfaction advocacy
and performance. Poor management decreases employee morale. Robbins (2002)
suggests that when employees feel valued and their needs are met they are likely to
exhibit good behavior within the organization. In order to obtain the best
performance from employees it is necessary to understand what motives then in
general the implications of motivation on management human beings are complex
and the manner in which employees are treated has a profound influence on their
work performance.
Several models have been developed in relation to the nature of an employee and
how he/she is motivated. These models seek to explain the nature of man, what and
how man is motivated.
2.4.1 The Rational Economic model
The rational-economic man model assumes that people are motivated by avoiding
unpleasant behavior and are attracted with what gives pleasure. Carrel’s et al (1997)
propose that this model which incorporates McGregor’s theory assumes that
managers hold one of the two opposed views of nature of man that is theory X and
theory Y. These two sets of assumptions which management may have concerning
employees affect the leadership behavior towards subordinates. McGregor’s theory X
model maintains that to get results is to control subordinates and threaten them
when necessary because employees are lazy, they dislike work and they avoid
responsibility. Workers therefore need close direction and supervision (Bates 2002).
Carrell et al (1997), stress that the proponents of this approach believe that the
authority of the employer is supreme and have a pessimistic view of man. McGregor
1960 thus proposes that bosses tend to treat subordinates according to their own
discrimination. However in his theory Y McGregor 1960 as cited by Robbins (2002)
assert that subordinates actually enjoy working and will strive to meet targets and
objectives to which they are committed, they have initiative and can work hard given
the opportunity. Armstrong (1998) points out that the central principal of
organizations that McGregor derived from theory Y is that of integration that is the
process of recognizing the needs of both the organization and the individual. This
will see man exercising self direction and self control in the achievement of
objectives to which he is committed.
In his theory Y the supervisor teds to build team spirit and feeling of commitment to
the organizational objectives. He also communicates both up and down and support
his team when necessary (Bates 2002). As a result all employees can make
significant contribution if encouraged. Low staff morale tends to be in environments
where employees feel they are taken advantage of where they feel undervalued or
ignored and where they feel helpless or unimportant (Swanepoel et al 2000).Robbins
(2002) claims that the responsibility for organizational performance will therefore
rest with management. Workers are only expected to do the reward and control
systems encourage and permit. McGregor’s rational economic model maintains that
money and material gain motivate employees as a result they are influenced by
those with power to influence material benefits. Schein (1972) further points out
that employee are motivated by economic incentives.
2.4.2 The Social Man Model
The model was propounded by Schein advocates that man is not driven by money
nor material gain but by social factors in the work environment. Employees in this
model respond more to their peers than monetary incentives and to controls of
management in determining there performance. The manager will only be concerned
with tasks and needs of people, subordinates feelings instead of manipulation and
control. Cole agrees with Swanepoel et al (2002) that acceptance of this view by
managers implies a close attention to people’s social needs with less emphasis on
task considerations.
Management will accept the reality of informal groups at the work place. The major
benefit of using this model would be the development of more loyal employees.
However, failure to respond to employees needs may result in unionizing and
causing more problems for management and in turn poor staff morale.
2.4.3 The Complex Man Model
Cole (2002) views motivation as an altogether more complex matter than previously
conceived. People are complex and variable they respond to a variety of managerial
strategies and are more affected by different tasks and different work groups. In the
analysis of nature of an individual Schein in Swanepoel et al (2000) claim that the
fore mentioned models are too general to have a deeper understanding of what
actually motivate employees to influence their work performance. However in the
complex man model Schein 1972 argues that no one fits in the two models above as
man is too complex to an extent that his needs may change depending on the
situation. Furthermore Swanepoel et al (2000) argue that people have different
needs even when in the same group. Swanepoel et al (2000) propose that
management must be able to diagnose and value these differences. Failure to do
this will result to low staff morale. Robbins (2002) suggests that merely
understanding the nature of employees is not enough, but also what motivates them
and how they are motivated. Theories of motivation have been developed to try to
answer these questions.
Carrel’s et al (1997) propose that operation of organizations logically begins with
people within the organization therefore organizations as entities do not behave or
perform it is individual within them who give them life and responsible for their
performance. Employees are the greatest asset no matter how efficient the
technology and equipment may be. It is no match for the effectiveness and
efficiency on staff of the organization. Internal differences that include values
attitudes, personality and perceptions make each person unique. These individual
differences cause people to choose a variety of behavior or decisions when faced
with the same situations thus managers and co workers are faced with challenge of
achieving organizational objectives through the efforts of diverse individuals. In an
organizational context the key questions is what factors are important stimulants
that will effectively motivate a person to extend high levels of effort to achieve
organizational goals. Employees expect that the attainment of organizational goals
will correlate with rewards they receive from the organization and the reward they
receive from the organization and the reward enable them to fulfill their personal
goals thus a circular process develops Fig 2.1 below in which higher levels of
employee motivation lead to greater quality and quantity of work which thus lead to
higher organizational productivity and profits that the organization to provide the
employee greater rewards and recognition (Carrel, et al 1997).
Fig.2.1 A Circular Model of Employee Motivation and Organizational
Success
Higher employee
motivation
Employee reward
recognition
Greater quality,
quantity of work
Higher
organizational
productivity
Carrell et al (1997) claims that the key elements required to make the above
intuitive model operational are the right rewards and recognition that will motivate
employees, employees perceptions that greater quality and quantity of work will
affect productivity of the organization’s ability to effectively link greater employee
rewards to higher levels of productivity. If there is any element missing then
employees may not be as highly motivated in the work place, for example an
employee may not believe that his or her own level of effort will affect the
productivity of the organization.
According Armstrong (2003) motivation is the process of encouraging people to
apply their efforts and abilities in ways that will further the attainment of the
organizations goals as well as satisfaction of their own needs. In other words
motivation is a set of processes, which stimulate guide and sustain goal directed
human behavior in an organization. Armstrong (2003) proposes that motivation is
inferred from or defined by goal directed behavior. It is concerned with the strength
and direction of behavior. Armstrong (1998) further asserts that motivation takes
place when people expect that a course of action is likely to lead to the attainment
of a goal: a valued reward one, which satisfies their particular needs. Purcell et al as
cited in Armstrong (2003) believes that discretionary behavior that helps the firm to
be successful is likely to happen when employees are well motivated and feel
committed to the organization and when the job gives them high of satisfaction.
Swanepoel et al (2000) have classified these theories of motivation into three
categories namely the content process and reinforcement.
Morale is the base of motivation. Motivation is a key component of productivity.
Without motivation employees may not perform to their highest level. Therefore
motivation is essential for the survival of the organization.
2.5 Theories of Motivation
According to Swanepoel et al (2000) a popular taxonomy of motivational theories
divides the various theories into content, process and reinforcement theories.
Content theories focus on factors that allegedly motivate people for example needs.
Process theories on the other hand try to analyze the process or manner in which
people get motivated. Reinforcement theories focus on how people can be
conditioned to exhibit the desired behavior.
The content theories are Maslow’s needs hierarchy, Alderfer’s ERG theory, Herzberg
two factor theories, McClelland’s achievement motivation theory and Locke’s goal
setting theory. The process theories include cognitive dissonance theory, Vroom’s
expectancy theory. Reinforcement is discussed below (Swanepoel et al 2000).
2.5.1 Content Theories of Motivation
2.5.1.1 Maslow’s needs Hierarchy
Robbins (2002) postulates that Maslow’s 1935 content motivation theory advocates
that within each individual there are five levels of needs. These range from
(increasing order) physiological (food, water and shelter) safety and security
(protection from physical and emotional harm).affiliation (need to belong to or
friendship), esteem (achievement, recognition) and self actualization or achieving
personal goals.
Carrell et al (1997) agrees with Maslow’s hierarchy of needs that individuals will
climb the ladder of need fulfillment until they have become self actualized. Bates
(2002) also asserts that Maslow’s hierarchy of needs at each level must be satisfied
first before people attempt to satisfy at the next level.
Armstrong (2003) concurs with the above authors’ hierarchical needs of Maslow and
states that when lower need is satisfied the next highest becomes dominant and the
individual’s attention is turned to satisfying this higher need. However Armstrong
(1998) notes that the process satisfying Maslow’s hierarchical needs is not as
straight forward process as suggested above. He argues that self fulfillment can
never be satisfied and that lower needs still exists Fig 2.2 below shows Maslow
Hierarchy of needs. As depicted in this hierarchical diagram sometimes called
Maslow’s Needs Pyramid or Maslow’s Needs Triangle, when a need is satisfied it no
longer motivates and the next higher need takes its place.
Fig 2.2 Maslow’s Needs Pyramid
Self Actualisation
Affliation Needs
Social Needs
Safety Needs
Physiological Needs
(Adapted from Swanepoel et al 2000)
2.5.1.2 Herzberg Two Factor Motivation theory
According to Carrel et al (1997) unlike Maslow’s hierarchy of needs motivation
theory, Hertzberg (1957) Two Factor theory distinguishes between two sets of
factors hygiene and motivation. The assumption is that the two factors are
necessary to motivate staff at a work place. Carrel et al (1997) assert that the
hygiene or maintenance factor including pay supervision working conditions, work
rules and policies pertain largely to the job environment are seldom mentioned as
causing positive job satisfaction. However these factors on their-own do bring about
motivation. The second group of factors that is motivators are specifically job
centered (recognition, achievement, responsibility support for achievement and
opportunity) provide motivation. As a theory of motivation Hertzberg’s ideas have
been effectively discredited mainly on the grounds that there is no evidence to
support his concept of two independent sets of factors in motivation. Campbell as
cited by Cole (2002) have claimed that in an empirical sense Hertzberg’s work has
been concerned more with job satisfaction or dissatisfaction rather job behavior.
2.5.2 The Process Theories
Carrel et al (1997) suggest that the process theories of motivation focus on how
individuals interact with their work environment as it affects their behavior.
(Swanepoel et al 2000) view the process theories as composed of the cognitive
dissonance and Vroom’s expectance theories mainly focus on how people are
motivated.
2.5.2.1 Cognitive Dissonance Theory
According to Robbins (2003) the cognitive dissonance theory was first proposed by
Festinger. Swanepoel et al (2000) argue that the cognitive dissonance theory
assumes that if a person does poorly a number of times he will do it poorly again the
next time even if he could better in order to be consistent with his perceptions of
incompetence. Therefore if a manager finds fault with a subordinate’s work and
accordingly corrects it the subordinate considers him or himself a failure.
2.5.2.2 Vroom Expectance Theory
On the other hand Vroom’s expectancy theory proposes that the tendency to act in a
certain way depends on the strengths of the expectation that the act will be followed
by a given outcome and on the degree to which that outcome is desired by the
individual (Swanepoel et al 2000). According to Carrel et al (1997) expectance
theory states that motivation is a function of expectancy (E) or probability that ones
effort will achieve a certain level of performance will be instrumental (I) in their
receiving rewards or outcomes for which they place a certain value or valence V.
These critical factors can be expressed in a single equation:
M=E*I*V
According to Bates (2000) Vroom’s expectancy theory is a complex theory which can
be summarized by saying the manager should know the individual needs and
strength of his staff and their expectations he must inform them of the connection
between performance and reward and conduct supportive performance appraisal
discussion with them.
2.5.3 The Reinforcement Theory
The theory focuses on how people learn to exhibit desired behavior. It is based on
the law of effect that is (behavior that leads to more favorable response is more
likely to be repeated than one that leads to less favorable response).Carrell et al
(1997) assert that this is achieved by giving valued rewards to one who has just
engaged in desired behavior. In practice when negative reinforcement is used for
example an employee receiving a written disciplinary notice that another unexcused
absence will result in termination usually leading to poor staff morale of other
members in the organization.
The theories above sought to highlight that organizations must put employees first
because only motivated employees can most effectively deliver. In the current talent
shortage organizations should also ensure they know who in their organization will
be their lifeblood for the organization’s future and could therefore be trained and
developed. Writing and implementing a succession plan will ensure organizations
invest time and energy into the employees.
2.6 Factors affecting staff morale on the shop floor
Staff morale is a very complex phenomenon and is influenced by many factors on
the shop floor. Each individual may be affected by different issues. According to Cole
(2007) several criteria seem important in the determinants of levels of staff morale
such as:
2.6.1 Mission Statement and Objectives of the Organization
Employees are highly motivated and their morale is high if their individual goal and
objectives are in tune with organizational goals and objectives. If a mission
statement is lacking employees have difficulties in performing their duties without
the correct information (Cole 2002).A clear mission statement is needed to establish
the direct and commitment through out the organization because mission statement
expresses the organization’s reason for existence since it focuses on what the
organization does and does not do (Carrell et al 1997).
Carrell
et
al
(1997)
further assert that mission statement not only states the product or service goals
and objectives of the organization but also the strategies, values and commitments
which provide direction and guidance to its employees, stockholders and customers.
The organization must determine and communicate the operational direction in order
to avoid turmoil. The mission statement should be effectively conveyed to all staff or
else or it could be ineffective.
2.6.2 Organizational Design
Robbins (2002) says that organizational design essentially means choosing an
organizational structure that is appropriate for strategy implementation and mission
accomplishment. Organizational structure is then defined by Carrell et al (1997) as
the formal relationship including the number of hierarchical levels, managers, span
of control, decision responsibilities and lines of authority. Organizational Design has
an impact on the quality of labour relations, particularly on the level of morale. Large
organization tend lengthen their channels of vertical communication and to increase
the difficulty of upward communication. Therefore staff morale tends to be lower.
Swanepoel et al (2000) states that an organizational design emphasis the
importance of achieving high levels of production and efficiency through extensive
use of rules and procedures, centralized authority
and specialization of labour
will lead to a tall, pyramid shaped structure with a hierarchy of many different levels.
Against this, flat structure increases levels of staff morale. Swanepoel et al (2000)
entails that organizational design that emphasis aspects like the importance of high
levels of adaptiveness responsiveness and development through limiting the rules,
regulations and procedures.
2.6.3 Training and Education
Poor training of employees is one of the most important aspects affecting staff
morale. For example if an employee is not imparted proper training he /she will have
low morale. Awareness training seeks to help employees recognize the value of a
diverse workforce and to treat people who are different from themselves with dignity
and respect. Absence of dignity and respect of other people’s view lead to low
employee morale. Decenzo and Robbins (2004) define training as a learning
experience in that it seeks a relative permanent change in an individual that
improves his or her ability to perform on the job. Cole (2002) defines training as the
preparation for an occupation or for specific skills it is narrower in conception than
either education or development. Training is more economically viable to the facility
than civil liability and damaging publicity which may occur from improper reactions
to unusual situations. Providing staff with desirable and informative training
will
improve officer job perception. Training also reflects upon professionalism of staff.
Maintaining a positive atmosphere must be reflected by the professionalism of
employees representing the organization. Encouraging staff to further their
education on issues relevant to their job functions reflects positively upon morale.
Education in general sense refers to the broad educational process covering preschool primary secondary and tertiary education, this usually occurs outside the
organization. Employees who are motivated to advance their knowledge of issues
which are confronted on the job tend to combat boredom and promote more
interest and involvement in the organizational environment. Promoting continuing
education allows staff to become diverse and knowledge regarding current situation
and future issues facing the work environment.
Training combined with education provides staff with improved self worth and an
increased job performance. Implementing programs designed to improve morale by
improving and developing professional and personal growth has a positive impact on
staff retention.
2.6.4 Good Leadership and Supervision
A supervisor is the best performer of an organization but if that person fails to lead
the individual is worthless. A failed leader becomes a detriment to staff and
institution alike. The nature of supervision can tell the attitudes of employees
because a supervisor is indirect contact with the employers and can have better
influences on the activities of the employees. Newstrom (2002) claim that
supervisors may influence employee morale by simply working among the officers
leaders do create a vision of the future that is followed by others, they are usually
enthusiastic they lead by example, they challenge the status quo. Leaders that
micromanage the work of others ignore organizational problems, encourage
subordinates to protect them from bad news and take the credit for others create an
environment with low staff morale (Carrell et al 1997).Unsuccessful supervisors
attempt to direct while sitting behind a desk and a closed door. It is utmost
importance of supervision to accurately identify issues which may have an effect
upon employee morale. A survey conducted by the United States Chamber of
Commerce was performed on 24 separate organizations to measure morale factors
and place them in order of importance. The results reflected a discrepancy between
supervision perceived importance of the ten morale factors. This reveals the need for
supervisors to properly recognize and promote behaviours which will maintain and
increase positive employee morale.
2.6.5 Staff Empowerment
According to Carrell et al (1997) the concept of employee empowerment is to give
non management employees the freedom to make decisions about their work
without any supervision approval. Employee empowerment is a primary approach for
encouraging valuing their jobs. This consists of a conscious and organized
development of involving employees in their work through inclusion. Staff should be
trusted to contribute in decision making goal setting and problem solving.
Restrictions on staff empowerment effect job satisfaction and creativity thus having
negative results upon morale. If the job gives an employee an opportunity to prove
his talents and grow personality he will certify like it and he will have high morale.
Involving employees by encouraging input on recommendations and plans of action
accept the challenge to initiate changes and expect to be rewarded according to
their performance to enhance morale issues.
2.6.6 Work Environment
The building and its appearance the condition of machines tools available at work
place provision for safety, medical aid and repairs to machinery all have an impact
on staff morale. A safe environment is required to reduce inappropriate inmate
behavior and increase employee job satisfaction. Point out that an environment of
negative morale will lower employee job satisfaction and reduce organizational
commitment. Employee morale is instrumental in creating a unified and functional
atmosphere.
Chapter 5
MARKETING
A market is any set of arrangement that allows buyers and sellers to exchange
goods and services. Marketing is a management process responsible for identifying,
anticipating and satisfying consumer’s requirements (needs and wants) profitably.
This is done by getting the right product at the right price to the place at the right
time.
Human needs are a state of felt deprivation. They are basic necessities people
cannot do without e.g. food, clothes etc. Wants take the form of human needs as
shaped by culture and individual personality. The people can do without them.
Human beings have unlimited wants, but there are limited resources, so people have
to choose products that offer the greatest value and satisfaction.
The marketing objectives





To increase profits and make the business grow by increasing sales revenue
and profits through marketing by selling more products as a result of
intensive advertising campaigns. Business aiming to grow often attempt to
create a competitive advantage.
To gain and maintain sales and market share. This is so because if the
business is to introduce a new product it will have to promote the product to
break through into the market. This can be achieved by charging low prices to
penetrate the market.
To differentiate products from those of competitors by changing packaging,
design, and ingredients advertising or charging high or low prices.
To introduce new products into the market if research indicates that this
could be essential.
To gain consumer knowledge about their needs and wants.
The purpose of marketing





To satisfy consumer‘s needs. If the business is to be successful then it has to
produce goods and services that satisfy consumer needs and wants.
To identify consumer needs and wants through market research.
To anticipate consumer needs and wants. This is trying to understand what
consumers want in advance. This is because consumer tastes and preferences
are changing faster nowadays so marketing should respond to these e.g.
butcher stocking goat meat before Christmas.
To compete effectively by providing products and services with the greatest
value to consumers. This results from well identified consumer needs and
wants.
To make a profit
Consumer and Business Marketing
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Consumer marketing is marketing to consumers or end users of products and
services e.g. marketing products in supermarkets.
Business to business marketing is where one business is engaged in
marketing its products to another business. This might include office furniture
producer marketing furniture to business users or a car manufacturer
marketing to a business.
Coordination of marketing department with other departments
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The marketing objectives will be achieved with assistance of other
departments. The marketing department will coordinate the work of other
departments to help achieve their marketing objectives.
The finance department uses sales forecasts of the marketing department to
come up with cash flow forecasts and operational budgets.
The finance department will have to ensure that enough capital is available to
fund the marketing budget.
The human resources department uses these sales forecasts to devise a
workforce plan for all departments’ e.g. additional staff. Recruitment and
selection of qualified staff is done to produce the increase in sales planned for
by the marketing department.
The production department will use market research data in developing new
products. Also sales forecasts can be used for capacity planning, raw material
purchases and acquisitions of new machinery.
Marketing management
This is the analysis, planning, implementation, and control of programmes designed
to create, build and maintain beneficial exchanges with target buyers for the
purpose of achieving organisational objectives.
Marketing management philosophies (concepts)
Production concept
States that consumer will favour products and services that is available and highly
affordable. The management should therefore focus on improving production and
distribution efficiency. The concept applies in two situations:
1. When the demand for a product exceeds supply so the management should
focus on ways to increase production.
2. When product cost is too high and improved productivity is needed to bring it
down. This helps to spread overheads over large quantities of products.
The organisation try to concentrate on efficient, low cost production with the
expectation that the goods will find a market provided the price is low enough. The
firm will try to sell what they make.
Product concept
States that consumer will favour a product that offers the best quality, performance
and features. The firm devote its energy to make continuous product improvements.
The firm maintains a detailed version of the new product idea stated in meaningful
consumer terms. It assumes that suppliers know best, it will produce high quality
goods and expect customers to buy them.
Product oriented firms exist in product areas where quality or safety is of great
importance e.g. bottled water plants and manufacturers of crash helmets.
Selling concept
States that consumer will not buy enough of a firm’s product unless the firm
undertakes a large scale selling and promotion effort. It is practiced with unsought
goods, those that consumers do not normally think of buying e.g. insurances. It is
practised when firms have over capacity. Their aim is to sell what they make rather
than make what the (market) consumers wants. It focuses on creating sales
transactions rather than building long term, profitable relationships with customers.
It assumes that customers who are persuaded to buy will like the product. However
disappointed buyers do not buy again and will tell ten others about their bad
experiences.
Marketing concept
It holds that achieving organisational objectives (goals) depends on determining the
needs and wants of the target markets and delivering the desired satisfactions more
effectively and efficiently than competitors do. It takes an outside –in approach. It
continually identifies reviews, and analyses consumer’s needs. It is led by the
market. It carries out large scale marketing efforts. The consumers are central in the
firm’s decision making. It starts with a well defined market, focuses on consumer
needs, coordinates all the marketing activities affecting customers, and makes profit
by creating long term relationships with customers based on customer value and
satisfaction. Customer value and focus are the paths to sales and profits.
Advantages of the marketing concept
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It can respond more quickly to changes in the market because of its use
market information.
It will be in a stronger position to meet the challenge of new competitors
entering into the market
It will be more able to anticipate market changes.
It will be more confident that the launch of a new product will be a success.
However
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It will have to consult the consumer continuously (research)
It will design the product according to the wishes of the consumers but the
consumers’ wishes are varied.
It will have to produce the product in the quantities that consumers want to
buy.
It will have to distribute products according to the buying habits and delivery
requirements of consumers which might be difficult and expensive.
To set the price of the product at a level that the consumer is prepared to
pay.
Societal marketing concept
This is the idea that the organisation should determine the needs and wants and
interests of the target markets and deliver the desired satisfactions more effectively
and efficiently than competitors in a way that maintains or improves society’s well
being. It questions whether pure marketing concept is adequate in an age of
environmental problems, resource shortages, rapid population growth, worldwide
economic problems and neglected social services.
Society (human welfare)
Consumers (needs, wants)
(profits)
Company
In fast moving consumer goods industry (FMCG) hamburgers, fried chicken, French
fries e.t.c are tasty and convenient foods offered at affordable prices .However they
are high in fat and salt. Environmentalists and consumer groups have voiced
concerns. The packaging also leads to waste and pollution. Thus in satisfying
consumer wants highly successful fast foods chains may be harming the consumer
health and causing environmental problems. Marketers should balance the three
considerations depicted above, that is company profits, consumer wants and
society’s interests. Businesses should put people first before profits.
Asset led marketing concept
Is a marketing concept which is responsive to the needs of the market. It takes into
account its own strengths and weaknesses when producing a good or providing a
service. Its strength might be production techniques, goodwill and branding. It
recognises that some businesses have failed due to a high quality product, but have
not met the needs of consumers or perhaps the product was too expensive or the
business might have failed to persuade retailers to stock the product.
Differences between marketing and selling
Marketing
It is market/customer oriented
It focuses on determining the needs and
wants of consumers
It is concerned about profits in the long
run
It focuses on tomorrow’s products and
markets
Selling
It is sales oriented.
It focuses on creating sales transactions
It is concerned about sales volume
increases
It focuses on today’s products and
markets
Factors which determine the choice of concept adopted (product and
marketing)
Nature of the product- The firms which operate in the edge of innovation or
technological changes like electronics, it must innovate so must be product oriented.
Policy decisions- The objectives of the business determine the concept e.g if it set
in terms of technical quality then product concept is used or if it is to increase
market share emphasis will be on marketing concept.
Management views/philosophy- If managers place emphasis on quality of
products then product concept is adopted.
Nature and size of the market- If production costs are too high then the firm has
to be market oriented to ensure that it meets the needs of consumers and avoid
unsold goods and possible losses
Degree of competition -In a highly competitive market the firm may resort to
research with little regard for a loss in market share.
Mass marketing
 Occurs when a business offers almost the same products to all consumers
and promotes them in almost the same way e.g. coca cola.
 Products are usually sold to a large number of consumers
 The products may be marketed in different countries that are global
marketing.
 The business can manufacture large quantities and the average costs can be
reduced due economies of scale.
 High sales and low average costs lead to high profits
However
 It is expensive to set up the production plant to provide mass marketed
products
 The products face competition in parts of the market from producers who
might be more effective in niche marketing or targeting market segments.
 It does not necessarily guarantee profitable products.
Niche marketing
 This aiming or targeting a product at a particular, often small, segment of a
market.
 It is the opposite of mass marketing.
Reasons for niche marketing
 Small firms are often able to sell to niche markets which have been
overlooked or ignored by other firms. The firms are able to avoid competition
in the short run.
 By targeting specific market segments, firms can focus on the needs of
consumers in these segments. This can allow them to gain competitive
advantage over firms targeting a wider market.
However
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Firms which manage to successfully exploit a niche market attract
competition. The niches by nature are very small to sustain two or more
firms. Large firms entering the markets may be able enjoy economies of scale
than small firms.
Many small firms involved in niche marketing have just one product aimed at
one small market. This causes a great risk of failure.
Niche markets have small numbers of consumers so tend to have swings in
consumer spending than larger markets.
Demand, Supply and Price relationship
Demand is the quantity of a product that consumers are willing and able to buy at
a given price in a time period. The law of demand states more of a product is
demanded at a lower price and less at a higher price.
Demand curve
Price
P1
P2
Q1
Q2
quantity
demanded
Importance of demand curves.
They can be used in analysing and planning their marketing activities. They enable
businesses to:
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Calculate revenue to be earned for any given price change e.g. from p1 to
p2.The revenue is calculated as follows = P1*Q1 or P2*Q2
Predict the likely reaction of consumers to price changes.
Predict the likely impact upon revenue of price changes.
Determinants of demand
 Price of a product-The lower the price the higher the quantity demanded.
 Disposable income of consumers, for most products the higher the income
the quantity demanded.
 Price of substitute and complementary goods. If the price of a substitute
product goes up e.g. butter the quantity of margarine demanded will go up.
 Change in population size and structure. An increase in population will lead in
increase in demand.
 Advertising and promotional activities .successful advertising increases
demand.
 Change in taste and fashion.
Supply is the quantity of a product that firms are prepared to supply at a given
price in a given time period. The law of supply states that more of a product is
supplied at a higher price and vice versa.
Determinants of supply
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Cost of production (labour and materials)
Taxes imposed on the supplier by the government
Government subsidies which reduces costs
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Weather conditions and natural factors
Advances in technology that makes production cost go up.
Elasticity of Demand
Is the degree of responsiveness of the quantity demanded following a change in one
of the determinants of demand
There are four types of elasticity’s of demand namely:
Price elasticity of demand
Is the degree of responsiveness of quantity demanded to a change in price of a
product.
P.E.D= % change in quantity demanded/% change in price
=(Q2-Q1)/Q1*100
(P2-P2)/P1*100
The value of P.E.D is normally negative because a fall in price (-ve) results in a rise
in demand (+ve).E.g. if the price of a cell phone increases from $40 to $50 the
demand will fall from 300 to270 cell phones.
P.E.D=270-300/300*100= -10%
50-40/40*100 = 25%
-0, 4 (the negative sign can be overlooked)
P.E.D of 0, 4 is less than 1.It is said to be inelastic. This shows that an increase in
the price of a product does not result in a significant change in quantity demanded.
Products like basic food have an inelastic demand. It is recommended to raise the
price of the product to increase the sales revenue of the firm .The lower sales will
mean lower cost so the profits will increase. If demand is inelastic the producer will
have to spend more on advertising to increase sales.
If the P.E.D is greater than 1 demand is elastic. A slight change in price results in a
proportionate increase in quantity demanded. It is necessary to lower the price of
the product to stimulate demand for the product. This will increase sales revenue
and total profits. However higher sales mean higher costs. Profits will only occur if
the increase in sales revenue is greater than increase in costs.
Factors that determine Price elasticity of demand
 Availability of close substitutes makes the consumers to switch to another
brand if there is an increase in the price of the other e.g. margarine and
butter.
 Nature of product, a necessity is less likely to be affected by increase in price.
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If the product is habit forming or addictive like tobacco a change in price may
not significantly affect quantity demanded.
Price of a product as a proportion of consumer’s income, thus very cheap
products e.g. matches are likely to be inelastic as the consumers will not care
too much about a 10% or 15% price increase.
Branding creates consumer loyalty. If the product is successfully branded its
product e.g. coca cola they are less likely to react to price changes.
Usefulness of Price elasticity of demand
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It can assist in pricing decisions as the prices determine sales revenue. Tenda
can raise prices on routes with low P.E.D (inelastic) and lower prices on
routes with high P.E.D
The analysis also underpins the strategy known as Price discrimination. Price
discrimination is charging the different prices to the same product.
It can be used to make sales forecasts. If the firm is considering a price
increase to cover costs of production and the P.E.D is known, then the
quantity demanded can be accurately forecasted.
It can be used for production planning, that is the quantity to be produced as
well as for manpower planning.
However
 The P.E.D assumes that nothing has changed, which is impractical. The
assumptions may be misleading e.g. if a firm reduce its price by 15%, it will
expect sales to rise, but if a competitor enters a market, sales might actually
decrease.
 The P.E.D can become outdated quickly and may need to be recalculated
because over time consumer tastes change and new competitors may bring in
new products so a years’ PED may be different from the other year.
 It is not always easy to calculate PED. The data used to calculate it comes
from past sales results following price changes. This data could be quite old
and market conditions might have changed.
 The results can be wrongly interpreted leading to wrong decisions. It is also
difficult to predict human behaviour.
Income elasticity of demand
 Is the responsiveness of quantity demanded for a product following a change
in consumer’s income.
Income elasticity of demand=% change in quantity demanded/%
change in consumer income.
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Income elasticity of demand is used to distinguish between normal and
inferior goods.
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Examples of inferior goods include basics like bread, bus transport and salt.
For the inferior goods as the disposable income increases, the consumers
substitute the inferior goods like sadza for rice and potatoes so the quantity
demanded goes down.
Their income elasticity of demand is negative.
Products with a positive income elasticity of demand are normal goods.
As the income increases the quantity demanded goes up.
Normal goods are perceived to be of high quality.
It becomes important to produce high quality goods in times rising incomes
and low quality goods when incomes fall.
Usefulness of Income Elasticity of Demand
 It can be used as a basis for manpower planning. The exact number of
employees can be determined.
 It can be used to classify goods as either being normal or inferior goods.
 It can be used for production planning and to make sales forecasts.
Cross Elasticity of Demand
 Is the responsiveness of quantity demanded for a product following a change
in the price of another product. An example is the reduction in the quantity
of fuel demanded following an increase in the price of cars.
 C.E.D=% change in demand for good A/% change in price of good B
 It is used to classify goods as either being substitutes or complementary.
 If C.E.D is positive the goods are substitutes. If the price of butter goes up,
this leads to a decrease in the demand for butter and an increase in the
quantity of margarine demanded to go up. Both changes are positive. These
goods compete with each other.
 If C.E.D is negative the products are complementary. An increase in price of
tennis rackets cause a decrease in the quantity of rackets and also tennis
balls demanded. Complementary products are used jointly.
Promotional (advertising) Elasticity of demand
 Is the responsiveness of demand for a product following a change in the
amount spent on promoting it.
 % change in demand for product/% change in promotional expenditure.
 It allows businesses to assess the effect of their advertising effort to judge
how far consumers are influenced by advertising campaigns. If it is positive
then an increase in advertising leads to an increase in quantity demanded.
The business will have to increase the expenditure on promotion to increase
sales.
 If it is negative then quantity demanded is not responsive to advertising
expenditure. It becomes necessary to reduce spending on advertising since
the increase in costs is not met by an increase in sales revenue.
Market location, size, share and growth
Successful marketing requires firms to understand which market they are operating
in, who their consumers are and where they are located, whether the market is
growing or shrinking.
Location
Firms that operate and sell products in the area they are located are said to operate
locally. Other firms may venture into regional or international markets.
Factors considered for making location decisions.
Pull Factors
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Large market in the proposed destination
Nearness to related industries (interdependency of industries)
Large pool of skilled labour
Availability of raw materials
Low levels of competition
Better communication services
Push Factors
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Exhaustion of raw materials
State interventions
Dwindling market
Intense competition from other businesses
Market Size
The total level of sales of all producers within the market
It can be measured in two ways:
1. Volume of sales units. This is the quantity of goods that are produced and
sold
2. Value of goods sold. This is the total amount spent by consumers buying the
products.
The market size is important because:
1. A marketing manager can assess whether a market is worth entering or not
2. Firms can calculate their own market share.
3. Growth or decline of the market can be identified.
Market growth
 The percentage change in the total size of a market over a period of time.
 Market growth depends on:
1. Changes in consumer incomes, a rise in consumer incomes help the growth of
market e.g. in Zimbabwe 2009
2. General economic growth, it leads to more firms opening and more people
being employed thus the market grows.
3. Technological changes can cause rapid growth in other markets. The sales
can go up when an innovation becomes available. An example is the growth
in the use of iPods and MP3 players and downloading music from the internet
is leading to the decline in the market for CDs.
4. Developing new products and markets ,this can lead to increased sales
5. Social changes like decline of marriages, increase in the proportion of working
women increase the market for child care and child support services like day
care centres.
6. Changes in population structure
7. Changes in legislation governing use of products
Market share
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The percentage of sales in the total market sold by one business. It describes
the proportion of a particular market that is held by a business, a product, a
brand or a number of business or products
Market share=(sales of a business/total sales in the market)*100
It might indicate a business that is a market leader.
This could influence other companies to follow the leader or influence the
leader to maintain its position.
It might influence the objectives of the business e.g. a firm with a small
market share may set a target of increasing its share by 10%
It may also be an indication of failure or success.
Advantages of a high market share
1. Sales are higher than those of competing firms and this could lead to high
profits
2. Retailers are keen to stock and promote the best selling brands. These
brands may be given prominent positions in shops.
3. As shops are keen to stock the product it might be sold to them with a
lower discount rate like 10% instead of 15% offered by competing firms.
4. Consumers are keen to buy the most popular brands because they are
market leaders.
Marketing Strategy
 This is a coordinated plan of action to identify, anticipate, and satisfy
consumer demand and thereby achieve the organisation’s objectives.
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It can refer to the techniques an organisation tends to adopt to gain a
competitive advantage.
 Components of a marketing strategy are:
1. Market research ,to identify consumer needs and wants to tailor goods to
consumers needs
2. Product planning and development that is creating products to satisfy these
needs
3. Pricing, that is determining the value placed on the product by customers
4. Distribution, that is movement of the product to consumers
5. Promotion, an exercise in communications that includes advertising and
selling.
Factors that may affect the marketing strategy
1. The objectives of the business e.g. if the objective is to increase market share
by 10% therefore a low, penetration pricing policy is adopted, using mass
marketing to a wider market in several countries or to maintain high product
quality image in the new product, but increase profit margin to 20% using
niche marketing to carefully selected target markets as well as high skimming
pricing policy
2. The resources available to the organisation. If the organisation has a lot of
delivery vehicles e.g. Delta then it can distribute its products to remote areas
to enhance product availability. This will increase market share.
3. The company’s organisational structure that is the marketing manager must
take into account other groups in the company in formulating marketing plans
e.g. top management, finance etc.
4. Situational analysis which is concerned with the current market conditions,
what the competitors are doing. It covers:
a) Current product analysis which focuses on product positioning, product
quality, features and packaging
b) Target market analysis which establishes important features of consumer
profiles that is high income or low. This will enable pricing strategy and
segmentation. This should establish whether it is a segmented or mass
market. The organisation should establish the consumers’ perceptions to
the company’s products e.g. Harare parts distributors’ products are
perceived to be of poor quality.
c) Competitor analysis, the organisation should identify its main competitors
as well as the strengths and weaknesses of their marketing mix e.g. a new
company entering a market for liquor production will identify Delta and its
strength in distribution. It is also supposed to identify potential future
competitors.
d) Economic and political environmental analysis through PESTLE.
e) SWOT analysis of the organisation i.e. management skills, financial
strength and potential internal weaknesses and the external environment,
the opportunities and threats that it presents to the business.
Marketing Mix
The set of controllable tactical marketing tools that is product, price, place and
promotion that the firm blends to produce the response it wants in the target
market. This consists everything that the firm can do to influence the demand for its
product. This includes the 4P’s
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Product (customer solution)
Refers to the goods and services the company offers to the target market.
Important features of the product to be manipulated include: Variety, quality,
features, brand name, packaging and services.
Price (customer cost)
The amount of money customers have to pay to obtain the product. It
includes allowances, discounts, and payment period and credit terms. Some
organisations like Ford does not charge full sticker price instead if negotiates
the price with each customer, offering discounts, trade in allowances and
credit terms to adjust for competitive situation and bring the price in line the
buyer’s perception.
Place (customer convenience)/Distribution
This is a broad concept that includes all the activities responsible for getting
the product to the consumer. It details the channels to be used, the range
and number of outlets that will sell the product and how these are linked to
the market segment. It includes aspects like channels, coverage, assortments,
location, transportation, and logistics. Delta maintains a large body of
independently owned shops and stockist that sell the company’s products.
Some are sold through wholesalers.
Promotion ( communication)
Activities that communicate the merits of the product and persuade target
customers to buy it. This involves advertising, personal selling, sales
promotion and public relations. Time scales for promotional activities are
important as some promotions like adverts may need to be repeated at
different stages of the product launch. The scale and type of advertising
campaign will depend on:
a)
The image being created for the product
b)
Market being targeted
c)
Price being charged
d)
Marketing budget available
Market segmentation
 The process of dividing a large heterogeneous market into small homogenous
market.
 It is dividing a market into distinct groups of buyers on the basis of needs
characteristics, or behaviours who might require separate products or
marketing mixes.
 A market segment is a sub group of a whole market in which consumers have
similar characteristics.
 To segment a market the firm should have a consumer profile. This is the
quantified picture of consumers of a firm’s products, showing proportions of
age groups, income levels, location, gender and social class.
Ways of segmenting a market
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Geographic segmentation
It is dividing a market into different geographical units such as nations, regions,
states, cities or
neighbourhoods. A company might to operate in one
geographical area e.g. European market. The geographical differences might result
from cultural differences, thus alcohol may not be promoted in Arab countries .Many
firms are localising their products, advertising, promotion and sales efforts to fit the
needs of individual regions. In Zimbabwe Alliance Cotton Company set up a Ginnery
in Norton and has branches in rural areas like Makonde, Hurungwe, Chegutu where
cotton growers are found. It is less costly to operate in these areas.Maggi and
Crosse & Blackwell soups are adapted to suit different tastes, by varying ingredients
from one country to another. However now consumer tastes are becoming uniform
across geographical boundaries so boundaries are becoming less significant in
determining tastes.
Demographic segmentation
Demography is the study of population data and trends, and demographic factors
such as age, sex, family size and ethnic background. The process divides the market
into groups based on variables such as age, gender, family size, family life cycle,
income, occupation, education, religion, race and nationality .Consumer needs,
wants and usage rates often vary with demographic variables and they are easy to
measure than most other types of variables.
a) Age and life cycle stage segmentation
It involves offering different products or using different approaches for different age
and life cycle groups. Johnson and Johnson used to produce baby products (baby
Powder) and now have included products for adults. R&B CDs may be marketed to
teenagers whilst hits of the 70s to older people. However marketers should guard
against stereotypes using age and life cycle e.g. although 18 year olds can drink
beer, others do not so advertising beer to 18 year olds might not be effective
always.80 year olds might require wheel chairs while others still play tennis.
Therefore age is a poor predictor of a person’s life cycle, health, work, needs and
buying power.
b) Gender segmentation
It is based on sex. It is widely used in clothing, cosmetics, toiletry and magazines.
Some perfumes (rose) ganelli are for ladies and others are men. Face powders and
ear rings are specifically for women. Also car manufacturers are now designing
vehicles that suit women better that have trunks that are easier to open glove boxes
to preserve such things as lipsticks
c) Income segmentation.
This is dividing based on income groups .It is used by manufacturers of automobiles,
clothing, cosmetics and financial services like Prestige or priority banking for
executives or high income earners .The company target affluent consumers with
luxury goods and convenience services e.g Barbours sells expensive clothing for high
income earners .Grey hound and Intercity bus companies target the affluent while
CAG is for low income earners. The Hammer car is likely to be marketed to high
income earners.
d) Religion
The business may divide the market according to religious groups. Food producers
and restaurants, butchers may concentrate on producing for Jews (kosher food).
Psychographic segmentation
This is dividing the market into different groups based on social class, lifestyle or
personality characteristics. The products people buy reflect their lifestyles, so
marketers often segment their markets by consumer’s lifestyles. Personality is also
used to segment the market. This grouping of people results in (i) clothes may be
geared towards those interested in ‘retro’ fashions from earlier decades like the so
called ‘revo’ (ii) Certain newspapers are geared towards opposition party voters
whilst others are geared towards ruling party voters.(iii) mobile phones provide
services such as internet access to business travellers
Behavioural Segmentation
This is dividing the market into groups based on consumer knowledge, attitude, use
or response to a product. This includes:
1) Occasion segmentation
This is dividing the market into groups according to occasions when buyers get the
idea to buy a product or use the product. It helps the firms to build up product
usage e.g. orange juice is most often consumed breakfast or lunch, but orange
growers have promoted drinking orange juice as a cool and refreshing drink at other
times of the day. Some holidays like mother’s and father’s day were originally
promoted partly to increase sales of candy, flowers, cards and other gifts. Also
marketers prepare special offers and adverts for holiday occasions. In Zimbabwe fire
crackers sell high over the New Year holiday.
2) Benefit Sought segmentation
This is dividing the market according to the different benefits that consumers
seek from the product. It requires finding major benefits people look for in the
product class, the kind of people who look for each benefit and the major brand
that deliver each benefit. The tooth paste market research found four benefits
namely Economic, medicinal, cosmetic and taste. People seeking to prevent tooth
decay (medicinal) tend to have large families and were heavy users of toothpaste
and conservative. Each benefit group had special demographic, behavioural and
psychographic features e.g.
Benefit
segment
Economic
Medicinal
Cosmetic
Taste
Demographic
Behaviour
Psychographic
Favoured brand
Men
Large families
Teens
Children
Heavy users
Heavy users
Smokers
Spearmint
lovers
High autonomy
Conservative
Active, social
High
self
involvement
Brands on sale
crest
Aqua fresh
Aim, Colgate
1) User status
2) Markets are segmented into groups of non users, ex-users, potential users
and first time users and users of a product. One study showed that blood
donors are low in self esteem, low risk takers, and more highly concerned
about their health while non donors are the opposite.
3) Usage rate
The market can be divided into groups of high, medium, heavy users of a product.
Thus a
firm would benefit by directing its efforts towards heavy
users of a product. British Airways
established the Executive club to encourage
and develop the custom of regular business travellers.
Market Segmentation and Strategy
Undifferentiated strategy is when the firm promote the product in the whole
market. The business does not segment the market but try to make the product
appeal to the whole market. This is done by firms producing goods in bulk where
customers want to buy a standard product. It could also be that the cost of
producing different products far outweighs the return. Customers might prefer to
buy cheap undifferentiated products than expensive one tailored precisely for their
needs.
Differentiated strategy is when the firm develop marketing strategies for
particular market segments. This could mean different price, advertisements,
packaging, place or channel of distribution as well as quality. A detergent
manufacturer might sell cleaning products to consumers and companies and larger
packs for companies.
Concentrated strategy is when a company focus on one segment of the market.
This is usually done by luxury brands like Gucci and Dior that sell to high income
earners only.
Advantages of market segmentation
 There is less wastage of resources as they are used more efficiently
 This gives the company a more competitive advantage in a particular market
segment
 It enables the firm to concentrate its marketing effort in one segment
precisely, design and produce goods that are specifically aimed at these
groups, leading to increased sales
 The firm may identify a Niche market through identifying groups of
consumers that not currently being targeted and these could be successfully
exploited.
 The products can be tailored to match requirements of the market leading to
customer satisfaction
 Differentiated marketing strategies can be focused on target market groups
therefore avoiding wasting money on trying to sell products to the whole
market as some consumer groups will never have the intention to buy the
product.
 Small firms unable to compete in the whole market are able to specialise in
one or two market segments
 Price discrimination can be used to increase revenue and profits
 There is quick response to needs of consumers by the firm
 Market segmentation facilitates the identification of excellent marketing
opportunities
However
 More resources are wasted in the development of differential products.
Product differentiation is a wasteful practice
 Research and development costs might be high as a result of marketing
different product variations
 Promotional costs might be high as different advertisements and promotions
might be needed for different market segments. Advertisement increase costs
without adding value to a product.
 Focusing on one or two limited market segments poses a danger that
excessive specialisation could lead to problems if consumer tastes and
purchasing habits change
 Extensive market research is needed
 It is more complex and time consuming
 It is associated with higher administration costs
Market Research
The process of collecting, recording and analysing data about the customer,
competitors and the market, for example a firm might gather information about the
likely consumers of a new product and use the data to help in its decision making
process. The data gathered might include:
 Whether or not consumers would want such a product
 What type of promotion will be effective;
 What style, shape, colour or form it should take;
 The price people are prepared to pay for it;
 Information about the consumers themselves like age, attitudes ,lifestyles etc
Reasons for carrying out research are classified as being descriptive,
predictive, explanatory and explorative. These include:

To reduce the risk associated with new product launches. This enables the
firm to assess the likely chances of a new product achieving satisfactory sales,
by investigating potential demand. Market research can be used to identify
consumer needs and tastes through primary and secondary research.
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To predict future demand changes, as this assists in corporate planning,
production planning, and manpower planning (predictive reason)
To explain patterns in sales of existing products and market trends. This is
done through time series and trend analysis.
To assess the most favoured designs, flavours, styles, promotions and
packages for a product.
To identify and understand the customer needs and wants as they are ever
changing
To avoid lagging behind rival firms, through identifying rivals, their activities.
To know who buys and who consumes
To know the reactions to products, packaging and price
Market research shows:
The market size and consumer tastes and trends
The product and its perceived strengths and weaknesses
The promotion used and its effectiveness
The competitors and their claimed unique selling points/propositions. Unique
selling points refer to the features of a product that may differentiate it from
its rivals. The USP help the business have a competitive advantage over
competitors.
 The distribution methods most preferred by consumers
 Consumers’ preferences for packaging.
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Market research process
1. Problem identification. This is the problem to be investigated like the type of
customers groups who buy our products. This leads the research process
being directed towards solving the problem
2. Setting research objectives which are to be in line with the original problem.
They should be achievable e.g. to identify the consumer groups that buy our
product A or B
3. The type of research and sources of data. This includes Primary and
secondary research.
External sources include: government and International publications and
statistics like (national income, family expenditure survey, demographic trends),
Trade press, trade association reports, company published reports and accounts,
activities of rivals and information from competitor like promotional material, data
from customer service about customer complaints, retail audit reports(from
electronic point of sale which can reveal sales at any time and can be used to show
the best selling products like CDs).
The following aspects of the data should be investigated:

The character of the collecting organisation as the data may have been
collected to prove something or may be biased like information from political
pressure groups
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Objectives of the original study are to be reconciled with the objectives of the
current study
Methods employed as inaccurate data might have been produced if the
sample selection or data collection were badly done
Timeliness since the data may have become out of date.
Definitions used in the research should match those at hand like Income, dept
store.
Advantages of Desk or Secondary research
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It is relatively easy, quick and cheap to collect, especially if the sources that
exist are known. This makes it very useful for smaller businesses
Several sources can be used. This allows the data to be checked and verified.
This allows a cost effective analysis of several sources of data.
Historical data may be used which make it easier to establish trends
It can be used before carrying out primary research which helps to establish
questions to ask in questionnaires.
It is inexpensive
It avoids repeating effort that is finding out what already exists
There is a wide choice of data that can be used for exploratory research.
Disadvantages of secondary research
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The data is not always in the form required by the firm. Adapting it may take
time.
The data may be out of date and not relevant, especially in fats changing
markets
The data might not be available
Coverage of existing information may be inappropriate, thus some aspects
covered may be not relevant.
There is little control over the quality of the information
Researchers must be aware of bias from published accounts and reports due
to window dressing
There can be problems of interpretation of research findings
Primary research is the collection of first hand data that is directly related to the
firms needs
Advantages of primary research
 It is up to date and therefore more useful than most secondary data
 It is relevant as it is collected for a specific purpose. It directly addresses the
questions the business wants answers to.
 It is confidential as no other business has access to this data. It can be used
to gain marketing advantages over rivals.
 Secondary data may be unavailable in a certain area
However
 It is costly to carry out primary research since the firm might use a research
agent
 It is time consuming to carry out the research
 There may be doubts over accuracy and validity because of the need to use
sampling and the risk that the sample used may not be fully representative of
the population.
4) The fourth step is to select the primary research methods
Basically there are 3basic techniques of field research to collect primary data.
These include surveys, observations and experiments. The researcher should
choose the most appropriate method.
The choice of the method is affected by:
 Relative costs of the method
 Time available to carry out research
 Type of information required. If empirical evidence is required then
experiments become appropriate
 Type of people to be investigated
 Degree of accuracy required
However it should be noted that:
 Primary research is expensive and time consuming
 The accuracy of findings causes a rise in resources employed and time
taken
 Costs should be controlled so that they do not exceed the benefits to the
firm
 It should not take too long to allow rivals to take advantage
5) Decide on the research technique. This will include formulation of
questionnaires and deciding on sampling methods.
6) Analysis, interpretation and evaluation of data. This is done to be able to
draw conclusions from the data
7) Recommendations, involves the strategy to be pursued in relation to the
product and marketing effort
Methods of primary research
Qualitative research involves collection of data about attitudes, beliefs and
intentions. The data collected is open to a high degree of interpretation. There are
often disagreements about the significance of the data. It includes use of Focus
groups and Interviews
Focus groups
This is a group of customers being brought together on one or a number of
occasions. They are asked about their attitude towards a product, service, and
advertisement or new style of packaging. It involves a group discussion in which
people are encouraged to freely express views and opinions on a selected subject. It
is a widely used method of obtaining feedback about new products, new brand
names and new advertisement. It is used as a means of obtaining both overt and
sub conscious attitudes and motivations. Researchers are present in the focus group
and they take part in the discussion only to stimulate and not lead the group to a
particular conclusion. They are a relatively cheap and easy way of collecting market
research information. The problem is that a fairly small number of respondents
may be representative so may not reflect the views of the whole market. Also it may
be time consuming and some members of the group may discuss issues not directly
related to the research. Focus groups are a form of qualitative research, so the data
is qualitative in nature can be difficult to analyse and present to senior managers.
Also some members of the group may discuss issues not directly related to the
research.
Interviews
This involves an interviewer obtaining information from one person face to face.
The interviewer fills out the questionnaire not the interviewee. The questions asked
are mainly open ones.
Merits of interviews
 The interview allows the respondent to detailed responses to questions
concerning them.
 It allows for time and scope for answers to be followed up in more detail.
 Long and difficult questions can be explained by the interviewer and the
percentage of responses that can be used is high.
 It allows the observation of reactions and it is very flexible.
 Visual material can be used in an interview.
 Skilled interviewer can elicit information in greater depth
Demerits
 There can be interviewer bias
 It can be time consuming and tends to rely on the skill of interviewer
 There can be respondent bias a they can give false answers to impress the
interviewer
 It is difficult to sample a scattered population
 It is difficult to control the interviewer.
Quantitative research involves the collection of data that can be measured. It
involves collection of statistical data such as sales figures and market share. The
data is less open interpretation than qualitative data. The methods include:
Consumer panel
It involves a group of consumers being consulted on their reactions to a product
over a period of time. They are widely used by TV companies to judge the reactions
of viewers to new or existing programmes.
Merits
 They can be used to consider how consumer reaction changes over time.
 Trends over time can be established.
 Control groups can be formed.
 It saves time as panel members know the procedures.
 The firm can build a picture of consumer trends.
Demerits
 It is difficult and expensive to choose and keep a panel available for research
over a long period.
 Also panel sophistication develops.
 Members tend to be not typical.
Observation and recording
The researcher observe and record how consumers behave. They can look out for
the amount of time consumers spend making decisions and how readily they notice
a particular display or how many take a product from the shelves. It can include a
stock to check and record sales over time. They can count the number of people or
cars that pass a particular location in order to assess the best site for a new
business. A great number of consumers can be surveyed.
However it does not give researchers opportunity to ask for explanations. It can
leave many questions unanswered e.g. it might show that a particular display is
unpopular but does give clues as to why. The results can be distorted if people are
aware that they are being watched.
Telephone Interview/survey
It allows interview to be held over the telephone.
Advantages
 It is quick
 It cover a wide geographical spread
 It produces a better response rate than postal survey
 It is undemanding of respondents as simple questions are used.
 It is less inhibited than face to face interview
Demerits
 Costs necessitate short calls
 It is biased as it excludes those without phones or not in the directory
 It is not possible to control respondents
 There is no visual stimuli
 It is limited to short ,simple questions
Postal surveys
This involves the use of questionnaires sent to consumers through the post.
Advantages
 It is relatively a cheap method of conducting field research
 There is no interviewer bias
 A wide geographical area can be covered
 Gives respondent time to check data
 Provides anonymity (identity of respondent is not known)
Demerits
 It is expensive in terms of postage
 There can be a low response rate
 It is limited to simple questions
 There is no control over respondents
Test marketing
This involves selling a product in a restricted section of the market in order to assess
consumer reaction to it. It is an experiment to test and assess the response of
consumers to changes in the marketing mix. It takes place by making the product
available within a particular geographical area. The region selected should reflect as
closely as possible the social and consumer profiles of the rest of the market.
The main merit is that it reduces marketing costs by targeting a particular market
before national launch. It reduces the risk of new product launch failure.
The demerit lies in choice of participants and difficulties in controlling random
variables e.g mood of participants or weather conditions
Questionnaires
Many field research methods use a questionnaire. It is a series of questions designed
to find out the views and opinions of a respondent. In designing a questionnaire it is
important to follow the following principles:
 Clarify the purpose of research
 Devise clear unambiguous questions so as not to confuse or mislead
respondents so technical language should not be used.
 Use language intelligible to the respondent
 Avoid leading questions, which encourage a certain answer e.g. Do you think
Diet coke is better than Diet Pepsi? (which brand of diet coke do you prefer
Pepsi or Coke)
 Follow a logical sequence in questions
 Avoid questions that tax memory too much
 Do not use multiple choice questions where one of the offered answers
appears to confer status on respondents
 Avoid questions on topics that respondents will be reluctant to answer
 Strike a balance between open and closed questions. Open questions give
respondents opportunity to reply in their own terms, uninfluenced by
guidance within the questionnaire or by the interviewer. e.g. what is your
opinion of Mazda cars?
Closed questions are those in which the respondents choose from a number of
specific responses.
Sampling
A sample is the group of people taking part in the market research survey selected
to be representative of the overall target market.
Sampling is the process of selecting individuals for inclusion in the sample.
Advantages of sampling
 It reduces costs of researching the whole market
 It saves on time since a few selected individuals are used
 It requires few resources like manpower
 It is more reliable as there is concentration on fewer units
Disadvantages
 There can be sampling error
 It can be done for convenience at the expense of representativeness.
Sampling methods
Probability sampling
This involves the selection of a sample from a population based on the principle of
random chance. It requires use of a sampling frame, the complete list of the
sampling population. The sample can be selected from the frame. This can include
the voter’s roll, phone directory, Nemakonde high pupils. The sample frames should
be evaluated for: completeness, accuracy, so that reliable estimates can be made
about the whole market and the chance of errors can be determined. However
probability sampling is complex and time consuming. It is more costly than non
probability sampling.
Techniques of probability sampling
Simple random sampling
This is the method in which each member in the population has an equal chance of
being selected. The sample is selected at random, like picking numbers out of a hat.
It can be done as follows:
 Make a list of all people in the target population,
 Give sequential numbers to each member of this population.
 A list of random numbers generated by a computer or can be picked out from
a hat.
 The selected numbers will make the people included in the sample e.g. if a
sample of 5 people is required then the first 5 numbers on the list is taken.
Advantage
 It removes bias from the sample
Disadvantages
 It assumes that all members of the group are the same which is not always
true
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It is costly and time consuming for firms to draw up a list of the whole
population and then contact and interview them.
Systematic sampling
It involves choosing a starting point in a sample and then selecting every nth item
thereafter. This is not a fully random method and will produce a bias if there is a
regular, recurring pattern in the frame. E.g. a supermarket wishing to study
buying habits of customers can decide to ask every 8th customer entering the
shop until the required sample has been reached.
Stratified sampling
The population is divided into sub groups with different opinions. The groups are
called strata. The sample reflects each subgroup in proportion to their
representation in the population as a whole. The selection of individuals within
each group is made on a random basis. If a firm wants to establish shoe polish
preferences at a school, it can use the following strata like class groups, age
groups etc. It is appropriate where a fair representation of respondents is
required in the sample. It is preferred by researchers as it makes the sample
more representative of the whole population and it is less likely to privilege a
particular subgroup.
Non Probability sampling
Quota sampling
This involves dividing the population into subgroups with quotas attached that
reflect known population characteristics in a variety of respects e.g. age, sex,
income, occupation. The selection of individuals is done on a non random basis.
An example might be that it is known that consumers of beer are: 80% males
and 20% females.Age:15-20 years =30%, 21-30 years=35%, 31-40 years=20%
and over 41 years=15%.The sample selected should conform to these
proportions. If a sample of 100 is needed, so 80 will be males and 20 females. It
is appropriate where the information is needed quickly and when time is not
available. It is also useful when proportions of different groups in the population
are known. It is also used when sample frame is not available. However it is not
possible to estimate sampling error since it is a non random method. The results
are not representative of the population and are not randomly chosen.
Cluster sampling
This involves separating the population into clusters based on geographical
areas. A random sample is then taken from the clusters which are assumed to be
representative of the population. It is used when survey results need to be found
quickly, such as opinion polls. It is used when the population is widely spread
and a full sample is not available.
Multi stage sampling
This involves selecting a sample from another sample. A researcher may choose
at random a country, then a district of that country, then a street in a chosen city
as well as a household in a street chosen. It is used when groups selected in a
cluster are too large, with the result that a sub sample has to be selected from
each group.
Judgemental sampling
The researcher chooses the samples based on who they think would be
appropriate to study. This may be used by an experienced researcher who may
be short of time as he has been asked to produce a report quickly.
Convenience sampling
Researcher chooses respondents based on the relative ease of access like
sampling friends, fellow workers.
Snowballing sampling
This is a highly specialised method of sampling .It involves starting with one
individual or group and then using these contacts to develop more. It is used with
highly secretive markets/products such as fire arms or expensive one off products
for a very limited range of customers.
Data Presentation
Methods of data presentation
Reasons for presentation of information
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It can be more concise and easier to understand than written information
It can take less time to interpret
It can be easy to identify trends clearly
It may be effective in creating an impact or an image
It can be used to impress a potential client
Bar charts
It is constructed using bars or blocks of equal width but varying length or height to
represent relative values of the data. The bars are drawn vertically or horizontally.
The sales of a firm can be shown as follows.
2011
2010
march
february
january
2009
2008
0
1000
2000
3000
4000
5000
6000
7000
Advantages
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Bar graphs show results clearly
At a glance the a reader can have a general feel of the information and
identify any trends or changes over a time period e.g. figure 1shows sales
January sales shows a general rise from 2008 to 2011.
Bar charts are more attractive than tables and may allow the reader to
interpret the data more quickly.
They are more appropriate when absolute size or magnitude of results need
to be presented and compared
There can also be a component bar chart and a percentage bar chart in addition
to the simple bar chage bar chart
april
march
sugar
rice
four
february
january
0%
20%
40%
60%
80%
100%
120%
The component bar chart is as follows
bulawayo
mutare
labour
materials
overheads
harare
chinhoyi
0
50000
100000
150000
200000
250000
300000
It is easier to compare changes between the components, although it is difficult to
compare
Histogram
This is a graph for grouped data. The area of each bar represents the relative
values. It measures relative frequencies of grouped data. Therefore interval width
can be different and might require the height of bars to be reduced. In histograms
there is no space between bars because the data measured is continuous rather
than discrete as with a bar chart. A frequency polygon can be plotted on to a
histogram by joining the mid points at the top of each bar is used to present visually
frequency data when the range of data has been broken down into class ranges and
for simple statistical analysis .e.g. identification of modal class.
Line graphs
The graph shows the relationship between two variables. It can be used to show
changes in a variable over time like a Time series graph. It is produced by joining
the coordinates together and this allows reference to trend in the data and shows up
seasonal or other fluctuations. They are used when
o time is one of the variables
o (ii) when the trend and regular variations need to be identified, this
might be the first stage in undertaking sales forecasting, which can aid
future decisions like production levels
o (iii) when two or more sets of time series data need to be compared
e.g
o Competitor’s sales are compared with the firm’s own performance.
4000
3500
3000
2500
Co A
2000
Co B
co C
1500
1000
500
0
o
Pie charts
2010
2011
2012
2013
They are used to display data that need to be presented in such a way that the
proportions of the total are shown clearly. The data collected is represented by a
circle. This is divided into a number segment. Each segment represents the size of a
particular part relative to the total. They are drawn using a protractor or spread
sheet software in a computer and the number of degrees adds up to 3600
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They are useful as readers get an immediate impression of the relative
importance of various parts.
They can be used to make comparisons over different time periods.
However
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They do not always allow precise comparisons to be made between the
segments.
If the total consists of a very large number of components, it may be difficult
to identify the relative importance of each segment.
It is difficult to show changes in the size of the total pie e.g. if total rises over
time it is possible to make the pie bigger but the exact size increase is often
difficult to measure s it involves comparing area of circles.
The pie chart for Schweppes product sales can be shown as follows. Orange
crush $84000, blackberry $34000, Raspberry $14000,and cream soda $12000
Sales
orange crush
Blackberry
Raspberry
Cream soda
Tables
They are used to present many forms of data. They may be used:
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If data are qualitative rather than quantitative
Where a wide range of variables needs to be expressed at the same time
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Where the numbers themselves are at the centre of attention
When it is necessary to perform calculations on the basis of the information.
It is easy to take information from a table than to interpret a graph or a chart
When there is a lot of text to include with the results such as detailed
headings
Pictograms
It is a form of a chart in which data are presented in the form of pictorial
symbols rather than bars. It is used when user wants to attract attention of
reader towards looking at the data. It is more eye-catching. They are imprecise
when using one symbol to represent a large number of results. It is not always
easy to divide symbols exactly so precise quantities cannot be obtained from the
graph.
Measures of central tendency
This involves calculating the most likely or common outcome from the data.
These are called averages. This is useful in a number of situations which are of
interest to the business:
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The level of stock ordered most often
The production level a department achieves most often
The average sales each month
The average number of days lost through injury
Arithmetic mean
It is calculated by totalling all the results and dividing by the number of items.
Mean (X)=Sum of items/number of items.
∑x/n or ∑fx/∑f
Uses of the mean
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When the range of results is small, the mean can be a useful indicator of the
likely sales level per period of time.
It can be used to determine sales level
It is often used for making comparisons between sets of data.
Advantages of mean
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It includes all data in its calculations
It is easily understood by managers
It is well recognised as the average as it is widely used

It is well organised and can be used further in other ways that assist in
understanding the significance of the results
Disadvantages of the mean
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It is affected by one or two extreme results making result meaningless
It is a distorted result and not commonly a whole number e.g. the common
shoe size is calculated to be 2, 56 for stock ordering.
Mode
This is the value that occurs most frequently in a set of data. The data is first put in
descending order and the recurring figures will be obvious immediately. It can be
used for stock ordering purposes, for stockholding purposes that is which colour,
size to stock most, and where averaging is affected and distorted by extreme values
like salaries.
Advantages
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It is easily observed
No calculations are required
It is easily understood and the result is a whole number
Disadvantages
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It does not consider all the data
It is time consuming for grouped data
The exact location may be uncertain as there may be more than 1 modal
class
Median
This is the value of the middle item when the data has been ordered or ranked. It
divides the data into two equal parts. When the number of items is odd the median
item=n+1/2.For even number of items it is n/2.For example with 20 items n/2 gives
10.The median item will be between the 10th and 11th items. These will be added
and divided by two. The median is mostly used in wage negotiations e.g. half of our
union members get less than $x. It is often used in advertising
Advantages
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It is less influenced by extreme figures
This makes it more representative than mean
It is easy to understand
It is represented by an actual item
Disadvantages
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When there is an even number of items then it is estimated
It is time consuming to determine for grouped data
It cannot be used for further statistical analysis
E.g. for this set of data: 120,122,128,122,120,135,128,120,130 calculate arithmetic
mean, mode and median
Mean =120+122+128+122+120+135+128+120+130=1125/9=25
Median=first arrange data in ascending order
120,120,120,122,122,128,128,130,135
N+1/2=9+1/2=5
The fifth item is 122
The mode is 120 the number with the highest frequency.
Range
This is the difference between the highest and the lowest value. It is used to
measure data dispersion or spread. Inter quartile range is the range of the middle
50% of the data.
Forecasting
This is an attempt to predict the future behaviour of a variable. It provides a basis
planning. Forecasting can be used in:
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Planning production schedules. The marketing department first have to
produce a sales forecast. This will determine the number of goods to be
produced.
Manpower planning that is the number of employees in the firm to meet the
forecasted demand of goods and services
Stock control as regards the raw materials to be acquired and stocks of
finished goods to be maintained.
Investment appraisal where the firm projects the expected cash flows of
different projects
Cost projections in the production process like material, labour and related
overheads at forecasted production level
Distribution planning of goods and services to meet the projected sales
Corporate planning that is strategic planning by top management
Market testing
Forecasting techniques can be divided into two groups:
Qualitative techniques
They depend on human judgement and experience and are used when:

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Data is scarce or unavailable e.g. when a new product is launched
Time frame is so long that data is of limited use
Techniques
Personal insight, these are forecasts based on individual judgement. They are
inexpensive but the level of accuracy is low.
Jury of experts uses the specialists within the firm to make forecasts for the
future. Senior managers meet and develop forecasts based on their knowledge of
their specific areas of responsibility within the business. It is quicker and cheaper
than the Delphi method. However it lacks the external view of market conditions and
consumer trends.
Panel consensus, is a panel of experts discussing issues to arrive at a consensus
forecast. There is pooling of knowledge and idea so accuracy is likely to be high.
However it is very adequate for most business purposes.
Market surveys involve data collection and analysis. They are included in
qualitative methods because even in the absence of data judgement is required.
Accuracy of forecasts depend on :
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Representativeness of the sample
Quality of the questions asked
Reliability of replies
Quality of analysis and conclusions
Historical analogy
It uses the idea of the product life cycle as a model to help understand the likely
trends in the demand for a product. The performance of one product provides an
analogy to predict trends in a similar product.
Delphi method
This involves a panel of experts responding to questionnaires. This is a long range
qualitative forecasting technique that obtains forecasts from a panel of experts. The
experts do not meet but are anonymous. The facilitator collects and coordinates the
opinions from experts who are sent detailed questionnaires. This avoids experts
being swayed by individuals who shout loudest. Extreme answers are often amended
and moderated so that a consensus is reached that represents the most likely
correct forecasts.
Quantitative techniques
Correlation methods involve establishing casual relationships between variables.
Casual methods involve use of mathematical models to link cause and effect
relationship between variables like price, or income and demand. The aim is to
identify variables that are believed to cause changes in the variables we want to
forecast. If the relationship is established between the variables, then it is possible
to forecast trends in one variable from movements in other variables. Links may
exist between sales and price, competitor’s promotional activities, levels of
disposable income, weather
However establishing correlation does not prove that there is a cause and effect
relationship. Sales could have been rising for other reasons entirely different. It fails
to consider other factors such as changes due to seasonal variations. Mathematical
methods of correlation analysis can be undertaken that do not rely on graphical
approach.
Time series analysis
A time series is a set of data recorded over uniform time periods, such as a year or a
month. It shows how the variable has behaved over time. It involves predicting
future levels based on past data. The business may predict future sales by analysing
sales data over the last 10 years. Analysing the data involves decomposing the data
to establish a pattern, which serves as the basis for predicting trends into the future.
The time series can be plotted on a graph and it is likely that the pattern will
conform to one the graphs below.
There can be fluctuations around a trend e.g.
1. Seasonal fluctuations are regularly repeated fluctuations associated with
seasons of the year, days of the week or even hours of the day. If a
fluctuation is repeated regularly it is a seasonal fluctuation.
2. Cyclical fluctuations occur in a repetitive cycle but over a medium term period
e.g. a boom or slump.
3. Random variations occur as a result of a major disturbance such as a war, a
substantial rise in disposable income following a tax cut, a change of
government, a change of consumer taste.
The time series data is made up of four elements that is trends, seasonal
variations, cyclical and random variations. Time series=T+ S+ C+ R
Forecasts are more likely to be reliable when
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The forecast is for a short period of time in future, such as six months
rather a long time.
They are revised frequently to take account of new data and other
information.
The market is slow changing.
There is plenty of back data from which to produce a forecast.
Market research data, including test marketing data is available.
Those preparing forecasts have an understanding of how to use data to
produce a forecast.
Moving Averages
This is a smoothing technique to isolate the trend from fluctuations around it. It
is important in constructing sales forecasts. The moving average is updated as
new information is received e.g. Inflation rate is published monthly is an average
of price rises in the previous 12 months. At each successive updating, one month
drops out of the calculation and is replaced by the latest month’s data. A basic
principle of moving averages is that the period chosen must coincide with the
cycle so for 12 period moving cycles we have 12 months represented to eliminate
seasonal fluctuations. The greater the number of periods in the moving average,
the greater will be the smoothing effect.
The calculation of moving averages
The first average covers the first 7 days starting with the Sunday week 1.The
next average, Sunday wk1 drops out will be replaced by Sunday wk2 and the
process is repeated. E.g
Day
Daily variation
Sunday
50
Monday
31
Tuesday
36
Wednesday
Sales
40
Moving total
337
Moving average
48, 1
-8, 1
Thursday
48
338
48, 3
-0, 3
Friday
66
339
48, 4
+17, 6
Saturday
66
Sunday
51
( 337+51-50=338)
The moving average is always centred, for odd numbers it is usually the middle
value in chronological order, Wednesday. For even numbers it is between the 2
middle numbers e.g. between June and July for a year. In the above example a 7
period moving average can be found by dividing the 7 day moving total by 7.The
7 periods centred moving average can be plotted onto a graph which will show a
trend. This will produce a smoother trend line than the figure showing the actual
sales and gives a clearer picture of the trend. After identifying the trend the firm
can now predict what can happen in future. The sales figure can be predicted by
drawing a line through the trend figures and extending it to the next period. This
is done by plotting a line of best fit all points in the trend. Computer software can
be used to calculate estimated sales using the ‘sum of least squares.’
Limitations of moving averages
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Moving average calculations of thousands of items of stock require the
storage of a considerable amount of data.
Moving average calculation takes no account of data outside the period of
the moving average
Equal weight is given to all values. It can be argued that the more recent
data is relevant and should be given a greater weight
Forecasting from the trend is an exercise in extrapolation of future data
from the past. We have to ask the extent to which we can forecast the
future from the past.
PRODUCT
A product is a good, service or idea consisting of a bundle of tangible and intangible
attributes that satisfies consumers and received in exchange for money or some
other unit of value.
Goods have a physical form while services have no physical form or existence.
Products can be classified as:
1. Capital goods that are produced for industrial markets and are used to
produce other goods
2. Consumer goods that are ready made for the end user e.g. a pen
Product positioning is the act of communicating the product’s key features so that
it creates an image/space in the minds of customers. It can refer to the way
consumers perceive a product in terms of its characteristics and advantages and its
competitive position. The key approaches to positioning include: Attributes, Quality,
Price, Benefit/application, and Usage.
Product mix is the variety of products a company sells. It is the total number of
products lines that a company offers to its customers. There are four dimensions to
product mix which are:
1. Width which pertains to the number of product lines that a company sells. If
a company has two product lines ,its width is 2
2. Length is the number of total product or items in a company’s product mix
e.g. Dairiboards’ products may have 3 product brands in each product line.
The length will be 9.
3. Depth is the total number of variations for each product. Variations can
include size, flavour and any other distinguishing characteristics e.g. if
Dairiboard’s sells 2 sizes and three flavours of yoghurt. The yoghurt has a
depth of 6.
4. Consistency pertains to how closely related product lines are to one another,
in terms of use, production and distribution
NEW PRODUCT DEVELOPMENT
A new product is an innovative product distinct from anything else in existence.
Factors considered when deciding to produce new products:
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Results of market research and test marketing
Value engineering and value analysis
Competition –to give the firm a competitive advantage
Profitability
Cost of production
Economic conditions
Resource availability
Firms develop new products for the following reasons:
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To replace declining products on the market as they come to the end of their
life cycle and keep up with changes in the market
For growth purposes for example Econet developed Ecocash for growth
purposes by increasing sales revenue offering a variety of products to
customers.
New products can be developed as part of competition. The mobile phone
industry has seen introduction of new products to fight competition and
remain relevant in the market.
To meet changing tastes and preferences of consumers as they constantly
changing.
To fully utilise resources within the organisation that might be under utilised
To respond to the dynamic technological environment as in the electronic
industry
Why do new products fail on the market
1. Due to inadequate market research as it could have been done for
convenience at the expense of representativeness
2. Misleading research findings. The research findings may not contain the
actual consumer needs and wants. The sample used might have been not
representative or there could have been researcher bias
3. There can be defects in the product like the product being of poor quality
resulting in poor performance
4. Activities of competitors who might have a competitive advantage over the
firms New product
5. Insufficient /Inappropriate marketing efforts that could include lack of
differentiating advantage as no or very little advertising might have been
done.
6. Distribution problems as the firm might have no access to distribution outlets,
to make product available to consumer s at their convenience.
7. Inadequate sales force to persuade personally customers to purchase
products
8. Unexpectedly high production costs which translate to high product prices
thereby reducing the demand of the product
Firms develop new products in two ways:
1. By acquisition of another firm, bringing in new products to their product lines
2. Internal development
Stages in New product development
1. Idea Generation
This is the systematic search for new product ideas. Ideas for new products can
come from:
a) Internal sources through the company’s own research and development. This
is a very expensive way and not all firms have research and development
departments.
b) The firm can pick the brains of its executives, scientists, engineers,
manufacturing and sales force as they have close contact with the final
consumers and may suggest improvements to existing products or even
completely new products
c) .Some firms encourage employees to think and come up with New product
ideas which makes employees feel important by their participation and
recognition
d) The firm can watch and listen to customers’ questions and complaints. The
firm should conduct a survey about consumer needs and wants
e) Consumers can also develop new products and use them, so the firm can get
these and put them on the market e.g. consumers can discover new uses for
a product for example Vaseline is discovered to have a repellent effect on
insects like mosquitoes then mosquito repellent is developed.
f) Competitors’ advertisements and other communications can give clues about
new products. The firm can buy new competing products, take them apart to
see how they work, analyse their sales and decide whether they produce a
new product or not.
g) Distributors and suppliers are closer to the market and can pass along
information about consumer problems and new product possibilities. Suppliers
can tell the firm about new concepts, techniques and materials that can be
used to develop new products. Other sources include trade magazines,
advertising agencies.
2. Idea screening
This is done to eliminate those ideas that stand the least chance of being
commercially successful. The process spot good ideas and drop poor ones as soon
as possible. Product development costs rise at later stages, so the company wants to
go ahead only with the product ideas that will turn into profitable products. There is
need to determine how the consumers will benefit from the product, whether it is
feasible to produce it and whether it will be profitable.
3.Concept developments and testing
Product concept is a detailed version of the new product idea stated in meaningful
consumer terms. Product image is the way consumers perceive an actual or
potential product .e.g. Discovery 4WD car is an expensive, appealing car to tourists
and those travelling in mountainous areas. Concept testing involves testing new
product concepts with a group of target consumers to find out if the concepts have
strong consumer appeal.
4 Marketing strategy development
This is designing an initial marketing strategy for the new product based on the
product concept. it consists 3 parts , the target market, planned product positioning,
sales, market share e.t.c .If the target market is younger, well educated, high
income earners .The discovery 4WD can be positioned to be more economical and
safe to operate more fun to drive and a high performance car. It will be offered in 2
colours that is black and blue, with power 4 wheel drive as well as being air
conditioned. The retail prices of $52 000 and a discount of 20% to dealers. Dealers
selling more than 20 cars per month will be given an additional 5% discount.
Advertising budget will be $300 000 40% being international 60% national.
5 Business analysis
This is the review of the sales, costs and profits projections for a new product to find
out whether these factors satisfy the company’s objectives. If it meets them then
the idea can move to the product development stage. The company can look at
sales history of similar products and conduct surveys of market opinion. After
preparing sales forecasts, the management can estimate expected
6 Product development
This is the strategy of offering modified or new products to current market
segments. This is developing the product concept into a physical product in order to
ensure that the product idea can turned into a workable product. The research and
development department will develop and test one or more physical versions of the
product concept. The firm’s R&D hopes to design a prototype that will satisfy and
excite consumers and that can be produced quickly and at budgeted costs .It should
have the required functional features and convey the intended psychological
characteristics .e.g. The discovery 4*4 well built, comfortable and safe.
7 Test marketing
This is the launch of the product on a small scale market to test consumers’
reactions to it. The small market should be as representative as possible. The
benefits of test marketing are:
 The actual consumer behaviour can be observed
 Feedback from consumers will enable a final decision to be made about
investing capital in a full scale launch
 Risks associated with a product failing after a full scale launch are reduced
 Any weakness in the product identified by consumer feedback can be
incorporated into the final version of the products.
However it can be very expensive and competitors are able to observe a firm’s
intentions and react.
Commercialisation
This is the full scale launch of the product which corresponds to the introduction
phase of the product life cycle. There is need to put in place a promotional strategy
to make consumers aware of new product availability using informative advertising.
Research and Development
This is the scientific research and technical development of new products and
processes. New product innovations allow businesses to survive and grow in rapidly
changing market places. The costs of R&D may be too high to recover so other firms
may decide not to carry out R&D.
Governments can provide a favourable environment for R&D in 2 ways
1. Providing some legal security to inventors and designers by allowing them to
‘patent’ or ‘register’ a design. This provides protection to the inventor from
unauthorised copying of the new idea or design. The inventor will be able to
secure profits from the product.
2. They can provide financial assistance to business engaging in R&D e.g. Tax
reduction incentives or offering grants to firms and universities departments
with close links to industry for a specific project
Factors that influence level of R&D expenditure by firms
1. Nature of industry –In rapidly changing technologies and consumer
expectations e.g computer and software products lead to the need for
substantial investment in R&D.
2. The R&D spending plans of competitors-The firm try to spend as much as or
more than competitors if market share and technical leadership are to be
maintained
3. Business expectations-If the business managers are optimistic about the
future state the economy and the rate of economic growth and demand ,then
they can agree to spend much in R&D
4. The risk profile or culture of the business refers to the attitude of
management to risk and whether shareholders are prepared to invest for the
‘long term’
5. Government policy towards grants to business and universities
Value Analysis/Value Engineering
This is the process of analysing whether a new product can be made more efficiently
(at a lower cost) without affecting its appeal to customers. It is an approach to cost
reduction in which components are studied carefully to determine if they can be
redesigned, standardised or made by less costly methods of production. The firm
decides on the best product characteristics and specifies them. Its aim is to optimise
the value of the product to the customer. The process eliminates any costs which do
not add value to product or improve performance of products and services. Thus for
example if a car has an expected life of 10 years but the engine can live for 15
years, it becomes important to look for a less costly components with a shorter life
span. This so because many firms will want to replace vehicle say after 5 to 10
years, they do not want assets that live forever. The product should be economic to
manufacture and easy to store and distribute. Design should take into account
production of scrap and waste material.
Factors influencing the design of a product include
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Performance of the product in terms of efficiency, reliability, ease of
operation, safety of operation, ease of maintenance
Appearance of the product
Legal requirements, i.e the controls over the product appearance like colour
toys
Economy of manufacture and distribution and storage
Environmental concerns on pollution like the switch to unleaded petrol by car
manufacturers
Market conditions, competitor activity
Importance of Value Analysis
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It enhances coordination between departments such as production and
marketing. The process can make use of cross departmental teams who
check to find ways to reduce costs of components.
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It enhances the production of better quality products by eliminating any costs
which do not add value and improving performance of the product.
It guarantees more competitiveness by improving product value. The
consumers prefer products that offer more value than others.
The process solves root cause problems and capture opportunities
It takes command of powerful problem solving methodology to use in
developing new products
It is an approach to cost reduction so reduces product costs and increases
profit margins
It assists in decision making that is determining the costs and benefits of
alternative courses in developing new products
It enhances efficient resource allocation by eliminating costs which do not add
value to products.
More simpler methods of production are used
Fewer components in products results in lower maintenance and repair costs.
PRODUCT LIFE CYCLE
The product life cycle shows the different stages that a product passes through over
time
and
the
sales
that
can
be
expected
at
each
stage.
There are four stages in the PLC
1. Introduction stage
The product is introduced into the market with the intention to build a clear identity.
Sales are low and profits may be negative as the costs are high when the product is
launched. Before offering the product to the customers it passes through the
development phase. There are high costs of R&D. Prototypes are produced and
market tests are carried out. The core focus is to establish a brand, a market and
demand for the product. The marketing mix is as follows:
 Product-This is concerned with branding, quality level and intellectual
property protections. These are obtained to stimulate consumers for the
entire product category. There is need to create the best first impression for
consumers.
 Price-A penetration pricing policy is a low price used to penetrate the market
and gain a market share. This is used for substitute products whose demand
is elastic and when there is intense competition. Skimming pricing policy is a
high price used for making high profits with the intention to cover initial cost
in a short time. It is used to cover costs. The aim is to maintain a high image
.It is used for unique product with inelastic demand and when the firm is
dominant. The pricing strategy depends on the company’s objectives.
 Place –Refers to the distribution of goods. Sufficient distribution is done to
produce to ensure product availability after being advertised. The distribution
is usually selective and scattered. If distribution is not ensured, trade discount
and cooperative advertising allowances to convince distributors to stock the
brand.
 Promotion- This is done to build brand awareness. Samples can be provided
and it is fruitful in attracting early adopters. Usually informative advertising is
used to let consumers aware of the product’s existence, its price, and where it
can be found and the main features. Sales promotion can be used to offer
free samples to encourage consumers to taste the product
Price incentives can be offered to traders to stock the product.
Growth stage
There are higher sales volumes that enable the firm to benefit from economies of
scale. New customers buy the product and there are repeat purchases. Costs may
fall down due to production increases. Profits grow as sales rise and costs fall. The
product penetrates the market. The firm tries to build up customer loyalty before the
entry of competitors. The competitors may launch their own version of products.
This can lead to a slow down of a rise in sales. The marketing strategy is as follows:
 The product strategy is to identify deficiencies and improve on these and
maintain existing quality. New features and improvements in the product
quality may be done. This is done to compete and maintain the market share.
 The promotion strategy is to continue with informative advertising but the
focus can move to brand building and persuasive advertising. This is done to
educate customers on specific benefits .When acceptability increases, more
efforts are made for brand preference and loyalty. The company can cut back
trade discounts and allowances after gaining trade acceptance. Sales
promotion incentives are given to encourage repeat purchases and build
brand image.
 The price strategy is to lower the skimming price that could have been
used to introduce the product to increase market share. However if the firm
had used penetration price with high demand at low competition it can be
increased to increase profits.
 The distribution strategy is to use intensive distribution as the demand
and acceptability increases in order to meet demand. Resellers start getting
interested in the product.
Maturity stage
The sales continue to rise but at slower rate. The product is now bought by the
majority of consumers so it’s established. Competition is high so at some point sales
will level off as competitors enter to compete away the profits. Brand preference is
now a crucial factor in the continuing process. The aim of the firm is to retain its
market share by capturing sales from weaker rivals.
 The promotion strategy is to use persuasive advertising to differentiate the
product from rival products. There is need to remind consumers of the
existence of the product. Sales promotion incentives can be used to fight
competition and encourage brand switching and continued loyalty. There is
need for sales promotion to encourage retailers to give more shelf space to
the product than that of competitors.
 The product strategy is to add more features and modify the product in
order to compete in the market and differentiate the product from
competition. It is best to get dominance over competitors and increase
market share.
 The price strategy is to reduce prices in order to compete due to intense
competition. This attracts the price conscious segment and retains the
customers.
 The distribution strategy is to add new distribution channels. Incentives
are offered to retailers to get shelf preferences over rivals.
Decline stage
The market is now saturated so sales and profits decline. This could be
due to technical obsolescence or change in customer tastes. Substitute
products flood the market. The firm seeks to cut its losses by cutting costs or
elimination of the product. The firm can maintain the product, reduce costs
and find new uses of the product. The firm can harvest the product by
reducing marketing costs and continue offering the product to loyal niche
markets until a zero profit. He firm can discontinue the product totally.
However the firm must take care not to remove the product too early. Some
products can have long or shorter life cycle like fads which do have a very
short life cycle.
Life cycle extension strategies {methods used to extend the life of a
product.}
 Finding new markets for existing products e.g. there has been a boom in
sports clothing as it is being used as fashion.
 Developing a wider range of products like lucozade which was originally used
for those recovering from illness but there is now a sports version
 Gearing the product towards specific target markets like banks have accounts
young people
 Changing the appearance, format or packaging of the product e.g. coca cola
is available in individual cans, in glass, or plastic bottles or multipacks.
 Changing ingredients or components like cars are equipped with CD or MP3
players and air conditioning as standard
 Updating designs like what car manufacturers are doing.
The product life cycle and capacity utilisation
Capacity utilisation is the extent to which a business uses the capacity that it has
to produce a particular product. It is the relationship between what the firm
produces and what it is capable of producing. A business working at full capacity is
unable to produce any more products. The relationship is as follows:
 At the launch sales are likely to be limited so there is spare capacity
 At the growth stage a business will often be expanding its operations and
using up spare capacity to meet the rising demand for the product.
 At the maturity stage the business may be operating at full capacity. If sales
continue to grow it must decide whether to invest to expand capacity.
 At the decline stage there will be under utilisation of existing capacity.
Usefulness of the PLC
 It illustrate the broad trends in revenue that a product might earn for the
business
 It will identify points at which business may need to consider launching new
products as older ones are in decline
 It will identify points at which extension strategies may be introduced
 It may help a business to identify when and where spending is required e.g.
on research and development at the start or on marketing at introduction and
when extension strategies are required
 It may help to identify points at which a business should no longer sell the
product
 It will help the business to manage its product portfolio
 It will give an indication of the profitability of a product at each stage in its
life cycle
 It will allow a business to plan different styles of marketing that a product
might need over its life cycle.
The Boston Consulting Group matrix (BCG)
A product portfolio is the range of products that a firm offers to different market
segments.
The BCG matrix is a portfolio planning method that evaluates a company’s strategic
business units in terms of their market growth rate and relative market share.
Strategic business units or product portfolios are classified as cash cows, stars, dogs
and question marks/ problem child.
It shows the growth and market share relationships. Market growth measures the
attractiveness of the product. Market share serve as a measure of company strength
in the market.
The BCG Matrix
The Boston Consulting Group Box ("BCG Box")
Stars are successful products which are performing well in an expanding market.
They have a high market growth rate and relative market share. The firm needs
heavy investment to finance their rapid growth. The firm will be keen to maintain
the market position of this product in what may be a fast changing market.
Promotion costs may be high to help differentiate the product and reinforce its brand
image. Stars are likely to generate high amounts of income. Using Dairiboard,
Yoghurt can be said to be a star.
The strategy that can be used with Stars is called Holding. This is continuing to
support the star products so that they can maintain their good market position. The
firm ca freshen the product in the eyes of the consumers so that high sales growth
can be sustained.
Cash cows are successful products that produce high positive cash flows and are
profitable. The sales of cash cows are high relative to the market and promotional
costs are likely to be low as a result of high consumer awareness. They are well
established products in mature markets. They can generate a lot of cash that can be
used to support other products. This strategy is called Milking (taking positive cash
flows from the cash cow products and investing in other products in the portfolio).
Chimombe can be regarded as a cash cow.
Problem child/ question marks are products with low market share and high
growth rate. They consume resources but generate little return. If it is a new
product it will require heavy promotion costs to help become established. They can
be financed by cash flows from cash cows. The future of the product may be
uncertain so quick decisions may need to taken if sales do not improve e.g. revise
design, relaunch or even withdrawal from the market. The firm should use the
strategy of Building that is supporting the problem child products with additional
advertising or further distribution outlets.
Dogs are low growth, low market share products. They may generate enough cash
to maintain themselves, but do not promise to be large sources of cash therefore
they offer little to the business either in terms of existing sales and cash flows or
future prospects. It may need to be replaced shortly. The strategy used with dogs is
called Diversifying. This involves identifying worst performing dogs and stopping
the production and supply of these products.
ANSOFF MATRIX
This is a model used to show the degree of risk associated with the four growth
strategies of market penetration, market development, product development and
diversification
Products
Existing
Existing
New
Market penetration
Product development
Market development
Increasing risk
Diversification
Increasing risk
Markets
New
Long term business success was dependent upon establishing business strategies
and planning for their introduction. ANSOFF matrix considered two main variables in
strategic marketing decision. These are:
1) The market in which the firm was going to operate
2) The products intended for sale
In terms of the market, managers have two options
1) To remain in the existing market or (b) To enter new markets.
In terms of the product the two options are:
2) Selling existing products or (c) To develop new products
Market penetration is achieving higher market share in existing markets with
existing products. This can be achieved by reducing prices of products so as to
stimulate demand for product and increase sales and market share. However this
could lead to price wars that can reduce profit margins of all firms in the industry.
Product development is the development and sale of new products or new
developments of existing products in existing markets. E.g. the launch of coke zero
took an existing product developed it into a slightly different version and sold it in
the soft drinks market where diet coke was already available. This involves
innovation.
Market development is the strategy of selling existing products in new markets.
This can include exporting products to overseas markets or selling in new market
segments e.g. Dell can use existing business computer systems and repackage them
for sale to consumer markets.
Diversification is the process of selling different, unrelated goods and services in
new markets. This strategy is done to spread risks. It involves new challenges in
both markets and products. It is a risky strategy.
Price
The price is the amount of money the customer pays for the product. Price is very
important because it determines the company’s profits and hence survival. Adjusting
the price has the profound impact on the marketing strategy depending on elasticity.
It is a compensation given from one party to another in return for goods and
services. The price includes what:
 The buyer is willing to pay
 A seller is willing to accept and
 The competition is allowing to be charged.
The Role of price
 A product cannot exist without a price
 The price affects the demand of the product and an inverse relationship exists
between the two
 It affects the economy because inflation is caused by rapid price increases
 Price provides a crucial role of providing the income
 It also determines the quantity supplied and consumed
 It regulates quantity available and consumed so during times of price controls
less is supplied and consumed
 Price serve as a signal especially through price incentives, (premiums) and
disincentives
( discounts)
 It communicates information to provide more or less of a product
 Lastly prices transfer ownership of goods, once you pay the price you are the
owner
Pricing Objectives
1) Profit maximisation is the greatest difference between sales revenue and
costs. Profits are maximised when Marginal revenue (MR)=Marginal costs
(MC).Firms are assumed to be profit maximisers
2) To get a target level of profits that can be in monetary terms or percentage.
3) To get an increase in market share, this can be achieved using penetration
pricing even to the extent of sacrificing short term profits. By building up
sales, the market share will increase long term profits
4) To maximise sales revenue by setting prices that maximise current sales
revenue, especially if they seek an early recovery of cash
5) To minimise risks by setting prices to maximise survival. Prices may be set to
meet competition or abandon competition in favour of non price competition.
6) To get a certain profit margin on each unit sold. This can be seen as
skimming pricing based on the assumption that buyers are still prepared to
purchase the goods despite the high price (demand is inelastic) and the firm
has sufficient lead over rivals for there to be little danger of high prices
attracting competitors in the immediate future.
Factors affecting Price decision
1) Cost of production since the price must cover the cost of production in order
for the firm to make profits. The costs include both fixed and variable costs
2) Market conditions- the monopolist or market leader has freedom in setting
prices. The monopolist can set prices anywhere along its demand curve. A
firm with high market share is dominant and can be a price setter. If the
market is competitive prices are likely to be closely related.
3) Competitor’s prices are usually used to set prices closer to those of
competitors to stay competitive in the market.
4) Business and marketing objectives thus if a firm aims to be a market leader
through mass marketing, thus will require a different price from those firms
which aim to select niche markets. A firm wishing to establish a premium
branded product sets high prices
5) Price elasticity of demand
6) Whether it is a new or existing product
Pricing methods
There are three broad categories of pricing methods. These are:
 Cost based pricing
 Customer oriented pricing
 Competitor oriented pricing
The choice of the pricing strategy will depend on:
1) The market segment being targeted
2) Stage in the life cycle of the product
3) The likelihood of repeat purchases behaviour
4) Competitive circumstances
Cost based pricing
This involves the addition of a profit element to the cost of production. The
following strategies can be used:
1) Mark up pricing which involves adding a fixed mark up for profit to the
unit price of a product. It is often used by retailers. A fixed percentage
mark up is added to the price of bought in materials e.g. if a textbook is
bought for $10 and a mark up of 20% is required. The selling price will be
=20% of 10=$2. The selling price will be $12. A higher mark up usually
leads to lower turnover or sales while a lower mark up leads to higher
sales.
2) Cost plus/ Full cost
This involves setting a price by calculating a unit cost for the product and
then adding a fixed profit margin. The costs of the product include both
allocated overheads and variable as well as fixed costs. A way of allocating
fixed overheads has to be found. This is said to be a fair and logical
method of pricing to recover overhead costs and maximise long term
profits.
Advantages of full cost pricing
 A price set will cover all costs of production
 It is easy to calculate for single product firms where there is no
doubt about fixed costs allocation
 It is suitable for firms that are price makers due to market
dominance
However
 Full costing ignores demand and price elasticity of demand
 It ignores the competitive situation in the market
 It does not take advantage of market potential that is the potential
to increase market share by lowering prices
 It is inflexible in the face of demand changes
 It exaggerates the precision with which costs can be allocated. The
allocation of overheads depends on level of output. If sales fall
average costs rise and prices could be raised
 It is not necessarily accurate for firms with several products where
there is doubt over the allocation of fixed costs.
 Poor methods of allocating overheads can result in overpricing and
under pricing due to under/over absorption
3) Target pricing is setting prices that will give a required rate of return at
a certain level of output/ Sales. A percentage mark up is added to variable
costs. The mark up covers fixed costs.
4) Contribution cost pricing
This is setting prices based on the variable costs of making a product in order
to make a contribution towards fixed costs and profits. It does not try to
allocate the fixed costs to specific products. The firm calculates unit variable
costs for the product and then adds an extra amount known as a contribution
to fixed costs. If enough units are sold, the total contribution will be enough
to cover the fixed costs and a return on profits.
Marginal costing is only suitable where the firm:
 Has spare capacity and can take advantage of increased sales
 Cannot put its resources into profitable use
 Is able to segment its market to avoid a diversion of its regular
customers to the low priced alternative. It is widely used in the service
industries which suffer from daily or seasonal fluctuations in demand
e.g. hotels, transport and holiday firms. Off peak prices are usually low
like trains, commuter omnibuses
5) Standard cost pricing is setting prices based on a mark up above
standard costs. Standard costs are the expected costs of production based
on certain standards.
Customer oriented pricing
1) Perceived value pricing involves charging a price that customers will be
prepared to pay. It is used in markets with where the demand is known to be
inelastic and a price s placed upon the product that reflects its value, as
perceived by the consumers in the market. This is to position a product in the
market. As quality is informally assessed by the price charged, It is important
to choose a price consistent with the image of a product, so prestigious cars
like Fortuner are perceived to be highly valued so should be priced higher
2) Psychological pricing is a pricing approach that considers the psychology
of prices and not simply the economics. The price is used to say something
about the product e.g. a highly priced car may be perceived to be having
higher quality than a lowly priced one. Also small differences in prices can
suggest differences in products. A price of $2, 99 is different from $3. The $2,
99 will likely be seen as a bargain price which offers value for money. The $3
can also suggest higher quality. Psychologists argue that each digit has
symbolic and visual qualities that should be considered when pricing. The
manufacturers of prestigious products will use rounded up figures like $100
not $99, 99.
3) Promotional pricing is temporarily pricing products below list prices and
sometimes even below cost, to increase short term sales. This takes several
forms. Supermarkets and Department stores can price a few products lowly
as Loss leaders to attract customers to the store with the intention that
customers will buy other items at normal mark ups. Loss leaders are product
sold at a loss on the individual product with the expectation that the loss will
be covered by extra profit on other product. The firm can offer discounts
from normal prices to increase sales and reduce inventories or clear excess
stocks. The manufacturer can offer cash rebate directly to customer
4) Skimming pricing involves charging higher prices when introducing a
product in the market, that can be reduced later as the product becomes
more acceptable and volume of sales increases. The firm will enjoy economies
of scale with the growth in sales, so firm can afford to lower prices. It is used
when the firm is price maker, the product is unique with no close substitutes
and there is little or no competition
5) Price discrimination can be used to charge different prices for the same
product in different market segments. This is viewed as an unfair pricing. It is
only acceptable if seller can prove that its costs are different when selling
them to different retailers. It can be used by airline operators who charge
different prices for the same journey.
6) Penetration pricing is charging low prices when introducing products to
encourage retailers and consumers to purchase the product in large
quantities so as to gain a high market share. It is used when competition is
intense and the product demand is elastic. It is used for the following
reasons:
I.
Consumers are encouraged to develop the habit of buying the product,
so that when prices rise eventually they will continue to purchase it
II.
Retailers and wholesalers are likely to purchase large quantities of the
product. This mean they will not buy from other suppliers and the firm
can gain a market share.
It is often used by large firms operating in mass markets to cover high production
costs like
production of canned drinks. It is not suitable for products with
a shorter life cycle.
Competitor Oriented pricing
This is charging prices based upon the price set by its competitors. The price set can
be plus or minus a certain percentage. Less attention is paid to costs and demand of
the product. The situations in which the method can be used include:
 In markets where there is one dominant firm and other firms simply follow
the price charged by the market leader. This is called price leadership
 In markets that have a number of firms of the same size but prices are still
the same to prevent price wars
 Destroyer pricing which exists where the price charged is below that of
competitors in order to try and force them out of the market.
The strategies that can be used include:
Competitive pricing that is setting prices slightly higher to tackle the price
leader but demonstrating important product differences. The strategy is easy to
use as there is no need to carry out thorough market research. It seems
relatively safe as the firm does not risk losing its market share. However:
 It lulls the price setter into passivity. The managers can lose sight of their
pricing responsibilities and reduce it to mere monitoring of competitor
prices and adjusting own prices. If however rivals are employing the same
strategy then prices may fall out of synchrony with current demand.
 Price matching can lead to a game of chicken. Low prices are used to
penetrate market and meet market share targets. This can lead to a
downward spiral of prices that can damage the company and the whole
industry.
Promotion
This is an attempt to draw attention to a product or business in order to gain new
customers or retain existing ones. This can include the use of advertising, sales
promotion, personal selling, direct mail, trade fairs, sponsorships and public relations
to inform consumers and persuade them to buy.
Promotion Objectives
 To increase sales by raising consumer awareness of a product
 To remind consumers about the product. This can encourage existing
customers to purchase the product and may attract new customers to buy
 To show that a product is better than that of a competitor by demonstrating
superior specifications or quality. This may encourage consumers to switch
purchases from another product.
 To create or reinforce the brand image or personality of the product
 To develop the image of a business rather than of a product.
 To correct misleading reports about the product or the business and to
reassure the consuming public after a scare or accident involving the product.
This builds up confidence in the product and may encourage the consumers
to purchase more of the product.
 To encourage retailers to stock and actively promote products to the final
consumers
Advertising
This is a non-personal one way communication to promote the sale of goods or
services through paid for advertisements in the media e.g. TV. This is a form of
above the line promotion undertaken by the business by paying for communication
with consumers. Advertisements are usually targeted towards appropriate target
markets by selecting the right media.
Types of advertising
Informative advertising are adverts that give information to potential purchasers
of a product, rather than trying to create a brand image. This is used to create
consumer awareness of the product. The information could be price, technical
specifications, places where the product can be purchased.
Persuasive advertising is trying to create a distinct brand image or identity for
the product. It is taken to promote own products at the expense of other firms’
products. The products of producers will be competing and having little differences
e.g. Heinz and Cashel valley beans. Competition among producers often results in
improved quality and reduced prices.
Reassuring advertising is aimed at existing customers. It tries to persuade them
that their purchase was correct and they should continue to buy from the firm.
Advantages of advertising
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It advises customers about the products available, their prices and where to
get the products
It creates brand loyalty and image
It increases sales thereby profit maximisation
It can be used to fight competition
It encourages repeat and first time purchases
Advertising reminds customers about the products available
It makes consumers to make a more informed decision as it offers choice to
consumers which allow them to make more informed consumption decisions
It gives valuable information to customers that might otherwise be difficult to
come by like how to use the product.
It also earns a lot of revenue for the television and radio and allows
newspapers and magazines to be sold at lower prices.
The advertising industry employs a lot of people directly through advertising
agencies and indirectly through jobs that may result from a successfully
advertised product. If demand for such a product goes up then more of it
might need to be produced leading to employment creation
It acts as a guarantee of product quality
It helps reduce sales fluctuations and assist in production planning
However
 Advertising is very expensive. It raises product costs and therefore prices
without adding value to the product. The money could be used to make
product improvements or price reductions to the benefit of consumers. It is
likely that consumers will pay more for the advertising costs than the firm
 It may persuade consumers to buy unnecessary and unwanted products. It
assumes that people are gullible in nature. This leads to a situation whereby
consumers are judged by how much they consume rather than their value as
human beings.
 It exaggerates the performance of a product e.g. washing powders
 It is wastage of resources as these could be put into some other profitable
use.
 Advertising can be used as a way of maintaining monopoly power by
preventing the entry of new rivals, thus it exploits consumers
 It stimulates wants that cannot be satisfied. Environmentalists are concerned
with high levels of consumption caused by advertising as the earth’s
resources cannot sustain this.
 It encourages people to buy products which are regarded as being damaging
to society.
 It also encourage behaviour which might be to the detriment of society as a
whole like the fast ‘macho’ driving often seen in advertisements for cars and
related products.
Types of advertising Media
Television is often used by business marketing consumer goods to a mass
market. The features are as follows:
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It produces sound and vision, it provides a wide coverage especially due
satellite television system accessible worldwide, advertising on colour
television is attractive and has greater impact on the audience,
advertisements can be repeated, detailed information can be given,
demonstration are possible on the television, advertisements can be in
different languages, audience can be targeted, can cater for both literate
and illiterate.
Radio has the following features
 It provides sound, it has personal impact or effect on people’s emotions, it
has a wide coverage, advertisements can be repeated and timed, producer
can target the group thus adverts can be placed during certain
programmes, message is transmitted fast, advertisements can be
produced in different languages, it caters for illiterate and blind.
Newspapers and magazines are an important media of advertising in mass
markets products. They can be used for targeting a particular market segment. It
can also be useful for smaller businesses which may make use of regional and local
newspapers such as Makonde star or the Telegraph. Newspapers have the following
features:
 Advertisements can be placed on daily, weekly or monthly newspapers,
provides a wide coverage, can be passed on for readership, can be timed
or placed in weekly or daily papers, adverts can be detailed, they can be in
colour for greater impact, it provides a written record, it is cheap, and
caters for a selected group.
Other Medias include posters, trade journals and the internet.
Factors considered when choosing advertising media
Cost –The cost of placing an advert in the TV or radio can be very expensive per
minute but however actual cost will depend on the time of the day the advert is
transmitted. The cost has to be measured against the effectiveness that is how
much new extra business will be generated by each extra dollar spend on
advertising expenditure. Managers should choose the media that falls within their
budget. The costs include media space and time, the advert production and use
of celebrities in TV and radio or cinema.
Size of the market –This refers to the areas to be covered by the
advertisement. A radio is suitable for a wide coverage. There is need to choose a
media that will best get to the audience the advertiser wishes to reach.
Profile of the target market audience- This is in terms of age, income levels
etc. This should reflect as closely as possible the target consumer profile of the
market being aimed. Advert for a Toyota Fortuner cannot be placed in the
Telegraph newspaper.
The message being communicated- Written communication is required for
giving detailed information about a product that needs to be referred to more
than once by potential customers. For products where there is need for creating
image, a colourful; TV advert is more effective.
The law – There are legal restrictions on the use of different media for
advertising certain products, such as cigarettes. There can be a limit on adverts
aimed at children.
The other aspect of the marketing mix- There is need to integrate other
aspects of the marketing mix. Advertisements can be part of a wider campaign
using other elements of the mix such as below the line promotion or pricing.
These elements may determine which media ton use for advertising.
Advertising agencies
These are firms who advise businesses on the most effective way to promote
products. They charge a substantial fee. They provide the following in devising a
promotional plan:
 They research the market, establish consumer tastes and preferences and
identify typical consumer profiles.
 Advise on the cost effective forms of media to be used to attract these
potential consumers e.g. sales promotion or persuasive advertising
 Use own creative designers to devise adverts appropriate to the media to
be used
 Film or print the adverts to be used in the campaign
 Monitor public reaction to campaign and provide feedback to the client
Sales promotion
This includes incentives such as special offers or special deals directed at customers
or retailers to achieve short term sales increases and repeat purchases by
consumers. This is a form of ‘below the line promotion’. This is a promotion that is
not a directly paid for means of communication, but based on short term incentives
to purchase a product.
The forms of sales promotion include:
1 Price promotion, which are temporary reductions in prices of products to
encourage existing customers to buy more and to attract new customers to
buy as the product now appears competitive. However increased sales affect
Gross profit of each item sold. This might have a negative impact on the
brands’ reputation from the discounted price.
2 Loyalty reward programmes, in which consumers collect points by
purchasing the product and redeem them for rewards, e.g. the Econet loyalty
points that were given 10 points for each $1 airtime bought and recharged.
These are focused on encouraging repeat purchases and discouraging
consumers from shopping with competitors. Loyalty cards provide information
about buying preferences e.g. Edgar’s cards. However there can be
administration costs to inform clients about loyalty points earned. Discounts
reduce gross profit on each product’s purchase.
3 Money off coupons is a versatile and better focused way of offering price
discounts. Coupons can appear at the back of a receipt, existing pack of a
product like on bottle tops or newspaper adverts. However they may simply
encourage purchase of goods the consumers would have bought already.
Retailers may be surprised by the increase in demand and not hold enough
stocks, leading to consumer disappointment. The proportion of consumers
using the coupon might be low if the reduction it offers is too small.
4 ‘Buy one, get one free’ encourages repeat purchases which reduces
demand for competitors products too. However there could be substantial
reduction in gross profit margin. Consumers may consider that if the scheme
is able to operate, are they paying a ‘normal price’ that is too high. If the
scheme is used to sell off stock that cannot be sold at normal prices, this
might damage the reputation of the firm. Current sales might increase, but
future sales could fall as consumers have stocked up on the product.
5 Point of sale displays in shops that can be a dump bin placed centrally full
of dumped products inside to attract attention of customers. This is normally
used with chocolates and other products at the points of sale (tills). However
best display points are usually offered to market leader products (with high
market share).
6 Money refunds are offered when the receipt is returned to the
manufacturer. However it involves filling in and posting off a form. This might
be a disincentive as it may take longer to get the refund.
Differences between Advertising and sales promotion
Advertising
Sales promotion
Non personal form of promotion paid by These are short term/ incentives given
the identified sponsor
to customers to promote sales
Gives a reason why you should buy a Provide an incentive to customers for
product
through
persuasive purchasing like refunds, loyalty points
advertisement
Creates awareness at introduction of Encourages
new products about new product, its products
price and place
repeat
purchases
Evaluate and inform consumers and Encourages bulk buying of products
persuades customers to buy
Sales promotion has increased in popularity due to :
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Sales promotions can be used as a method to break into a new market or introduce a
new product into an existing market. They can be used as a way of extending product
life cycle of existing products
They encourage consumers to sample a good or service which they might not have
bought otherwise. Once initial purchase has been made it is likely that further purchases
will be made.
Customers feel ‘rewarded’ for their custom so they develop loyalty to a particular
product or business
Customers identify products or businesses with things that they like or are attracted to.
A customer is more likely to purchase a product.
Sales promotions provide business with feedback on the impact of their marketing
expenditure for example through the number of coupons returned or amount spent on
loyalty cards.
Trade Fairs and Exhibitions
They are used by firms to promote their products. They are visited by both industrial and
ordinary consumers. Trade fairs are used to :
1 They give the chance to show how a product actually works. This is important for
complex technical goods. Promotion of industrial and agricultural machinery is often
done through trade fairs.
2 Consumer reaction to a product can be tested before it is released onto the market.
3 Some trade fairs are held overseas. They can form a part of a firm’s international
marketing strategy
4 A trade fair may attract press coverage. New products may be launched to take
advantage of this.
5 They allow customers to discuss a product with members of the management team.
6 Technical and sales staffs are available to answer questions and discuss the product.
7 To make contacts with customers
Direct Mail
This is sending information about a product through the post. The consumer can actually
buy the product by placing an order by post or telephone. It can take the form of direct emailing, where consumers or businesses receive product information through their email
inbox. It is a means of direct marketing.
Personal selling or Direct selling
This is when a member of the sales staff communicates with one consumer with the aim of
selling the product and establishes a long term relationship between the company and
consumer. This can be done over the telephone, by setting up meetings, in retail outlets or
by knocking on the doors. It tends to be used for highly priced and highly technical
products. This applies mostly to firms supplying industrial products. It enables individuals to
be given personal attention rather the standard message given by other promotion
methods. The individual consumer needs can be dealt with and the product can be tailored
to meet their needs. Reasons for using personal selling include:
 Creating awareness of and interest in a product
 Explaining the functions and technical aspects of a product
 Obtaining orders and , in some cases, making deliveries
 Encouraging product trials and test marketing
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Providing rapid and detailed feedback from the consumer to the producer via the
sales representative
However, it can be expensive since the cost of maintaining the sales staff can be very
high. Also consumers do not like callers so there are legal and ethical issues about the way
products are sold. (There can be too much pester power as customers feel being pressured
to buy the products). Also success depends on the skills of salesman.
Public relations
This is an attempt by a business to communicate with groups that form its public. The
groups can include government, shareholders, employees and customers. The aim is to
increase sales by improving the image of the business and its products. This can be used to
launch new products using a press conference where journalists will be provided with details
about the product and its performance, with the hope that this will later appear in an article
or in the News slot on TV. Businesses may appoint Publicity managers who promote
favourable press stories and respond to criticisms and try to ensure that there are no
unfavourable press notices. Customers appear to attach greater importance to messages
conveyed through public relations. Public relations can be done through:
1 Press conferences by inviting journalists to a company presentation, where they
are given information. The business may take opportunity to launch a new product.
Free products can be provided to conference members (trade customers) to try out.
2 Press releases are written accounts of events or activities which may be considered
newsworthy.
3 Donations to the community like ZB bank donating computers to Nemakonde,
Mimosa donating a mini bus to Chinhoyi University. This is done to create good public
relations.
4 Sponsorship which can be a payment by a company to the organisers of an event
so that the company name becomes associated with the event. In Zimbabwe schools
netball U17 is sponsored by Stella Tea (Tanganda), while boys U16 soccer is
sponsored by Coca Cola.
5
Company visits by customers as part of public relations
Branding
This is the strategy of differentiating products from those of competitors by creating an
identifiable image and clear expectations about a product.
A brand is a name, term, symbol or design or any other feature that allows consumers to
identify the goods and services of a business and to differentiate them from those of
competitors
A brand might be one product, a family or range of product, or the actual business itself.
Importance of branding
 To create brand loyalty as consumers often have a high degree of loyalty to popular,
well established, brands. Firms can only compete in markets if they have strong
brands. If brand loyalty is achieved then persuasive advertising is reduced. It
therefore reduces the amount spend on advertising
 To help recognition. A product with strong brand name is likely to be instantly
recognised by most consumers. This could be because consumers trust the product
and therefore are willing to buy the product.
 To differentiate the product and give an identity which aids identification. It is
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important in markets where products are fairly similar so that a firm’s products can
be clearly distinguished from others.
To gain flexibility when making pricing decisions as the greater the loyalty of
consumers to a particular brand, the more room for manoeuvre a firm will have in its
pricing decisions.
To develop a brand image as it is argued that consumers respond to brand images
they can identify. If consumers identify strongly with a brand they are often prepared
to go to great lengths to pay for the brand of their choice.
It provides a sense of security, reassurance about the quality of goods inside the
package. This arises out of the familiarity with the brand.
It adds value to the product making it more appealing to customers. The essence of
a brand is its perception by buyers.
Characteristics of successful brands:
 Easy to pronounce and spell especially if the firm is operating in international markets
.e.g. Lux
 It must be short and straight to the point so it is easy to remember for example Nike
 It must convey the benefits and characteristics of the product like quality, quantity
and benefits/ uses like Flora Pro-active, Pot ’O’ Gold.
 It must be distinctive
 Must help customer to identify when buying
 It must be capable of being legally protected by being different from other brand
names so it can be registered as a Trademark.
 It must be internationally acceptable by not carrying offensive meanings in other
languages.
Successful brands deliver four levels of meaning, these are:
 Attributes (which can include colour, shape, weight, height, texture), Values, Benefits
and Personality. A Mercedes Benz suggest such attributes as benefits, attributes as
being ‘well built, well engineered, durable, high prestige, fast and expensive car’
Types of Brands
1 Family brands(manufacturer brand) containing the name of the company
making the product like Heinz baked beans
2 Family brands covering a range of products but not containing the name of the
company. They cover a range of products that are in competition with other products
of the firm that are in a different family. The main aim is to appeal to different
segments of the market and reduce the chance of brand switching.
3 Distributor brands are also called own label brands. They are products
manufactured for wholesalers or retailers by other businesses. The wholesalers sell
them under their own brand name like OK pot ‘O’ gold, TM super saver. They allow
retailers to buy from the cheapest manufacturers reducing oits cost.
4 Generic brands (Individual brands) are products that only contain the name of
actual product category rather than the company name eg aspirin and carrots.
Packaging
Packaging performs the utilitarian function of containing and protecting the product. It
protects the product and retain its freshness.
Advantages of packaging
 It helps to identify the product using colour, logos and designs on the packaging in
advertising as themes
 It aids promotion to provide a constant reminder of the product
 It can attract customers by being colourful
 If the goods are competing with rivals they have to be distinctive
 Packaging can be used to prolong the life of the product by revitalising interest or
enabling the product to penetrate new markets.
 It aids self service and help to build brand loyalty
 It preserves the contents like tinned beans
 It contains instructions on how to use the product
 It can be used after the product has been consumed like empty buckets which
contained cooking oil.
 It makes handling easier and convenient
However:
 Packaging is expensive
 It increase the prices of the product to final consumer
 It contains legislative prohibitions (not for under 16)
 Some type of products package can be provocative like jiggies which have pictures of
wrestlers.
 Packaging can pollute the environment
Promotion budget
The financial amount set aside by a business for spending on marketing during a certain
time period.
Factors determining the promotional budget
1 Percentage of sales. If sales increase, the expenditure will also increase. However it
has the weakness that if sales go down due to inadequate promotional activities,
then the budget goes down
2 Objective based budgeting as the budget is based on the promotional support
required to meet the sales level required
3 Competitors’ budget is used by firms of relatively similar size in terms of sales; they
can match each other marketing spending. However this can raise promotional costs
as firms try to outdo each other
4 Funds available which make big firms like to be able to advertise while small firms
cant. Budgets are set based on what firms can afford
5 Last year’s budget (incremental budgeting). This takes last year’s budget and adds a
percentage to reflect different sales targets.
Distribution
It refers to the channel of intermediaries a product passes through from producer to
final consumer. It involves a strategy of moving products from point of creation to
the point of consumption in an efficient and low cost manner so that it is convenient
for the consumer
Players in the distribution channel include:
Manufacturer, agent, wholesaler, retailer and consumer
These can be arranged as follows:
Producer
Route 4
A Agent
Route 3
Route 2
Route 1
Wholesaler
Retailer
Consumer
Route 1
It involves direct marketing from producer to customer. It is used in industrial
markets for the supply of capital goods, mail order firms/manufacturers, factory
shops or farm shops, airline tickets sold over the internet.
Advantages
 There is no intermediary so there is no mark up or profit margin taken up by
other businesses.
 Producer has complete control over the marketing mix of the product, that is
how the product is sold, promoted and priced to consumers
 It is quicker than other channels
 It may lead to fresher food products
 Direct contact with consumers offers useful market research
Disadvantages
 All the storage and stock holding costs have to be paid by the producer
 No retail outlets limits the chance for consumers to see and try before they
buy
 It may not be convenient for consumers
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No advertising is paid for by intermediaries and no after sales service offered
by shops
It can be expensive to deliver each item sold to consumers
Route 2
It is used by large retailers with own warehouses, holiday companies selling holidays
via travel agents or where the whole country can be reached using one level route.
Advantages
 Retailers hold stocks and pay for storage costs
 Retailers has the product displays and offers after sales service
 Retailers are often in locations that are convenient to consumers
 Producers can focus on production and not selling
Disadvantages
 Intermediaries take a profit margin that make the product more expensive
 Producers lose some control over the marketing mix
 Retailers may also sell products from competitors so there is no exclusive
outlet
 Producer has delivery costs to retailer
Route 3
This is the traditional channel in consumer markets. Small retailers depend on
wholesalers for supplies and manufacturers are also keen to avail themselves tp the
services of wholesalers.
Advantages
 A wholesaler holds goods and buys in bulk from producer
 It reduces stock holding costs fo producer
 Wholesalers pay for transport costs to retailers
 Wholesalers breaks bulk by buying in large quantities and selling in smaller
quantities
 It may be the best way to enter foreign markets where producer has no direct
contact with retailers
Disadvantages
 Another intermediary takes a profit mark up and may make final goods more
expensive to consumers
 Producer loses further control over the marketing mix
 It slows down the distribution chain
Factors influencing the distribution channel
1 Nature of products- industrial products tend to move directly to consumers
2 Geographical dispersion of target market, thus if consumers are widely spread
throughout the country then more intermediaries are used
3 Level of service expected by consumers like after sales service of cars means
that internet selling is not appropriate
4 Technical complexity of product like business computers are sold directly as
they require a great deal of technical knowhow among the sales staff and
supporting service team
5 The unit value of the product as high value products like cars can be sold via
sales persons while low value items like exercise books use wholesalers and
retailers
6 The number of potential customers affect thus commercial aircraft tickets are
sold directly
Importance of distribution
Distribution channels provide time, place and ownership utility. They make
products available when, where and in the sizes and quantities that customers
want. Distribution channels provide a number of logistics or physical distribution
functions that increase the efficiency of the flow of goods from producer to
customer. They reduce the number of transactions necessary for goods to flow
from many different manufacturers to large numbers of customers. This occurs in
two ways. The first is called breaking bulk where wholesalers buy goods in large
quantities and sell them in smaller quantities. They reduce the number of
transactions by creating assortments, thus providing variety to customers so that
they can buy different products from one seller at a time. The channels transport
goods and store them. They move them from their point of production; hold
them in their warehouses until they are bought by consumers. Intermediaries
provide customer services such as offering credit to buyers and accepting
customer returns. Sometimes retailers can assist manufacturer by providing
repair and maintenance service for the products they handle. The channel
members also perform the risk taking function. This is associated with goods that
may not be sold or can be stolen in the warehouse or can be damaged. The
channel members provide a lot of communication and transaction functions. They
provide two way manufacturers. They may supply the sales force, advertising
and other marketing communications necessary to inform consumers and
persuade them to buy. The channel members can be valuable sources of
information on consumer complaints, changing tastes, and new competitors in
the market.
Current trends in Distribution
 Increased use of internet for direct selling of goods and services e.g. ebanking and direct selling of insurance online
 Large supermarket chains perform the function of wholesalers as well as
retailers, holding stocks in their warehouses
 Using a variety of different channels e.g. Dairiboard have their own ice
cream van to sell directly as well supply to retailers
 Increasing integration of services where a complete package is sold to
consumers e.g. air flights, car hire and hotel accommodation all sold or
distributed to consumers at the same time.
Internet Marketing
This is the marketing of products over the internet. It can involve several different
marketing functions:
1 Selling of goods directly to consumers or other business as orders are placed
online through the company website
2 Advertising using the company’s website or ‘pop-up’ on another firms website
e.g. a car insurance company may pay to have a banner advert on a car
manufacturers website
3 Sales links are established by visitors to a website leaving their details and
then the company emails them or calls them to attempt to make a sale
4 Collecting market research data by encouraging visitors to the website to
answer questions that can provide important consumer data
5 Dynamic pricing using online data about consumers to charge different prices
to different consumers over the internet.
Advantages
1 It is relatively inexpensive when compared to the ratio of cost and the
number of potential consumers reached
2 Components can reach a worldwide audience for a small proportion of
traditional promotional budget
3 Consumers interact with the website and make purchases and leave
important data about themselves
4 The internet is convenient for consumers to use if they have access to a
computer
5 Accurate records can be kept on the number of visitors or clicks and the
success rate of different web promotions can be quickly measured
6 Computer ownership and usage are increasing in all countries of the world
7 Selling products over the internet involves lower fixed costs than traditional
retail stores
8 Dynamic pricing is made possible
Disadvantages
1 Some countries have low speed internet connections and in poorer countries,
computer ownership is not wide spread
2 Consumers cannot touch, smell, feel or try on tangible goods before buying.
This may limit their willingness to buy certain products online
3 Product returns may increase if consumers are dissatisfied with their
purchases once they have been received
4 Cost and unreliability of postal services in some countries may reduce the cost
advantage of internet selling.
5 The website must be kept up to date and user friendly. Good websites can be
expensive to develop.
Viral marketing
This is the use of social networking sites (face book, twitter) or sends text messages
to increase brand awareness or sell products
Integrated marketing mix
The key marketing decisions complement each other and work together to give
customers a consistent message about the product.
Intensive and selective distribution
Intensive system is seeking maximum possible number of stockists for the firm’s
products. This increases market exposure, sales volume, market share profit.
Selective distribution is deliberate restricting of the number of stockists of the
products. This is when:
1 The customer expects and or requires advice or after sales service
2 Selectivity confers status on the product like products sold at Edgars
3 The producer wishes to exert control over the intermediary
4 The market is insufficient to warrant more intensive distribution
Channel support strategies
This is the use of intermediaries which reduces the marketing risk and marketing
effort for the manufacturer, so they can concentrate on production and product
development.
To force goods through the channel the following strategies can be used:
Push strategies are aimed at intermediaries. These include discounts, increased
dealer margins, dealer competitions, point of sale displays, incentives for sales staff
(commissions), trade advertising, and Trade exhibitions
Pull strategies are generic the selling strategies. The business approaches
customers directly rather than using intermediaries. This includes direct mail,
telemarketing direct response marketing which involves asking target consumers to
take action e.g. complete the tear off slip, as well as emailing to potential customers.
Operations Management/ Production
Production is converting inputs into outputs. The management of production is
called Operations management. It is concerned with the use of resources called
inputs that is land, labour and capital, to provide outputs in the form of goods and
services.
The production processes can be referred to as the transformation process. This
refers to the making of tangible goods and intangible services such as banking.
During transformation Value is added to inputs that are bought in the business so
that the resulting output can be sold at a profit.
Value added is the difference between the cost of purchasing new materials and
the price the finished goods are sold for. It can also be defined as the difference
between total revenue of a firm and cost of bought in materials, service and
components. It is the net output representing firm’s contribution and production
process. It is different from profits in that profit is the difference between price at
which goods or services are sold and all costs of production.
The following are the ways of adding value to products:
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Adding utilitarian functions like adding whatsApp to a Gtel 306 phone
Identify new uses for the products like using Johnson powder by older ladies
Product redesign
Packaging
Promoting the product
Branding
Cost reduction / production efficiency
Exclusive and luxurious retail environments
Importance of value addition
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It allows firms to market their products more successfully emphasising
strength of brand as opposed to just a commodity.
The product can achieve a unique selling point. Unique selling points refer to
the features of a product that may differentiate it from its rivals. The USP
help the business have a competitive advantage over competitors.
The product will obtain a competitive advantage over its rivals
Higher added value products are less price elastic and harder to copy
It contributes towards higher profitability as the product is price inelastic&
more competitive
It leads to improved corporate image and it also promotes customer loyalty
The degree of value added will depend on:
1. Design of the product –well designed, high quality products will be more
demanded at higher prices
2. Efficiency of production which reduce waste. Increasing productivity will
reduce costs per unit and this will increase value added if prices remain fixed.
3. Impact of the promotional strategy on convincing consumers to pay more for
the product than the cost of the inputs.
The production process can involve many stages before physically selling the goods
and services. These include:
1. Converting a consumer need into a product that can be produced efficiently
2. Organising operations so that production is carried out efficiently like ordering
stocks
3. Deciding on suitable production methods
4. Setting quality standards and checking they are maintained
Branches /Stages of production
Primary production involves the extraction of raw materials from nature/land. It
includes agriculture, mining, fishing
Secondary production comprises manufacturing and const
ruction activities. It relies on primary production for its inputs
Tertiary production involves the provision of services. These are subdivided into :
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Direct services which are provided personally like teaching, nursing
Commercial services or distributive services which are provided through
trade and commerce. They assist trade like banking, transport
Objectives of Operations management
Production planning is done for the following purposes
1 To relate sales requirements to the available production capacity on a time
basis which ensures that goods are produced when they are required
2 To make sure goods are produced in the quantities required and that they
are of the correct quality
3 To ensure that production costs are minimised
4 Production should add value to outputs. In order to reduce costs, the firm
should increase plant capacity and produce more products. This reduces
average unit costs. This is referred to as economies of scale. Workers can be
trained to improve productivity. Productivity is the output per unit of input. If
labour productivity increases labour costs per output declines.
Poor production planning leads to:
 Excessive production costs
 Excessive shortage costs resulting from failure to meet customer delivery
dates
 Necessity to carry out rush hour production orders which may result in the
production of defective products
 Excessively long working hours
 Frequent delays in production caused by material, parts and labour shortages
 Short production runs resulting in uneconomic quantities
 Excessive production set up costs resulting from short production runs, the
need to divert goods away from one customer to another to fulfil more urgent
orders
Plant Location
This refers to the site where actual production is to take place. Factors to be
considered when choosing a site include:
Quantitative Factors
1. Availability of labour which is an important factor for labour intense
businesses
2. Nearness to supply of raw materials which is necessary where raw materials
are bulky and need to be transported like timber Industry is better off running
its operations in Mutare. Nature of raw materials is difficult to store like
perishables.
3. Transport facilities. Transport adds value to the location chosen. The site
should be accessible by transport. Accessible land is more valuable.
4. Costs associated with the purchase of freehold premises
5. Government incentives aimed at encouraging investors to invest in the rural
areas particularly at growth points
6. Nearness to markets which is aimed at reducing costs of transporting the
finished goods. Producers of capital equipment and delicate capital equipment
consider this factor.
Qualitative Factors
1. Local bye laws and attitudes in relation to building plans and regulations. The
attitude of the local population needs to be checked as well. Some people
might be opposed to industrial development should they view it as a
disturbance to ecology
2. Housing and social factors are important to firms that cannot build own
houses for their employees they will have to locate where there are built
accommodation already. There is also need to consider availability of
education, health and recreational facilities.
3. Environmental concerns make the business organisation to choose areas that
less sensitive to the environment.
Factory layout
This should be carefully designed to secure maximum flexibility, coordination and
security, safety, accessibility, visibility, efficiency, minimum handling and minimum
movement.
Types of factory lay out
1. Layout by process is characterised by clustering of machinery performing
similar tasks and is associated with batch production. It is flexible. Process
layout accommodate many different product routes, it ensures high utilisation
of machinery in a batch set up and provides back up machinery in the case of
breakdown. There is greater product movement than in layout by product
2. Layout by product is a system in which machines and tasks are arranged
according to the sequence of steps in the production of a single product. The
layout is associated with line and flow production.
Advantages include:
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Handling is reduced
Work is simplified and broken down into smaller tasks
Control of the process is facilitated
Limitations
It requires a high volume of output of a limited range of goods
3 Cell layout is associated with a method of organising known as Group
technology. It involves the formation of tasks, jobs and products into ‘families’
with the resources required being formed into cells. Machines dedicated to
the sequences of production are grouped into cells. The group contains about
6-15 workers who work solely in the group. They produce a specified family
of products. The equipment is solely used by the group and is housed in an
area reserved for the group.
Advantages
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There is reduced preparation time
There is improved efficiency as a result of standardisation and simplification
Lower handling time
Reduction in stocks
Improved social relations
Fixed position layout is used where resources are taken to the site at which
production occurs. This is the case in large construction projects.
Maintenance is work carried out to maintain or restore production facilities. This is
important because:
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It enables the firm to satisfy customer demand
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To maximise the useful life of equipment
To maintain safety standards
To minimise production costs
To minimise the disruption to operating processes
Production Methods
Job production
This refers to the production of one-off items specifically designed for the customer.
It is used when orders are small. The products may be small or large (like building a
ship) and are often unique like specially designed wedding rings and cakes, designer
suits. Each individual product has to be completed before the next product is
started. At any time there is only one product being made. There is a wide variety of
goods and services that can be produced. Jobbing production is arranged by
process, hence machines carrying out the same or similar operations are clustered
together and the product moves from one work station to another. The firm do not
hold stocks of raw materials and finished goods.
Advantages of job production
 The demand can be forecasted
 The products are made according to customer specifications like wedding
gowns and dresses for individual tastes. It is also possible to change
specifications of the job at the last time even if production has actually began
 It leads to greater customer satisfaction as the goods are tailor made
 Production schedules can be prepared when customers arrive
 Limited stock of materials may be kept so this reduces stock holding costs like
security, warehousing
 The producer has personal touch with customers which make the producer
more responsive to customer needs
 It tends to be motivating to workers because they produce the whole product
and can take pride in it. The tasks employees carry out often require a variety
of skills, knowledge and expertise. Their work will be more demanding and
interesting. This is part of job enrichment. The job may be taken out by a
team aiming at the same objectives. This should help raise the level of job
satisfaction.
 The organisation of the job is fairly simple. Because only one job is done at a
time, coordination, communication, supervision and inspection can take place
regularly. Also it is easier to identify and deal with problems such as a poorly
cooked meal in a restaurant.
Disadvantages
 This production process tends to be expensive as it takes too long time to
produce the product
 It is labour intense and the labour force needs to be skilled and the possibility
of using labour saving machinery is limited and cost saving is not easy to
achieve
 The production process can be slow
 Buyers dictate specifications which are varied so there is need for flexibility
 Specialist machinery may be underutilised
 Labour costs tend to be high because production tends to be labour intensive.
This is because the workforce tends to be skilled and versatile and such
employees are will be more expensive.
 There is a variety of goods produced subject to many specifications, which
leads to a wide range of tools, machines and equipment. This can prove to be
expensive. Also it may not be possible to achieve economies of scale because
only one ‘job’ is produced at a time.
 Selling costs tend to be high especially if the product is highly complex and
technical. The sales team will have to be well qualified, able to cope with
questions and deal with problems concerning sales and installation. Some
firms employ agencies to help reduce their selling costs (for a fee)
 Once product demand rises, job production may become too costly. There
might be need to use a better method to speed up production. However job
production might continue with individuality not use other efficient production
methods
Batch Production
This is producing a limited number of identical products. It is used when demand for
a firms’ product or service is regular than one off. Each item in the batch passes
through one stage of production before passing on to the next stage. The production
process involves a number of distinct. It can be used in making bread. Batch
production allows a firm to use division of labour. There is repetition of processes.
There is stock piling unlike job production. The production is not continuous. The
change over between batches means that resources are idle during the changeover
period. It is possible to vary each batch. The ingredients could be changed to
produce brown bread or white bread or the style of baking tin could be changed.
Products can be produced in very large or small batches, depending on the level of
demand. However larger batches lower unit costs. New technology is being
introduced to make batch production more efficient.
The batch size depends on:
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Demand for the product
Length of time until the next production run of the same product is planned
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The level of finished goods stock planned
The number of back orders that exists
Economies of scale that can be taken advantage of
Advantages of batch production
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Division of labour is possible when each worker concentrate on one operation
than the whole task. This reduces the need for costly, skilled employees
There are economies of scale that can be enjoyed due to an increase in the
scale of operation. Average unit costs of production falls at higher levels of
production.
There is flexibility in the batch as it can be changed to meet customer’s
wishes. The settings on machines can be changed to suit customer
specifications, such different sizes of clothes. It is particularly suitable for a
wide range of similar products.
Less variety of machinery would be needed than in the job production
because the products are standardised. It is also possible to use more
standardised machinery.
It often results in stocks of partly finished goods which have to be stored.
This means the firm can respond more quickly to an urgent order by
processing a batch quickly through the final stages of production
Disadvantages
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Careful planning and coordination are needed as machines and workers may
be idle, waiting for a whole batch to finish its previous operation. There is
often a need to clean and adjust machinery before the next batch can be
produced. This can mean delays like in brewing companies, one day of the
week is used to clean equipment before the next batch begins
Some machinery may have to be more complex to compensate for the lower
skill levels required from the labour force. This can lead to higher costs
The workforce may be less motivated, since they have to repeat operations
on every single unit in the batch. In addition, they are unlikely to be involved
with production from start to finish.
If batches are small then unit costs will remain relatively high
Money will be tied up in work-in-progress, since an order cannot be
dispatched until the whole batch has been finished.
Flow production
The process makes use of a dedicated plant to manufacture a single product on a
continuous (24hour) basis. The production is on a large scale to ensure
continuous supply of products. The production is organised so that different
operations can be carried out, one after another, in a continuous sequence. The
factory layout is by process in a logical sequence in order to minimise the time
and cost of movement. The products are standardised and demand can be
forecasted. Production is made for stock to meet demand which is known on a
daily basis. The method can be used for the production of different products like
newspapers, food, and vehicles. Coca cola uses this method. The can or bottle is
of a standard size. The cans move through various stages independently. The
firm can make changes to contents of containers and labelling without altering
the production process.
Features of Flow production
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It is capital intensive
It produces large quantities of products with consistent demand which can
be forecasted
 The products are simplified and standardised
 Semi-skilled workforce, specialising in one operation only
 Large amounts of machinery and equipment
 Large stocks of raw materials and components
 They are able to take advantage of economies of scale
 The labour is employed on a shift basis to maximise production output like
at National breweries or United Bottlers or Delta (Chibuku breweries)
Advantages
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Unit costs are reduced as the firms gain from economies of scale
Labour costs are low since the process is highly mechanised
Constant rate of output should make the planning of inputs relatively simple
Quality tends to be consistent and high and it is easy to check the quality of
products at various points throughout the process
The need to stockpile finished goods is reduced as the production line can
respond to short term changes in demand
In many industries the process is automated. Production is controlled by
computers. Many of the operations are performed by robots and other types
of machinery. Once the production process is set up and running products
can flow off the end nonstop for lengthy periods of time. This can reduce the
need for labour, as only machines supervisors are needed.
Disadvantages
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The set up costs are very high. An enormous investment in plant and
equipment is needed. Firms must therefore be confident that demand for the
product is sufficient over a period of time to make the investment pay
The product will be standardised. It is not possible to offer a wide range and
meet different customer’s needs. However, modern machinery is becoming
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more flexible and is beginning to overcome this problem. This is due to mass
customisation of products e.g. a range of different cars can be produced on
the same production line like cars of the same model range with different
colour, engine size, trim and interior design.
Worker motivation can be a problem with a number of manual workers doing
repetitive and boring tasks. Factories with flow production lines tend to be
noisy. Each worker will be involved in a very small part of the job cycle. These
problems lead to low worker morale, labour turnover and absenteeism is high
Breakdowns can prove costly. The whole production system is
interdependent. If one part of the supply or production line fails the whole
system may break down.
Difference between batch and flow production methods
 Batch production is the manufacture of different version of the same basic
product in batches (e.g. different colour, types of paint, different varieties of
jams etc)
 There is some repetition of production which is for stock (rather than to
order). Production is not continuous. Change-over between batches means
that resources are idle at times. Consequently, production managers have to
plan production schedules to minimize changeovers. The machinery employed
will be specialised for production of the firm's products, but yet flexible
enough for different batches.
 Flow Production requires specialist machinery. Because of the high capital
investment requirement, it is essential to achieve high level of utilisation. This
requires a high level of sales of a fairly standardized product made for stock.
 Flow production links up with a strategy of undifferentiated marketing
whereas batch production suggests that the product is tailored to suit the
needs of particular customers or segments.
 The manpower required is specialist, but low in skills and performing
repetitive task as compared to batch production where the levels of skills
required are comparatively high.
 The great advantage of line production is that with long production runs unit
costs will be very low as compared to batch production.
 Factors Influencing the choice of Production Method
 Cost –Production methods like Flow production is expensive and difficult to
build. However job and batch production methods are relatively cheap.
 Level of technology-Technology give the firm flexibility to produce a variety of
product models from one basic design and production process. The
development of robots has been a great advantage to flow production
 Level of demand-If market demand is small like market for designer suits then
job production is used and flow production for fast moving consumer goods
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whose demand is high and consistent. They are produced using mass
production and mass marketing is used to sell them
Availability of raw materials-large scale production requires large quantities of
raw materials than job production
Reliability of suppliers-Flow production requires a reliable supplier of raw
materials since demand for the product is high and consistent. Breakdowns in
supply affect the production process
Qualification of staff-Job production requires technically skilled workers than
flow which requires semi skilled labour.
Availability of personnel-Job production requires less number of employees
than batch and flow. Flow will therefore be able to operate if there is a large
pool of employees
Factors considered when changing production methods
Factor
Job
Batch
Flow
Size of order
Very small
Small
High
Volume of output
Low
Medium
High
Product range
High
High
Low
Product variation
High
High
Low
Flexibility
process
of High
High
Low
Dedication
machinery
of Low
Low compared to High
flow
Capital investment
Low
Higher than job
High
Economies of scale
Low
Higher than job
Greater economies
Level of labour skill
Highly skilled
Less
job
skilled
than Low level of skills
Capital and labour intensive strategies
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Capital intensive production techniques involve employing more machinery
relative to labour.
Labour intensive production techniques involve using a larger proportion of
labour than capital
Factors determining the choice between labour and capital intense production
techniques
The nature of the product as the case with everyday products with high
demand are mass produced using more machinery. The provision of services
is largely labour intense
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The relative prices of the two factors. If labour costs are rising then capital
intense techniques are used. In developed countries labour is more expensive
and a great deal of manufacturing is capital intense
The size of the firm. As the firm grows and the scale of production increases
it tends to employ more capital rather than labour intense strategies.
Advantages of capital intensive strategies
Generally more cost effective if large quantities are produced
Machinery is often more precise and consistent
Machinery can operate 24hrs
Machinery is easier to manage than people
Disadvantages of capital intense strategies
There are huge set up costs
Huge delays and costs if machinery breaks down
Can be inflexible as much machinery is highly specialised
Often poses a threat to workforce and could reduce moral
Advantages of labour intense strategies
Generally more flexible than capital as the workers can be retrained
Cheaper for small scale production
Cheaper for large scale production in countries like China and India
People are creative and can therefore solve problems and make
improvements
Drawbacks
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People are difficult to manage than machines. They have feelings and react
People can be unreliable. They may go sick or leave suddenly
People cannot work without breaks and holidays
People sometimes need to be motivated to improve performance
Scale of operation and productive efficiency
Productive efficiency occurs when the average cost per unit of output is at its
lowest.
Reasons why firms may not be productive efficient:
The firm may not be paying the cheapest price for the materials they buy in
The firm may be employing more workers than is necessary
The firm may be using outdated technology
The firm may be holding too much stock
It could have badly organised or inappropriate production methods
Inefficiency could be due to failing to manage human resources effectively as
the workers may be:
Demotivated and not be working as hard as they could
Not have received sufficient training
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Apply for a job, but fail to get it despite being the best candidate because of
poor recruitment procedures
Suffer from weak leadership and be less productive
Be in a poorly organised business where the organisational structure is a
barrier rather than a help to efficient working
Be underemployed and have too little to do because of over recruitment due
to poor workforce planning
Be unable to do their jobs fully because poor workforce planning has led to
under recruitment of staff
Economies of scale
Internal economies of scale
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Purchasing and marketing economies. Large firms get better rates when
buying raw materials and components in bulk. Large businesses can find it
cost effective to acquire its own fleet of vans and Lorries for distribution
purposes. The administration costs do not increase in proportion to size of
sale
Technical economies of scale. Larger production plants are often more
efficient as the capital costs and running costs of plants do not rise in
proportion to their size e.g. the cost of a double Decker bus will not be twice
that of a single Decker as the main costs the engine and chassis do not
double. The increased size may mean doubling of output not costs. This
results in a fall in average costs. This is called the principle of increased
dimensions. Another technical economy is that of indivisibility. It assumes that
firms need a particular item of equipment but fail to make full use of it like
$400 paid for a lap top by a small business used twice by a part time
accounts clerk. The cost will be the same if it is bought by a large firm
which will make more use of it reducing average costs of the machine. As the
firm grows it may change from job to flow production thus improving
production efficiency.
Specialisation and managerial economies of scale. Large firms may employ
specialist managers. This improves efficiency and average costs fall. If
specialists are employed in small firms there would be indivisibility.
Financial economies of scale are enjoyed by large firms that have a wider
variety of sources of finance from which to choose. Sole traders cannot sell
shares to raise more capital. Also large firms borrowing large sums usually get
better interest rates than small firms.
Risk bearing economies. Large businesses can diversify to reduce risk.
Breweries have diversified to provide soft drinks (Delta)and food
External economies of scale

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Labour-The concentration of firms may lead to the build up of a labour force
equipped with the skills required by the industry. Training costs may be
reduced if workers have knowledge or gained skills from another firm in the
same industry. Local colleges or even local government may offer training
courses aimed at needs of the local industry
Ancillary and commercial service providers are attracted to growing firm to
serve its needs. These can include banking, insurance, marketing etc
Co-operation can be made possible by firms in the same industry which can
join forces to fund research and development centre for the industry.
Diseconomies of scale
These arise if the business expands the scale of its operations beyond the minimum
efficient scale. Internal diseconomies of scale are caused by problems of managing
large businesses like:




Communication becomes more complicated and coordination more difficult
because a large firm is divided into departments
The control and coordination of large businesses is also demanding. This is
because more employees mean added responsibility and more supervision
Motivation may suffer as individual workers become a minor part of the total
workforce. This can cause poor relations between management and the
workforce
Technical diseconomies also arise in case where firms build too large plants
which in case of a break down production will stop rather if two smaller ones
were built.
External diseconomies of scale
They may occur due to overcrowding in Industrial areas. The price of land, labour,
services and materials might rise as firms compete for limited amount. Congestion
may lead to inefficiency as travelling workers and deliveries are delayed.
Factors influencing the scale of operation




Technical economies of scale that are possible
Specialisation’s benefits in a more complex production system. It could be
labour or machinery specialisation
Purchasing economies
Marketing economies
Production costs
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
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A cost is the expenditure or outlay which represents an offer made in order to
obtain an economic benefit. The expenditure is necessary for and contributes
to the continuation of economic activities.
The cost implications of productions include:
Which products should we produce or discontinue to produce
Should we buy or hire/ lease the proposed equipment
Should the firm manufacture a product component or outsource it/ buy it
from outside
Should the firm change its manufacturing methods
Uses of cost data

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


Costs can be used to calculate profits or losses of the business
Cost data can be used by management to make pricing decisions
Past cost data can help to set budgets and determine resource requirements
at different levels of output. Past data will act as targets
Comparing cost data can help a manager make decisions about resource use.
This facilitates choice of the production method e.g. if labour rates are low
then labour intense methods can be used.
Keeping cost records enables comparisons to be made with past periods of
time. This enables efficiency and profitability of the product to be measured
and assessed.
Calculating costs of different options assist managers in decision making and
help improve business performance. It also helps to control business activities
Types of costs
Producer’s view



Direct costs are costs which can be clearly identified with a product and can
be allocated to a cost centre. Direct costs include direct materials, direct
labour.
Direct materials consists of primary material which form an integral part of
the end product e.g. for a desk the wood and metal form direct materials.
Quantity is proportional to the volume of production
Direct labour refers to the costs of all essential labour physically expended on
the manufacture of the product like wages
Indirect costs are costs that cannot be identified with a unit of a product or allocated
accurately to a cost centre. They are often referred to as overheads. Indirect costs
include indirect materials and labour. Indirect material is the secondary material
which does not form part of the end product and quantity is not directly proportional
to volume of production like machinery lubrication oil. Indirect labour refers to costs
of labour not expended on the manufacture of the product like wages of
maintenance personnel or supervisors
Economist view
Costs can vary with production increase, but in the short run costs may be classified
as:
Fixed costs (FC) are costs which remain fixed in the short run no matter what the
level of output like rent. They can be shown diagrammatically
Costs
Output
Average fixed costs are total fixed costs divided by the units produced. Fixed
costs per unit
will decrease with production increases
1. Variable costs vary as output changes e.g. direct materials costs used in
making desks
Average variable costs= total variable costs/units produced
Costs
Output
2. Semi variable costs include both fixed and variable costs e.g. the water
charge can include a fixed charge plus the cost per unit or sales person’s fixed
basic pay plus commission
3. Marginal costs are additional costs of producing one more unit of output,
and it will be the extra variable cost needed to make this extra unit.
Break even analysis (Cost volume profit analysis)
This is the study of the interrelationships between costs, volume and profit at
various levels of activity. Breakeven point is the level of output at which total costs
equal total revenue. Neither a profit nor a loss is made. Breakeven analysis is an
important tool in short term planning. Breakeven analysis can be undertaken in two
ways:
 The Graphical method
 The equation method
Assumptions of Breakeven analysis
 All costs can be resolved into fixed and variable costs
 Fixed costs will remain constant and variable costs proportionately with
activity
 Over the activity range being considered costs and revenue behave in a linear
fashion
 The only factor affecting costs and revenue is volume
 Technology, production methods and efficiency remain unchanged
 There are no stock levels or that stocks are valued at marginal cost only
Breakeven analysis by formulae
1. Breakeven point= Fixed costs/contribution per unit
2. Contribution = selling price-marginal cost (commission is also marginal cost)
3. Breakeven point in sales value=(Fixed costs* selling price per
unit)/contribution per unit
4. Level of sales to result in target profit(units)=(Fixed costs+ target
profit)/contribution per unit
5. Level of sales to result in target profit(sales)=(FC + target profit)*selling
price/contribution per unit
Worked example:
A company makes a single product with a selling price of $10 and a marginal cost of
$6. Fixed costs are $60 000 per annum. Calculate
a. Number of units to breakeven
b. Sales at breakeven point
c. Number of units to be sold to achieve a profit of $20 000
d. What level of sales will achieve a profit of $20 000 per annum
Solution:
1. Contribution=Selling price-marginal costs (variable costs per unit)
= $10-$6
= $4
2. B.E.P =FC/contribution per unit
= $60 000/$4
=15 000 units
3. Sales @ B.E.P= 15 000*$10
= $150 000
4. Number of units to achieve $20 000= $60 000+$20 000/$4
= $80 000/$4
= 20 000 units
5. Level of sales =20 000*$10
=$200 000
Margin of safety is the amount by which the sales level exceeds the breakeven
level of output.
M.O.S=Current production level- breakeven point
If the current production level of production is 500 units and the B.E.P is 300 units.
M.O.S=500-300
= 200 units
Production over B.E.P = (200/500)*100
=40%
At production levels below B.E.P the firm is making a loss, at levels above B.E.P the
business is making profits and a positive M.O.S is produced.
The Graphical method
Total revenue
Profit @ anticipated
Production level
Cost (000)
Profit
sales
Total costs
200
B.E.P
Variable costs
100
Loss
Fixed costs
0
200 000
350 000
Output
The above graph is prepared from the following information; selling price $1 per
litre, marginal costs $0, 5 per litre, fixed costs $100 000. Total capacity is 400 000
litres, expected production level is 350 000 litres.
Explanation
 Fixed cost line is horizontal, showing that fixed costs are constant at all levels
of output
 Sales revenue starts at the origin (0) because if no sales are made there can
be no revenue
 The variable cost line starts at the origin (0) because if no goods are
produced, there will be no variable costs
Factors affecting breakeven point
 Selling price per unit. An increase in selling price lowers BEP while a decrease
in selling price increases BEP.
 Fixed costs. A reduction in fixed costs will reduce the BEP while an increase in
fixed costs raises BEP
 Variable costs. A reduction in variable costs lowers the BEP while an increase
in fixed costs results in a rise in the BEP.
Total
revenue
line
(original)
TR2
TR1
Total cost line (original)
Usefulness of Breakeven analysis
 The charts are easy to construct and interpret. The analysis provides useful
guidelines to management on B.E.P, safety margins and profit /loss levels at
different rates of output
 Comparisons can be made between different options by constructing new
charts to show changed circumstances
 B.E.P analysis can be used to assist managers when taking important
decisions, such as location, whether to buy new equipment
 The equation provides a precise B.E.P result
 Helps to establish a margin of safety, an indication of how much demand a
business can afford to lose before making a loss
 It enables managers to see the effect of changes in selling price or variable
costs
 Managers estimate the number of products a firm can make and sell to begin
to make a profit
However
 The assumption that costs and revenue are always represented straight lines
is unrealistic. Not all costs variable costs change directly with output
 Not all costs can be conveniently classified into fixed and variable.
Introduction of semi fixed costs makes the technique more complicated
 There is no allowance made for inventory levels on the breakeven chart. It is
assumed that all units produced are sold. This is unlikely to always be the
case.
 It is unlikely that fixed costs will remain unchanged at different output levels
up to maximum capacity
Costing
This is the process of determining/ ascertaining the costs of producing a product or
service
Rationale for costing
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To provide data on total product costs
To provide data for price setting
To calculate profitability of products
To decide from alternative courses of action
To control expenditure by comparing actual with expected expenditure
In calculating the cost of a product, both direct labour and materials should be easy
to identify and allocate or charge to each product. The costs can be allocated using
the following method.
1. Full absorption costing
2. Contribution costing
Important concepts
1. Cost centre –This is a section of a business, such as a department to which
costs can be allocated or charged
2. Profit centre is a section of a business to which both costs and revenues can
be allocated, so profit can be calculated
Why do firms divide operations into cost and profit centres?
 It improves accountability as individual department will be held accountable
for their performance.
 The performance of cost and profit centres largely depends on the quality of
work done by employees. The organisation can offer incentives for
departments to achieve the targets. This should help to motivate them.
 Cost and profit centres provide information for decision making like the
decision on the product to discontinue comes from a profit centre.
 Managers and staff will have targets to work towards and if the targets are
reasonable and achievable they can motivate them
 The targets can be used to compare with actual performance and identify
those areas not performing very well and those performing well
 Individual performance of divisions and their managers can be assessed and
compared
 The work can be monitored and decisions can be made about the future like
should the price be lowered or increased?
However
 Managers and workers may consider their part of the business to be more
important than the whole organisation itself. There could be damaging
competition between profit centres for resources and a reluctance to share
valuable information leading the performance of the whole business suffering
 Some costs (indirect) can be impossible to allocate to cost and profit centres
accurately and this can result in inaccurate overhead cost allocations
 Reasons for good or bad performance of one particular profit centre may be
due to external factors not under its control such as state of economy,
competition or weather
 Operating cost and profit centres may result in the business as a whole
wasting money. If all centres are responsible for performing the same tasks
there may be duplication of tasks wasting resources.
 Some of the staff given responsibility of running a cost or revenue centre
may not have the skills to do so. This might create pressure and demotivate
staff.
Absorption costing
This is a method of costing in which all fixed costs and variable costs are allocated to
products or services. The total overheads incurred by the business and share or
‘apportion’ them on the basis of one or more methods of allocation. The methods
that can be used include:

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
Number of units produced/sold
Total direct labour hours
Total machine hours
Floor space occupied
PG Limited produces cement and the following costs are incurred:
Direct
labour
$5
Direct
material
$8
Variable
production
overheads
$2
Fixed
production
overheads
$5
Total
production
costs
$20
Given that selling and distribution costs are : fixed $120 000 per annum, variable
15% of sales value and budgeted normal output is 36 000units per annum. Selling
price $35.Production figures are given below
December
January (2009)
Production
3200
Sales
3000
(2008)
2000
1500
The profit statement will be produced as follows for January:
Sales
(30
000*35)
$105 000
Less cost of sales
Opening stock (500*$20)
Manufacturing cost (3200*$20)
Less closing stock (700*20)
Gross profit
10 000
64 000
74 000
14 000
60 000
45 000
In this case there is over absorption. The budgeted production is 36 000/12=3 000
units per month. The firm produced 3200. So fixed overheads are over absorbed by
(200*5=$1 000). This increases gross profit to $46 000.
The variable selling and fixed selling overheads are then deducted from Gross profit.
Gross profit
Variable selling (15%of 105 000)
Fixed (120 000/12)
25 750
Net profit
46 000
15750
10 000
20 250
Advantages of full absorption costing
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Relatively easy to calculate and understand
It is relevant for single product firms
All costs are allocated, which enable the calculation of profit and loss
It is a good basis for making pricing decisions in a single product firm
It ensures all costs are fully recovered. This means that business will cover
their costs as long as the actual costs and level of activity are similar to the
budgeted
It is fair provided overheads are not allocated in an arbitrary way. This is
because costs are apportioned to those activities that actually incur them
Disadvantages for full absorption
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It may be misleading in decision making, since there is no attempt to allocate
each overhead costs to each cost centre on the basis of actual expenditure
incurred
Arbitrary methods of overhead allocation can lead to inconsistencies between
departments and products
If it is used, it is essential to allocate on the same basis overtime to enable
sensible year by year comparisons
Some costs are difficult to apportion exactly to a particular cost centre like
electricity costs
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
Absorption costing can be complex, time consuming and expensive to gather
detailed information from different cost centres. This is particularly the case
for small firms that do not employ specialist cost accountants.
Cost information used might be inaccurate. This is because the figures are
generally based on historical data which may not reflect future costs or
activity levels
Contribution/Marginal costing
This is a costing method that allocates only direct costs to cost/profit centres not
overhead costs. The marginal cost of a product is its variable cost.
Marginal cost=Direct labour + direct material+ direct expenses+ variable overheads
Contribution is the revenue gained from selling a product less its marginal cost.
This is not the same as profit.
Contribution =Sales- Marginal cost
The economist view of marginal cost is the additional cost incurred by the production
of one extra unit
The accountant’s view of marginal costs is the average variable cost which is
presumed to act in a linear fashion
From the previous example, contribution=$35-$15=$20
The profit statement will look like
Sales (3000*35)
Less marginal cost of sales
Opening stock(500*15)
Marginal manufacturing cost (3200*15)
105 000
7500
48 000
55 500
10 500
45 000
15 750
Less closing stock (700*15)
Variable selling costs (15%*105 000)
Contribution
Less
fixed
costs($5*3000)+($10
(production+ selling)
Profit
000)
60 750
44 250
25 000
19 250
Fixed overheads are treated as period costs and do not form production costs.
Decision Making and Marginal costing
Contribution costing can be used to make the following decisions:
1. Should a firm accept a special order/contract or purchase offer
below full cost price
This is used if the firm has spare capacity, or if it is trying to enter a new market
segment. This is usually found in hotels at off peak hours, low rates can be used
arguing that it is better to earn contribution from additional guests than leave
rooms empty since fixed costs will have to be paid anyway. If contracts are
accepted below full unit cost, this can lead to an increase in the total profits of
the business.
However
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Existing customers may learn of the lower prices being offered and demand
similar treatment. Thus if all goods and services are sold just above marginal
costs, then profit making becomes unlikely
When a high price is a key feature like skimming pricing policy to establish
and maintain brand image, then a lower than full unit cost is not good
It is not applicable where there is no excess capacity. The offer may lock up
spare capacity which could be used for future full price business
In some circumstances lower priced goods may be resold into the higher
priced market segment
There is need to find out whether fixed costs will not alter later
Example: X ltd approaches A ltd intending to purchase cement at $9 below its total
cost of manufacture of $10. The marginal cost of manufacture is $6. Should the firm
accept this X ltd would purchase 3500 units up from 3 000 units it sells monthly.
Solution:
Contribution=$9-$6=$3
Total contribution=3500*$3=$10 500
Since the offer produces a contribution that will be used to cover fixed costs,
therefore it should be accepted. The increase in sales of 500 units benefits the
organisation
2 Should a firm Drop a product/stop making a product/ close a branch?
If a firm is producing more than one product, marginal costing shows managers
which product is making the greatest or least contribution to overheads and profit. If
full absorption is used a manager might be forced to drop a product that seem to be
making a loss, even though it might be making a positive contribution. This will
reduce overall profits e.g.
A company produces three products with the information shown below
X
Y
Z
Sales
32 000
50 000
45 000
Total costs
36 000
38 000
34 000
Net profit
(4 000)
12 000
11 000
Total costs comprise 2/3 variable costs, 1/3 fixed costs
Total
127 000
108 000
19 000
The directors consider that Product X shows a loss so should be discontinued.
Should the firm drop product X:
Solution: Fixed costs=1/3*108 000=36 000
Product X
32 000
24 000
8 000
Product Y
50 000
25 333
24 667
Product Z
45 000
22 667
22 333
Total
Sales
$127 000
Less marginal costs
$72 000
contribution
$55 000
Less fixed costs
$36 000
Net profit
$19 000
Product X produces a contribution of $8 000. Should it be dropped, the position will
be:
Product
Contribution
Y
24 667
Z
22 333
Total
47 000
Less
fixed
36 000
costs
Net profit
11 000
Therefore dropping product X with an apparent loss of $4 000 reduces total profits
by $8 000, which is the contribution of product X.
3 Make or buy decision
The management may be faced with the dilemma of whether to make a
product/component or buy it. The major thing is to compare buying price and the
marginal cost of manufacturing.
Example: A firm manufactures a component AB500 and the cost for the current
production level of 50 000 units are:
Materials
$2,50
Labour
$1,25
Variable
$1,75
overheads
Fixed overheads
$3,50
Total cost
$900
Component AB500 could be bought at $7, 75 and the production capacity utilised
will be unused. Should it be bought or manufactured?
Solution:
Comparing the buying price $7, 75 and full cost price of $9, 00 suggests the
component should be bought in. However the correct comparison is between $7, 75
and marginal cost $5, 80. The cost of manufacturing is lower therefore there is a
variable cost saving so is should be manufactured. Fixed costs of $3, 50*50 000
=$175 000 would continue to be paid because the capacity would not be used and
the fixed costs will not be absorbed into production. If bought overall profits will fall
by ($7, 75-$5, 50)*50 000=$112 500
Decision making with a limiting factor
A limiting factor is a factor which puts a limit on the level of output of the
organisation like machine capacity, labour hours, and raw materials. When this
prevents the business from satisfying customer demand, the most profitable product
mix must be determined. To maximise profit produce those products that makes
best use of scarce resources.
Example: Chinhoyi hotel produces four products for which the following information
is available.
A
B
C
D
Selling price per unit
70
100
85
55
Less variable costs per unit
48
60
55
34
Contribution per unit
22
40
30
21
Machine hours per unit
2
10
5
3
The estimated demand for the next month is 600 units of each product. However
due to essential maintenance work machine capacity in the month will be limited to
9000 hours. Determine the optimum product mix for the next month.
Solution: Calculate contribution per limiting factor (machine capacity)
A
B
C
D
Contribution per unit
22
40
30
21
Machine hours
2
10
5
3
Contribution per machine hour
11
4
6
7
Rank products
1
4
3
2
The ranking of products show the order in which they are going to be produced. The
optimum production plan will be as follows:
Product
Units
Machine hours
A
D
600
600
2
3
Total machine
hours
1 200
1 800
C
600
5
Total
Available hours for production of B will be (9 000-6 000=3 000)
3 000
6 000
Therefore 3 000/10=300 units of B
The total contribution produced by this production mix will be:
Product
Contribution
A
600*22
B
300*40
C
600*30
D
600*21
Total contribution
This is only possible when there is only one scarce factor.
Total contribution
13 200
12 000
18 000
12 600
55 800
Advantages of Marginal costing
 It is simple to operate. Unlike absorption costing the difficulty in sharing fixed
costs between products and cost centres is avoided. There is the advantage
that under and over absorption of overheads is avoided
 It is a useful decision making tool. It can be used when ranking products or
choosing between orders in the event the business is faced with limiting
factors or choosing between orders. It is also useful when deciding whether
to make or buy in a particular product or component
Disadvantages
 In some industries it is inappropriate particularly when fixed costs
represents the majority of a firm’s costs , like the cost of carrying one
more passenger in a train can be zero. Most of the operator’s costs are
fixed. If the customers only pay variable costs only that could ticket
issuing, the business will make great losses as the variable costs will not
cover huge fixed costs. However this can also explain the need to fill
empty seats at discount fares as long as fixed costs are already covered.
The money earned will add a lot to revenue than it does costs.
 When valuing stocks in final accounts SSAP 9 stocks and work in progress
states that absorption costing should be used and not marginal costing.
 It can lead to bias in costing calculations for example a cost centre that
uses a high proportion of overheads may be making a positive
contribution. However, when the amount of overheads is taken into
account that same centre may be making a loss for the business.
Inventory Management
Manufacturing businesses may hold four types of stocks. These include:
-Raw materials
-Work in progress
-Finished goods
-Miscellaneous items like fuels, stationery and fuel
Reasons for holding stocks are:
Transactionary motive. In the business there should be sufficient raw
materials stocks to satisfy production needs. It should be kept in stock, drawn
any time .WIP allows production to operate smoothly. These are partly
finished goods. The value of WIP depends on the length of time needed to
complete production and production method used. Finished goods should be
enough to meet customers’ requirements and cope with an increase in
demand for seasonal goods.
The precautionary motive should allow for increases in demand by
increasing rate of production quickly. The business can take advantage of bulk
buying discounts and allow for variations in the supply of raw materials.
Speculative motive anticipating price increases and therefore reduce stock
out costs.
Stock management
Stock levels should be effectively managed to avoid the following problems:
-There might be insufficient stocks to meet unforeseen changes in demand
-Out of date stocks might be held if an appropriate stock rotation system is
not used especially for fresh foods which can go stale or fast changing
technological products
-Stock wastage might occur due to mishandling or incorrect storage
conditions
-Very high stock levels may result in excessive storage costs and high
opportunity cost for the capital tied up in stocks
-Poor management of the stock purchasing function can result in late
deliveries, low discounts from suppliers or too large a delivery for the
warehouse
Therefore the manager should know the costs of holding stocks and costs of
running out of stocks.
Stock holding costs
Opportunity cost of capital tied up in stocks as it earns no revenue. It could
be used to buy a fixed asset or left in the bank to earn interest.
Storage costs may be high as finished goods and raw materials occupy
more space in the warehouse. Special conditions like refrigeration may be
needed. Staff is needed to transport and safe guard stocks. The stocks might
need to be insured against theft or damage. If the finance used was a loan
then this will incur interest. Storage costs may include rent, rates,
maintenance and heating, costs for the space taken up, equipment
costs(refrigerators), handling and record keeping costs, insurance and
security
Spoilage costs for the perishable goods which may deteriorate over time.
Some goods may become outdated and become difficult to sell. There could
be holding losses arising from evaporation, deterioration, theft and damage in
stores and in transit. However there may be off setting holding gains during
time of inflation
Administrative costs related to placing and processing orders, handling
costs and the cost of failing to anticipate price increases.
Stock out costs
-Lost sales as the firm can’t supply customers ‘from stocks’ then firms holding
high stock levels will benefit. This might lead to future lost orders too as
customers tend to be loyal to consistent suppliers. In purchasing contracts,
there can be a penalty if delivery dates cannot be met on time. This leads to
loss of goodwill
-Idle production resources and time due production stoppages. This leaves
equipment lying idle as well as labour. The cost f lost production output and
wasted resources could be so high
-Special orders could be expensive due to urgent orders given to suppliers to
deliver additional stocks due to shortages. Extra administration costs of
ordering are incurred
-Overtime , rescheduling and related costs arising from the need to expedite
special orders
-Small order quantities leads to loss of bulk buying discounts and transport
costs will be higher as many deliveries will be made. Higher prices are usually
paid when ordering small quantities with unusually short deliveries to make
up for shortages of goods
Factors influencing stock levels
-Level of demand as stocks should be held to satisfy demand and unexpected
increase in sales and unexpected demand. There is need for Buffer stocks to
cater for this. High levels of stock are kept if the firm’s product demand is high
-Stock holding costs affect the level of stock. If it is expensive to hold stocks
then only a small amount is kept so furniture dealers may keep low levels of
stock
-Nature of the product as goods like perishables are kept at very low levels as
almost the entire stock of finished goods are sold in one day like bread. This
applies to those easily affected by technological changes
-Lead time which is the time taken for a stock purchase to be placed, received,
inspected and made ready for use. The longer the lead time, the higher the
minimum level of stock needed
Stock out costs may prompt a firm to hold more stocks to avoid them if they
are high
-The amount of working capital available as a business that is short of working
capital will not be in a position to more stock even if it is needed
-Production method used
-Reliability of suppliers. If suppliers are more reliable then low stock levels can
be kept than if they are unreliable
Stock control
Economic order quantity is the ordering quantity that minimises the balance between
stock holding costs and reordering costs.EOQ is affected by:


Ordering costs
Stock holding costs
Economic Order Quantity= (√2Co*D/h) where:



Co- Cost of ordering
D-Annual demand
H- holding cost per annum per unit
E.g A uses 500 units of SAE 40 each year. The cost of procuring each batch is $600
and holding cost of each unit is $300.
EOQ =(√2Co*D/h)
(√2*500*600/300)
√2000
44.7 units
Number of orders 500/44.7=11.2 times per year
Graphical Method
A company purchases a raw material from an outside supplier at a cost of $9 per
unit. The total annual demand for this product is 40 000 units and the following
additional information is available.
Required
annual
return
in
$0,9
Other
holding
costs
$0,1
Holding
costs
per
$1,0
Costs per purchase order
Clerical
costs,
stationery
$2,0
Calculate the EOQ
(i)
stock
is
10%
per
unit
purchase
order
and
postage
Tabulation Method
Order quantity
100
200
300
400
500
600
800
1000
Average stock/units 50
100
150
200
250
300
400
500
No
of
purchase 400
200
133
100
80
67
50
40
orders
Annual holding costs $50
$100
$150
$200 $250 $300 $400 $500
Annual
ordering $800 $400
$266
$200 $160 $134 $100 $80
costs
Total relevant costs $850 $500
$416
$400 $410 $434 $500 $580
The order quantity of 400 results in the least costs of $400 so is the economic order
quantity.
900
800
700
600
500
Annual ordering costs
Total relevant costs
400
Annual holding costs
300
200
100
0
100
200
300
400
500
600
The EOQ is found at the point where the holding costs equal the ordering costs
Just in time stock control
This is a series of manufacturing and supply chain technique that aim to minimise
inventory levels and improve customer service by manufacturing not only at the
exact time customers require but also in the exact quantities they need and at
competitive prices.
The concept attempts to avoid holding stocks by requiring supplies to arrive just
when they are needed in the production process and completed products are
produced to order. Inventory is reduced to an absolute minimum or eliminated
Aims of J.I.T



To ensure a smooth flow of work through the manufacturing plant
To ensure flexible production process responsive to the customers’
requirements
A reduction in capital tied up in inventory
This involves the elimination of all activities performed that do not add value
commonly called WASTE. Examples of waste include:





Inventories of raw materials, work in progress and finished goods
Material handling
Quality problems (rejects and reworks)
Delays in the shop floor
Long lead times
Waste can be removed by:





WIP –reducing batch size
Raw materials-deliveries made to shop floor just in time for use
Scrap and reworks-emphasis on total quality control of the design, process
and materials
FG stocks-reduce lead times so that all goods are made to order
Material handling-redesign of the shop floor so that goods move directly
between adjacent work centres
A Just in time manufacturer looks for a single supplier who can provide high quality,
frequent and reliable deliveries rather than lowest price. In return the supplier can
expect more business under long term purchase orders, providing greater certainty
in forecasting activity levels.
Smaller frequent loads are required at shorter notice. The haulier (transporter) is
regarded as a partner to the manufacturer and there can be penalties for non
delivery. The reduction in inventory levels reduces holding costs but ordering costs
go up.
J.I.T is a pull rather than a push system of production and each process ‘pulls’ more
parts from the preceding process using a card signal (Kanban in Japanese). The
Kanban is a means by which a customer (succeeding operation) instructs a supplier
(preceding operation) to send more parts. Using two bins the empty bin is wheeled
out to the component production section with its Kanban order card. This triggers
production of the component to be completed J.I.T before the other bin runs out.
Requirements for J.I.T
1. Employee flexibility – The employees must be multi skilled and prepared to
change jobs at short notice. There is no point in a worker continuing to
produce an item if it leads to stock building. They should switch to making
different items at short notice.
2. Employee commitment to the work and there should be excellent employeeemployer relations as any industrial problem could lead to a break in supplies
and the production process can stop
3. Good relationships with suppliers so that they are prepared to supply fresh
supplies at short notice (short lead times)
4. Total quality or zero defects since quality must be everyone’s priority. Make
products right first time. Any poor quality products will mean that customer
will not receive goods on time.
5. Accurate demand forecasts since demand forecast can be converted into
production schedules that allow calculation of the precise number of
components of each type needed over a certain period.
6. Flexible equipment and machinery
7. Latest Information technology equipment for accurate data based records of
sales, sales trends, reorder levels allows very low or zero stocks to be held.
Advantages of J.I.T
1. Higher quality goods are produced
2. Improved customer service
3. Capital tied up in stocks is reduced and stock holding costs are reduced
4. Reduction in manufacturing lead times
5. Increased equipment utilisation
6. Greater flexibility leads to quick response times to demand changes
7. Increased workforce participation and motivation as they are given more
responsibility and encouraged to work in teams
8. Space released from holding stocks can be used for a more productive
purpose
9. Continuous emphasis on improvement and problem solving
Disadvantages
1. It requires a high degree of delegation
2. Advantages of bulk buying are lost and delivery costs rise
3. The business is vulnerable to a break in supply and machinery
4. It does not work in the case of irregularly used products or specially ordered
goods
5. J.I.T purchasing requires reliable and flexible suppliers and a lot of trust is
placed in that
6. It requires an atmosphere of close cooperation and mutual trust
7. Ordering costs may rise because of small orders
8. It requires a change of culture of the business
9. There can be difficulties in coping up with sharp increases in demand
10. There can be loss of reputation if customers are let down by late deliveries.
Stock control chart
Maxm level
5000
4000
Reorder
2000
Buffer stock
Lead time
The chart is used to record stock levels, stock deliveries, buffer stocks and maximum
stock levels over time. The manager will be able to determine order size and
quantity as well as an analysis of what would happen if an unusual event occurs
1. Buffer stocks are the minimum stocks that should be held to ensure that
production could still take place should a delay in delivery occur or should
production rates increase. If the uncertainty of delivery/production is high
then buffer stocks are held. This reduces the costs of shutting down
2. Maximum stock level= Reorder level +EOQ-buffer stocks
3. Reorder quantity is the number of units ordered each time
4. Lead time is the normal time taken between ordering new stocks and the
delivery. The longer the time, the higher will be the stock level reordered.
Two bin system
It is a system of inventory control in which two bins are used. When one bin is used
up, it triggers the need to reorder additional stock. The stock in the other bin is
enough to be used until the other order is received. The order quantity is equal to
the amount in the bin
Quality management
Quality is fitness for purpose. It is the totality of features and characteristics of a
product or service that bear on its ability to satisfy stated or implied needs. It also
implies safety in use. Quality is crucial to business profitability and survival. It has
two aspects
Quality of design means that the products are suitable for the purpose to which
they will be put. The firm should establish customers’ requirements; these should be
met fully in the design and specifications of products
Quality of conformance is the extent to which the goods that are produced
conform to the specifications laid down. Therefore quality procedures are designed
to ensure that the design of products satisfies customers’ requirements and that
these are consistently of a high standard.
Process type and Quality control
Jobbing and project production
The task and quality are normally integrated and depend on the skills of people
doing the job and supervising the work. The person performing the task and
supervisors are responsible for quality.
Batch production
The work has been deskilled. There is a separate quality control and inspection.
Employees and their line managers are responsible for quantitative aspects of the
output. There is an emphasis on detection of defects rather than ‘getting it right first
time’
Flow production
Quality is determined by the process as it reintegrated into the task. Employees are
engaged in monitoring and therefore, quality and task are naturally integrated.
Quality control process
Quality control refers to the techniques, processes or policies practised by a firm to
maintain a desirable level of quality of operations or products. It ensures that during
design, production and servicing both work and materials are within limits and will
produce the desired product performance.
1. Preventive or Feedback control
This is a proactive approach in which control is focused on inputs i.e. human
resources, machinery and materials. By inspecting and controlling the variables that
go into the production process, and there will be greater consistency of quality of
the finished product with fewer defective goods produced.
2. Concurrent control
This involves the monitoring of ongoing activities to ensure the consistency of the
quality of the product as it is progressing. It is ideally proactive in that it prevents
defective products being produced. Quality control check points are built into the
process
3. Feed back control
It focuses on output. It is reactive and designed to detect defective goods at the
production line.
Statistical quality control
This is based on the assumption that perfect quality is unattainable and or too
expensive. This involves the trade off between costs of quality control and costs of
product failure.
Costs of product failure include

Scrap, reworking faulty goods, downgrading goods, inspection, waste
materials, warranty claims, complaints, lost sales opportunities, loss of
customer goodwill, legal claims and product liability costs
Costs of maintaining quality

Verification costs, inspection costs, quality audit, appraisal equipment. This
includes costs of preventing errors like additional maintenance, training,
special investigations, and quality planning.
The costs can be illustrated graphically
Prevention and inspection costs
Costs
Costs of product failure
% made correctly
The optimum point O does not mean zero defects, but the amount of quality control
that minimises the total cost of achieving consistent quality. In some production
methods like job it is possible to produce, inspect or test every item. However it is
not more common to use sampling methods because:




Sampling is quicker and cheaper
Some tests damage or destroy the product
Sampling smoothes out random variations
Deterioration from excessive handling would result from 100% inspection
Acceptance sampling involves testing a random sample of existing goods and
deciding whether or not to accept an entire lot based on the quality of the random
samples
Statistical process control
It involves collecting data relating to the performance of a process. It involves
testing a random sample of output from a process to determine whether or not the
process is producing items within a preselected range. The data is presented in
charts, diagrams and graphs. It is used to reduce variability, which is the cause of
most quality problems. Variations in products, delivery times, methods, materials,
people’s attitudes and staff performance often occur. Statistical data may show that
worker attitudes may have led to variations in output late on Friday afternoon
Control by attributes
It is used in situations where the product is either acceptable or unacceptable.
Acceptable quality level is the maximum number of defective goods per 100 that
for purposes of acceptance sampling can be considered satisfactory. The number
does not have to exceed AQL of the lot. If the % is greater than the specified
amount then the lot is said to be of Low quality. The specified amount is the Lot
tolerance percentage defective (LTPD). However it is possible that some bad
work is passed. This probability of passing a low quality good is consumer’s risk. The
producer’s risk arises when a satisfactory quality product is rejected. The risks are
reduced by multiple sampling.
Control by variables
This refers to measurable features like size, weight where normal distribution
applies.
Advantages of quality control






There is a reduction in waste
There is a reduction of defective work
It reduces costs of rework
There is improved productivity
Maintenance of a level of quality necessary for customer satisfaction.
Helps to improve the utilisation of machines and labour
Weaknesses of inspecting for quality





This is looking for problems and is therefore negative in its culture. It can
cause resentment among workers, as inspectors believe that he has been
successful when he finds a fault. Workers may consider it satisfying to get a
faulty product passed by inspectors
There is an implied mistrust between employees and inspectors which is not
good for working relationships and motivation
The job of inspection can be tedious so inspectors become demotivated and
may not carry out their tasks efficiently
If checking takes place only at the specific points in the production process,
then faulty products may pass through several production stages before being
picked up. This could lead to a lot of time being spent finding the source of
fault between quality check points.
It takes away from workers the responsibility of quality. The workers will not
see quality as their responsibility and will not feel that it is part of their task to
ensure that it is maintained. This can be demanding and will result in lower
quality output.
Quality Assurance
This is the system of agreeing and meeting quality standards at each stage of
production to ensure customer satisfaction. It is a commitment by a business to
maintain quality throughout the organisation. It involves checking by workers
their own products against agreed quality standards. The aim is to stop problems
before they occur rather than finding them after they occur. It also takes into
account customers views obtained through market research.
Differences between Quality control and Assurance
Quality assurance puts more emphasis on prevention of poor quality products by
designing products for easy fault free manufacture rather than inspecting for
quality. It stresses the need for workers to get it right the first time and reduces
the chances of faulty products occurring or expensive reworking of faulty goods.
It establishes quality standards and targets for each stage of the production
process for both goods and services. Quality checks components, materials and
services bought into the business at the point of arrival or delivery not at the end
of production process when many resources and time would have been used or
wasted
The stages at which quality standards are agreed include: product design, quality
of inputs, production quality, Delivery systems and customer service including
after sales service.
Advantages of quality assurance




It makes everyone responsible for quality, and this can be a form of job
enrichment
Self checking and making efforts to improve quality increase motivation
The system can be used to trace back quality problems to the stage in the
production process
It reduces the need for expensive final inspection and correction or
reworking of faulty products
Importance of Quality assurance systems





Involving all staff can promote team work and a sense of belonging which
aids motivation
To set quality standards for all stages of production so that all materials and
production phases are checked before it is too late and whole products has
been completed
To reduce costs of final inspection as this should become less necessary as all
stages and sub sections of the process have been judged against quality
standards
To reduce total quality by installing in the whole organisation a culture of
quality. It can lead to reduced costs of wastage and faulty products
To gain accreditation for quality awards as it can give the business real status
like ISO 9000
ISO 9000 is an internationally recognised certificate that acknowledges the existence
of a quality procedure that meets certain conditions. The certificate does not prove
that every good produced or service provided by the business is of good quality. It
indicates that the business has a system of quality procedures in place. To obtain
the ISO 9000, the firm has to demonstrate that it has:





Staff training and appraisal methods
Methods of checking on suppliers
Quality standards in all areas of the business
Procedures for dealing with defective products and quality features
After sales service
ISO 9000 helps the organisation to:








Examine and improve systems, methods and procedures to lower costs
Motivate staff and encourage them to get things right first time
Define key roles, responsibilities and authorities
Ensure that orders are consistently delivered on time
Highlight product or design problems and develop improvements
Record and investigate all quality failure and customer complaints and make
sure that they do not reoccur
Give a clear signal to customers that it is taking measures to improve quality
Produce a documented system for recording and satisfying the training needs
of new and existing staff regarding quality
Total Quality Management
This is a process involving everyone in an organisation in continuously improving
products and processes to achieve on every occasion, quality that satisfies and
exceeds customer’s needs. It means managing the organisation so that it excels in
all dimensions of products and services that are important to its customers.
Everyone has the responsibility for delivering quality to the final customers. The aim
at each stage is to define and meet customers’ requirements in order to maximise
satisfaction of final customer. The workers have to be given training. The workers
should accept that quality of their work is important. They should be empowered
with responsibility of checking the quality level before passing their work to the next
stage. There has to be ‘Zero defects’ that is achieving perfect products every time.
The main elements of TQM are:





The customer is the driver of changes
Continuous improvement
Employee participation
Partnership with employees
Commitment from top management





Trust in workers abilities and acceptance of responsibilities and willingness to
contribute
Flexibility, training of workforce
Communication skills
Change in culture
Recognition and reward
Merits of TQM







There is improved quality
Increased productivity
Increased market share
The business gains a competitive advantage
A release of employee potential
There are increased profits
Reduced waste as a result of Zero defects
Benchmarking
It is a technique used by some businesses to help them discover the best methods
of production available and then adopt them. It involves management identifying the
best firms in the industry and then comparing the performance standards, including
quality of these businesses with those of their own business. The purpose is to
improve its performance and sustain competitive advantage. It involves:




Finding out what makes the difference , in customer’s eyes, between an
ordinary supplier and an excellent supplier
Setting standards for business operations based on the best practice that can
be found
Finding out how these best companies meet those standards
Applying both competitors standards and their own to meet the new standard
and if possible to exceed them
Types of Benchmarking include




Competitive benchmarking involves comparing the performance of an
organisation’s products and processes with those of key competitors
Internal benchmarking involves comparison between one part of the
organisation with similar practices in other parts of the same firm
Functional benchmarking involves comparison of a function like invoicing
in two or more organisations
Generic benchmarking involves comparison with the practices of world
class organisations.
There is need to decide on the type of benchmarking to use and decide the scope of
the exercise which include those activities that will make significant improvement in
customer relationships
Benchmarks that are important for customer service include:




Consistency of product
Correct invoicing
Shorter lead times and improved after sales service
Shorter delivery times
The business can also benchmark product service, core business processes, support
services, employee performance, and supplier performance
There is need to collect data and analyse this data to identify ‘performance gaps’
between market leaders and the organisation. This is done as follows.







Identify the aspects of the business to be benchmarked like delivery speed
Measure performance in this area (delivery records)
Identify the firms in the industry that are considered best using benchmarking
schemes operated by government or industry organisations
Use comparative data from the best firms to establish the main weakness in
the business. This can be obtained from specialist industry publications or
contacts with customers
Set standards for improvement, as there could those of best firms or higher
to get competitive advantage
Change processes to achieve the set standards
Re-measurement is done to see if the new, higher standards are being met
Advantages of benchmarking







It identifies best practices
It facilitates the setting of performance goals
It identifies ways of improving performance
It is a proactive improvement process involving learning from others
It motivates staff by showing them what is possible
It provides early warning of competitive disadvantage
It can result in a continuous updating of performance
Disadvantages of benchmarking


It requires resources and the costs of comparisons may not be recovered by
the improvements made
It can fail unless there is commitment from top management to implement
change arising from the exercise


The process can result in mere copying others rather than being innovative
It depends on obtaining relevant and up to date information from others in
the industry.
Quality Circles
It is based on staff involvement in improving quality using small groups of
employees to discuss quality issues using team working and participation can lead to
motivation and quality improvements. The aim is to investigate quality problems and
present solutions to management. If the group is empowered, it can put
improvements into effect itself.
Benefits as discussed before
Business Process Re-engineering
It involves redesigning of core business processes with the aim of streamlining
operations and eliminating wasteful non value added steps. It requires a radical
rethinking of processes from a holistic view taking into account technologies,
strategy, processes and human resources within the whole organisation. It focuses
on processes not individual functions. The process seeks to reduce costs, improve
quality and change culture like TQM.
It also emphasises the importance of teams and empowerment, and requires
support of top management.
Advantages






It revolves around customer needs and helps give an appropriate focus to the
business
It brings about cost reduction which increases the organisation’s
competitiveness
It encourages a strategic view of operational processes
It overcomes the problem of short sightedness arising from concentration on
functional boundaries
It can result in the elimination of unnecessary activities
It encourages creativity and innovation in teams
Demerits



It requires considerable commitment
It is incorrectly seen as a once and for all cost cutting exercise, thus
producing hostility
It requires a high level o expertise and good team work
Advantages of Quality Systems










There is customer satisfaction and repeat purchases due to good experiences
with quality of a product. Satisfied customers will give word of mouth
recommendations to friends
Good publicity from consumer pressure groups and consumer oriented articles
in media
Reputation for quality encourages retailers to stock the firm’s products, so this
will increase the distribution outlets for a products and lead to customer
loyalty
It is easier to establish new products in the market as consumers will
associate the business’s good reputation
It also results in prolonged product life cycle
It allows the brand to be built around a quality image and branding is an
important form of non price differentiation for businesses
It saves any cost associated with customer complaints
It may allow pricing advantages that is charging higher prices than those of
rivals in that market segment. Thus quality can be used as a unique selling
point and this gives the firm competitive advantage in the market
Goodwill will accrue to the firm
There can be international competitiveness
Disadvantages of Quality systems







Market research to establish expected customer requirements needs to be
carried out
Staff training costs to ensure that standards are understood and operations
needed to check them can be undertaken
Material costs of the process like rejecting below standard materials and
components before they are used in the production process will lead to higher
expectations from suppliers
Equipment costs for checking standards at each stage like laser machine for
accuracy of panel fitting on a vehicle
Inspection and checking costs
Reworking of faulty products or rejection wastage costs. The aim of quality
assurance system is to reduce this to absolute minimum
Stopping production to trace and correct quality problems will disrupt output
Work Study
This is a generic term for a series of analytical techniques used to determine the
most efficient use of labour in relation to the other inputs into the production
process. It was developed from the work of Taylor and Gilbreth in Scientific
management. Taylor argued that a systematic study of work operations would result
in the identification of the ‘best’, most efficient and most productive methods of
carrying out tasks.
Aims of work study








To improve the flow of work to avoid bottlenecks in the production process
To improve employee performance
To improve utilisation of space, equipment and materials
To increase efficiency, productivity and ultimately, profitability
To provide a basis for incentive pay schemes, such as piece rates, which
reward workers for the amount they produce rather than time spent on
premises
To improve planning by the provision of standard times and procedures
To plan a more even spread of work among employees
To provide a basis for costing of jobs in the future
Work study has two components:
Method study and Work measurement
Method Study
This is the systematic recording and evaluation of ways of doing work (both existing
and proposed) as a means of developing easier, more effective methods and thereby
reducing costs. It implies that there is a best method of performing a task. This can
be discovered by means of scientific approach. The basic steps of method study
include:








Select the job to be studied
Observe and record information about the job and methods used, recording
devices taking the form of process or flow charts, motion charts, layout
models and templates, string diagrams, film/videos
Examine and analyse the information
Identify ways of improving the method which might take the form of
eliminating operations, combining operations, devising different physical
movements, altering machines or tools, altering sequence of operations,
eliminating any duplicated efforts
Develop revised /improved methods
Implement the new method
O
Record and evaluate the new method, making adjustments where necessary
Work measurement
This is the application of techniques to establish the time for a qualified worker to
carry out a particular job. The purpose of measuring the time required to complete a
job is to provide information for production schedules, manpower planning
requirements, costing, incentives payments and monitoring of performance.
The basic steps involved are as follows:




Select the work to be measured
Define the basis for measurement, undertake the measurement, obtain the
details of their work, making allowances for variable factors and personal
needs
Rate performance of the individual in relation to the average or norm
Establish a standard time and a standard performance. Standard time is the
total time a job should be completed at standard performance and
circumstances in which the work takes place. Standard performance is the
rate of output that competent workers will naturally achieve during an
average working day or shift. However it will be achieved provided workers
are
Business Finance
Businesses are funded by a combination of debt and equity finance. Financial
managers among other things have to make a financing decision which involves
deciding on the level of funds required e.g. $ 100 000, which type of funds to raise
e.g. debt or equity and how to raise the funds.
Finance managers have to make also an investment decision which focuses on how
to profitably use the funds raised.
Factors considered when choosing a source of Finance.
 The cost of capital- This refers to the opportunity cost of capital or the
expenses related to the capital for example interest on loan.
 Risks involved which is the probability of variation of the return on
investment.
 Tax Implications-If an organisation wants to take advantage of a tax
reduction then it has to go for loan because loan interest is tax deductible.
 The effect on control of a business Loan or debt capital does not affect the
control of a business. This is because it does not increase the number of
ordinary shareholders. Issue of shares affects the control of the business.
 Terms and repayment periods. Mortgages are long term loans which do not
allow earlier settlement of loan before the agreed period while short term
loans allow for this arrangement.
 Availability of different sources of funds- large firms has a variety of sources
of funds available to their disposal at the expense of small firms. Small firms
are riskier to lend funds than large firms.
 Amount required If a large sum is required then the issue of shares and
debentures is applicable because they have high administration costs then for
small amounts the short term bank loans and overdrafts will do.
Why firms need finance
 To develop new products.
 To acquire fixed assets
 To develop new markets
 To finance export trade
 To provide working capital items such as stocks of raw materials.
Classification of sources of Finance
Sources of funds can be classified as either being; (1) Internal or external
(2) Debt or equity
Internal sources of funds
 Retained profits
 Personal savings
 Rights issue
 Sale of surplus or idle assets
 Accumulated depreciation funds
Advantages of Internal sources of Funds
 There is no repayment of the principal
 There is no interest payment as in the case of loans and debentures
 There is no change in the balance of shareholder control.
 There is no immediate additional costs involved like an issue of share capital
(share issue costs)
 There is limited need for authorisation by non management stakeholder’s e.g.
board of directors.
External sources
This includes all the funds from outsiders such as banks and suppliers.
(1)
Ordinary
Shares
A company can raise capital by issuing shares to the public. A shareholder
owns part of the company’s net assets and earns a return in the form of a
dividend at the end of each trading year.
Why companies issue shares?
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To raise cash to invest in a particular project’
It may wish to be floated on the stock exchange market.
Shares may be issued to shareholders in another company in a takeover bid.
Ordinary shares form a permanent source of capital since they are not
redeemable. (The company cannot buy back its ordinary shares).
Ordinary shareholders collectively own the company and stand last in line for
rewards on investment (dividends) and in the event of Liquidation. Liquidation is
winding up a business which can be voluntary or forced. This means that they
receive their dividends when the preference shareholders have and debt holders
have received their dividends and interest respectively.
If a business becomes insolvent that is unable to pay its dues to creditors, ordinary
shareholders have the last claim on whatever remains. If nothing remains they will
lose and if a greater part remains they will benefit thus they are high risk takers.
Ordinary shareholders carry a vote in the management of the business but however
their control may be limited .e.g. the payment of dividends is not guaranteed and
the amount depends on the financial performance.
The board of directors can declare the dividend and the general shareholders cannot
vote to increase the dividend.
If no dividends are declared in the year then no dividends will be paid.
The company is required to maintain a shareholder register which should show each
member’s interest in the business.
The size of the business the voting rights which paid.
The size of interest indicates the voting powers at meetings.
Shares can be issued at a nominal authorised value e.g. a dollar each or above the
nominal value (at a premium) e.g. $1.20.
Preference shares
These are entitled to a fixed percentage dividend which is paid before any
distribution is [made to ordinary shareholders.
The dividend is stated as follows 10% preference shares.
Preference shares are classified as:
1. Cumulative preference shares.
These shares can have their unpaid dividends carried forward and becomes payable
when the company makes sufficient distributable profits.
2 Non cumulative preference shares stand to lose their dividends in the year the
dividends are not declared and the arrears will not be carried forward.
Preference share dividends are only paid if the company makes sufficient
distributable profits.
3. Convertible preference shares are those that are issued as convertible and can be
converted to ordinary shares at a predetermined date and rate.
Preference shares have a lower risk than ordinary shares.
Methods of Issuing Shares
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Offer for Sale- the Company issues shares to an issuing house or a merchant
bank that in turn offers them to the public at a higher price. The company has
to publish a prospectus giving details of its business and the capital to be
raised.
Public Issue- This is whereby shares are offered to the market directly by the
company rather than through an issuing house. A prospectus is used to
appeal to the public to purchase the shares. To avoid the risk of under
subscription the share issue is underwritten by a financial institution e.g. a
merchant bank like Merchant bank of central Africa (MBCA) .Underwriting is
the act of trying to guarantee the business the issue of shares that all shares
will be purchased so as to raise the required amount. The financial institution
agrees to purchase any shares or securities not taken up at the issue price.
The financial institution is called the underwriter. The underwriter charges a
fee payable whether or not they are called upon to take up the surplus
shares. The underwriter will then sale the surplus shares in the market at a
higher price later.
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Placing- The shares are sold privately to clients of the issuing house that
handles the issue.
Sale by tender- The investing public is invited to submit bids with the shares
being sold to the highest bidder. The bid should state the number of shares
intended to be bought and the price.
Rights Issue-This is issuing shares to the existing shareholders at a discount
from the market price in proportion to their shareholding in order to raise
additional capital. It is an inexpensive way of raising funds since no
advertising and underwriting costs are incurred.
Bonus issue-Shares are issued to the shareholders on a prorata basis utilising
the retained earnings and reserves. It is a mere restructuring of the balance
sheet and it does raise additional capital. It is can be referred to as a ‘scrip
issue’ that is the conversion of reserves into capital. A scrip dividend is when
shareholders dividends are converted into shares instead of being paid out as
cash.
DEBT CAPITAL
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These are long term interest paying debt known as loan stock or debentures.
Holders of debentures are creditors of the company.
There is legal commitment to pay interest on debt as well as to repay the
capital sum when it is due.
This increases the risk of insolvency as the creditors have power to force
liquidation if interest payments are not made, under the contractual
agreement.
To the company interest on loan is allowable against tax.
The existence of fixed interest charge in a business is called Gearing. With
debt capital interest payments are made irrespective of profitability.
However interest payments become difficult to make in times of high interest
rates.
Mortgage bonds
Is a long term loan secured by the mortgagee for the purchase of land and
buildings usually payable over 30 years.
The loan is usually secured over land and buildings.
The borrower makes the promise to repay the loan on a separate document
called the mortgage bond.
The borrowing party is called mortgagee while the lender is called the
mortgagor.
Mortgage bonds are available from building societies like CABS.
Mortgage loan allow lender to charge interest rates in relation to changes in
bank rates.
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Bank rate is the interest rate which the central bank charges on specific
advances to commercial banks.
The central in Zimbabwe is the Reserve Bank.
If the borrower fails to meet the payment obligations of the bond a law suit
may result in the sale of mortgage security property to the highest bidder in
an auction and proceeds of sale are used to repay the lender.
Any sum left over will be paid back to borrower and if the amount is
insufficient further court action may be taken to recover the difference. The
mortgagee can apply for an increase in the loan.
Debenture
A debenture is a financial certificate that is issued by a company and pays a
specified rate of interest at specific intervals.
To safe guard the interests of debenture holders they can appoint a trustee.
The trustee will act on behalf of debenture holders to intercede if the terms of
the debenture trust deed or Articles of Association in relation to the
debentures were breached eg failure to pay the correct amount of interest
instalments or exceeding the prearranged borrowing limit.
Debentures can place a limit to the borrowing a company which must not be
exceeding. Merchant banks usually act as Trustees.
Debentures are not part of share capital or holders are not owners of the
company but are creditors of the company.
In case of non payment they can enforce liquidation of the company.
This is done by appointing a Receiver which deprives the shareholders control
over the company.
Debenture can be secured over specific a asset which does restrict utilisation
of asset, or an unsecured (naked) debenture there is no specific security set
aside repayments.
Advantages of loan capital
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Interest on loan is tax deductible to the company. This reduces the tax
liability of the business and in turn the effective cost of the debentures.
Secured debentures form an attractive and safe investment to investors since
in times of high or low profits they receive their fixed interests’ payments.
Debentures form a temporary source of finance for the company and can be
repaid when the company’s financial position improves. However flexibility in
timing of repayment depends on terms and conditions agreed upon.
When the terms of agreement permits the firm can buy its own debentures in
the open market and either cancels them if the firm has surplus funds.
Debenture holders are not owners of the firm so do not interfere with the
running of the business as long as their interest payments are met.
Disadvantages of Debentures
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Interest on loan is payable even though the firm makes a loss. This may
cause undue financial hardships on a firm that continuously makes losses.
A specific charge on fixed assets makes debentures attractive but however a
company may not have the fixed assets to offer as security.
If debentures are redeemable in the form of annual appropriations of the
company’s profits they may result in lower dividend for ordinary
shareholders.
In the event of the company failing to meet the terms of the issue, the
debenture holders can enforce liquidation of the firm.
With some assets securing the debentures a company may be restricted from
using the asset.
The firm can be restricted from taking out further loans before the existing
one is repaid.
Convertible loan stock or debentures
Is a class of stock that is issued as fixed interest loan initially but there is an
option to convert the loan into equity shares at a specific rate and time. The
conversion rate price often increases overtime with increased expectations as to
the share prices and returns from shares. The investor will gain a stake in the
company while maintaining the status of being a creditor and the security of
fixed interest. The company benefits by securing funds at fixed interest rates
lower than the payable on non convertible stock and a tax relief on interest.
Advantages of convertible loan stock to Issuing Company.
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Stock can be issued at a lower coupon rate which is useful in times of
high interest rates.
Interest on loan is tax deductible unlike dividends.
It is a form of deferred equity there is no cash outlay on redemption.
It may be calculated as equity for gearing purposes unlike ordinary loan
stock.
If share prices are depressed, it may be easier to issue loan stock.
Advantages to the Investor
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The market value of the stock cannot fall below that for similar ordinary
stock of same coupon rate.
Increase of share price will cause the value of conversion to rise because
this is the amount the investor will receive.
Stock holders will be paid before shareholders in the event of liquidation.
Differences between debt and Equity capital ( ordinary shares)
sssssOrdinary shares
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Contributory capital i.e. capital
contributed by shareholders.
Shareholders are owners of the
company
Earn dividends
Dividends may fluctuate (for
ordinary shares)
Dividends are paid only when
profits are made
Are not attached to or secured
against company assets
Dividends are paid after interest
on loan has been paid
A risky form of investment or
capital
Can be ordinary or preference
shares
Shareholders cannot force a
company (if dividends are not
paid)
Shareholders are paid after
debentures on liquidation of a
company
Ordinary shareholders have
voting rights at annual general
meetings
Are irredeemable
Dividends cannot be paid out of
capital
There is no legal requirement
even though there is need to keep
shareholders happy
Debentures
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Loan capital i.e. money borrowed from
financial institutions and individual
investors
Debenture holders are creditors to the
company
Earn interest
Interest is at a fixed rate
Interest is paid whether or not profits
are made
Are mortgaged against company assets
Interest is paid before dividends on
shares are paid
A secure form of investing or loan
Can be naked or mortgaged
Debenture holders can force a company
into liquidation(if interest is not paid)
Debenture holders are paid first before
shares of liquidation of a company
Debenture holders have no voting rights
at annual general meetings
Are redeemable
The interest on loan can be paid out of
capital to avoid the risk of insolvency
There is a legal requirement to pay the
interest on loan
Leasing
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This is an agreement that transfers the use or occupancy of a fixed asset in
consideration for a payment usually in the form of rent.
The parties to the agreement are the lessor (financier) and lessee.
The lessor purchases the asset and provides it for use by the lessee.
The lessor is the legal owner of the asset so ownership does not pass to the
lessee.
Leasing is provided by the Leasing company of Zimbabwe. There are two
forms of leases.
Operating lease
 This includes short term rentals appropriate for office equipment, contract
hire agreement for the provision of vehicles.
 These do not have to be reported on the face of the balance sheet. It does
not cover the economic life of the asset.
 At the end of the contract the asset is leased to someone else.
 It is useful in the case of high technology products which can quickly become
obsolete, the risk bearing being borne by the lessor.
 Servicing and maintenance is the lessor’s responsibility.
 The lessor is able to make profit from leasing the equipment and get tax relief
on the purchase of the asset.
 To the lessee it is cheaper and easier than taking out a bank loan to buy an
asset.
Finance Lease.
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These are leases in which the lessor will expect to recoup the whole or most
of the historical cost of performing the contract during the initial period of
rental, referred to as the basic lease period.
The lease period is for the greater part of the asset’s economic useful life. At
the end of the lease period the asset is either further leased or sold by the
lessor or lessee.
Finance leases are reported on the face of the balance sheet.
It gives the lessee the rights and obligations of ownership and is a form of
borrowing that increases capital gearing Lease rentals are generally
deductible for tax purposes in the hands of the lessee. Also servicing and
maintenance is the lessee’s responsibility.
Advantages of Leasing
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It minimises the initial capital outlay.
It is cheaper and easier than taking out a bank loan to buy an asset.
Maintenance and serving is the lessor’s responsibility (operating lease).
Equipment can be updated to avoid the risk of obsolescence.
It is a form of pay as you use.
Disadvantages of Leasing
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All lease rental payments are outflows. They reduce liquidity of the business.
The payment is greater in the long run.
Lease might place limitations on the use of an asset or compel the use of
complementary goods.
Sale and Lease back.
This involves the sale of a business asset such as a building to a finance
company that then the asset available for use by the business on a lease basis.
The asset is rented for a long time and rent is reviewed every few years.
Advantages
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It releases capital for use in the business.
More cash can be raised than if the asset was used for security in a
mortgage loan.
Disadvantages
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The business no longer owns the asset.
Rent must be paid.
Fewer assets remain to support future borrowing.
Hire Purchase
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This is hiring with an option to purchase. It is a method of paying for an asset
by instalments.
The hire purchase instalments include capital and interest payments. It is
financed by a finance house.
The customer pays a deposit which depends upon the company’s policy and
the creditworthiness of the customer.
The interest payments are allowable against tax and capital allowances can
be claimed on the asset.
The financier (supplier) remains the legal owner of the asset until the last
instalment is paid.
The supplier can repossess the asset if the payment obligations are not met.
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This applies if the client has paid less than two thirds of the amount.
The products on hire purchase cannot be resold by the customer
The hire purchase is governed by the hire purchase act.
The goods on hire purchase are insured
Advantages of hire purchase to the Buyer
1. There is no need for the buyer to save the full amount for the goods
2. Buyer can use the goods whilst paying for them
3. Profits generated from using the product can be used to pay for them e.g.
a sewing machine or a Delivery van
4. The firm can buy expensive goods e.g. Delivery van and machinery
5. Goods are under guarantee during the HP period
6. The payments are spread over a long time
7. The buyer enjoys an improved standard of living
8. The buyer is afforded legal protection during the HP period
Disadvantages
1. The buyer may overspend by buying on impulse
2. The goods are expensive due to finance charges i.e. interest and insurance
3. The goods can be repossessed in case of default
4. The buyer possesses goods without owning them
Advantages to the seller
1. Increases sales and profits of the firm as customers like credit
2. It encourages impulse buying
3. Obtains commission from the finance company
4. Insures the goods during the HP period
5. The seller has the right to repossess the goods if buyer defaults before
payment of one third of the purchase price
Disadvantages
1. Capital is tied up in book debts
2. The repossessed goods may not be fit for resale
3. It increases bad debts and clerical paper work
4. Suffers from bad publicity resulting repossessions
Short term sources of Finance.
Bank Overdraft
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This is a flexible form of finance available to current account holders
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It allows the account holder to withdraw funds in excess of the available
amount.
It is unsecured, renewable and interest is charged only on the balance
outstanding each day.
The interest rates are usually high.
There is no penalty for repayment of an overdraft.
Trade Credit
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It is finance provided by suppliers rather than financial Institutions.
This refers to buying goods on credit from suppliers for resale.
It is interest free form of finance.
Suppliers can encourage prompt payment by offering discount.
Trade credit can extend to 30 or 90 days or more.
It gives firm enough time to sale their goods and gets money to pay them.
Customers save a lot of money by receiving discounts for prompt payments.
It is quite flexible as it can be increased if the need arises.
However the customers may be charged interest on overdue amounts.
The supplier takes the risk of bad debts like in the event a customer dies.
Debt factoring
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Involves buying of invoiced debts from a client usually a trading company.
The debts are purchased free of recourse.
The factor is usually a finance house.
The firm will not have to deal with bad debts as the factor will become
responsible for debt collection.
 This relieves the client of the administration and supervision of Trade credit.
 The company will have assured cash flows; generally the factor will advance
about 80% of the value of the debt within 2-3 days of an approved date.
The factor provides 3 services namely.
 Sending out invoices, collecting money from debtors and keeping a record of
the debtors’ ledger up to date.
 Provides an insurance service by protecting the client’s debts from default.
 Provides cash to the client (80%).The 20% will cover the factor’s
administration costs and profit margin.
Factoring is particularly useful to firms trading in markets that require a considerable
period of trade credit and to companies that are expanding rapidly as it will leave
other lines of credit open for use elsewhere in the business.
Advantages of debt factoring
 It releases more time for the owner of the firm to invest more time to
expanding the business.
 It enables the firm to solve their temporary or seasonal problem.
 The firm makes savings in administration costs that arise from debtors’ e.g.
bad debts, debt collection, and legal costs of suing a debtor.
 It may lead to improved credit control, fewer bad debts, shorter debt
collection periods and better liquidity for the client company.
Disadvantages
 Small firms find it difficult to find a factoring agent as they are considered
riskier.
 Sometimes factors are reluctant to take on clients with seasonal trading
patterns.
 The use of a factor can adversely affect the image of the client, as the public
can think it is doing so because of financial problems and hence confidence in
it is lost.
Sales Aid Financing
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Is an alternative to offering their own trade credit, the suppliers of capital
equipment and vehicles to both home and foreign market offer finance at the
point of sale through a third party finance company.
It is prevalent in South Africa retail motor trade.
The rates may be subsidised by manufacturer, the dealer or both to attract
business by easing the burden of capital expenditure on a major item.
The finance house will settle at the point of sale rather than extending trade
credit.
The payment is received in full generally without recourse in case of bad
debts.
Invoice Discounting
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Is a variant of factoring where the company borrows from the invoice
discounter on the security of its own debts, but continues to collect the debts
itself.
The amount advanced is up to 80% of amounts invoiced. It is preferred by
many firms because it does not hand over the management of their
relationships with debtors to a third party.eg Edgars.
Securitisation-This is the practice whereby the bank instead of lending money
to the company, it raises funds by selling the company’s securities to the bank’s
other customers. The interest rates under this arrangement are lower.
Working capital management
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Working capital is the capital available for conducting the day to day
operations of the business, normally the excess of current assets over current
liabilities.
This is done to minimise the risk of insolvency while maximising the return
on assets.
A firm must have sufficient working capital to allow it to operate smoothly and
have sufficient funds to pay its bills as they fall due.
The availability of cash and cash equivalents to pay its short term debts is
called Liquidity.
If the firm has insufficient cash resources to meet its payment obligations it
may be forced into liquidation by its unpaid creditors, even if its profitable
liquidation is when a firm cease trading and its assets are sold for cash to pay
its creditors.
If a shortage of cash is anticipated the firm should arrange for possibly an
overdraft to overcome liquidation.
If there is a short term cash surplus it should be invested in short term
marketable securities.
A firm should not over provide for working capital as this leads to: Excess stocks
o Excess debtors
o Excess cash lying idle in the bank or at hand.
The situation where the firm over provides for working capital is called
Overcapitalisation. There is an opportunity cost of capital tied up in stocks, debtors
and idle cash. This cash could be invested profitably and earn a return for the
business.
The Working capital cycle
The key pressure points on working capital cycle are creditors, stock and debtors.
Working capital cycle=Debtor days +Stock turnover days-creditor days.
Debtor days= (Debtors/credit sales)*365
Stock turnover days = (Average stock/cost of sales)*365
Creditor days= (Creditors/Credit purchases)*365
Example
2010
2011
Debtors
115000
200000
Creditors
101000
190000
Credit sales
1200000
1600000
Credit purchases
800000
1166000
Opening stock
42000
54000
Closing stock
54000
100000
2010
Debtor days
(115 000/120 000)*365
=35 days
Stock turnover days
Creditor days
(48000*365/788 000)
2011
(200 000/1600 000)*365
46days
(77 000*365/1120 000)
=22 days
=25days
(101 000*365/800 000)
(190 000*365/1166 000)
=46 days
=59 days
Comments
Debtor days –This is the credit period given to the debtors. In general a shorter
credit period is preferable. This makes the firm receive cash earlier and improve its
liquidity position. This also reduces the risk of bad debts. In 2010 it was 35 days
shorter 46 in 2011.Shorter credit periods may force customers to deal with firms
offering longer credit periods. The business can encourage prompt payment by
offering discounts .This improves liquidity but reduces profitability. In 2011 it could
have been increased in attempt to increase sales. Increases in sales can increase
profitability but put the business at the risk of bad debts.
Creditor days –This is the debt period given to the business by its suppliers.
Generally a longer period is preferable .In 2011 the period increased to 59 days. This
enables the business to use the cash reasonably. This can lead to loss of discounts
for prompt payments. Also it may lead to the suppliers charging interest on overdue
amounts which an expense to the business. The supplier can place restriction such
as cash only to the business or refuse to offer credit.
Factors affecting the Length of Working capital cycle
1. Profitability versus Liquidity position.
2. Management efficiency in controlling creditors and debtors.
3. Industry norms.
Profitability versus Liquidity position
An unprofitable business can survive if they have liquidity whilst a profitable business
can fail if it runs out of cash to pay their liabilities. Profitability and liquidity issues
are affected by the following aspects.
Credit sales-The business can extend trade credit so as to increase sales. Increase in
sales also increases profits. Trade credit is a way of financing a customer using its
cash resources. This reduces the cash available in the business.
Capital expenditure-The cash outlay to acquire fixed assets reduces the cash in the
business. The expenditure is not treated as an expense in the income statement so
it does not affect the profits generated by the business.
Cash purchases-The purchases of goods for cash is an outlay of cash. It reduces of
liquidity. In the trading profit and loss account the total of both cash and credit
purchases is deducted from turnover. Cash purchases are normally used to obtain
cash discounts from suppliers which can increase profits. Discounts increase profit
margins thus increasing profitability.
Depreciation-This represents part of the cost of the asset consumed during the year.
It does not involve an outlay of cash thus it is a non cash item. It is provided for and
deducted from Gross Profit as an expense in line with the prudence concept in the
Income Statement. This reduces the profits of the business without an effect on
cash.
Accruals-Arise from services offered but not paid for in accounting period under
consideration. The unpaid amount is treated as an expense in the Income
statement. This treatment is in line with the Matching Concept. It reduces the profits
of the business without affecting the cash position of the business. Prepayments are
payments made in advance for services not yet rendered. The amount prepaid is not
included in determination of profits in the income statement so it reduces cash
position without affecting the profitability.
Capital Injections and redemptions –Additional capital introduced or new shares
issued increase the cash available in the business. Since the amount is not from
normal trading activities it is not credited to the trading account as sales revenue.
This effectively does not increase profits but only the cash available. Capital
redemptions have the opposite effect
2. Management efficiency in controlling debtors and creditors.
A good credit control system will establish an optimum length of the working capital.
This involves managing debtors and creditors effectively.
3. Industry norms
Retail supermarkets have few credit customers and high inventory turnover. They
can negotiate longer credit period from suppliers. The construction industry will
normally have longer working capital cycle.
Sources of Liquidity
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Cash at bank
Short term investments that can easily be converted to cash
Cash inflows from normal trading operations
Overdraft facility
Working Capital ratios
Current Ratio=current assets/current liabilities
It measures the ability to cover current liabilities using current assets. The standard
is 2:1 or 2 times. If it is below this say 1:1 it means current liabilities cannot be
covered with current liabilities. This causes the risk of insolvency. If it is above 2:1 it
means the business has excess cash tied up in either stocks or debtors or just lying
idle in the bank. There is an opportunity cost of the cash tied up.
Quick ratio or Acid test ratio =Current assets-stock/current liabilities
Stocks are the most difficult assets to convert to cash. To give an accurate measure
of liquidity the stock is deducted from current assets. The standard is 1:1.A
Company with a poor acid test ratio should have a standby overdraft facility to
ensure they meet the short term needs to service payments of current liabilities.
Overtrading
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Occurs when a company grows rapidly without adequate increase in long
term capital to fund the increased working capital requirements.
When a company grows the increased sales level is accompanied by higher
levels of stock and possibly more credit extended to customers.
The value of credit received from suppliers also increases with the volume of
sales.
However the effect of the growth is that more cash need to be invested in
working capital.
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

If the increase in sales is permanent then working capital should be funded
by extra permanent long term capital.
If not it will be met by an increase in short term creditors or a deteriorating
cash balance.
If this happens the cost of purchases tend to rise because the company no
longer qualifies for prompt payment discounts or bulk buying discounts
because cash shortages force it to buy in smaller quantities.
Eventually suppliers may cut off supplies.
Relations with the banks can also be strained if increases in borrowing are
not planned or if the company exceed the overdraft limits.
The customer is also affected if the company fails to provide a full range of
products because it cannot afford to have adequate stocks or press the
customer for payment.
Symptoms of Overtrading






Strong growth in sales and falling profit margins
Decline in debtor days (pressing them for early payment)
Net profit margins showing big declines. This could be due to increased
wages of sales team, bad debts, and writing off obsolete stocks
Increased bank borrowing
The current and quick ratio decline indicating a decline in short term financing
position.
Increased creditor days
Methods of relieving overtrading





Faster debt collection (pressing debtors too much causes the firm to lose
customers)
More efficient stock control e.g. using Just in time
Slower payment to the creditors but there are penalties like interest on
overdue amounts
Increase bank financing
Slow down rate of stock turnover growth by allowing WIP to be finished
and sold thus reducing the amount of working capital needed.
Ways of Improving cash flows
There are two main ways of improving cash flows.
1. Increase cash inflows
2. Reduce cash outflows
The aim is to improve the cash position of the business and not sales revenue
or profits.
Methods of increasing cash inflows.
1 Bank overdraft
The business can have a flexible loan and draw as much as possible up to the
agreed limit. However the interest rates may be high and the overdrafts can be
withdrawn by the bank causing insolvency.
2 .Acquiring short term loans
3. Sale of excess or idle assets-cash will be generated by selling the redundant asset
but selling them quickly can result in low prices and the asset may be needed at a
later date.
4. Sale and Lease back-This is the Sale of a business asset to finance the company
and leased back to the firm again. However, leasing costs add to the annual
overhead costs. There can be loss of potential if the asset rises in the price and the
asset could have been used as collateral security.
5 .Reduce credit terms to customers-this brings cash flows forward. The firm can
accelerate inflows from customers but however customers may prefer to purchase
from firms that offer them credit terms.
6 .Debt Factoring-A finance house can buy a customer’s bill from the business and
offer immediate payment reducing the risk of bad debts. However only about 80%
of the debts will be paid by the Factoring Company and this reduces profits of the
firm.
Ways to reduce cash outflows


Delay payments to suppliers- Cash outflows will fall in the short term but
however, suppliers may reduce any discounts offered with the purchase.
Suppliers can either demand cash on delivery or refuse to supply at all if they
believe that the risk of not being paid is high.
Delay spending on capital equipment-However efficiency may fall if outdated
and inefficient equipment is not replaced which will make expansion difficult.




Cut overhead spending that does not directly affect output.eg promotion.
However future demand for the product may be reduced by failing to promote
the product effectively.
Delay tax payment but there is an interest cost added
Reduce the level of dividend paid out.
Leasing as it does not require huge cash outflow
Management of working capital items
Debtors are customers who buy on credit. They can be managed by:
i.
ii.
iii.
iv.
v.
vi.
Assess the creditworthiness of the customers. The information can be
obtained from trade references, traders and bankers.
Set a limit to the amount of credit granted to each customer.
Negotiate cash discounts to clients who pay promptly, but this reduces profit
margins of the business.
Taking out credit insurance from financial institutions (debt factoring).
Not extending credit to customers or extending it for shorter period of time.
Implementing formal collecting procedure for overdue accounts.
Creditors –These are suppliers who agreed to supply goods on credit and have not
yet been paid. They can be managed by:
1. Increase the range of goods and services bought on credit from different
suppliers. This may be easy if a business has a good credit rating. However
an unpaid creditor may refuse to supply and this causes production
bottlenecks and discounts may be lost.
2. Extend the time period taken to pay creditors. The larger the business is the
easier it is to extend the credit taken. This improves the firm’s working
capital.
Inventories
i.
ii.
iii.
Keep smaller inventory levels to reduce stockholding costs
Use computer systems to record sales and therefore inventory levels and reorder levels become easy to determine.
Use J.I.T inventory system of inventory control.
Cash –This represents the residual value in working capital analysis. Cash out
flows deplete Cash reserves and result in the need for overdrafts. Cash shortages
can be solved by a reduction in debtors, stocks or an increase in creditors. Cash
inflows increase cash reserves. The cash position of the organisation should be
monitored. This ensures that cash shortages do not act as constraints to the
business.
1. If the organisation has excess cash it can use it for:
i. Early payment to creditors in order to claim discounts
ii. Deposited or invested in short term interest bearing securities.
iii. Used to buy marketable securities like shares.
iv. It can be lend profitably to other businesses
v. Used to make forward purchases of raw materials of prices are
expected to go up
Advantages of keeping working capital high
Inventory
1. There are few stock out costs
2. Bulk purchase discounts
3. Reduced ordering costs
Debtors (receivables)
1. Customers like credit and therefore it is profitable as it attracts more sales
Cash
2. Ability to pay on time creditors and this reduces risk of insolvency
3. Take advantage of unexpected opportunities
4. Avoid high borrowing costs
Creditors (Trade payables )
1. This preserves our own cash
2. It is a cheap source of finance
Advantages of keeping working capital levels low
Inventory
1. Less cash is tied up
2. Low storage costs
Debtors
1. Less cash is tied up in debtors
2. Low chances of bad debts
3. There is reduced costs of credit control
Cash
1. The company is less vulnerable to a takeover
2. Can invest surplus cash to earn higher returns
Creditors
1. Can take advantage of prompt payment discounts
2. Can retain good credit status
3. Can obtain more favourable supplier treatment
Causes of cash flow problems
1. Lack of planning (budgeting and budgetary control )
2. Poor credit control
3. Allowing customers too long to pay
4. Expanding too rapidly (overtrading)
Zimbabwe Stock Exchange
This is a market where individuals and institutions seeking finance and those with
finance can meet. This is where stocks and securities can be traded. It is a market
for buying and selling shares and bonds and other second hand securities.
Functions of the stock exchange
 Listing of companies on the stock exchange
 De-listing of companies after assessing their performance
 It provides a ready and continuous market for the purchase and sale of
securities. It also acts as an outlet for the sale of listed securities.
 It encourages capital formation. The stock exchange creates a habit of
saving, investing and risk taking among the investing class and converts
savings into profitable investments.
 It regulates company management by setting out a code of conduct for
dealers to protect investors against unfair business dealings. Listed companies
have to comply with the regulations of the stock exchange and they operate
under the supervision of the stock exchange authority.
 It facilitates public borrowing .It acts as a platform for marketing government
securities and enables government to raise public debt easily and quickly. It
allows government and companies to raise capital
 It serves as an economic barometer that is it indicates the state of health for
companies and the national economy. It also provides investors with names
of reputable companies. It also approves shares of companies to be bought
and sold.
 It facilitates evaluation of securities. This enables the investors to know the
true worth of their shareholdings at any time. The stock exchange establishes
prices for shares and quotes and publishes prices for shares.
Advantages of listing a company on the stock exchange





Once a listing is obtained ,a company will generally find borrowing funds
easier because its credit rating will be enhanced
Additional long term funding can be raised by a new issue of securities
Future acquisitions will generally be easier because the company will the
ability to issue equity as a consideration for the transaction
Share option schemes can be arranged to attract the highest calibre of
employees
The profile of the business, its board and its management team will be
improved.
Disadvantages of listing a company





Publicity will not always be of advantage. An unquoted company will be
able to conceal its activity because of its lower profile in the community
at large.
The costs of entry are high
At least some control will be lost when shares are available to the public.
The requirements of listing onerous and compliance is enforceable
The company may be more exposed to a hostile takeover bid
The Stock exchange is divided into two markets:
The Primary market which is concerned with new share issues or shares being
issued for the first time
Secondary market which is concerned with the trading of shares and securities
already in use
The Capital Market
Is a market in which individuals and institutions trade financial securities
Organisations in the public and private sector often sale securities on the
capital
market in order to raise funds. The stock market and bond market are part of the
capital market.
It is an institutional agreement to borrow and lend money for a longer period of
time. Capital instruments mature for a period above 1 year. It provides long term
debt and equity finance for the government and corporate sectors.
Capital markets can provide forex loans, consultancy services and underwriting of
share issues.
The Money Market
A segment of the financial market in which financial instruments with high liquidity
and very short term maturities are traded, It is used as a means of borrowing and
lending in the short term.
Money markets securities consist of negotiable certificates of deposits, banker’s
acceptance cheques, treasury bills, commercial paper.
Money markets is distinguished from the capital market on the basis of the maturity
period, credit instruments and the institutions
Maturity period –Money market deals in the lending and borrowing of short term
securities while capital market deals with long term financial securities.
Nature of credit instruments- The credit instruments dealt with in the capital
market are more heterogeneous than those used in the money market. Too much
diversity creates problems for investors.
Credit instruments-The main credit instrument used in the money market are
collateral loans, acceptances, bills of exchange. On the other hand instruments used
are stocks, shares, debentures, bonds, securities of government.
Institutions-Important financial institutions operating in the money market are the
Central bank, commercial banks, acceptance houses and non bank financial
institutions, bill brokers etc. Important institutions in the capital market are the stock
exchange, commercial banks, insurance companies, mortgage banks/ building
societies.
Purpose of funds-Money market meets the short term credit needs of the
business, it provides working capital to the industrialist, while on the other side it
provides long term credit needs of the industrialist and provides fixed capital to buy
land and machinery.
Risk-The degree of risk is small in the money market. The risk is greater in the
capital market. Maturity period of less than 1 year gives less risk of default.
Basic role-The basic role of the money market is that of liquidity adjustments while
in the capital market it is to provide long term finance, secure investment capital.
Relation with central bank-The money market is closely and directly linked with
the reserve bank of the country. The capital market feels the central banks’ influence
but mainly indirectly and through the money market.
Investment Appraisal
It is an evaluation or assessment of the economic viability of a project determining
which project to choose.
Capital budget is a programme of capital expenditure covering several years. It
includes authorised projects and projects under consideration. One stage in the
capital budgeting is investment appraisal and its features are:
Assessment of the level of expected returns earned for the level of expenditure
made.
Estimate future costs and benefits over the project’s life.
When a capital project is evaluated, the costs and benefits of the project should be
evaluated over its foreseeable life usually the expected useful life. A typical project
involves an immediate purchase of a non current asset. The asset will be used for a
number of years where it is used to increase sales revenue or achieve savings in
operating costs. There will also be running costs for the asset. The asset may have a
residual value.
Methods of investment appraisal
 Payback Period
This is the period of time a project will take to pay back the money spent on it. It
is based on cash flows and provides a measure of liquidity.
The decision rule is to take projects which pay back within a specified time.
Choose a project with the fastest pay back.
Payback period for even cash flows=Initial investment/annual cash flows
E.g. an expenditure of$ 2 million is expected to generate Net cash inflows of
$500 000 each year for the next 7 years.
Payback period=2000000/500000=4 years
To calculate the payback period in years and months multiply the decimal by 12
e.g. an expenditure of $1,8million with annual cash inflows of $350000
Payback period =1800000/350000=5,1429years
=5 years 2months (0, 1429*12=1, 7 months)
Payback period for uneven cash flows.
The payback is calculated by working out the cumulative cash flow over the life
of the project .e.g. a project is expected to have the following cash flows:
Capital outlay $1900 000. The outflows are, year 1 (300 000), year 2 (500 000),
year 3 (600 000), year 4 (800 000), year 5 (500 000).calculate the payback
period.
Solution
Year
Cash flow
cumulative cash flows
0
(1900 000)
(1900 000)
1
300 000
(1600 000)
2
500 000
(1100 000)
3
600 000
(500 000)
4
800 000
300 000
Payback period =3 years plus (500 000/800 000*12)
3 years 8months
Each year’s cumulative figure is simply the cumulative figure at the start of the
year plus the figure for the current year. The cumulative cash flows change from
negative to positive in the fourth year. This shows all the capital has been repaid
.It is assumed that cash flows arise throughout the year uniformly. However
assuming that cash flows arise at the end of the year the payback will be 4 years.
Advantages of Payback period
 It is simple to calculate and understand
 It favours projects with high initial cash flows
 Rapid payback minimises the risk that are time related and leads to rapid
growth.
 In rapidly changing technology situations if the new machine will be
scrapped in a shorter period because of obsolescence then a quick
payback is essential.
 In situations of improving investment conditions i.e. when investments are
expected to improve in the near future then attention is given to those
projects which will release funds soonest.
Disadvantages
 Total Project returns may be ignored i.e. those cash flows arising after the
payback periods are totally ignored.
 Time value of money is ignored
 It is subjective-No objective measure of the length of time should be set as
minimum
 Project profitability is ignored.
Accounting Rate of Return
ARR=(Average annual profits before interest and tax/Initial investment or average
investments)*100
Average investment=Initial investment +scrap value/2
NB scrap value and useful life can be used to calculate annual depreciation
Advantages




It is simple to understand
It links with other accounting measures
It uses all cash flows
It focuses on profitability
Disadvantages
 Ignores the time value of money
 It includes later cash flows which might be less accurate
Net Present value
Involves discounting all the relevant cash flows associated with the project back to
their present value
All cash outflows are treated as negative and inflows are treated as positive.
The NPV represents the surplus funds earned on the project therefore if net present
value is positive the project is financially viable. If NPV is zero the project breaks
even. The decision rule is to choose a project with a positive net present value.
Assumptions used
All cash flows occur at the start of the year or the end of the year.
Initial investments occur at Year zero and other cash flows begin at year 1.
E.g. the cash flows for a project are as follows
Year
flows
0
1
2
3
4
cash
(25 000)
6000
10 000
8000
7000
The cost of capital is 6%.calculate the NPV.
Solution
Year
0
1
2
3
4
cash flows Discount factor discounted cash flows
(25000)
1
(25 000)
6000
0,943
5660
10000
0, 8899
8900
8000
0, 8396
6717
7000
0,792
5545
26 882
(25 000)
Net Present Value
1822
Advantages





It considers the time value of money
It is an absolute measure of return .It represents true surplus.
It is based on cash flows not profits.
It considers the whole life of a project
It should lead to maximisation of share holder wealth
Disadvantages
 It’s difficult to explain to managers
 It requires knowledge of the cost of capital
 If is relatively complex.
Internal Rate of Return
Represents the discount rate at which the NPV of an investment is zero. It
represents a break even cost of capital
The decision rule is to accept projects if the IRR is greater than the cost of
capital
Calculate the NPVs for the project at two different costs of capital
Use the following formula finds the IRR.
IRR=L+ (NL*(H-L))/Nl-NH
L=lower rate of interest
H=Higher rate of interest
NL=NPV of lower interest rate
NH=NPV of higher interest rate
A potential project’s cash flows give net present values of $50 000 at a discount
rate of 10% and ($10 000) at a rate of 15%.calculate the IRR
IRR=10 %+( 50 000*(15-10)/50 000-(-10 000)
10% +4,166
14,166%
E.g. A business undertakes high risk investments and requires a minimum
expected rate of return of 17% per annum on its investments proposed capital
investment has the following expected cash flows:
Year
cash flows
0
(50 000)
1
18000
2
25000
3
20 000
4
10 000
Calculate the NPV at a discount rate of 15% and 20%
Use the NPVs to calculate the IRR
Solution
Year
0
1
2
3
4
5
6
7
C.F
(50000)
18 000
25 000
20 000
10 000
NPV
D.F (15%)
1
0,869
0,756
0,6575
0,5718
D.C.F
D.F (20%)
(50 000)
1
15 652
0,833
18904
0,6944
13150
0,5787
5718
0,4822
53 424
(50 000)
3424
D.C.F
(50 000)
15000
17361
11574
4823
48 758
(50 000)
(1242)
IRR=15 %+( 3424*(20-15))/3424-(-15)
=15%+3,669
=18,669%
18,669 > 17% the cost of capital so the project should be accepted
Advantages of IRR
 It considers the time value of money
 It is a percentage and therefore easily understood.
 It uses cash flows not profits
 It considers the whole life of the project.
Disadvantages of IRR




It is not a measure of absolute profitability
Interpolation provides estimates
It is fairly complicated to calculate
Non conventional cash flows may give rise to multiple IRRs
Net Present Value compared to internal rate of return
 NPV can be used to distinguish between two mutually exclusive projects
 It tells us the absolute increase in shareholder wealth as a result of accepting
the project, at the current cost of capital
 It is a better technique for choosing projects
 IRR simply tells us how far the cost of capital could increase before the
project would not be worth accepting
Qualitative factors affecting investment decisions
1. Human relations-some investment projects can have a huge impact on
the staff in an organisation like plant automation might lead to mass
redundancies
2. Ethical considerations like a chemical manufacturing firm may build a plant
that does not minimise financial costs but reduce environmental damage
to enhance the image of a company so that it is seen to be a good
corporate citizen
3. Risk involves the financial position in which the business finds itself in
when assessing the project. This could be as a result of state of the
economy and markets into which a business sells. Projects with a longer
payback period are riskier than those with a shorter period.
4. Government legislation as the investments may take place to conform to
legal requirements like installing an anti pollution equipment to bring down
emission to the environment even though this investment could make
losses for the business
5. Availability of funding affect projects since some projects may fail to get
started due unavailability of funds as the firm may not be able to raise the
required capital
6. Business confidence affects in the sense that optimistic managers tend to
invest in capital projects. This is because the managers see the future as
better as and brighter than the average. The pessimistic managers may
delay or abandon possible investment projects.
Interpretation of Financial Accounts
Users of Accounting Information
Business Managers
 To measure the performance of the business to compare targets, previous
time periods and with competitors’
 To help them take decisions such as new investments, closing branches and
launching new products.
 To control and monitor the operation of each department and division.
 To set target or budgets for the future and review these against actual
performance
Banks
 To decide whether to lend money to the business
 To assess whether to allow an increase in overdraft facility
 To decide whether to continue an overdraft facility or loan
Banks are specifically interested in the following financial statements:
 Statement of Financial Position to determine gearing, value of assets
 Statement of comprehensive Income(trading ,profit and loss account)
 Statement of cash flows
Creditors
 To see if the business is secure and liquid enough to pay of its debts
 To assess whether the business is a good credit risk
 To decide to press for early repayment of outstanding debts
Customers
 To assess whether the business is secure
 To determine whether they will be assured of future supplies of the goods
they are purchasing.
 To establish whether there will be security of spare parts and service facility
Government
 To calculate the tax due from the business
 To determine whether the business is likely to expand and create jobs and be
of increasing importance to the country’s economy.
 To assess whether the business is in danger of closing down, creating
economic problems.
 To confirm that the business is staying within the law in terms of accounting
regulations.
Investors (shareholders)
To assess the value of the business and their investment in it
To establish whether the business is becoming more profitable
To determine what share of the profits investors are receiving
To decide whether the business has potential for growth
If they are potential investors, to compare these details with those of other
businesses before making a decision to buy shares in a company
 If they are actual investors ,to decide whether to sell all or part of their
holding





Local community
 To see if the business is profitable and likely to expand which could be good
for the local economy
 To determine whether the business is making losses and whether this could
lead to closure.
Importance of Financial (accounting) Information
 Accounting records confirm details of the transactions that took place.
 They provide management with information on performance in terms of
profitability and liquidity
 They enable evaluation of business in terms of liquidity and profitability
 They provide information for owners of the business, investors and
government.
However
 Accounts are affected by problems of incompetency which leads to wrong
information for decision making.(Errors in financial records prepared by
incompetent leads to wrong profit figures)
 It is prone to window dressing; the act of presenting the company
accounts in a favourable light, to flatter business performance. This can be
done for the following reasons
 (i)to influence the bank to lend more money to the business.
 (ii) To reduce the tax payable by lowering the net profit.
 (iii)To reduce the dividend payable
 (iv) to encourage prospective investors to purchase more shares in the
business
 (v)Managers might want to attract praise and financial rewards for good
performance (performance related rewards)
 (vi) If the owners want to sell it the better the financial position the higher
the price they are likely to get form the disposal.
Common Ways of Window dressing
 Selling assets such as buildings at the end of the financial year to give the
business more cash and improve liquidity position these assets could then be
leased back by the business
 Reducing the amount of depreciation of fixed assets such as machines and
vehicles in order to increase declared profit and increase asset values
 Ignoring the fact that some customers who have not paid for the goods
delivered may ‘never pay’, they are called bad debts. This is deliberate failure
to apply the prudence concept
 Giving stock levels a higher value than they are probably worth
 Delaying payment of bills or incurring expenses until after the accounts have
been published.
 Manipulating sales revenue in the profit and loss account e.g. realising sales
revenue when an agreement of sale has been signed.
 Changing asset values by way of revaluations e.g. land and buildings
 Writing off research and development costs immediately rather than
capitalising them or writing them over a long time .This reduces current year
profits significantly.
 Writing off costs from closure of factories and goodwill from acquisition of a
company at once in the same year so that profits will be better since there
will be no more depreciation of goodwill in future years.
Accounting ratio analysis
Profitability ratios
Gross profit margin (percentage) = (Gross profit/Sales)*100
A reduction in the G.P percentage can be as a result of:



i.
ii.
iii.
iv.
v.
A rise in the price of goods purchased not passed on to customers
It may have been necessary to purchase the goods from a different supplier
at a higher price
A cut in the profit margin on sales due to:
The need to increase sales volume
As an introductory offer for a new product
As a result of seasonal sales
To dispose out of date or damaged stocks
To increase cash flows when the business is in short supply of cash.
Gross profit mark up= (gross profit/cost of sales)*100
Net profit percentage= (Net profit/sales)*100
Net profit mark up (net profit/cost of sales)*100
A decrease could be as a result of increase in Administration, Selling and
distribution cost or an increase in interest on loan.
Return on capital employed= (Net profit before and tax/capital employed) *100
Capital employed=equity +long term loans or Net assets. If ROCE is lower than
interest rates in the market, it indicates that the business would have prospered
by depositing the amount in the bank. The figure is before tax and interest so as
to enable comparison of company’s performance year by year in a situation
where the rates of tax and interest change. This also enables it to compare
performance when the company has loan capital and when it has equity only.
Liquidity ratios
These include current ratio, quick ratio and rate of stock turnover.
Stock turnover=cost of sales/average stock
It is the time that elapses before stock is sold. It is important for the following
reasons:
 The more quickly the stock is sold the sooner the profit is realised and the
more times the profit is earned in the financial year. A slow stock turnover
rate may indicate that excessive stocks are held and the risk of obsolete
stock increases.
 It may increase the stock holding costs and administration costs and
insurance.
 Large quantities of slow moving stocks mean that capital or cash is tied up
in stock and not earning revenue. However different industries have
different stock turnover rates.
Importance of Liquidity ratios
 Before new suppliers may extend credit to a customer, the liquidity
situation of the business is considered to assess the credit worthiness
 Management will identify which working capital items are not properly
managed e.g. capital tied up in stock, cash lying idle in the bank.
Investment ratios
Gearing is the fixed cost capital expressed as a percentage of the total capital.
Fixed cost capital is the money that finances the company in return for a fixes
return. It includes debentures and preference share capital.
Gearing ratio=Debentures +Preference
cap+debentures+pref shares +Reserves.
share
capital/ordinary
share
A company is said to be highly geared if it is more than 50% and lowly geared
if it is below 50%.Gearing involves risks. The risk arises if the profits fall and
interest rates are high. The firm may fail to make interest payments leading
forced liquidation. Also if more profits are used to pay interests, then less will
be left for dividend payments. Lenders of the company such as banks maybe
concerned if it is geared. This may indicate that the proportion of profits used
to pay interest and fixed dividends is great. A highly geared company is solely
dependent on loans, showing that shareholders are unwilling to invest more of
their own money in the company. This shows less confidence in the company’s
future and performance. Also more assets will be pledged reducing control
over them.
Advantages of gearing



There is no dilution of equity control
Lenders have no voting rights and do not interfere in the running of the
company
Interest on loan is tax deductible
Debt/equity ratio=
capital)*100
(Debentures+
preference
shares/Ordinary
share
Interest cover
The ratio measures the number of times the profit generated covers loan interest.
Lenders are concerned about the ratio and need assurance that profit before interest
and tax covers interest payments several times. Shareholders are also concerned as
a good interest cover enables dividend payment as it is paid after interest payment.
A ratio of 1 is unsafe and is bad news for the shareholders.
Interest cover= (Profit before interest/Interest payable)
Earnings per share
Earnings refer to the profit left for the ordinary shareholders after interest, tax and
preference dividends have been met. Ordinary dividends are paid out of earnings.
Undistributed earnings increase reserves and the balance sheet values of shares.
E.P.S =Earnings/No of ordinary shares issued.
An increase in EPS can allow an increased dividend to be paid and a small increase
in retained profit added to reserves.
Price Earnings ratio
It shows the number of times the price paid per share on the market exceeds the
EPS.
PER=market price per share/earnings per share.
It is a measure of the confidence in the ability of the firm to maintain its earnings in
future. It is an important ratio for investors as it gives a quick and easily
understandable indicator of the market assessment of a company’s prospects.
Dividend cover =Profit after tax and preference dividend/dividend on ordinary
shares. If the cover is too low, a decline in profit may lead to the dividend being
restricted or not being paid at all. If it is too high, shareholders may decide that the
directors are adopting a mean dividend policy to increase retained profit that could
be used in future. A dividend cover of 2 to 3 times may be considered normal.
Dividend Yield= (Dividend per Share/Market Price per Share)*100
It measures the dividend paid out against market value of shares. A higher ratio may
attract potential shareholders. However dividend yield could be high due to the fall
in share prices. Dividends may be paid out of reserves even in times of low
profits/loss.
Earnings Yield= (EPS/MPS)
Asset Utilisation ratios
Fixed Asset turnover =Sales/fixed assets. It measures how the assets acquired are
used to generate sales revenue. An increase in shows efficient utilisation of the
assets
Current Asset turnover =Sales /total current assets
The debtors and stock levels are determined by the level of sales. Increases in sales
are usually accompanied by higher stock levels and debtors.
Usefulness of ratios
 Accounting ratios facilitate the evaluation of business performance, that is
profitability and liquidity
 They can be used in forecasting and planning
 Ratios summarise accounting data
 Identifying problems before they become acute e.g. profitability and liquidity
situations.
 To assess performance by key business stakeholders e.g. suppliers and
investors.
 They enable comparisons to be done over time or with other similar firms.
Limitations
 Accuracy of predictions using ratios depends on the quality of information
from which they are calculated
 The ratios ignore qualitative factors e.g. motivation, management efficiency.
 Policies used make inter firm comparisons misleading e.g. depreciation
policies.
Management and Financial accounting
Financial accounting involves collection and recording of daily accounting
transactions.
Financial accounting involves the preparation of published reports and accounts of a
business such as Income statement, balance sheet and cash flows.
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It is for external use.
Financial accounts are usually prepared twice a year.
The financial accounts are bound by the rules and concepts of the accounting
profession (accounting standards).
Company accounts must observe the requirements of the company’s Act.
It covers past data.
It acts as the steward (custodian) of financial resources
Management accounting is the preparation of information for internal reporting
purposes only.
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The reports are prepared for managers.
It involves analysis of internal accounts such as departmental budgets
budgetary control (variance reports), ratio analysis.
Accounting reports and data are prepared when required by managers and
owners.
There is no set of rules are used so the accounts will be produced in the form
requested.
It can cover past time periods, but can also be concerned with the present or
projections into the future e.g. budgets and cost projections.
It seeks to support decision making by the provision of information
Accounting concepts and conventions
Double entry principle For every transaction there is a debit and credit entry. The
transaction is looked at from two angles, so there are two sides to a transaction, the
receiving and giving side.
Realisation concept
Sales revenue and profits should be recorded in the accounts, when they have been
invoiced, and legal ownership has been transferred to debtors. This is when goods
have been provided to the customer. The customer is now legally bound to pay for
the goods unless they can be proven to be faulty.
Accruals concept/Matching concept
The firm should match revenues and costs incurred in the same accounting period.
This leads to accruals and prepayments. Accruals arise when services have been
supplied to the business but have not been paid for at the time the accounts are
drawn up e.g. unpaid electricity bill at end of the year. This is added up to the total
for electricity expense in the Income Statement to determine profits .The amount
owing is treated as a current liability in the balance sheet.
Money measurement principle
Only items and transactions that can be measured in monetary terms are recorded
in the business accounts .Items such as experience of management cannot be
recorded in the books of accounts.
Prudence concept (conservatism)
It states that accounts should be provided for and record losses as soon as they are
anticipated. Profits should not be recorded until they have been realised, that is until
it is certain that goods and services have been sold at a profit.
Capital and revenue expenditure
Capital expenditure is made when a firm spends money either to buy fixed assets
or add to the value of an existing asset. This includes:
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Acquiring fixed assets
Bringing fixed assets into the firm
Legal costs of buying buildings
Any other costs needed to get the fixed asset ready for use
Installation and assembling costs
Costs of testing whether the items are functioning properly
These costs elements form part of the cost of an asset and are debited to the asset
account and credited to the bank
Revenue expenditure is meant for the day to day running of the business e.g. fuel
for motor vehicles, repairs to assets
Differences between capital and revenue expenditure
Capital expenditure
Expenditure on buying or improving fixed
assets
Usually involves large sums of money
Provides long term benefits to the firm
Reflected in the Balance sheet
Increases production capacity
Revenue expenditure
Expenditure on the day to day running of
the business
Involves small amounts of money
Provides short term benefits to the firm
Reflected in the Income statement
Maintains production capacity
The Main Business accounts.
Income Statement (Statement of comprehensive income)
It is a financial statement which records the revenue, costs and profits or losses of a
business over a given period. It shows the gross profit and the net profit.
Gross profit is pure profit from trading activities before deducting expenses. It is
obtained by deducting cost of sales from sales.
Cost of sales is equal to opening stock + purchases less closing stock.
Net profit is the profit obtained after deducting operating expenses from gross profit.
Retained profit is that part of profit which is not distributed as dividends to
shareholders. It is kept in the business and belongs to the shareholders.
The income statement shows how the net profit is split up or appropriated between
dividends (the share of profits paid to shareholders as a return on investment) and
retained profits.
Uses of the Income Statement (IS)
The I.S. can be used to measure and compare the performance of a business over
time or with other firms. Ratios can be used to help with this form of analysis.
The actual profit data can be compared with the expected profit levels of the
business.
Bankers and creditors of the business will need the information to help decide
whether to lend money to the business based on profitability and gearing.
Prospective investors may assess the value of putting money into a business from
the level of profits being made.
Balance Sheet (Statement of Financial position)
It is an accounting statement that records the values of business assets and
liabilities and shareholders’ equity at one point in time.
Elements of the Balance sheet
Fixed Assets
An asset is a resource or an item of monetary value that is owned and controlled by
the business as a result of previous transactions from which future economic
benefits are expected to flow to the business.
Fixed assets can be tangible like motor vehicles or Intangible assets.
Intangible assets are those assets which do not have a physical form or substance
but are of income earning value to the business e.g. patents, copyrights, brands,
goodwill and investments.
Liabilities are the financial obligations of a business that it is required to pay in
future.
Shareholders equity is the total value of assets less total value of liabilities. It comes
from capital invested and retained profit of the business.
Share capital which is the total value capital raised from shareholders by the issue of
shares.
Working capital is the sum of current assets less current liabilities.
A balance sheet shows the net worth of the business. This refers to the level of
capitalisation, the actual amount of capital that belongs to the firm.Net worth is
important because it gives investors or creditors an opportunity to assess the
leverage (gearing),liquidity and credit worthiness of the firm.
Goodwill is the value of the business less the value of the net assets.
Goodwill=Purchase price –value of net assets
Purchased goodwill is included as an intangible fixed asset in the balance sheet.
The goodwill is then amortised (depreciated) over a period of up to 20 years
Limitations of the balance sheet
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A balance sheet is prepared at a certain date and it is in a sense a snapshot
of the position at that date. It is possible that the position will change
fundamentally within a short space of time.
The balance sheet only includes items that can be expressed in monetary
value so it ignores assets which cannot be expressed in monetary terms.
There is a considerable discretion over the valuation of assets .e.g. Net Book
value of assets varies with the method of depreciation used and the stated
value of stocks depends on the method of stock valuation used.
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The balance sheet does not reveal the current value of assets unless property
is revalued to show its current value.
It does not show the value of the business unless it includes the value of
intangible assets especially goodwill.
Cash flow statements (IAS7)
IAS7 states that a statement of cash flows should report cash flows during the
reporting period classified on the basis of operating, investing and financing
activities.
The standard does not recognise return on investment and return on servicing of
finance. Cash flows from operating activities are those which are primarily derived
from an entity’s primary revenue generating activities. These include:
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Cash receipts from royalties, fees, commissions and other revenue
Cash receipts from sale of goods and services.
Cash payments to suppliers for goods and services.
Cash flows from investing activities are those which show the extent to which
expenditures are made for resources intended to generate future revenue. These
include.
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Cash payment to acquire fixed asset, intangible assets
Cash receipts from the disposal of fixed and intangible assets.
Cash flows from financing activities are those which are based on transactions
between the firm and its capital providers. These include cash flows from issue of
shares, debentures and long term loans or their redemption.
Advantages of cash flows
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It directs the attention to cash flows, on which a business survival depends.
It shows which part of the business generates more revenue and which one
uses more cash.
The liquidity position of the business can be evaluated.
It helps stakeholders to see how much cash the day to day operations raised.
Creditors are more concerned about the firm’s ability to repay loans than its
declared profits.
Profits are subjective as they depend on the firm’s accounting conventions
used in constructing the accounts while cash flows are objective
The cash position of the business is more important for management decision
making and is also meaningful to shareholders.
Cash flows can be used to show how capital expenditure was financed.
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It can be used to project future cash flows, assess the future ability to pay
debts, dividends and interest.
The cash flow statement can be prepared using the following two methods
1 Direct method
2 Indirect methods.
Using the indirect method the following should be taken note of:
Net profit before interest and tax is used and adjusted for non cash items that are
charged in the income statement. The non cash items do not involve movement of
cash e.g. bad debts, depreciation, loss/profit on disposal e.t.c. Also adjustments are
done to working capital items that are stock, debtors, creditors, accruals and
prepayments.
An increase in stock might mean more money was used to purchase more stock and
thus it is cash outflow and vice versa.
A decrease in debtors might mean more cash was received when our debtors paid,
this is an inflow.
A decrease in creditors means we made payments to our creditors and this is an
outflow.
Cash flow presentation format
Cash flows from operating activities
Net profit after interest and tax
xxxxxx
Add back: Tax
xxxxxx
Interest
xxxxxx
Net profit before interest and tax
xxxxxx
Adjust for non cash items:
Add back: depreciation
Bad debts written off
xxx
xxx
Increase in provision for bad debts
xxx
Goodwill written off
xxx
Cash flow from operating activities
xxxxxxx
Cash flows from investing activities
Fixed asset acquired
(xxxxxx)
Cash from disposal of fixed asset
xxxxx
Net cash flows before financing activities.
xxxxxx
Cash flows from financing activities
Issue of shares
xxxxx
Long term loan issued
xxxxx
Dividends paid
(xxxx)
Debentures redeemed
(xxxx)
Net cash in/out flows
xxxxx
Cash at the beginning
xxxxx
Closing cash and cash equivalents
xxxxx
Direct Method
Cash from operating activities
Cash receipts from customers:
Sales
xxxxxx
Increase in receivables (debtors)
xxxxxx
Xxxxxx
Cash paid to and on behalf of suppliers and employees:
Cost of sales
xxxxxx
Decrease in inventory
(xxxxx)
Decrease in creditors’
xxxxxx
Other income statement expenses paid for cash
Interest paid
xxxxxx
Taxation paid
xxxxxx
Cash flows from operating activities
xxxxxx
NB the other sections are the same as in the indirect method
Stock valuation
Stock valuation is necessary for the pricing of materials issued from stores and for
the final accounts for the business. This figure affects cost of sales. This eventually
affects the profits generated by the business. The prudence concept states that
stocks should not be overvalued; they should be valued at the lower of cost or net
realisable value.
Methods of stock valuation
First in fist out (FIFO)
It is based on the assumption that materials are used in the order they were bought.
The oldest stock is issued out first and the price paid for the first batch of materials
is used for all issues until the first batch is used up. Thereafter the issues price paid
for the next batch is used until depleted.
Closing stock is valued in terms of more recent purchase prices. This produces a
higher figure of closing stock and therefore a lower cost of sales figure. This in turn
produces a higher figure for gross profit.
It is acceptable for Inland Revenue for tax purposes as costs are close to those
actually incurred and the value of closing stock is close to current market values.
However if FIFO is used for costing purposes it has the disadvantage that it lags
behind the current prices. There will be a delay before the prices paid for materials
will be passed on to production.
Advantages
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It is realistic
Based on the assumption that issues are made in order of goods received
Based on prices paid
Closing stock based on recent prices
Acceptable under companies act for tax
Demerits
 Identical items will be priced differently because they are deemed to be from
different batches.
 It value stock at latest prices which in inflationary times lower cost of sales
and overstates profits.
Last in first out (LIFO)
This is based on the assumption that issues are drawn from the last batch. When
that has been used up, the price of previous batch is used. Production is charged
with price of the costs that are close to current market prices but closing stock is
valued at a price for the oldest existing stocks. This understates the value of
closing stocks and thereby reduces both cost of sales and gross profit. Thus LIFO
understates profitability of the business therefore it is not acceptable to Inland
Revenue for tax purposes
Advantages
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Price of the latest item is passed on to production
Value of closing stock is easy to calculate
Based on prices paid
Issued at the most recent prices
Disadvantages
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Unrealistic because it assumes that recent stock is used first
Closing stock is not valued at most recent prices
Not acceptable for tax purposes but under companies act
Identical items issued at different prices because they are deemed to be from
different batches.
Weighted Average Cost (AVCO)
All stocks are valued at a single representative average cost, calculated by
dividing the total value of stock purchases by the number of items. The average
price is used for all stocks issued. It smoothes out price fluctuations but does not
reflect the actual prices paid for the stock.
Advantages
 Prices averaged out, thus recognising that all items should be included in
the calculations.
 Variations in prices are minimised
 Has the effect of smoothing out costs of production and cost of sales.
 Profits of different periods can be realistically compared
 Acceptable under SSAP and companies act.
Disadvantages
 The average does not represent prices paid actually
 A new average must be calculated with every purchase of stocks
Depreciation
This is part of the cost of a fixed asset that is consumed during the period it is used
by the firm. Firms depreciate assets to spread the cost of the asset over its useful
life rather than full amount in the year of purchase in line with the matching
concept. It is a fairer way of treating fixed assets and helps to avoid overstating
profit or fixed assets in line with the prudence concept.
Causes of depreciation
1. Wear and tear-the assets become worn out through usage
2. Obsolescence –the assets have to be replaced because new technology has
been developed or machines which were acquired for the production of
particular goods are of no use because the goods are no longer produced e.g.
machinery used to manufacture typewriters.
3. Passage of time-An asset acquired for a limited period of time loses value
as time passes by .e.g. lease of premises.
4. Using up or exhaustion-this is used with assets of wasting nature. The
assets get used up or depleted with usage e.g. mines quarries and oil wells.
Factors considered when deciding on the amount of depreciation
1Cost of asset, 2 estimated useful life, 3 estimated residual value, 4 Usage
Expenditure on the purchase of fixed asset is capital expenditure and is not debited
to the profit and loss. However, the cost of using the fixed asset to earn revenue
must be charged in the profit and loss account. This cost is depreciation.
Methods
Straight line method
Total depreciation is spread evenly over the number of years of its expected life. A
fixed amount is deducted per year from the value of the asset and charged to the
Income statement as an expense. The annual profits are uniformly affected by this
method. It therefore facilitates comparisons of the profits over time.
Depreciation=cost-estimated residual value/estimated useful life in years.
E.g a machine of $20 000 cost is expected to have useful life of five years, at the
end of which time is expected to be sold for $5000.The depreciation charged each
year is:
Depreciation=$20 000-$5000/5
=$3 000.
The ledger entries are a debit in the Income statement and a credit in the provision
for depreciation. The other option uses a fixed percentage of cost e.g 10% on cost
which gives $2000 every year.
This method of depreciation should be used for asset that is expected to earn
revenue evenly over their useful working lives. It is used when the pattern of
earning power is uncertain. It should be used to amortise the cost of assets with
fixed lives such as leases.
However cars, trucks and computers tend to depreciate much more quickly in the
first and second years than in the later years. This is not reflected by this method.
Also repairs and maintenance costs of an asset usually increase with age and this
will reduce the profitability of an asset. This is not adjusted by fixed depreciation
charges.
There is no recognition of the very rapid pace at which advances in modern
technology tend to make existing assets redundant.
Reducing balance method
Depreciation is calculated as a fixed percentage of the written down value of the
asset each year. It takes into account the decline of asset value which is greatest in
earlier years and slows down later.
E.g. a machine of $20 000 is expected to have a useful life of five years. The
estimated residual value is 5000.Depreciation is calculated at 25% per annum on
reducing balance method.
Depreciation: year 1 25% *20 000=$5 000
Year 2
25 %*( 20 000-5 000)=3 750
Year 3
25 %*( 20 000-8750)=2812,5
The method should be used when it is considered that an asset’s earning power will
diminish as the asset gets older.
The reduction in the charge for depreciation compensate for the increases in the
cost of maintaining and repairing asset as they get older.
The consistency concept states that the chosen method of depreciating an asset
should be used consistently to ensure that the profit or loss of different accounting
periods can be compared on a like for like basis. The depreciation method causes
fluctuations in the net profit figures since a higher depreciation figure is charged in
the earlier years. Comparisons over time and with other firms become difficult.
BUDGETARY PLANNING AND CONTROL
A budget is a detailed financial plan usually quantitative covering a defined period of
time often one year.
Budgetary control is a control technique whereby budgeted and actual data are
compared one after the other and the managers accountable for any differences
take the necessary control actions or revise the budget.
Functions of budgeting
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Planning-budgets fit into the overall planning system of an organisation. It
involves planning for what must be done, how this must be done and the
eventual outcome expected. Organisations define goals and objectives. It
plans sales strategies, employment of material and administrative capacity.
Budgeting facilitate coordination of activities through discussions over the
allocation of resources to different departments and divisions. The
departments will have to be coordinated and made to work together to
achieve set objectives.
There is effective allocation of resources. The business will not spend
resources more than it has access to. It will set priorities on how to use
funds.
Budgeting facilitate setting of targets to be achieved. Employees work better
if they have realistic targets. This motivates them if they achieve those
targets
Budgeting facilitate monitoring and control of expenditure. It enables
managers to compare actual performance with the budgeted target.
Variances will be identified and causes identified for corrective action to be
taken.
It enables modification of plans if the targets set are unrealistic or
unattainable.
Budgets can be used to assess performance of individual employees. Actual
performance is measured against a quantitative target.
It leads to improved communication between employees, departments in the
organisation. This may be through budget meetings to discuss allocation of
resources.
It facilitates management by exception, with deviations reported and
investigated.
By giving freedom within the budget, middle management can be motivated.
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Budgeting clarifies responsibilities of budget centres.
HOWEVER
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Budgeting is costly to the business. It uses up resources like time taken up
setting budgets and other related costs.
It may lead to unnecessary expenditure by departmental heads towards year
end if they realise they still have some unused allocated funds to justify future
budget increases.
The budgets prepared depend on the accuracy of information available and
plans.
There is rigidity especially with budgeted costs. This is a problem in budgetary
control and analysis when variances arise. This can constrain business
activities e.g. budgets can be set so that older vehicles must be kept rather
than replaced which can lead to customer dissatisfaction and lost orders
because deliveries are unreliable.
Budgets may demotivate workers who fail to meet targets and also if the
workers are not consulted when setting budgets it will be more difficult to use
the budget to motivate them
Budgets may lead to departmental conflicts over allocation of resources.
Workers may view budgets as pressure devices imposed by management
Some managers may overstate expected costs and understate revenue to
avoid responsibility for future over expenditures. Thus budgets can be
manipulated to become easy to achieve and make the department look
successful so it may not help to achieve business objectives.
Managers can become overly dependent on the budget and neglect the
process of management. Also some may be too focused on the current
budget and may take actions that undermine the future performance just to
meet current budgets e.g. to keep labour costs down in the current budget
the manager might reduce staffing levels on customer services so this
reduces costs now but could lead to customers moving away from business
due poor customer care. (spending long time to be served at bank )
Types of budgets
There are four types of budgets
Fixed budgets are prepared on the basis of a given level of activity which may be
expressed in terms of output expenditure and/or sales. Fixed budgets may change
as revisions are made to reflect changing circumstances. They are reasonably easy
to prepare when the level of activity is known or can be predicted with some
confidence. In the public services the level of resourcing often determines the level
of activity and may be established in advance of the financial year.
Flexible budgets identify those variable or semi variable costs and recognise that
costs behave in different ways. Some costs are fixed over time but others may vary.
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for planning purposes - where an organisation is unclear or unsure about
activity levels;
for control purposes - at the end of each control period the budget can be
prepared retrospectively to reflect the actual level of activity achieved.
They can be prepared on a marginal or absorption costs basis - if the former is used
then fixed costs per unit will be fixed in advance. If absorption costing is used then
fixed costs will have to reflect the actual fixed cost absorbed at the level of activity
achieved. This model has applications in the manufacturing, service and public
sectors, e.g.
in the manufacturing sector plant and equipment costs account for a large
proportion of total costs and tend to be fixed;
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Labour costs in public sector organisations are often fixed as they are part of
a permanent payroll. The only variable elements may be as a result of
overtime
Flexible budgets are used in the following situations:
1. Under inflationary conditions when the purchasing power of money
changes rapidly. This makes variance analysis meaningful so there is need
to flex the budget.
2. In times of fluctuating exchange rates as appreciation and depreciation of
local currency leads to variations in purchasing power of local currency.
Incremental budget
This involves using the previous year’s budget, adjusted for known factors (such as
new legislative requirements, additional resources, service developments, and
anticipated price inflation and pay awards). This means that existing operations and
the current budgeted allowance for existing activities are taken as the starting point
for preparing the next annual budget. It is relatively straightforward and is of most
relevance in services where there is little year-on-year change in service activity. It is
called incremental budgeting since the process is mainly concerned with the
increment in operations or expenditure that will be incurred during the next budget
period.
A key characteristic of this approach is that budget preparation takes place through
a process of negotiation and compromise. Incremental budgeting is therefore based
on a fundamentally different view of decision making than that of more rational
approaches.
In summary its main characteristics are therefore:
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a reliance on the current year budget to create the next year’s one;
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concentration on multi scale incremental changes in policy from one year to
the next;
Negotiation and compromise between interest groups to achieve an
acceptable budget.
The actual process itself is relatively straightforward. As the next year’s budget
depends on the current one then time is a major factor. Since implementation
specifically precludes the setting of outputs or objectives there is an emphasis on
inputs instead. The key stages are:
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Establishing the base – to do this it is necessary to decide what committed
expenditure is and then make adjustments to reflect unavoidable changes,
e.g.
full year effects of staff appointments;
full year effects of the capital programme;
salary increments;
nonrecurring items which should be removed;
External factors e.g. changes in legislation or government funding regimes.
updating for changes in price levels for labour, goods and services;
adding to the implications of the development budget to reflect proposed
savings and growth;
Aggregating and producing the new budget.
The merits of incremental budgeting are that:
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it is easy to understand as it is retrospective, makes marginal changes and
secures agreement through negotiation and consensus;
it is cheap;
it allows concentration upon key areas of change as far as policy makers are
concerned;
in the public sector it is useful because outputs are difficult to define and
quantify;
The budget is stable and change is gradual.
Incremental budgeting does, however, have a number of disadvantages:
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it is backward looking as it looks to past budgets rather than future
organisational requirements;
it does not allow for an overall view of performance;
it does not facilitate identification of budgetary slack.
the use of simple inflation increases can lead to perverse outcomes because
resources must be acquired in uneven amounts, e.g. two persons must be
employed. For other resources, e.g. equipment, resources will tend to be
fixed and committed over very wide range of activity volumes. As long as
demand is lower than the capacity supplied by the committed resource no
additional spending will be required;
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it is often underpinned by data or service provision which is no longer
relevant or is inconsistent with new priorities and objectives; it encourages
inertia and empire building;
it is reactive rather than proactive;
it assumes that existing budget patterns are relevant and satisfactory.
Zero based budgeting (ZBB)
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It presumes that budgets can be recompiled from first principles i.e. from a
zero base and focuses on programmes and activities rather than departments
or units.
The preparation of operating budgets from a zero base even though the
organisation might be operating more or less as in previous years the
budgetary process assumes that it is starting anew’.
The process is usually applied to new services which, genuinely, are being
built up from a zero base.
The budget holders should present their requirements for resources in such a
fashion that all funds can be allocated on the basis of cost benefit or similar
evaluative analyses.
The cost benefit approach is an attempt to ensure value for money, it
questions long-standing assumptions and serves as a tool for systematically
examining and perhaps abandoning any unproductive projects.
The principle characteristics of ZBB are:
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the involvement of all executive managers in the budgeting process;
the justification of resources for current and proposed activities;
the determination of objectives;
the assessment of alternative ways of achieving these objectives;
no costs or activities should be factored into plans just because they featured
in current or previous ones.
ZBB is best suited to discretionary and support services and thus has extensive
potential application to the public sector. With discretionary costs such as advertising
or training managers have some discretion as to the amount they will budget for the
activity in question. There is no optimum relationship between inputs (as measured
by the costs) and outputs (measured by the revenues generated). Furthermore they
are not predetermined by previous commitments. In effect managers are free to
determine what quantity of service they are willing to provide and there is no
established method for determining the appropriate amount to be spent in particular
periods.
The key benefits of using ZBB can be summarised as follows:
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it is a systematic reappraisal of the base budget;
it focuses attention on outputs in relation to value for money;
there is involvement of managers at all levels;
it creates a ‘questioning’ attitude;
there is a clear definition of organisational objectives and goals;
it has the ability to be adapted to changing circumstances;
it enhances knowledge of inputs and outputs;
it improves communication and management consensus;
there is ultimately a better allocation of resources;
Underpins much of the thinking behind the current efficiency agenda.
It does have potential disadvantages however:
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it is complex and requires special skills and training;
it is expensive and there is a tendency towards bureaucracy and excessive
paperwork;
there can be problems with performance measures and priority criteria;
the specification of minimum levels of service is threatening to some
managers and may be a demotivating factor;
The process of identifying decision packages and determining their cost,
purpose and benefits is extremely time consuming. Furthermore there can be
too many decision packages to evaluate and there can often be insufficient
information to enable them to be ranked;
There may be uncertainty about costs and resources of alternate, untried
options.